I have been following the markets through this whole credit crunch, but nothing wowed me like the simultaneous fall of both Lehman Brothers (LEH: 0.00, N/A (N/A)) into the abyss of bankruptcy and Merrill Lynch’s (MER: 26.11, -0.34 (-1.29%)) marriage with Bank of America (BAC: 34.37, +1.30 (+3.93%)). American International Group (AIG: 3.02, -0.29 (-8.76%)) is also following in their footsteps as the insurer struggled to stay afloat and eventually received government backing. It is evident that change is necessary going forward and it is important that businesses become proactive before the government institutes further regulation. Spending the summer in financial services, I was surrounded with thoughts and ideas regarding the problems at hand. Having experienced this credit meltdown, I have assimilated a lot, and after much consideration, it seems like it is time to embrace the Universal Banking Model.

What is the Universal Banking Model?

The first question running through everyone’s mind must be, “What is this Universal Banking Model?” The model is simple, it is a corporate structure where a financial services company offers both investment services and commercial savings and loans services together. The model is prevalent in Europe and is visible here as well. If you look at the list below, I have listed domestic entities that are structured around the universal banking model descending in terms of market capitalization.

The names on the list are familiar, all four companies have participated in the slew of write downs for the past 12 months. All the companies above not only offer commercial banking services such as regular checking and savings but also investment banking services. After last weekend’s events, Goldman (GS: 135.50, +2.50 (+1.88%)) and Morgan Stanley (MS: 27.10, +2.31 (+9.32%)) were the two pure bulge bracket investment banks left. Now, after this past Sunday’s declaration, both are holding companies under heavier regulation but allow the ability to establish a depository business. There are pros and cons to this banking model and like every decision, we must balance the benefits with the risks.

Benefits

• Bank deposits help balance investment banking operations
• Diversification of revenues
• Increased synergies
  • Lead to cost savings
  • Cross selling opportunities

In my opinion, the benefits are great for banks who are operating risky, volatile divisions that are seeing a lack of growth due to the current credit crisis. The steady stream of revenues from servicing commercial and retail customers can offset weaknesses in more lucrative areas such as investment banking. The new model also provides these entities with the ability to cross sell services to clients, bringing in even more revenues for the company. The banks that currently operate on such banking models are “one stop shops” for people who want to take care of all their financial services in one location. The aspect I like about this movement and expansion of the universal banking model is the realization of synergies not only from cross selling opportunities but also from cost savings initiatives. For example, the BofA and Merrill merger can help managers weed out inefficiencies and senior management can retain the better operations and technology infrastructures that allows the front office to grow. The idea of margin expansion, increasing revenues, and diversification does seem great, but there are severe risks associated with a universal bank.

Risks

• Effusion of risk to more stable operations
• Difficulties in merger integration
• Too big to manage
• Synergies are not realized

The universal banking model offers plenty of benefits if implemented properly, but also has significant risks. The first being the difficulty of merging two operations, since many banks will find it in their best interest to buy small local banks or more establish regional entities. These acquisitions can cause integration issues where problems can occur in areas ranging from technology to corporate culture that can delay profitability. Under such a model, this difficulty in integration will kill any synergies possible, which will kill shareholder value. The huge problem with such universal banks such as Citi is that the sheer size of the bank will make it hard to manage. Alterations will need to be made, where each large division has it’s “own CEO” who can individually manage and report to the Board of Directors. This division of responsibility can help deter another risk; the effusion of risk from more volatile segments to more stable operations. Wachovia was one bank that realized such a problem.  Profitable segments such as the general bank and Wachovia Securities were deemed insignificant due to the losses from the investment bank. This problem will be hard to tackle, but I’m sure as this new model evolves, management can find ways to address this issue.

The Future of Goldman and Morgan

The above benefits and risks associated with such an operating model are just the tip of the iceberg that can either send corporations operating under the universal banking model ascending to fame or bury them with the likes of Bear Stearns and Lehman Brothers. It was evident that Goldman Sachs and Morgan Stanley will have to make some moves to operate on the same level as their peers at JPMorgan or Citi. A lot of people believe that Goldman will not acquire or establish a commercial bank and I find this questionable. In the coming months, Goldman will not enjoy the strict regulations they face and will shop around for a regional bank. I think it would be far fetched to see them attempt to penetrate the commercial banking business independently since it is so saturated. Morgan Stanley will also probably merge with another large bank (they were in talks with Wachovia), so do not be surprised if both sides come back to the table. It makes no sense to operate without a commercial arm if these companies are regulated like one. As Adam Brown says, “It is the End of An(other) Era.” The upcoming months will be interesting as investors gain more insight and can evaluate the future of these large universal banks.