Capital rules

Brokerages are enjoying a rare sweet spot in their business cycle. The M&A market is buzzing, companies are lining up to raise new funds, and both stocks and bonds afford great sales and trading opportunities. At the same time, Wall Street firms have mostly kept in place the spending constraints they had imposed in the past couple of years. As a result, earnings at major investment banks are the strongest they’ve been since the technology bubble burst in 2000. Still, skeptics wonder whether brokerages are prudently handling their gains so they can compete effectively and manage their risk if another disaster strikes.

It appears that they are.

Institutional Investor‘s annual ranking of the top 100 broker-dealers in terms of capital shows that firms are using their rising profits to cover, or at least mitigate, the risks they take in high-stakes trading and investment banking deals, and they are fattening their cushions against losses for when the cycle inevitably turns down again. The total consolidated capital of the 100 biggest brokerage firms -- the sum of equity capital and long-term debt -- rose 20 percent in 2003, to $564.6 billion.

“More than ever capital strength is a core concern to almost every constituent we have -- regulators, ratings agencies, customers,” Morgan Stanley CFO Stephen Crawford pointed out at a recent Smith Barney Citigroup investor conference.

Merrill Lynch & Co., which earned a record $4 billion last year, is tops in consolidated capital for the 16th straight year (see table). Merrill’s total increased by $14.3 billion, or 17 percent, to $96.2 billion at year-end; equity capital rose by $4.8 billion, or 19 percent, to $30.3 billion.

Some of Merrill’s rivals have been hiking consolidated capital at an even faster clip: Lehman Brothers Holdings earned $1.7 billion in fiscal 2003 and bolstered its capital by 20 percent, to $58 billion; Bear, Stearns & Co. ($1.2 billion in earnings), by 22 percent, to $37.5 billion; Morgan Stanley ($3.8 billion), by 26 percent, to $82.8 billion; and Goldman, Sachs & Co. ($3 billion), by 37 percent, to $79.1 billion. This focus on raising capital levels shows no signs of shifting. Morgan Stanley lifted its total another 16 percent, or nearly $14 billion, in the fiscal quarter ended February 29, to $96.4 billion.

“Results are strong, and both capital and returns on equity are just about where you’d expect them to be at this stage of a normal cycle,” says Guy Moszkowski, a brokerage and investment banking analyst at Merrill Lynch in New York.

“You always strive to accumulate capital, which is the way you gain market share,” explains Thomas Peterffy, founder and chairman of Greenwich, Connecticutbased Interactive Brokers Group, an institutional broker-dealer that increased its consolidated capital by 26 percent, to $1.6 billion, and jumps from 25th to 20th place on II‘s list.

With more capital, traditional investment banking firms can fund capital-intensive business lines like fixed-income trading and can compete more aggressively for business with well-heeled rivals such as the securities units of commercial banking companies. These competitors are also boosting their capital at double-digit rates. Deutsche Bank Securities raised its capital level by 28 percent, to $7 billion; and Citigroup Global Markets Holdings (combining two units listed separately last year), by 32 percent, to $59.4 billion.

Moszkowski notes that the traditional securities firms have thus far fended off the commercial bankers. “Goldman Sachs is still at the top of the league tables in equity underwriting and M&A,” says the Merrill analyst. That’s in part because the securities industry has gotten much smarter in managing its capital, says John Weisel, a New Yorkbased partner at consulting firm Accenture. “Ten years ago the mantra was ‘Win the deal,’ not ‘Manage capital in the most efficient way,’” he says. “Now capital and how it is allocated is a top-of-mind issue.”

>> Click here for the The Institutional Investor capital position Ranking.