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Capital rules

Wall Street is setting earnings records. So far, brokerages are using their riches wisely: Capital positions are stronger than ever.

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.

WHO HAS THE MOST EMPLOYEES
Rank 2004Rank 2003FirmNo. of employeesNo. of retail brokers No. of institutional brokersNo. of offices
1 1 Morgan Stanley43,775 10,300 150 500
2 2 Merrill Lynch & Co.38,200*

600
3 3 Citigroup Global Markets Holding31,430 11,127 573 646
4 5 Edward Jones21,908 8,744
8,397
5 4 UBS21,871 7,750 887 527
6 6 A.G. Edwards & Sons15,879 6,873 84 707
7 7 Charles Schwab & Co. 15,000

376
8 10 Goldman Sachs & Co.12,854 N/A N/A N/A
9 12 Lehman Brothers Holdings11,760 719 2,368 35
10

-

Bear, Stearns & Co.9,399

9 11 9 Credit Suisse First Boston9,249


12 13 Fidelity Brokerage Services5,841 5,432 0 91 13 14 Raymond James Financial4,536 4,658 149 1,648 14 17 Legg Mason Wood Walker4,078 1,323 133 143 15 15 Deutsche Bank Securities3,862 540 2,165 24 16 16 Banc of America Securities3,706
2,473 29 17 19 J.P. Morgan Securities3,202
2,218 66 18 30 Oppenheimer & Co. 3,013 1,704
95 19 18 Piper Jaffray2,971 830 113 111 20 22 Morgan Keegan & Co.2,772 717 176 146 21 21 Quick & Reilly / Fleet Securities2,752 2,029 2,029 1,450 22 20 TD Waterhouse Group2,722 1,673
159 23 24 Robert W. Baird & Co.2,207 664 33 68 24 26 National Financial Services1,845 0 692 16 25 28 Janney Montgomery Scott1,834 932 50 74 26 25 Ameritrade Holding Corp.1,715 468 21 3 27

-

H&R Block Financial Advisors1,624 1,060 0 160 28 27 McDonald Investments 1,624 554 75 61 29 31 Advest1,603 486 89 86 30 8 Wachovia Capital Markets1,578
789 19 31 35 Jeffries Group1,426 55 187 34 32

-

CIBC World Markets1,327
128 2 33 23 ABN AMRO1,244
603 13 34 34 Neuberger Berman1,242 41 61 18 35 32 Barclays Capital1,213

4 36 29 J.J.B. Hilliard, W.L. Lyons1,150 450 0 80 37 37 Ryan Beck & Co. 1,042 463 9 35 38 40 Southwest Securities933 127 11 25 39 39 Knight Securities 900 0 90 11 40 42 Stephens 881 125 102 16 41 44 HSBC Securities (USA)880 0 85 4 42 43 Scott & Stringfellow841 248 81 58 43 46 Nomura Holdings America811 0 369 5 44 45 William Blair & Co. 747 70 24 3 45 49 D.A. Davidson & Co.735 232 25 36 46

-

RBS Greenwich Capital645
309 5 47

-

Nuveen Investments643 0 0 7 48

-

Ferris, Baker Watts642 251 55 37 49 50 SunTrust Capital Markets640 35 281 19 50 47 SG Cowen Securities Corp.620 N/A 123 6






*Excludes 200 full-time employees on salary continuation at year-end 2003.