CREDIT CRISIS: Goldman, Morgan Shifting to Bank Charter Raises Compliance Questions

The government promptly approved yesterday a request by investment houses Goldman Sachs and Morgan Stanley to change their status to bank holding companies.

But the shift raises several compliance question marks, only some of which I will address here.

Firstly, the background. The change will put the two Wall Street institutions under the regulatory thumb of the Federal Reserve. It will also grant Goldman and Morgan Stanley permanent access to the Fed’s short-term funding, including its emergency loans. Currently, Goldman and Morgan have had access to the funds temporarily since last March.

Goldman already maintains two banks — which the investment bank called “active deposit taking institutions” – Goldman Sachs Bank USA and Goldman Sachs Bank Europe PLC. Goldman says the two banks hold more than $20 billion in customer deposits. Goldman also says it is “moving assets from a number of strategic businesses, including our lending businesses, into GS Bank USA.”

The why of the move is just, well, remarkable. Here’s what Goldman said in a statement:

“We understand that the market views oversight by the Federal Reserve and the ability to source insured bank deposits as providing a greater degree of safety and soundness. We view regulation by the Federal Reserve Board as appropriate and in the best interests of protecting and growing our franchise across our diverse range of businesses.”

That is a remarkable condemnation of its previous business model, which apparently did not provide the markets with a sufficient “degree of safety and soundness.” Goldman saw no choice but to embrace the bank charter.

Certainly, more stringent capital reserves are part of the package when you adopt a banking charter. Goldman disclosed that the Fed has monitoring Goldman’s Tier 1 capital and that its current capital ratio at the end of its third quarter was 11.6%. But any more stringent capitalization requirements are like kryptonite to an investment bank, especially one with as much institutional aggressiveness as Goldman. That is just one element of why this shift is remarkable.

The other is compliance related. I am no lawyer, but I can think of at least one major areas of banking compliance that could give Goldman Sachs Bank fits: the Community Reinvestment Act. The Community Reinvestment Act (or CRA, Pub.L. 95-128, title VIII, 91 Stat. 1147, 12 U.S.C. § 2901 et seq.) is a United States federal law that requires banks and thrifts to offer credit throughout their entire market area and prohibits them from targeting only wealthier neighborhoods with their services, a practice known as “redlining.” The purpose of the CRA is to provide credit, including home ownership opportunities to underserved populations and commercial loans to small businesses, according to the formal Wikipedia entry. The law clearly applies to Bank Holding Companies.

It is fair to say that most of the recipients of Goldman loans, certainly commercial loans, are not going to be “to underserved populations and … to small businesses.”

At the very least the change in charter drastically changes the dynamic at Goldman and Morgan Stanley. Then again, the entire dynamic in banking has changed over the last eight days.