Morgan Stanley's president just explained the bank's 'WTF moment'

Kelleher, speaking at Morgan Stanley's European Financial Conference Tuesday, described the problems that business was facing a couple of years ago — and how he and Ted Pick, who runs sales and trading, decided to address it.

"Clearly we were all running outsized fixed income businesses — far too much capital, far too much leverage, far too much liquidity trapped in, very sloppy way of dealing with derivatives — all that stuff," Kelleher said.

Still, many banks held off from cutting back, fearing that if they cut too soon they might miss out on a hoped for rebound in revenues. Kelleher said that in the third quarter of 2015, the low point in global fixed income revenues, Morgan Stanley "had a WTF moment."

"It's like, what if we're wrong?" he asked rhetorically.

Rather than pushing ahead with the status quo, hoping to capture some of the revenue rebound, Kelleher and Pick thought strategically about what changes to make to the business.

They asked themselves:

"What do we know about fixed income for the next three years in terms of secular change and whatever else that will make a difference? What's going electronic, what isn't? What's happening in terms of collateralization, counter-party credit and so on? What's happening in the credit markets? And what's happening with our investors in terms of portfolio turnover and so on?"

One thing that became clear was in rates and foreign exchange, Morgan Stanley was getting "the worst of both worlds," referring to the fact that the business was electronifying, compressing the bid–offer spread, while volumes weren't increasing.

They also noticed that bonds had started trading differently in European credit markets. "The amount of primary trading to secondary has completely inverted," Kelleher said, attributing that to increased regulations.

They downsized both of those businesses. All in all, Morgan Stanley laid off 25% of its fixed income headcount in the fourth quarter of 2015.

Since then, revenues have actually improved markedly. Revenues came in at $1.5 billion in the most recent quarter, the three months to December 31, well ahead of the $1.01 billion expected by analysts, and down only marginally from the third quarter.

"We have improved our fixed income business, we have definitely climbed up the counter-party rankings to very good positions, and we feel we got it right," Kelleher said. "Now does that mean I'm suddenly going to say, let's grow fixed income dramatically here? I'm not. Neither is Ted."

He said that we will see a gradual pickup in fixed income activity "when central banks get out of the way," but not a significant pickup for the next several years.

And when it does happen, "It won't be anything like in the glory days of leverage."