Morgan Stanley is not likely to pursue a retail bank acquisition while it scrambles to complete its joint venture with Citigroup Inc brokerage unit Smith Barney, Morgan Chief Executive John Mack said.

Mack, speaking at the investment banking giant's annual meeting Wednesday, said the Smith Barney deal, which will give Morgan Stanley a controlling stake in what is by some measures the country's largest brokerage, is a top priority. The transaction is expected to close by the third quarter if not sooner, executives said.

Our hands are full with Smith Barney. That's our No. 1 focus, Mack told reporters after the meeting. For us to go out and think about acquiring anything right now just makes no sense.

A press report from Japan's Nikkei service recently fanned speculation that Morgan Stanley, which wants to expand its retail financial services and expand deposit funding, was hunting for a bank acquisition.

Maybe something was lost in translation, Mack joked.

Since becoming a bank holding company in September, Morgan Stanley has laid out plans to expand its retail financial services, namely wealth management. Consumer banking was deemed a key business that would help bring in more deposits and reduce the firm's reliance on financial markets for funding.

Comments from Chief Financial Officer Colm Kelleher last week played down the firm's interest in acquiring bank branches, deposits and assets.

Beyond its capacity for pursuing bank deals, Morgan Stanley has its hands full with several other challenges.

Chief among them is changing its compensation practices to appease lawmakers angry at big bonuses paid by banks that received government assistance last fall. At the same time, Mack explained, there is still plenty of competition from rival banks for the biggest revenue generators.

During the meeting, Mack told shareholders the bank has suffered an exodus of some key employees -- to foreign banks, trading firms and companies outside the financial services realm -- after U.S. lawmakers imposed pay limits on banks that accepted federal bailout funds.

I had one hedge fund say to me, 'I can hire anyone I want from your firm and from Goldman,' recalled Mack. Goldman Sachs Group also received federal funds.

Mack later told reporters that exodus overstated the problem, though some units lost as many as a dozen employees.

During the meeting, Mack noted Morgan Stanley was the first U.S. investment bank to establish clawback provisions designed to provide long-term incentives for employees.

Under such a system, bonuses awarded one year could be reduced or eliminated if an employee's actions that generate profit one year later hurt the firm.

Morgan Stanley, which last week reported its second straight quarterly loss, also continues to adapt itself to a new world of intense government regulation, lower leverage and a reduced appetite among bank shareholders for risk.

Mack told shareholders Morgan Stanley is pushing ahead with plans to reduce holdings in hard-to-trade assets and pull back from high-risk or capital intensive businesses. Proprietary trading and principal investing, which involve betting the firm's own capital, are being chopped down and may be shed.

Morgan has also slashed mortgage loan origination. Morgan toward the end of the real estate boom acquired Saxon Capital, a firm that underwrote and services subprime mortgages.

By comparison, the bank will devote more resources to lower risk flow trading, or trading on behalf of clients, Mack said. Other growth areas, he said, are equity derivatives, foreign exchange, commodities and interest-rate products.

Mack assured shareholders that market conditions, which sank Lehman Brothers last fall, swamped Morgan Stanley and slammed banking shares, finally may be improving.

We're seeing signs of light in the capital markets, Mack said. He noted Morgan underwrote the first major initial public offering this year and was sole manager of a junk bond deal.

Mack also said the firm's asset management division, while struggling with poor performance in some funds, remains a critical component of the company.

Unlike recent years, when investors were angry about credit losses or the performance of former CEO Philip Purcell, Mack faced a largely contented crowd of shareholders. Investors reelected all 11 directors and approved the addition of a Mitsubishi UFJ Financial Group Inc <8306.T> executive to the board.

MUFG last fall purchased a minority stake in Morgan Stanley, providing vital capital during the depths of the financial crisis.

Shareholders also rejected proposals to split the office of chairman and CEO, both held by Mack.

(Reporting Joseph A. Giannone; Editing by Brian Moss, Richard Chang)

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