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When John Mack returned to Morgan Stanley as chief executive in 2005 after a heated boardroom split, the move was widely seen as a victory for the firm’s investment bankers and traders. Those masters of the universe had chafed under the leadership of Philip Purcell, who had hailed from the company’s lower-brow retail brokerage and credit card subsidiary, Dean Witter, Discover & Co. Mack, who started his career as a Morgan Stanley bond trader, seemed just the man to restore Morgan’s core investment banking franchise to its former glory.

It’s no small irony, then, that as Mack prepares to step down as CEO at the end of this year, the firm’s strongest point is arguably its retail brokerage arm, not the investment bank. The latter business has racked up tens of billions of dollars in losses on subprime mortgages and other bad assets over the past two years and has so far missed out on the revival of Wall Street trading profits this year. The brokerage arm, however, has risen to the top of the industry thanks to a $2.7 billion merger with Citigroup’s Smith Barney unit. And it’s a sign of the times that the brokerage’s boss, James Gorman, is succeeding Mack as CEO.

Morgan Stanley Smith Barney, the new venture owned 51 percent by Morgan and 49 percent by Citi, is the world’s largest brokerage firm, with $1.42 trillion in client assets and 18,444 financial advisers — ahead of longtime industry leader Merrill Lynch & Co., now an arm of Bank of America Corp., which has $1.3 trillion in assets and 15,008 advisers. Morgan still trails in terms of profitability, but Gorman has already made strides and vows to prevail on that measure as well.

“We are No. 1,” the 51-year-old tells Institutional Investor in an interview. “We are creating a distribution giant with a lot of muscle.”

Indeed. Morgan Stanley Smith Barney now claims 29 of the top 100 advisers as ranked by revenue, according to Barron’s, compared with 22 for Merrill Lynch. In the fast-growing field of separate managed accounts, the new venture boasts assets of $320.6 billion, surpassing Merrill’s $259.8 billion.

Citigroup analyst Keith Horowitz estimates that the venture will increase retail brokerage’s contribution to total earnings at Morgan Stanley to some 30 to 35 percent, assuming the firm exercises its option to take 100 percent ownership of the unit in the next five years, compared with 20 to 25 percent recently. Morgan Stanley’s net brokerage revenue rose 46 percent from the first to the second quarter of this year, to $1.9 billion; the period included just one month’s contribution from Smith Barney.

Challenges abound, though. Morgan Stanley and  Smith Barney suffered combined outflows of brokerage client assets of $32 billion in each of the first and second quarters of this year; Smith Barney also saw 1,106 advisers walk out the door in the first quarter. Gorman and his top executives face a tough task in integrating the two businesses and keeping top talent and clients happy at a time when financial turmoil has prompted many retail investors to pull back from the markets.

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