* Gorman defends FICC strategy at annual meeting
* Reducing risk-weighted assets will allow buybacks, dividend -Gorman
* Wealth management profit target may be lifted in June -Gorman
PURCHASE, N.Y., May 14 (Reuters) - Of the five or six problems that sat atop the desk of Morgan Stanley Chief Executive James Gorman a year ago, only one remains: making sure the bank's bond trading business shrinks to profitability rather than obscurity.
At Morgan Stanley's annual meeting on Tuesday, Gorman identified fixed-income, currency and commodities (FICC) trading as the one place where he still has to prove himself to investors, after shepherding his bank through a crisis of confidence last year related to a ratings downgrade.
Since then, Morgan Stanley's share price has nearly doubled and its credit spreads have recovered to 2007 levels, Gorman said. But while investors have confidence in his plans for the increasingly profitable wealth management business, doubts remain about bond trading, where Morgan Stanley lags rivals and did not meet expectations last quarter.
"There will be a group out there that will always ask, why aren't you as big as the big banks? That's always going to be a question," Gorman said after the shareholder meeting on Morgan Stanley's sprawling suburban campus in Purchase, N.Y.
He compared Morgan Stanley to a boutique retailer that isn't as big as a department store, but is still highly profitable: "We're a different kind of firm," he said. "Not everybody's going to be the same."
Yet Gorman is dogged by questions about his strategy because Morgan Stanley is not a highly profitable boutique; its return-on-equity last year was 5 percent, just half the level analysts say is necessary to meet its cost of capital. Weak performance in bond trading is holding back returns.
The business is in the middle of a turnaround plan that includes unwinding ancient trades that tie up capital and stepping back from risky areas of trading, like structured products, in favor of standardized, higher volume areas like interest rate derivatives, foreign exchange and credit.
Morgan Stanley suffered a setback last year when trading clients fled out of concern about an impending downgrade. Moody's threatened to cut Morgan Stanley to just a couple of steps above junk, but eventually decided on a Baa1 rating.
Since the downgrade in June, Morgan Stanley has been building back business, but its performance has been choppy. Some analysts have suggested it would be better off exiting the business entirely, as UBS AG is doing.
Gorman defended his strategy on Tuesday, saying his plan to reduce risky assets and bulk up so-called "flow trading" will not only make the business more profitable, but free up capital to return to shareholders through buybacks or dividends.
Morgan Stanley is slashing risk-weighted assets from the $390 billion it had at September 30, 2011 to less than $200 billion by the end of 2016. With a 10 percent capital weighting, that will free up $19 billion in capital, some of which Morgan Stanley plans to return to shareholders, Gorman said.
"The problem is the risk-weighted assets and the long-tail legacy assets that we've been working off, and then once you take the capital out, the business is quite profitable," Gorman said. "It's dead money; we're not recreating that money - it's just dead. Some of it goes back to the mid-90s."
Gorman also said management will probably lift profit margin target for its wealth-management business, which has been exceeding a "mid-teens" goal the past two quarters.
"We'll wait til we get to the middle of the year and then we'll probably revise it up," he said.
After Morgan Stanley announced plans buy Smith Barney in 2009, Gorman told shareholders the business could reach a pretax margin of 20 percent. He cut the target in 2011, as merger expenses, weak client activity and low rates weighed on profits.