Why Are Banks Are So Rich?

| Tue Apr. 20, 2010 8:32 AM PDT

Annie Lowrey writes about the continuing spectacular profitability of Wall Street banks:

This is not quite a picture of a healthy industry. In a competitive marketplace, prices and fees at Wall Street firms should fall and margins should become thinner. 

....The profits point to a lack of competition. That is one thing the Dodd bill — via derivatives regulation — attempts to fix. Right now, Wall Street firms do not bid for big derivatives contracts — they simply quote a price and work over-the-counter. For that reason, derivatives are wildly profitable for the companies. The Dodd bill will force derivatives pricing to become public to the market, driving down margins as companies compete.

Over the past several decades, finance has gotten bigger, faster, more global, and more computerized. In other words, more commoditized. That should drive profits down. But it hasn't. James Crotty of the University of Massachussetts calls this Volcker's Paradox, "the seemingly strange coexistence of intense competition and historically high profit rates in commercial banking," because it was first pointed out by Paul Volcker back in 1997. And in a paper he wrote a couple of years ago, Crotty identified four reasons for this paradox:

  1. Rapid growth in the demand for financial products and services in the past quarter century.
  2. Rising concentration in most major financial industries that makes what Schumpeter called “corespective” competition and the exercise of market power possible (thus raising the possibility that competition is not universally as intense as Volcker assumed).
  3. Increased risk-taking among all the major financial market actors that has raised average profit rates.
  4. Rapid financial innovation in over-the-counter derivatives that allows giant banks to create and trade complex products with high profit margins.

So: rising demand, reduced competition, higher leverage, and the growth of opaque OTC derivatives that are easy to overprice because they're one-off products that can't be easily compared to each other. As Lowrey says, the Dodd bill might address reason #4 if it ends up truly forcing most derivatives to be exchange traded, but it doesn't do much about the other three. Most likely, then, financial sector profitability is going to stay high even after financial reform has been passed, and that means the power of bankers over Congress is going to stay high too.

UPDATE: I've been trying to remember all day where I first saw this paper. Answer: over at Mike Konczal's place. He links to it here, along with lots of other interesting commentary about bank profitability.

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