Why Are Banks So Profitable?

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A number of other bloggers have already linked to it, but James Crotty’s paper “If Financial Market Competition is so Intense, Why are Financial Firm Profits so High?” (PDF) is worth reading. It takes on what he calls the “Volcker Paradox” namely the fact that the very same deregulation efforts that appear to have increased competition in the financial services industry also seem to have made it more profitable rather than, as you normally see when competition increases, less profitable:

In 1997 former Federal Reserve Board Chairman Paul Volker posed a question about the commercial banking system he said he could not answer. The industry was under more intense competitive pressure than at any time in living memory, Volcker noted, “yet at the same time the industry never has been so profitable.” I refer to the seemingly strange coexistence of intense competition and historically high profit rates in commercial banking as Volcker’s Paradox. In this paper I extend the paradox to all important financial institutions and discuss four developments that together help resolve it. They are: rapid growth in the demand for financial products and services in the past quarter century; 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); increased risk-taking among all the major financial market actors that has raised average profit rates; and rapid financial innovation in over-the-counter derivatives that allows giant banks to create and trade complex products with high profit margins.

Back in 1994, Gary Gorton warned precisely that exposing the traditional banking sector to increased competitive pressure would lead to increased risk-taking and bailouts.