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What accounts for Wall Street's profits?

Earlier today, I speculated on why Wall Street is able to post such remarkable profits. In a competitive market, there's really no place to make 27 cents on the dollar. Some other firm will come in and offer the same services for 24 cents, and then someone will undercut them at 19 cents, and so it will go until the profit margin narrows. Wal-Mart, for instance, has a profit margin of around 3.5 percent. Ah, capitalism.

Not so in the financial sector, though, which ever since deregulation has been posting higher and higher profit margins. In 2007, economist James Crotty tried to figure out why:

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.

The only one of these that might be a good thing is the growth in demand for financial products. But the other players here are market concentration (bad), increased risk-taking (bad) and the turn towards complex financial products that no one understood and thus were easier to slap high prices on (bad). And that actually understates the case: The growth in the market was for complex financial instruments that seemed to offer high returns with no risk but that went on to blow up the economy (bad). Full paper here (pdf).

By Ezra Klein  |  April 20, 2010; 2:20 PM ET
Categories:  Financial Regulation  
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Comments

The spread between savings (0.01% on Fidelity and Vanguard money markets vs. 8%, 18% and 21% or more on credit cards, for example) seem at historic highs.

And banks increasingly trade for their own account in the securities markets. And I know that they are not 100% zero-sum games, but they are more or less earning money of small investors by betting against us, just as Goldman did in its soon-to-be infamous ways.

Posted by: RalfW | April 20, 2010 2:39 PM | Report abuse

The short answer is greed. The longer answer is impatience. Clients are demanding high returns at low risk, so that's what wall street sold them - at an enormous profit. Hey, why invest in the stodgy bond market, with its meagre, albeit low-risk, returns? Or even in equities & their better (8% long term) returns, though with a stronger boom/bust cyle? Look over here! I have some collateralized debt obligations that are returning big numbers - and here's the kicker, we've removed all the risk! Have your cake, eat it & sell it all at the same time. YOU CAN'T LOSE.

People buy that stuff. "Hey, if Goldman Sachs says its a no-lose deal..."

Posted by: bsimon1 | April 20, 2010 2:53 PM | Report abuse

Are high profit margins necessarily bad for our national interests? It depends on from whom banks are profiting. If its china's soverign wealth fund or iranian investors, then more profit the better. If it is struggling american companies, bad.

Posted by: Levijohn | April 20, 2010 3:05 PM | Report abuse

Ponzi schemes and gambling.

The 'high interest rates' aren't earned on actual investments, they're being earned on gambling that the spiral of non-existent shadow products will not end by the time you pull your money out. Basically, advertise high, pay out low, and hope you get your bonus before the investors go broke.

Derivatives is gambling, pure and simple, you're just trying to beat the odds without anything backing it up. From an individual investor standpoint you can no longer tell which investments are based on reality and which on purely beating the odds. Heck, even if you invest in a real company that makes real goods, they could be completely destroyed because the financial instutions they utilize in their business practices fail.

Posted by: Jaycal | April 20, 2010 3:09 PM | Report abuse

If I could borrow from the government for basically (if not actually) free, charge people 18-29% interest, and also have the option of having the government buy up any failed investments at an inflated price, while also skimming a little bit off nearly every trade with a super-computer housed right next to the hardware of the exchange itself, all while a large network of pundits and think tanks praised me for my amazing ability to efficiently allocate capital as people's 401k's crumbled, I could probably make a damn good profit as well.

What I want to know is what is actually a "profit" in terms of generated economic expansion, and what is merely a transfer of wealth.

What I mean by that is if I buy an iPhone, I have less money, Apple has more, they make a profit, and I got a product I wanted. That I understand as profit. But I am not sure I understand, "Oh, you lost all your money, but I bought a yacht," as "profit" in a way that is meaningfully different from the idea that the guy who mugged me last year also made a profit.

Posted by: nylund | April 20, 2010 3:21 PM | Report abuse

Hi Ezra,

Let me try to answer Chairman Volcker's (for whom I have the utmost respect) question as a life insurance actuary who once worked in a major life insurance company's Enterprise Risk Management Department.

The short answer is that businesses link profit to risk. If greater risk is being undertaken, then a greater profit margin is demanded. The analogy is similar to health insurance: the individual and small group health insurance markets require insurers to bear far more risk than the large group market, so the profit margin requirement is higher because of the higher risks involved. This, of course, is the first lesson you learn as an actuary.

Posted by: moronjim | April 20, 2010 3:28 PM | Report abuse

I think it's also important to point out that they are posting these profit margins while paying their employees Obscene Amounts Of Money. If compensation were anything like what it is in the rest of the economy, their profit margins would be even more astronomical.

Posted by: rayrick1 | April 20, 2010 3:38 PM | Report abuse

kind of makes insurers and their measley 2-3% profits look kind of meek doesn't it.

Next up, EXXON/MOBIL.

Posted by: visionbrkr | April 20, 2010 4:23 PM | Report abuse

kind of makes insurers and their measly 2-3% profits look kind of meek doesn't it.

Next up, EXXON/MOBIL.

Posted by: visionbrkr | April 20, 2010 4:24 PM | Report abuse

Another possible explanation.

We know long run returns on investments are not as good as Wall Street profits would suggest. But Wall Street bills on short run profits. In the long run they are effectively providing negative value to the customers; charging more than their services are worth. But because of the inherent protections when things go bad for Wall Street, they're protected from the consequences of imposing those costs.

A second way of saying the same thing. Wall Street is heavily subsidized by the government. The recent bailouts, but also bankruptcy procedure, Federal Reserve policy, and favorable tax treatment.

A third way of saying the same thing. Wall Street has found a large externality, so they only pay a fraction of their costs.

Posted by: zosima | April 21, 2010 5:50 AM | Report abuse

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