High Financial Firm Profits: Volcker's Paradox

The paper begins by introducing Volcker's Paradox, a puzzle observed by former Federal Reserve Chairman Paul Volcker in 1997. He noted the commercial banking industry was facing unprecedented competitive pressures, yet simultaneously achieving record profitability. This apparent contradiction forms the central theme of the research. The author aims to expand the scope of this paradox beyond commercial banking to encompass all significant financial institutions and offers a multi-faceted explanation.

The paper outlines four key developments that help explain the paradox. First, there's been rapid growth in the demand for financial products and services over the past 25 years, fueling industry expansion. Second, increasing concentration within major financial industries has reduced the intensity of competition, despite appearances of a cutthroat market. Third, significant deregulation, culminating in the 1999 repeal of the Glass-Steagall Act in the US and similar trends globally, has fostered increased competition and market globalization. Finally, technological advancements, particularly in computing and telecommunications, have created global, opaque, and difficult-to-regulate financial markets, facilitating phenomenal growth and complexity, especially within derivative markets. This technological leap allowed any financial firm to compete with any other, regardless of location.

A substantial rise in financial firm profitability since the early 1990s is a defining characteristic of what is termed the 'Golden Age of Finance'. The paper shows this using various metrics, including return on assets and equity for commercial banks, overall financial sector profits, financial sector profits as a percentage of GDP, and comparing the performance against non-financial corporations. These impressive profit figures, especially considering the commonly held belief that the Golden Age of modern capitalism ended in the 1970s, highlight a unique period of prosperity within the financial sector. The analysis predominantly focuses on US financial firms.

A critical element contributing to high profits is the innovation of complex derivative products by major commercial and investment banks. By primarily selling these products over-the-counter (OTC) instead of through exchanges, these institutions shield their profit margins from the pressures of intense competition. The high volume and complexity of OTC derivative trading creates an environment less susceptible to the destructive price competition observed in more transparent exchange-traded markets. The paper also mentions that much of the risk associated with these activities remains hidden from view, located off-balance-sheet. This opacity makes a full assessment of risks incredibly difficult and requires investigation into firm, industry and systemic risk factors.

The section highlights a significant increase in financial firm profitability since the early 1990s. This surge is documented using multiple metrics: return on assets (ROA) and return on equity (ROE) for commercial banks (as depicted in Figure 1), overall real profits of the financial sector (Figure 2), financial sector profits as a percentage of GDP (Figure 3), and a comparison to the profitability of non-financial corporations (Figure 4). The data reveals impressive gains over a 14-year period, suggesting a notable shift from the generally accepted end of the Golden Age of modern capitalism in the 1970s. The analysis primarily uses data from US financial firms, providing a focused perspective on the American financial landscape during this period of unprecedented growth.

The remarkable increase in financial sector profits is attributed to a combination of exogenous and endogenous factors. Exogenous factors, dominant in the 1980s and early 1990s, represent external influences such as a substantial increase in the demand for financial products and services. This heightened demand, described as secular flows, contributed to increased leverage and recurring asset price bubbles. Endogenous factors, becoming more significant after the early 1990s, represent internal responses within the industry. High profits spurred increased output and innovation in products and services. Therefore, both external market forces and internal industry reactions worked in tandem to drive the sustained growth of the financial sector, creating a period marked by exceptional profitability.

This section details the significant increase in market concentration within the banking industry. The period between the end of World War II and 1979 saw relatively few bank failures, usually fewer than ten per year. However, between 1984 and 2003, a staggering 2700 banks failed, with the majority (three-quarters) occurring during the 1987-1991 crisis. This led to a dramatic reduction in the total number of banks, from over 15,000 in the late 1970s to under 8,000 by 2002 (citing Jones and Crutchfield 2005, p. 33). This consolidation is further highlighted by the changing ownership of assets: in 1990, the top three commercial banks owned just 10.5% of industry assets, but this figure rose to 19% by 1997 and 31% by 2000, with the seven largest banks controlling nearly 50% by 2003. This concentration wasn't limited to the United States.

The high profitability is linked to evidence of collusive behavior and non-competitive fee structures, particularly within the private equity and hedge fund industries. Private equity funds typically charge management fees of 1.5% to 2% of assets under management, plus a 20% share of profits exceeding a benchmark return. A Financial Times article (March 8, 2007) mentions Morgan Stanley's former CEO highlighting 'friction costs' of 11% annually. Furthermore, Froud and Williams (2007, p. 10) report little evidence of competition on fee levels. These high fees, taxed at the low capital gains rate, contrast sharply with the assumption of intense competition. Similar lucrative fee structures are observed in the hedge fund industry. The existence of these non-competitive fees, even in the face of mediocre performance in some private equity funds, points to factors beyond intense competition driving profitability.

The section describes practices within the private equity industry that further suggest anti-competitive behavior. Private equity firms are accused of forming 'clubs' where members cooperate to share takeover bids, reducing price competition and increasing industry profits. The Financial Times' Lex column raised concerns, and the Wall Street Journal (October 10) reported the Justice Department's investigation into potential anti-competitive actions. The scale of these activities is significant, with the combined buying power of private equity firms estimated as high as $2 trillion (10% of the US stock market). The increasing size of targets (e.g., the $45 billion TXU bid) necessitates these collaborative efforts, further limiting competitive bidding. Examples like the 'Goldman, Morgan Stanley Tango' reported by the Wall Street Journal (January 24, 2007) showcase how this collaboration involves the most powerful players in the industry.

This section challenges the prevailing belief that increasing non-interest income would reduce risk in the banking sector. While many financial economists predicted that a shift towards fee-based activities (non-interest income) would lead to less cyclical income and improved portfolio diversification, empirical studies have contradicted this assumption. Research by Kevin Stiroh at the New York Fed indicates that non-interest income growth is significantly more volatile than net interest income growth, primarily due to highly volatile trading revenue. This volatility increased the covariance between net interest and non-interest income, worsening the risk-return tradeoff. Stiroh's findings, supported by research from economists at the Chicago Fed (DeYoung and Rice 2004), show a positive and increasing correlation between net interest and non-interest income growth, undermining the expected diversification benefits and highlighting the increased risk associated with higher reliance on non-interest income streams.

The section examines the role of securitization in shaping bank profitability and risk. While securitization allows banks to sell risky assets and receive fees, this process introduces a 'lemons problem'. Banks often retain the riskiest loans or tranches (often termed 'toxic waste') within securitized pools to reassure investors. This means that while banks sell substantial volumes of loans, the portion they retain represents the highest risk segment of the portfolio. This practice, along with the use of credit derivatives, potentially increases risk rather than mitigating it. The IMF's Raghuram Rajan's perspective is cited, emphasizing that banks' use of credit derivatives is often for trading purposes, maximizing leverage and profit, rather than purely for hedging.

The section discusses the challenges of accurately assessing risk within the increasingly complex financial system. Traditional methods of reviewing financial statements and balance sheets are insufficient due to the prevalence of off-balance-sheet activities and the rapid evolution of derivative positions. The reliance on Value at Risk (VAR) models, while prevalent (according to Davis 2003), has significant limitations. The accuracy of VAR models depends heavily on the correlation matrix of asset prices, which is susceptible to changes over time and is often inaccurate during crises. Historical correlations often break down during periods of market stress, leading to underestimation of risk. The extreme complexity and opacity of today's financial institutions, coupled with rapidly changing global markets, make accurate risk assessment nearly impossible, potentially leading to excessive risk-taking.

This section analyzes the changing income streams and risk profiles of investment banks. Historically, investment banks derived income primarily from advising on mergers and acquisitions (M&A) and initial public offerings (IPOs), activities inherently volatile. However, a recent significant shift has occurred, with a greater emphasis on trading assets for clients and on their own accounts—an even riskier venture. This change has happened despite high revenues from traditional M&A advisory due to a global boom in the market. The larger the investment bank, the more pronounced this shift towards proprietary trading. Davis (2003, p. 82) highlights this reliance on proprietary trading, emphasizing the increased risk involved in using the firm's own capital for trading, a departure from the past when profits were mainly generated through advisory services and acting as agents. This increased risk is further amplified by the rising importance of in-house hedge and private equity funds.

The high-risk strategies adopted by investment banks are further incentivized by their compensation structures. Unlike commercial banks, where compensation is a relatively modest percentage of net income, investment banks rely on high-powered, high-priced 'rainmakers' to generate profits. Compensation often reaches 50% of net income. The 2006 bonus pool at Goldman Sachs, totaling $16 billion distributed among 26,500 employees, serves as an illustration of this significant compensation tied to risk-taking behavior. This structure further intensifies the incentive to pursue high-risk, high-reward strategies, amplifying the potential for substantial gains but also equally substantial losses. While legitimate hedging practices do exist, the cost of hedging and the complexity of hedging strategies (often involving dynamic derivative trading) limit their use, leaving the firms exposed to considerable risk.

The section explores the complexities of hedging strategies and their implications for systemic risk. Dynamic hedging, which involves adjusting positions continuously based on market changes, aims to reduce risk but can be highly problematic under stress. During market downturns, price falls and volatility rises, forcing hedged-asset sales, reducing liquidity, and potentially accelerating price declines. This is further aggravated by automated dynamic hedging systems. The 1987 stock market crash provides a case study of the danger of such systems. Raghuram Rajan's observation is highlighted; that as originators of credit risk, banks hold first-loss positions and during a downturn they are forced to demand liquidity precisely when it is scarce, potentially amplifying losses. Jean-Claude Trichet’s quote that 'we don’t know where the risks are located' (Financial Times) summarizes the regulatory challenges stemming from the complexity of modern financial instruments. Regulators allowing banks to utilize their own risk models (like Value at Risk or VAR) creates a situation of self-regulation that can be overly optimistic.

This section highlights growing concerns about systemic risk within the financial system. While hedge funds and derivatives are acknowledged for their potential to reduce individual risk, New York Fed President Timothy Geithner's remarks suggest they may have increased the likelihood of a severe systemic crisis. The interconnectedness of the global financial system and the opacity of many financial instruments, including those traded over-the-counter (OTC), make it extremely difficult to assess potential exposure to extreme events or 'tail events'. The fact that many market insiders express serious concern about systemic risk underscores the gravity of the situation. The rapid pace of change and innovation makes it difficult to predict and manage these risks. The author notes the co-dependence of individual/market risk and systemic risk, with aggressive investment strategies potentially fueling the likelihood of a major crisis.

The section emphasizes that significant, unexpected problems ('tail events') will inevitably occur and test the resilience of the new financial system. The 1980s commercial banking crisis, triggered by the Latin American debt crisis (Mexico's default in August 1982), is cited as an example of a previously considered improbable event becoming reality. The author questions the ability of commercial banks to effectively absorb risk and provide liquidity during a systemic crisis, as they have in the past. The traditional approach of letting commercial banks absorb most risk is deemed outdated, with a preference among mainstream analysts for dispersing risk more widely, even in the absence of precise knowledge about the extent or location of that risk. This shift in strategy raises concerns about whether the entities holding the dispersed risk will be capable of managing it effectively during a crisis.

Government and international financial institution interventions, along with rising market concentration and aggressive monetary policy, have allowed financial firms to profit from high-risk strategies without fully facing the consequences. These interventions, while preventing systemic meltdowns, have increased moral hazard. The IMF's September 2005 assessment that while near-term risks seemed reduced, potential future vulnerabilities were accumulating is highlighted. The author references Plender's Financial Times article (January 30, 2007), discussing 'embedded leverage' and the high probability of another major shock with potentially greater consequences than past events. Concerns are raised regarding the ability of central banks to effectively manage a crisis in the current opaque and global financial system compared to the 1998 LTCM rescue. The author concludes that the current system's vulnerability suggests potential for serious, and perhaps catastrophic, problems in both the short and intermediate term.