Wednesday, April 21, 2010

Why have financial sector profits increased ?

Kevin Drum looks at 4 possible explanations listed by James Crotty of the University of Massachussetts (who wrote specifically about commercial banks).

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.

I'm not convinced that 3 is a source of profits separate from 1.

Consider 2 ways to bear more risk -- to increase leverage and to sell safe assets and buy riskier assets. I will discuss increasing leverage and then other ways of bearing more risk.

One way to increase leverage is to convert equity to debt (in an leverage buy out, a take over or a share repurchase). This reduces total measured profits as interest paid is counted as a cost and dividends paid aren't. Another way to increase leverage is to borrow and expand the scale of operations. Expanding the scale of operations is explanation 1. Increased leverage can't be an alternative or additional explanation of increased total financial sector profits.

How about shifting to more risky assets (OK and to risky liabilities too which means writing CDSs and is a very recent phenomenon) ? I consider bearing risk to be providing a financial service so if the banks bore more risk they provide more financial services. I will discuss financial services other than bearing risk below.

Assume efficient markets (a big assumption)

In that case there are two ways for the financial sector to bear more risk -- there is more total risk to bear or they leave less of it for the rest of the economy.

Now assume efficient risk sharing (a huge assumption I need complete markets too) Well with efficient risk sharing (a very big assumption) total risk is aggregate risk, the sum of risks. This doesn't seem to have increased, not even counting the latest recession. Certainly perceived aggregate risk decreased. Also there is much too little of it to justify financial sector profits.

But of course we don't have efficient risk sharing -- there are individual risks which average out and yet hurt individuals. The financial sector profits by helping us average such risks out. However, they don't have to bear risk to do this and, besides, that for sure is providing more financial services. Also it sure seems that everyone is bearing more individual risk. The shift from defined benefit pensions to 401(k) is a huge shift of risk to individuals. Assuming efficient markets, I just don't see how increased willingness to bear risk could increase total financial sector profits there has to be more undiversifiable risk to bear or less born by everyone else.

So much for the efficient markets hypothesis. Look it is already abandoned with the opaque instrument explanation 4. So let's assume that investors are irrational. Oh well then it is easy for their to be huge financial sector profits, a fool and his money are soon parted, and it is easy for financial sctor profits to change if other people become more irrational or become irrational in a way which makes it easier to take their money.

Let's imagine, just bear with me, that the average person thinks he is smarter than average. This means that the average investor might think he can beat the market. This means that people will trade actively and will pay fees. Also if professional traders are less irrational than amateur traders, they will make higher trading profits. Now I don't believe this so I am willing to stick to the explanation based on fees (counting bid ask spreads and such like). An increase in irrational over confidence or an increase in the convenience of trading can cause increased financial sector profits. This is really an explanation of the increased demand for financial services.

Some time ago, this friend of mine explained to me that it is possible for irrational investors to create risk and for rational traders to bear more risk because irrational investors are more numerous or more aggressive, but the root cause is the increased irrationality and not increased willingness to bear risk.

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