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If Financial Market Competition is so Intense, Why are Financial Firm Profits so High? Reflections on the Current ‘Golden Age’ of Finance

  • James Crotty

In 1997 former Federal Reserve Board Chairman Paul Volcker 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.”�In this paper, Crotty�refers to the seemingly strange coexistence of intense competition and historically high profit rates in commercial banking as Volcker’s Paradox. He extends the paradox to all important financial institutions and discusses four developments that together help resolve it: rapid growth in the demand for financial products and services in the past quarter century; rising concentration in most major financial industries; 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 last section of the paper discusses the role of moral hazard in today’s financial markets. Has the conventional belief that financial investment strategies that were formerly considered too risky have been made safe (and profitable) by modern risk-management techniques increased the likelihood of a future systemic financial crisis?

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Paper provided by Political Economy Research Institute, University of Massachusetts at Amherst in its series Working Papers with number wp134.

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Date of creation: 2007
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Handle: RePEc:uma:periwp:wp134
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  1. Gianni De Nicoló & M. G. Zephirin & Philip F. Bartholomew & Jahanara Zaman, 2003. "Bank Consolidation, Internationalization and Conglomeration; Trends and Implications for Financial Risk," IMF Working Papers 03/158, International Monetary Fund.
  2. Raghuram G. Rajan, 2005. "Has Financial Development Made the World Riskier?," NBER Working Papers 11728, National Bureau of Economic Research, Inc.
  3. James Crotty, 2005. "The Neoliberal Paradox: The Impact of Destructive Product Market Competition and Impatient Finance on Nonfinancial Corporations in the Neoliberal Era," Research Briefs rb2003-5, Political Economy Research Institute, University of Massachusetts at Amherst.
  4. Robert DeYoung & Tara Rice, 2004. "Noninterest Income and Financial Performance at U.S. Commercial Banks," The Financial Review, Eastern Finance Association, vol. 39(1), pages 101-127, 02.
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