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).