Why investment bank profits persist

October 1, 2009
Karl Smith:

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One of the odder riddles of the financial markets is how they can be so highly competitive and so highly profitable at the same time. The financial innovation debate seems to be helping us find an answer, as clearly articulated by Karl Smith:

It’s not that firms refuse to compete by providing consumers the best products – its that they cannot compete in this way because consumers will naturally gravitate towards products which are bad for them.

That is, if you are offering a product that is just the same as the standard vanilla product but has some hidden tail risk then you can necessarily offer it a lower price.

Why don’t firms compete on offering products with hidden tail risk, and see prices driven down that way? Because there are extremely high barriers to entry when it comes to starting up a firm offering sophisticated financial products. Also, the unspoken rule among investment bankers that you try never to compete on price has somehow become an article of their faith among their clients, too, who tend not to trust investment bankers who try to compete on price. Hence the fact that Bill Hambrecht’s eminently sensible IPO method has signally failed to catch on, while the old fashioned give-the-bank-7% method remains standard.

More to the point, as Arnold Kling says, “a lot of the trick of investment banking is to figure out a way to transfer risks to taxpayers”. If you compete with other bankers, you drive down the profitability of your industry, and ultimately your own paycheck. Bankers tend to be hyper-aware of how much their competitors are paying, and they don’t like doing anything which is likely to bring that number down.

On the other hand, if the money you’re making is coming not from your competitors but rather from taxpayers — if they’re essentially insuring the excess downside on your bets for a premium of $0 — then the sky’s the limit in terms of how much money not only you can make, but all your other competitors potential employers can make as well. What’s not to love? The only people who are liable to object are regulators, and they often have half an eye on getting a lucrative financial-sector job as well.


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