Abstract
In 1997 former Federal Reserve Board Chairman, Paul Volker, observed that the commercial banking industry was under more intense competitive pressure than at any time in living memory, ‘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 evaluation of this ‘paradox’ to all important and profitable financial markets and discuss three developments that together help resolve it. First, the demand for financial products and services has expanded very rapidly in this period. Second, while competition has indeed increased in many areas of financial services, it has not increased everywhere. Rising concentration in many financial markets has made it possible for key firms to exercise pricing power, while a spectacular increase in non-market, over-the-counter sales of complex financial products has allowed giant banks to achieve high profit margins in these markets. The core assumption of the ‘paradox’ is thus not universally valid. Third, all major financial market actors have increased the risk involved in their investment strategies and this has led to high average profit rates in the exceptionally stable financial conditions of the past few years. However, high risk strategies always bring low profit rates at some point; that is why they offer higher returns most of the time. When the exceptionally profitable conditions of the past few years evaporate, as they may be doing now, the high profit component of the paradox will vanish as well.
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