Emanuel Derman on financial sector returns

Last night I held a panel at Columbia about the economic system and the principles that should govern it. One interesting question raised but not answered by Prof Bhagwati was: Why are the returns to the finance industry so great? No one had a really good explanation but two reasonable ones were: the existence of cartels, and secondly, that financial firms' outsize returns are periodically wiped out by risks they weren't paying adequate insurance for. [emphasis mine]
Those both sound reasonable to me. More specifically, I find the cartel argument (or more broadly speaking, obstruction of competition) compelling for retail banking (e.g. through high switching costs and lack of transparency), traditional investment banking (e.g. M&A advisory, IPOs, debt issuance, etc.), and private equity (e.g. the emergence of mega-deals and club deals in the last boom). I find the high returns/tail risk argument compelling for trading operations, hedge funds, and private equity (e.g. the massive use of leverage that fueled the last boom).

Incidentally, I used to work in finance and at the time rather enjoyed Derman's My Life as a Quant.

Update: Felix Salmon looks at a similar question for credit cards:

It’s pretty clear from this chart that between them, the big credit card issuers absolutely have the ability to set prices. It’s also clear just by looking at their marketing materials that none of them is particularly interested in competing with the others by reducing the maximum interest rate that they charge.

In most contexts, a chart like the one above would I think bespeak a competitive market. But in credit cards, I’m not so sure.

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