Like most economists, I’m not allergic to the idea of profits. I take them as a signal that in some area of an economy people’s willingness to buy a certain product exceeds the costs of producing that product – thus profits are a means of encouraging additional production in this domain. Yet it is provocative, even for me, to observe that about a quarter of all corporate profits go to the financial services sector. Here is a figure from Paul W. Wilson in his article, “Turbulent years for US banks: 2000-20(Review: Federal Reserve Bank of St. Louis,
third quarter 2022, p. 189-209).
If you would like to see the data underlying this calculation, it is available from the United States Bureau of Economic Analysis at “Tcapable 6.16D. Corporate profits by industry/.” To be clear, financial services include much more than banks: it is “credit intermediation and related activities; securities, commodity contracts and other financial investment and related activities; insurance companies and related activities; funds, trusts and other financial vehicles; and banks and other holding companies.
What makes this interesting is that financial services, as a share of value added in GDP, has accounted for around 7-8% of GDP in recent decades, according to the US Bureau of Economic Analysis. (To see the “Value added by industry as a percentage of gross domestic product», table, line 55). So the question is why financial services account for 7-8% of GDP, but around 25-30% of all corporate profits.
One possibility, as noted at the start, is that earnings send a signal that the US economy would benefit from a dramatic expansion in financial services. While I’m sure financial services could benefit from innovation and entry, like other industries, it’s not at all clear to me that as a society we are asking for a much larger amount big in financial services.
Another possibility is that competition in financial services is limited, perhaps due to entry difficulties and regulatory costs, leading to higher profits for incumbents. In the specific area of banking, Wilson notes:
The number of commercial banks and thrift institutions insured by the Federal Deposit Insurance Corporation (FDIC) increased from 10,222 at the end of the fourth quarter of 1999 to 5,002 at the end of the fourth quarter of 2020. During the same period, of the 5,220 banks that disappeared, 571 left the sector due to bankruptcies or assisted mergers1, while the creation of new banks slowed. From 2000 to 2007, 1,153 new bank charters were issued, and in 2008 and 2009, 90 and 24 new charters were issued, respectively. But from 2010 to 2020, only 48 new commercial bank charters have been issued. The drop in
the number of institutions since 2000 continues a long-term reduction in the number of banks operating in the United States since the mid-1980s.
A lack of competition in the financial sector essentially implies that when financial transactions are involved – whether companies or households – this sector is able to carve out a bigger piece of the pie than it would otherwise be. probably if there were more competitors. A more subtle possibility is that at least some of the profits attributed to the financial sector have in fact been created in other sectors of the economy, but that, through various accounting transactions, these profits are instead reported in the financial sector.
A final possibility is that the way GDP measures the value added of the financial services sector tends to underestimate the size of the sector. After all, it is difficult to separate what the financial sector produces into changes in the quantity of services produced, changes in the quality of those services (as financial technology evolves), and prices for each service.
I have no evidence to back up my suspicions here. But when a sector’s profit share is much larger than that sector’s value added, consistently over several decades, something is wrong.