Something for Wall Street to Be Sad About

Here from Matt Zeitlin and Matt O’Brien (there was a huge fad in the ‘80s for naming future economics writers “Matt”) is something the princes of Wall Street may have good reason to be sad about:

This is the “return on equity” that investment banks are earning, one measure of profitability. It’s of particular interest in the financial sphere because financial firms use so much leverage (i.e. debt) to finance their activity. A moderately profitable investment financed with a firm’s own money (retained from previous profits, for example) is going to earn a modest return on equity. But if you manage to finance that exact same investment with only a tiny amount of your own money and a huge amount of debt, that can produce a very high return on equity. It’s the search for a high return on equity (which creates large dividends, bonuses, and other fun stuff) that leads banks to take on lots of leverage. And it’s the leverage that makes the financial system vulnerable to crisis.

The much-lower post-crisis return on equity tells us that even as bank profits have made a comeback, the pre-crisis leverage party hasn’t. That’s good news for the country but bad news for Wall Street. And it makes a lot more sense than being sad that not enough people will return your phone calls.