Roger W Ferguson, Jr: Technology, information production, and market
efficiency
Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson
Hole, Wyoming on 31 August 2001.
* * *
I am pleased to participate in this symposium on the information economy. My colleagues in Kansas
City deserve thanks for again having arranged a stimulating program. I will begin by discussing some
issues that relate directly to the paper by D'Avolio, Gildor, and Shleifer. I will then offer some broader
comments on the actual or potential effects of information technology in markets for financial services.
This paper fits into the large literature on the economics of imperfect information. This line of research
has generated important insights concerning economic behavior and the functioning of markets,
showing in particular that imperfect information can lead to outcomes that are distinctly less favorable
than those under complete information. Andrei Shleifer (with many co-authors) has been a leading
contributor to this field.
The current paper argues that advances in information and communication technology have improved
the functioning of financial markets in many ways but that this technology also has a dark side that
may harm market efficiency. This concern centers on the stock market and reflects the following
argument. Improvements in information technology - most notably, the rapid growth of the Internet
have made participating in the market much easier and cheaper and, as a result, the market has
drawn in many new and unsophisticated investors. These "noise traders" cannot differentiate between
accurate and distorted information about a given company. Thus, company managers see greater
opportunity to boost their firm's stock price by fooling investors through the release of distorted
information - and have a strong incentive to do so because of the shift toward stock-based
compensation and the widespread use of equity financing in the "new economy". In the end, according
to the paper, more information is available, but its quality has deteriorated, which reduces the benefit
from information technology for market efficiency.
Because the incentive to produce distorted information is so strong, the authors doubt that market
mechanisms alone can correct the problem. They advocate a two-pronged strategy of enhanced
disclosure requirements and investor education to improve market efficiency. These recommendations
are very sensible. The emphasis on disclosure has long been a cornerstone of the regulatory
framework in the United States, and it lies behind recent initiatives at the SEC to combat what the
commission views as a variety of conflicts of interest that threaten the integrity of our financial markets.
The authors' other recommendation - greater education of investors - is also important, especially
given the broadening participation in financial markets. The Federal Reserve, along with other
government agencies, is working to promote financial literacy in several ways - by issuing regulations
that make comparing financial products easier, by producing educational materials for the public, and
by supporting private-sector initiatives, such as programs that design and disseminate course
materials for use in schools.
Although I certainly concur with the policy recommendations in the paper, I have some suggestions for
tightening the analysis that lies behind those recommendations. For example, the paper implies that
financial disclosure is generally weaker than in the past, and uses the media focus on pro forma
accounting as one proof of the increasing weakness of financial disclosure. Increases in pro forma
disclosures do not necessarily imply that misleading information is always being disclosed. While the
authors demonstrate that, in a small number of firms, earnings from pro forma numbers are high
relative to GAAP earnings, it is not clear from the paper how severe a problem exists with regard to
these disclosures. Similarly, while the paper attempts to show that earnings management can fool the
market, virtually all the evidence is based on data from the 1970s, 1980s, and early 1990s, and thus it
may not be relevant for the later years. Moreover, the analysis of more recent effects of earnings
distortions tends to be loose. For example, the paper argues that the high turnover of shares in
optionintensive companies may indicate that their shareholders are relatively unsophisticated - on the
thought that the omission of option-related costs from GAAP earnings overstates the firm's true
income and that uninformed investors trade heavily on this noise-ridden news. Perhaps. But the paper
ignores other plausible explanations for the high turnover that may be unrelated to the sophistication
of shareholders. One such explanation is that option-intensive firms are concentrated in the high-tech
sector, where the flow of news and, hence, trading opportunities are greater than elsewhere in the
economy.
My second suggestion is that the authors be more careful about asserting that information technology
has greatly expanded the presence of uninformed investors in the equity market. Based on my reading
of the available data, this occurrence seems far from clear, and I would like to spend a couple minutes
indicating why.
Let's begin by looking at the aggregate data on household equity holdings from the Federal Reserve's
flow of funds accounts.1 These data include direct holdings by households, along with the various
forms of indirect equity holding that involve professional management (such as investing through
mutual funds). If uninformed individuals have played a growing and direct role in the equity market, as
the paper argues, we might expect to see that direct holdings by households have become a larger
share of the total equities outstanding. However, as Chart 1 shows, we see just the opposite. This
result may reflect the fact, as indicated in Chart 2, that over the past decade, households have been
reducing the portion of their equities that they hold directly and have increasingly invested through
mutual funds and variable annuities (which are essentially mutual funds combined with life insurance).
That is, households have been handing over more and more of their equity portfolio to professional
managers, who tend to be relatively well informed investors.
Household-level data on equity ownership paint a similar picture. It is true, as shown by Table 1 in the
paper, that the number of U.S. households owning equity in some form has increased substantially.
However, this table also shows that relatively little of this increase reflects broader direct ownership of
equity. According to the Federal Reserve's Survey of Consumer Finances - which is the original data
source for this table - only 19 percent of U.S. households owned individual stocks outside retirement
accounts in 1998, barely above the 17 percent share in 1989. Like the aggregate data, these figures
suggest that new investors have largely been putting their money in managed accounts.
What do we actually know about the new investors who have chosen to buy individual stocks in recent
years? To my knowledge, the best source of such information is the "Equity Ownership in America"
survey conducted in 1999 by the Investment Company Institute and the Securities Industry
Association. The following table uses these data to compare the households that first purchased
individual stocks after 1995 with the households whose first purchase was between 1990 and 1995.2
I've split the sample at 1995 to assess whether the increased access to information and sharply lower
trading costs since then have lured a cohort of clearly uninformed investors to the market.
As the table shows, the two groups of investors appear to be similar in important respects. There is
almost no difference in median age (early 40s) or income (about $62,000) between the two groups,
and investors in both groups tend to be well educated, although the proportion with a college or
postgraduate degree is a little lower for the new-investor group. With regard to their portfolios, the
median investor in each group held only a few stocks and did little or no trading in 1998.3 The
new-investor group tended to have a higher self-assessed tolerance for risk, which might suggest that
these investors gravitated more to technology stocks, which have had such a wild ride in recent years.
However, it's also noteworthy that this group had more exposure to the equity market through prior
ownership of stock mutual funds than did investors who first purchased individual equities between
1990 and 1995.
Selected characteristics of households
that first purchased individual stocks in the 1990s
(Median 1998 values, except for variables calculated as percentages)
First purchase of individual stocks outside
retirement plans
Household characteristics
1990-1995 After 1995
Age as of survey 42 41
College or postgraduate degree (percent) 63 52
Income $62,500 $62,100
Financial assets as of survey $120,000 $70,600
Number of individual stocks owned as of survey 3 2
Number of individual stock transactions in 1998 0 2
Willing to take more than average risk (percent) 44 55
Already had owned a stock mutual fund (percent) 33 41
Source: Unpublished tabulations provided by the Investment Company Institute, based on data from the "Equity Ownership
in America" survey, jointly sponsored by the Investment Company Institute and the Securities Industry Association in 1999.
These observable characteristics are, of course, only crude proxies for what we really want to
measure - the degree of market knowledge and sophistication. Still, this survey provides little reason
to believe that the new purchasers of individual stocks are especially likely to be duped by misleading
information. The survey results, combined with the data indicating a shift toward institutional holdings
of equity, cast doubt on the authors' assertion that information technology has "brought
unsophisticated investors in droves to the stock market".
I would feel more comfortable with an alternative story, which goes as follows. The late 1990s were a
period of optimism about the prospects for the U.S. economy, reflecting the pickup in productivity
growth that was generated, in large part, by information technology. The resultant optimism about the
economy's growth prospects was accompanied by a complacent attitude toward risk, fed by the long
bull market dating back to the early 1980s. In this environment, many investors - not merely
newcomers - purchased stock on the belief that business plans would become reality. The problem
was not, for the most part, that new investors came to dominate the market but that many investors'
attitude toward and perception of risk changed markedly. This explanation of recent events, which
avoids the less-compelling aspects of the paper, appears to provide a stronger foundation for the
authors' observations.
Given the panel topic of finance in the information age, I would now like to broaden the discussion by
considering the actual or likely effects of technology on product attributes, pricing, and welfare in
markets for other financial products. Since I read the paper to be focused mainly on the retail market, I
shall continue in that vein.
For a number of retail financial products, new technologies have surely led to a general increase in
welfare. New delivery technologies, such as the Internet, when combined with automated underwriting
and credit scoring, have given borrowers the opportunity to select from a broader set of providers of
credit cards, mortgages, and even some types of small business loans - one of the most
informationally opaque financial products. Competition has been enhanced as new technology makes
it easier for non-banking institutions to offer these products and for out-of-market financial firms to
compete with local financial institutions. In addition, securitization - which is also dependent on
advances in information technology - has broadened the pool of lenders by allowing loan originators to
package risk and then shift the risk to the parties best able to bear it.
At the same time, automated underwriting and credit scoring are improving the ability of lenders to
evaluate and price credit risk, which has allowed credit to be extended to a wider range of borrowers.
The rapid growth in the market for subprime mortgages is but one example of the broader access to
credit. In effect, advances in information technology are helping to ameliorate a key imperfection in
loan markets - namely, the outright denial of credit to relatively risky borrowers in the face of limited
information. Recent events indicate that this product market is still evolving.
Automated underwriting and credit scoring are also substantially reducing the time and cost involved in
making credit decisions. These savings contribute to the overall welfare improvement brought about
by information technology. In the area of mortgage lending, for example, credit decisions today are
routinely made in minutes rather than days and at much lower cost than a decade ago. Freddie Mac
reports that the cost of originating mortgage loans processed through their system has fallen hundreds
of dollars, helping to overcome one of the main barriers to homeownership - a lack of available
savings to meet closing costs and downpayment requirements. Another benefit of automated
underwriting is that credit decisions have become more transparent, to both lenders and potential
borrowers. Individuals can easily obtain their credit report and credit score, check whether any
information in the report is incorrect, and learn how they can improve their credit standing.
In short, while the paper raises important concerns about equity markets, other areas of finance
provide evidence that the information age has brought significant benefits in the form of increased
transparency and competition, lower costs, more appropriate pricing, and broader access to credit.
Technology has also expanded the ways in which customers can conduct business with financial
institutions, which has the potential to increase welfare. For example, the need for "in-person visits"
has diminished as financial service providers have established centralized call centers to facilitate
telephone banking, developed web sites to allow Internet banking and software to permit PC banking,
and promoted the use of direct deposits and pre-authorized debits. According to recent statistics,
nearly 40 percent of all U.S. banks now provide some form of web site through which they can
communicate with customers, and almost 15 percent provide web sites that can be used to conduct
banking transactions. These numbers are growing rapidly. Of the banks with more than $500 million in
assets, nearly 50 percent now provide web sites that can be used to conduct transactions. As the
need for in-person visits declines, we might expect customers to broaden the geographic area within
which they search for providers of financial services, leading to increased competition. Clearly,
mortgages and credit cards already fall into this category of financial product.
Nonetheless, the implications of these newer delivery channels for banking products other than
mortgages and credit cards seem more potential than real for the vast majority of bank retail
customers. For example, despite the expanded options made available to customers as a result of
technological advances, data collected in the Federal Reserve's 1998 Survey of Consumer Finances
and 1998 Survey of Small Business Finances indicate that households and small businesses still rely
very heavily on in-person visits to carry out their financial transactions. Eighty-one percent of
households surveyed in 1998 indicated that they used in-person visits as a means for conducting
business with a financial institution, and 86 percent of small businesses indicated that during 1998
they relied upon such visits as their most common method for dealing with their primary financial
institution. Only 6 percent of households reported having used a computer to conduct business with a
financial institution in 1998. Electronic access to financial institutions, no doubt, will continue to grow,
and the next Federal Reserve Survey of Consumer Finances will provide valuable data about the
changes through 2001. In the meantime, the facts I have highlighted and other data already available
demonstrate that the use of electronic technologies for dealing with a financial institution deserves
monitoring and continuing analysis and evaluation.
It is also worth noting that some technology-driven financial services have been commercial failures. In
the world of payments, stored value cards are clearly technically viable but have yet to be widely used.
The "cashless society" appears little closer today than when that phrase began to be used forty years
ago. One likely explanation is that network effects are important in determining which innovations
succeed or fail. In many retail payment experiments, too few consumers or merchants use a payment
network or a new instrument for these technology-driven services to become economically viable.
In concluding, the paper has added a note of caution to the discussions of the potential
welfareimproving elements of finance in the information age. Though I have taken exception to some of the
detailed analysis in the paper and noted that other financial products likely have been enhanced by
the emergence of new technologies, it is clear that technology has not changed all elements of the
delivery of financial services or cured all market imperfections. Likewise, not all technology-derived
financial products have achieved commercial success. The authors are to be commended for
reinforcing these common-sense lessons. By doing so they give further impetus to both financial
literacy and regulations that foster market experimentation and development while appropriately
protecting those that need to be protected and responding to market imperfections when they appear.