The Review of Financial Studies Information Technology and Financial Services Competition ∗

We analyze how two dimensions of technological progress affect competition in financial services. While better technology may result in improved information processing, it might also lead to low-cost or even free access to information through, for example, informational spillovers. In the context of credit screening, we show that better access to information decreases interest rates and the returns from screening. However, an improved ability to process information increases interest rates and bank profits. Hence, predictions regarding financial claims’ pricing hinge on the overall effect ascribed to technological progress. Our results generalize to other financial markets where informational asymmetries drive profitability, such as insurance and securities markets. Informational considerations have long been recognized to determine not only the degree of competition but also the pricing and profitability of financial services and instruments. However, recent technological progress has dramatically affected the production and availability of information, thereby changing the nature of competition in such informationally sensitive markets. This paper investigates how advances in information technology affect competition in the financial services industry, in particular, credit, insurance and securities markets.1 We focus on two aspects of improvements in information technology: better processing and easier dissemination of information.2 To fix ideas and illustrate the basic intuition, we formulate our model in the context of credit market competition. In our model, differentially informed financial intermediaries compete for borrowers of varying credit quality. These intermediaries can obtain a privately informative signal by conducting credit assessments whose success depends on the state of the information technology and the effort expended in gathering and interpreting borrower-specific data.3 We show that the two dimensions of technological progress, as defined by advances in the ability to process and evaluate information, and in the ease of obtaining information generated by competitors, can have very different impacts on the competitiveness of lending markets. In situations where banks have established business relationships with borrowers, our model delivers sharp predictions. We find that advances in information technology that improve the ability to process information make markets less competitive. This decrease in competition occurs because such improvements widen the informational gap between competitors who invest resources in gathering information and those who do not. Consequently, informed intermediaries obtain higher rents as a result of technological progress and informationally captured borrowers suffer through higher interest rates. Moreover, as returns to processing information increase, banks exert The consequences of advances in information technology can be seen in the birth of on-line banking, the lowering of economic barriers to entry through better means of communication, and in modern credit and insurance risk assessment techniques such as scoring methods. Shapiro and Varian (1999) also single out these two dimensions of the information technology revolution in their discussion of network economics and the role of information in competition. The Federal Reserve Bank of Dallas (1999) estimates that, in the last 30 years, processing power, storage capacity and transmission speed have multiplied by tens to hundreds of thousands with usage costs falling dramatically. Recent literature has argued that the special nature of bank lending, relative to other forms of credit, provides banks with private information over their borrowers; see, e.g., James (1987) or Lummer and McConnell (1989) for evidence to this effect. See Sharpe (1990), Rajan (1992), or von Thadden (1998) for theoretical models illustrating this point. more effort in this direction, compounding the original impact of technological change. At the same time, technological progress also facilitates the dissemination of information. Other market participants may freely observe part or all of any information collected so that second-hand access to proprietary information becomes less costly or even free.4 We show that easier access to information levels the playing field for competitors and erodes banks’ rents, helping borrowers avoid informational capture by informed intermediaries. Faster dissemination of information increases competition among lenders and benefits borrowers through lower interest rates. Informational spillovers, however, by decreasing the returns to acquiring information, also decrease banks’ incentives to screen borrowers and gather information. We also allow for competition between banks to establish business relationships. We find that, for a wide set of parameter values, our earlier results concerning improved information processing carry over to situations where intermediaries compete to be an informed lender. Specifically, we show that as long as the information obtained by lenders is not too accurate, technological progress raises the expected interest rates for borrowers. Hence, even such ex ante competition between banks does not necessarily imply that all gains from technological progress will be passed along to customers in the guise of lower borrowing costs. Our results suggest that technological advances have the potential to undermine property rights over information. If so, intermediaries may find it worthwhile to invest resources in asserting these rights. Hence, we extend our model to consider efforts by an information-gathering intermediary to protect its proprietary intelligence. We show that, if outside access to private information is not too widespread, technological advances lead to more effort being spent on decreasing spillovers and preventing expropriation of information. However, when property rights over private information are very weak, further advances will erode bank profits to a point where intermediaries reduce both screening and spillover prevention effort. We apply our model to insurance and securities markets and find the same effects of technological improvements at work. For example, who most benefits from the wider availability of information through the new SEC regulation Fair Disclosure depends on the ability to obtain and process A paper that makes a similar assumption on the information gathering activity of banks is Cetorelli and Peretto (2000), who focus on the feedback between competition among banks and the incentives to gather information.