Financial Institution Advantage and the Optimization of Information Processing

Chapter 5The Return on Analytic Assets

Economists have long used the concept of a production function to organize thinking about and abstractly represent how multiple inputs are converted into output. In introductory economics courses (and beyond), the concept is often cast in terms of two primary inputs, labor and capital. This may constitute an oversimplification in many contexts but is potentially relevant in ours, particularly when we recognize that a financial institution's capital (in the economic sense, not the financial sense) consists largely of its information processing system.

At its core, the fundamental use of production functions is cost-benefit analysis under feasibility constraints and the identification of an optimal mix of inputs. The actual estimation of production functions has a somewhat checkered history and has seen some of its most successful applications at the industrial or sector level for broader economic planning and policy purposes. At the firm level, actually estimating functional relationships is meaningful only when processes and technologies are stable over time and the data needed to estimate the functions is available. Neither of these two conditions applies over most of the range of products and services offered by financial institutions. And yet the revenue generated through the provision of these products and services is effectively the result of combining labor and capital, where the capital is the relevant component of the firm's information ...