Liberti and Petersen (2019)

Liberti, Jose Maria, and Mitchell Petersen. “Information: Hard and Soft.” Review of Corporate Finance Studies, March 2019.

From the authors’ abstract: “Information, which can arrive in multiple forms, is a fundamental component of all financial transactions and markets. We define hard and soft information and describe the relative advantages of each. Hard information is quantitative, is easy to store, and can be transmitted in impersonal ways. Its information content is independent of its collection. As technology changes, the way we collect, process, and communicate information, it changes the structure of markets, the design of financial intermediaries, and the incentives to use or misuse information. We survey the literature to understand how information type influences the continued evolution of financial markets and institutions.”

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3252869

Excerpt - ‘Lost Information’:

“Part of the reason that hard information is less costly to communicate is that there is less of it. The replacement of soft with hard information inevitably results in a loss of information (as when an analog signal is converted to a digital signal). This is why it is possible to use a smaller bandwidth to transmit the information. As an example, compare two methods of making a loan approval decision. First is the stereotypic credit scoring decision, in which a finite number of quantitative variables are weighted and summed to obtain a credit score. The loan is approved if the value of the score is above a critical value. Now compare this to the traditional relationship approach to lending. After spending several hours discussing the borrower’s investment plans and using the loan officer’s years of experience with the borrower and knowledge of the local business environment, a decision is rendered. Both decision- making methods lead to a binary approval or rejection decision, but the first requires less information as inputs into the decision.

“The reduction of information is never good, as long as processing costs are zero. However, decision makers (e.g., the loan approval committee of a bank) have limited time and attention to devote to each decision. To prevent information overload, decision makers need the information to be boiled down to what is important. The larger the organization and the higher one goes in the organization, the more the information needs to be concentrated or the decision-making authority needs to be dele- gated. The question then becomes, not whether information will be lost, but how important the lost information is.”

lk comment: While this is not a sustainable finance study, the arguments made are highly relevant to practitioners. ESG data may be hard (e.g., the number of women on a board of directors) or soft (an expert opinion on a firm’s human rights record). The conflation of these two types of data can lead to significant confusion. One potential benefit of ESG rating systems is that they can ‘harden’ soft information, in the same way that credit ratings do (as discussed in the paper). The price of this is the loss of nuance and detail, which some stakeholders may find to be unacceptably distortive. The paper underscores the importance of understanding which type of information we are dealing with when using ESG data, and of understanding the limits that are thereby imposed on the quality and communicability of analysis based on that data.