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J U L Y / A U la U b I 1 9 9 4

A review from the
Federal Reserve Bank
of Chicago



Remember—central bankers
are paid to worry!
The impact of lean
manufacturing on
sourcing relationships
Does program trading cause
stock prices to overreact?


Remember—central bankers
are paid to worry!..........................................................................................2
Silas Keehn

A transcription of a speech presented by the President of
the Federal Reserve Bank of Chicago to the International
Swaps and Derivative Association on March 18, 1994.

The impact of lean manufacturing
on sourcing relationships.............................................................................8
Thom as H. K lier

How does lean manufacturing affect sourcing relationships?
The author outlines recent developments in the structure of
the U.S. automobile supplier industry and presents evidence
that the role of supplier companies has been changing.

Does program trading cause
stock prices to overreact?...........................................................................19
Jam es T. M oser

Stock price reversals indicate that noise traders overreact to
new information. The author tests whether the frequency of
price reversals depends on the extent of program trading.
Finding no association between the two, he concludes that
program trading does not cause prices to overreact.

E<:<)N( )M1 C PE RSPE( 11V KS
Karl A . S c h e ld , Senior Vice President and
Director of Research

Editorial direction
Jan ice W e iss , editor
D a v id R. A lla rd ice, regional studies
S tev e n S tron gin , economic policy and
A n n e W e a v er, administration


N a n cy A h lstro m ,

typesetting coordinator

R ita M o llo y , Y v o n n e P e e p le s , typesetters
K ath leen S o lo tro ff, graphics coordinator
R oger T h r y se liu s, T h o m a s O ’C o n n e ll,
L ynn B u sb y-W ard , John D ix o n , graphics
K athryn M oran , assistant editor

J u ly /A u g u s t 1994 V o lu m e X V III, Issue 4

the Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors' and do not necessarily reflect the views of
the management of the Federal Reserve Bank.
Single-copy subscriptions are available free of
charge. Please send requests for single- and
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ISSN 0164-0682

Remember— central bankers
are paid to worry!

Silas Keehn


The follow ing is a transeriplion of a speech presented by

Mr. Keehn, President o f the
Federal Reserve Bank o f
Chicago, to the International
Swaps and Derivative Association on March
18, 1 9 9 4 .

It is a pleasure to be here and to have a
chance to review my thoughts on the deriva­
tives markets with you. I firmly believe that
these exchanges between regulators and indus­
try participants serve an important and mutual­
ly beneficial purpose, and I think a good deal
has been accomplished by the recent discus­
sions. As you are all aware, the derivative
markets are without question the fastest grow­
ing and most exciting area in the financial
industry, but that growth is beginning to attract
some unwanted yet perhaps healthy attention.
To put it mildly, your press has not been very
good lately. Between Metallgesellschaft, the
recent case of Gibson Greetings, the cover of a
major business magazine, and a blizzard of
government and industry reports, it seems as
though everyone is suddenly worried about
This shouldn’t come as a big surprise. The
complexity and rapid pace of change in your
markets has simply outstripped the ability of
all but the most qualified specialists to keep up.
Even sophisticated individuals can feel over­
whelmed when confronted with concepts such
as digital and embedded options, “swaptions,”
caps and collars, and the seemingly endless
variety of clever new combinations. It’s easy


to understand why an outsider, or more to the
point, a legislator, would find these markets
confusing and perhaps even sinister.
But my viewpoint is somewhat different.
As a central banker, I am concerned not so
much with the complexity of the market but
with its underlying integrity. The Federal
Reserve, as the nation’s central bank, has the
ultimate responsibility for the health and effi­
cient operation of the financial system. In that
role, our job is not to eliminate risk, but in
cases where there are conflicts, to make trade­
offs between risk and efficiency.
Having said that, let me clearly emphasize
that I have no doubt that derivatives play a
useful role in modem financial strategies. To­
day, to an extent that would have been hard to
imagine just twenty years ago, it is possible for
a firm to separate different risks—currency,
interest rate, and commodity—and sell off
those that the firm doesn’t want to retain and
keep those it does. The flexibility and low
costs of these products have allowed firms to
manage risk and pursue new business in ways
that were simply impossible in earlier times.
The very real and significant advantages of
these financial strategies have demonstrated
themselves dramatically in the marketplace.
L e g itim a te c o n c e rn s

But legitimate concerns have developed,
and remember—central bankers are paid to
worry, and high growth rates and high concen­
trations are two hot buttons that always get our
attention. One need hardly repeat the standard
if admittedly flawed numbers about the incred­


ible growth in derivative activities to under­
stand why there are calls for significant regula­
tory controls.
In the five-year period ending 1992, the
notional value of swap contracts outstanding
increased from an estimated $865 billion to
some $4.7 trillion. This compares to the
$3.6 trillion in total corporate debt outstanding
in the U.S. Within the banking system, the
use of swaps over this same period increased
from a notional value of $705 billion to
$2.1 trillion, a level equivalent to seven times
the aggregate amount of bank capital. These
growth numbers are matched by even more
worrisome concentrations of risk in the dealer
market. According to the 1993 Swaps Monitor
Survey, the ten largest dealers account for
about half of the outstanding interest rate
swaps, and the ten largest dealers in currency
swaps account for 40 percent of the market.
Such numbers, even if somewhat overstated,
have an unfortunate resonance with previous
problems in the financial system. As the his­
torical record demonstrates over and over
again, high growth and undue concentration of
risk are a recipe for trouble.
Lending to less developed countries
(LDCs) in the 1970s is a good example. While
it was advertised by some as a low-risk way of
recycling the massive inflow of petrodollars,
that argument was less than compelling. In
hindsight, bankers underestimated the risks and
saw an elusive opportunity to increase earnings
by aggressively expanding their LDC lending.
Another classic example was the energy
area. If you go back to the period when energy
lending really began to escalate, bank manage­
ment was convinced that this was an appropri­
ate way to build up earning assets at compara­
tively high rates of return and with little per­
ceived risk. Unfortunately for those banks and
for the deposit insurance agencies, it turned out
that energy prices could go down as well as up.
Once again, high growth combined with an
insufficient appreciation of the risks involved
led to disastrous results for many banks. I am
not saying that very rapid growth per se is
necessarily fatal, but rather, it is a warning
signal. As growth accelerates, even small
mistakes can grow into major problems.
S o m e p e rsp e c tiv e

But before the parallels between the
growth in derivatives and LDC and energy



lending become overdrawn, it is important to
remember, first, that notional value is at best
only a rough guide to the true size of the mar­
ket and the actual risks being undertaken. Bet­
ter data, based on market value and segmented
by type of contract, and adjusted for double
counting and netting, are clearly necessary in
order to understand the actual risk exposures
that have developed in these markets. Second,
it is important to remember that derivatives are
primarily a risk management tool, not a risk
acquisition tool—and that even what may seem
like a significant derivative risk of an individu­
al institution may be offsetting an equivalent
but opposite risk in the rest of its portfolio.
This is not to say that there aren’t risks,
but rather, that much of the risk associated with
derivatives arises not from their existence but
from their possible misuse— a very important
distinction. A product that allows firms to
eliminate large risks quickly and easily also
allows them to acquire those risks, and thus in
turn to expose others in the system. This raises
both counterparty and systemic issues that the
Federal Reserve cannot ignore.
Certainly the market understands these
issues. The development of triple-A-rated
subsidiaries, as well as the high capital and
collateral requirements that the market is de­
manding of dealers, is clear evidence of just
how seriously the market takes these risk
management issues. After all, no borrower
would ever require that a bank have a triple-A
credit rating before accepting an energy loan
from it. From the standpoint of central bank­
ers, the prudence demonstrated by customers
in the derivatives markets is a good sign that
the market is working and managing risk on
its own.
While some would advocate significantly
restricting off-balance-sheet activity, I believe
we need to avoid burdensome regulation. On
the basis of both our supervision of individual
banks and our research, it’s our judgment that
banks are using derivatives to manage risk
better, and that if anything, the growth in de­
rivatives represents a positive development in
overall portfolio risk management. It is this
belief that leads me to try to make clear to you
what I think is necessary if these markets are to
continue to grow and develop without signifi­
cant and potentially burdensome regulation
being imposed from the outside.


T h e n e c e ssa ry c h a n g e s

Let me comment on the changes that I
think are necessary on the part of the industry,
the Federal Reserve, and others if these mar­
kets are to continue to innovate and to meet the
growing demand for risk management tools.
The critical question we need to answer is how
best to deal with the real and perceived risks
posed by these markets in a way that will allow
the innovation necessary to compete in this
very competitive marketplace and yet protect
the system from major disruptions.
In my view, we must begin by understand­
ing the difference between regulation and su­
pervision. While some tend to use these words
fairly interchangeably, there is a very impor­
tant distinction between the two. Supervision
is institution-specific and relies heavily on the
industry and the institution to define and fol­
low good business practice. It is the funda­
mental element in the examination process.
Regulation relies on rules to prevent “bad prac­
tices.” In my experience, regulation in rapidly
evolving markets is either too little too late,
frequently overreacting after the problems have
already developed—or too much too soon,
stifling innovation and hampering the market’s
ability to provide needed services. While this
may be an overgeneralization, I think that for
almost any financial activity, the more that
official regulation can be displaced by effec­
tive supervision and industry standards, the
better off the financial system will be.
S e lf-re g u la tio n

In this vein, I would urge that the industry
provide for self-regulation to the greatest ex­
tent possible. You know the competitive re­
quirements of your markets and the current and
future needs of your customers better than we
do, and you are in a better position to assess
the operational implications of alternative
systems of control. I would also urge that you
continue to develop and improve standards
(regulations) that will provide for safety and
soundness in these activities. The Group of
Thirty report was a good first step, but only a
first step. Eventually, the rules will need to be
far more specific.
There needs to be an industry self-policing
system that has teeth and that will, through its
actions, be respected. Clearly, the Internation­
al Swaps and Derivative Association has an
important role to play in this process. Such an


organization will significantly lessen the need
for external sources to impose restraining regu­
lations, a very real danger as long as some
view these markets, no matter how unfairly, as
free-wheeling gambling casinos. In this light, I
would also suggest that the industry should
spend more time discussing the real economic
benefits produced from the use of derivatives
and depend less on the general defense of the
need to compete. This will help make much
clearer the trade-offs implicit in restricting
these activities.
The Federal Reserve has been actively
doing what we can to help. We have consis­
tently promoted the development of industry
groups and provided them with the necessary
legislative and regulatory tools to help them
manage the risks on their own. Following the
passage of the Financial Institutions Reform,
Recovery, and Enforcement Act (FIRREA),
which altered the treatment of derivatives for
bankrupt institutions covered by deposit insur­
ance, the Federal Reserve, among others,
sought and achieved significantly broader and
more legally secure treatment of netting agree­
ments. The Federal Deposit Insurance Corpo­
ration Improvement Act (FDICIA) extended
netting to securities brokers, dealers, and non­
bank participants on the Clearing House Inter­
bank Payments System (CHIPS), as well as to
appropriate financial institutions as determined
by the Federal Reserve. On February 1 of this
year, we released the final rules for use in
determining which institutions will be covered
by the FDICIA netting provisions; these new
rules took effect on March 7. As a result of
these actions, it will be substantially easier for
firms to manage their credit risks and to re­
solve insolvency problems in these markets in
the future.
We have also recently approved an exten­
sion of the hours that our wires for moving
funds electronically will be open in order to
reduce temporal risk and to allow institutions
to work at reducing Herstatt risk. I am pleased
to say that the Chicago Fed played a major role
in promoting these changes. But I will also
have to admit to having been surprised by the
industry’s response when the extended hours
proposal was going through the comment
phase. Particularly in a Chicago context, I had
thought that this would be enthusiastically
supported, but frankly, the comments we re­
ceived were underwhelming.


A c c o u n tin g sta n d a rd s

Beyond Federal Reserve actions, there is a
lot to do in terms of the functioning of market
mechanisms and just as importantly, improving
the public’s perception of these markets, if
they are going to be free to prosper in the fu­
ture. At the broadest level, I think we need to
see better accounting standards. Hopefully, the
Financial Accounting Standards Board’s new
recommendations on derivatives and hedge
accounting will be a significant first step in this
direction. Well-designed accounting standards
can substantially aid both the supervisors’ and
the market’s ability to monitor these activities.
If market discipline rather than regulation is to
provide the basic control mechanism for these
markets, then it is imperative that financial
reporting provide the information required for
informed assessments.
Good financial reporting standards with
extensive disclosure can also help reassure the
markets that derivatives are in fact assisting
financial institutions and customer firms to
manage their risks better rather than allowing
them to gamble with their stockholders’ mon­
ey. Further, good accounting practices will
help taxing entities get a better handle on the
appropriate tax treatment of derivative activi­
ties. Such changes will allow market partici­
pants, supervisors, and legislators to under­
stand and monitor the markets better as well as
provide a basis for the outside auditing of these
activities. But this is not the whole solution,
since such accounting information is available
only at specific points in time.
The strength and weakness of the deriva­
tives market is that it allows institutions to
make radical changes in their market exposure
almost instantaneously. But this advantage
must be supported by the development and
enforcement of internal procedures within
individual institutions so that problems do not
develop between financial statements. With
this as a lead-in, let me shift from broad indus­
try concerns to some important institutionspecific issues.
A t th e firm level

To limit the development of potentially
damaging problems, some absolutely essential
elements must be a part of any organization’s
basic thinking.
First, risk measurement systems are para­
mount. The institution simply has to know on



a current basis the magnitude of the risks that
are going onto its books. For many of the
newer participants in these activities, this may
seem very complicated, but without a good risk
measurement system an institution is bound to
get into very serious trouble.
Second, effective controls need to be in
place. Management needs to establish limits
for various categories of risk, and the controls
dealing with these risks must be adequate to
the task.
Third, there must be clear organizational
separation for those generating the risks (the
marketing or sales side of the business) from
those approving the risks or changing the limits
for individual categories. While this may seem
pretty basic, there have been any number of
banks that have gotten into trouble— some­
times fatally—because they did not effectively
separate these two fundamental aspects of the
credit or risk extension process.
Fourth, the management information sys­
tems must be accurate, understandable, and
available on a current basis at senior levels of
the organization. With activities evolving at
very great speeds as derivatives do, a 200-page
report two weeks after the fact just won’t do.
A real-time exposure monitoring system, or at
the very least, an end-of-day monitoring sys­
tem that provides accurate, understandable
reports of risk and exposure measurement to
senior management is a sine qua non.
Fifth, for any of this to work in practice,
senior management must have a fundamental
understanding of these derivative activities.
Choosing the right people to work in and man­
age these areas is important, but it is not
enough. It is too easy and far too simplistic to
view derivatives as a purely specialized func­
tion that the specialists can be trusted to do
right. For some, I will admit that esoteric
derivative activities are very complex and very
challenging. But as a management precept, it
just makes sense that if you don’t understand
it, don’t get involved.
Sixth, as a related management issue and a
thought that will probably strike this group as
totally unacceptable, if I were in the senior
management of an organization dealing heavily
in these activities, I’d very carefully watch the
compensation schemes that are in place. While
bonus and incentive plans that are driven by
the institution’s overall success are appropriate


and beneficial, those that provide for very
heavy incentive motivation on a highly indi­
vidual basis, almost regardless of the institu­
tion’s total results, are fraught with peril.
And finally, I also think it is important for the
industry to develop outside auditing standards
for firms’ risk management procedures. Pru­
dent management practice, as well as the de­
mands of public and investor confidence, will
require that such audits be done in a credible
and regular fashion.
T h e Fed eral R e se rv e 's role

Even with the best control mechanisms
and procedures in place, there are still concerns
at both the institutional and system level, par­
ticularly those that relate to the integrity of the
payments mechanism—the pipeline through
which our entire economy flows. We at the
Federal Reserve, who in my view have the
ultimate responsibility for the integrity of the
financial system, cannot in good conscience
ignore these issues.
Derivatives and other innovations in the
financial industry have generated an explosion
in the flows through the payments system.
What was once a simple loan involving month­
ly payments between two parties can turn into
a veritable parade. Starting with a loan, an
interest rate swap, and maybe a currency swap,
the loan can then be sold off directly or securi­
tized. Each of these contracts in turn may spur
offsetting hedges on the part of the financial
intermediaries, or secondary loans as the pieces
are sold off to investors. To get some idea of
the potential systemic implications of this
explosion in financial activity, you only have
to look at the massive increase in transactions
running through the payments system. In
1970, there were $15 of financial transactions
for every dollar of gross domestic product
(GDP). By 1980 the ratio had increased to $30
to one, and by 1990 it was $78. Over half
these transactions are cleared through CHIPS,
which didn’t even exist in 1970. And this is
not solely a U.S. phenomenon. In Japan, for
example, the growth in financial transactions
has been even more staggering, going from 15
yen of financial transactions for each yen of
their GDP in 1970 to a ratio of over 115 yen to
one by 1990. Almost all of the growth has
been in large dollar settlement systems related
to securities and foreign exchange transactions.


One can only imagine the chaos that would
ensue if anything seriously impeded these rapid
movements of money in which the equivalent
of our annual GDP flows every three business
days. Clearly, there is sufficient risk here to
warrant careful monitoring and extreme care on
the part of Federal Reserve to make sure that
no single failure or pattern of financial entangle­
ments can seriously damage the payments sys­
tem. It is precisely this risk that clearly and
dramatically explains why the Federal Reserve
remains so interested in the orderly development
of the financial system and why we continue
to argue that our responsibility for monetary
policy and for the underlying stability of the
financial system implies a direct and continuing
role in the supervision and regulation of the
major players.
R e g u la to ry c o n s o lid a tio n

Let me conclude with a few comments
about the Federal Reserve’s future role in the
supervision and regulation of financial activity.
As you know, the Administration has proposed
that the current federal regulatory process for
depository institutions be consolidated into a
single agency. If this were done, the Fed would
cease to have supervisory responsibilities but
would continue, of course, to have responsibility
for monetary policy. We have strongly objected
to this proposal and have counterproposed a
structure that would simplify the current frac­
tionalized system and eliminate duplicative
examinations for most institutions. Our view on
this issue stems from our monetary policy re­
sponsibilities and our need to react to a variety
of events and circumstances with an appropriate
monetary policy response.
As the nation’s central bank, the Federal
Reserve System has the overriding responsibili­
ty for the integrity of the financial system in its
many dimensions. This responsibility extends
into parts of the system where we do not have
specific supervisory or regulatory authority.
Over the years that I have been president of the
Federal Reserve Bank of Chicago, I have seen
any number of examples where this authority
and responsibility, either explicitly or implicitly,
has been important in dealing with some genu­
inely systemic issues. Happily, most of the
instances that come to mind have been invisible
because we were able to contain them before
they exploded onto the public scene. But they


had the potential of becoming damaging in a
systemic sense and would have become so had
we not responded. In 1987 and again in 1989,
in both Chicago and New York, the Federal
Reserve through its supervisory apparatus
played an important role in making sure that
the financial system continued to function.
As you well know, the state of the art in
derivative activities is rocketing ahead at
breathtaking speed as depository institutions
become more heavily involved in these in­
creasingly complex activities. Our supervisory
responsibilities, already very difficult, will
become even more so, but by having the level
of involvement that we do, we can reach judg­
ments on the safety and soundness of individu­
al institutions as well as the controls, proce­
dures, and management information systems
that are in place. This involvement is essential
to maintaining the integrity of the financial
system, which in turn directly relates to our
overriding monetary policy responsibilities.
In my view, and it’s one that I feel very
strongly about, there is an absolutely direct
interrelationship between these two very fun­
damental and very important responsibilities.
If anything, the increased rate of innovation
and interconnection between markets and the
phenomenal speed at which modem trading
systems operate argue that the Federal Reserve
needs, at the very least, to maintain its current
level of involvement in order to live up to our
obligations to the financial community and to
the country. We need to be able to count on
the sound and continued smooth operation of



the payments system and on our ability to
unwind problems and continue to operate even
under severe stress. Our margin for error is
continually narrowing, and careful monitoring
is necessary.
I believe that the Federal Reserve’s ap­
proach based on supervision and on industry
input, combined with our strong desire to pro­
mote economic efficiency, will lead to the best
solutions. It has been argued that such respon­
sibilities are inconsistent with our role in mon­
etary policy. Personally, in addition to the
obvious and important connections I just noted,
I think it’s a good thing to have a supervisor
who cares about economic outcomes as much
as safety. As Chairman Greenspan commented
at the Federal Reserve Bank o f Chicago’s Bank
Structure Conference last year, “zero bank
failures is not the optimal number”; the system
needs to provide for risk and innovation. The
key is to stop problems that develop at individ­
ual institutions from growing into larger sys­
temic problems. Supervision must always be
tempered by the desire for growth, both in the
financial sector and in the economy as a whole.
While it is difficult to judge just how the
legislative process on this issue will develop, I
think the proposal that the Fed has put forward
is a good one, and I hope that wisdom and
sound judgment will prevail.
Again, it has been a very great pleasure for
me to be with you this morning, and I appreci­
ate having this opportunity to review my
thoughts with you. Thank you.


The impact of lean manufacturing
on sourcing relationships

T h o m as H. K lier

During the last decade, U.S.
manufacturing has experi­
enced various changes in its
cyclical and structural envi­
ronment. Among them are the
severe back-to-back recessions of the early
1980s and the widespread restructuring efforts
undertaken in its wake, as well as increased
foreign competition, great exchange rate vola­
tility, and most recently, the build-down in the
defense sector. In addition, the very core of
manufacturing has been changed by the intro­
duction of a new paradigm, the so-called lean
manufacturing system. It deserves special
attention because of its potential long-term
Since the early 1980s, manufacturers have
moved away from the traditional Fordist sys­
tem of mass production toward a system of
lean production.1 Fordism separated intellectu­
al and manual work and broke down the latter
into easily learned, repetitive steps. Based on a
continuously moving assembly line, Fordist
manufacturing could mass-produce a limited
number of models at very low cost and there­
fore came to dominate most of the world’s
manufacturing from the mid-1950s through
about 1980. Lean manufacturing, by contrast,
emphasizes quality and a speedy response to
market conditions, using technologically ad­
vanced equipment and a flexible organization
of the production process. By all accounts,
lean manufacturing is a more efficient system
of production. Aoki (1988) suggests this is


because its methods of organizing and coordi­
nating production allow a speedier and more
timely horizontal coordination between differ­
ent manufacturing operations and a subsequent
reduction in costly inventory.
Lean manufacturing was pioneered and
first applied successfully by Toyota Motor
Company in the 1950s; since then it has be­
come the practice of many Japanese manufac­
turing companies.2 Recently American manu­
facturers have adopted it in order to compete
effectively both at home and abroad. Adopting
lean manufacturing also affects the way a com­
pany is managed and how it structures its rela­
tions with customers, employees, and suppli­
ers; the ramifications of this change extend far
beyond the shop floor of the assembly plant.3
U.S. automakers introduced lean manufac­
turing rather quickly. In turn, they greatly
influenced the way many other businesses
organized their factories, especially auto sup­
pliers. The Midwest felt the greatest impact
from these developments since it is the center
of automobile assembly in the U.S. (see figure
l).4 Complementing recent work by Ballew
and Schnorbus, this article examines how the
introduction of lean manufacturing affected the
structure of the auto supplier industry and the
relationships between assembler and supplier
Thomas H. Klier is a regional economist at the
Federal Reserve Bank of Chicago. He would like
to thank Bob Schnorbus, Bill Testa, and Janice
Weiss for their helpful comments.


T h e c h a n g in g s tru c tu re o f th e
a u to m o b ile s u p p lie r in d u stry

The U.S. automobile supplier industry is
large and diverse, encompassing firms that
produce thousands of different parts, from a
simple gas cap to a complex engine. Table 1
outlines the recent trends in the motor vehicle
parts and accessory industry as defined by
standard industrial classification (SIC) 3714,
“motor vehicle parts and accessories.” The
establishments in SIC 3714 account for about
two-thirds of all shipments of automotive parts

and stampings.6 As it is almost impossible to
describe the industry by means of published
census data, the following analysis draws on
other sources of information.7
The structure and development of the
automobile supplier industry must be analyzed
in the context of developments in the automo­
bile industry, since the demand for suppliers’
products is derived from the demand for auto­
mobiles. Cyclical and structural conditions of
the auto industry also tend to shape the suppli­
er industry.8 The major recent structural
change to affect the auto industry has been the
implementation of lean manufacturing tech­
niques. Lean manufacturing is characterized
by an emphasis on product quality; quality
controls are incorporated into the production
process, for example through the use of “lean”
inventory stocks for intermediate and finished
goods, and through including multiple respon­
sibilities in individual job descriptions and
encouraging worker participation in production
management. Lean manufacturing takes an
integrated approach to the various aspects of
manufacturing. The idea of a concurrent de­
sign process forces everyone who at some
point has a stake in the product to work closely
with designers instead of coordinating the
various functions sequentially from design to
assembly. For example, production engineers
can voice their concerns during the design
process and that way improve ease of manufac-


Employment, shipments, and value added for the auto supplier industry*
Year_____ Total em p lo y m en t_____ Shipm ents_________ V alue added



(million dollars)

V alu e added per em ployee

(million dollars)

(thousand dollars)




*D e fin e d as SIC 3714.
Sources: U .S . D e p a rtm e n t of C om m e rc e, (197 9 -1 99 1 , 1987).




turing of the product early on in its life cycle.
Finally, lean manufacturing relies on subcon­
tractors to produce a greater proportion of the
value added and emphasizes speed in order
processing, production, and delivery. The
successful start-up of Japanese transplant assem­
bly facilities in North America and Europe dem­
onstrated the transferability of lean manufactur­
ing to other socioeconomic environments. Re­
sulting competitive pressures forced its adapta­
tion by the Big Three. In turn, the automobile
supplier industry in the U.S. has been undergo­
ing a transition of its own.
Coinciding with the arrival of Japanese
transplant motor vehicle assembly plants, about
260 transplant supplier companies have set up
shop in the United States since 1981 (see figure
2).9 The vast majority have located in the Mid­
west, close to the Japanese transplant assembly
plants (see figure 3). While at the outset trans­
plant suppliers mainly supplied the transplant
assembly plants, they have since been compet­
ing for business from the Big Three. The pres­
ence of supplier companies with experience in
the application of lean manufacturing increased
the pressure for domestic suppliers to adopt the
new techniques.
Given lean manufacturing’s emphasis on
low inventories and frequent deliveries, sourc­
ing relationships based on lean manufacturing
can function best when supplier and receiver are
located fairly close to each other.1 An analysis
of the geographical pattern of the locations of
Japanese auto assemblers and suppliers in the
U.S. bears this out." Japanese suppliers oper­
ating in the U.S. are typically located within
about a 200-mile radius, or five hours’ driving
time, of their main customer.
As table 2 indicates, the domestic auto
industry is still dominated by captive parts com­
panies that are part of the corporate structure of
the assembler (see figure 4).1 Domestic suppli­
er companies also show less evidence of a
changed location pattern since the arrival of
lean manufacturing. That is not surprising,
since it would require a change in already exist­
ing locations. Yet empirical studies have found
a break in the location of auto supplier compa­
nies away from the pattern which prevailed
until the 1970s.1 The change is ascribed to
several factors.
First, lean manufacturing has brought an
increase in the purchase of parts from indepen­
dent suppliers rather than from captive parts



Transplant auto supplier start-ups
number of facilities
75 r









Source: McAlinden and Smith (1993).

companies. Whereas captive suppliers tend to
be heavily concentrated in urban areas of
Michigan, Ohio, and Indiana, newly estab­
lished plants of independent suppliers are usu­
ally located in smaller communities in nonmet­
ropolitan or outlying metropolitan counties.1
A second reason for the changing location
pattern of domestic suppliers is that the geo­
graphic structure of auto assemblers itself
underwent a restructuring, starting in the late
1970s. According to James Rubenstein, the
branch assembly plant system, which was set
up to minimize transportation costs by produc­
ing identical vehicles at multiple locations, was



The ten largest first-tier suppliers in North America

C o m pany

Total N orth Am erican
a u to m o tiv e sales, 1992


(million dollars)
GM Automotive
Components Group


Ford Automotive
Components Group



DuPont Automotive


Fibers, finishes, plastics, elastomers,
composites, lubricants


Magna International Inc.


Systems: seating and bumper, door
and panel, engine and transmission,
metal body


Nippondenso America Inc.


HVAC, electrical and electronic
products, fuel management
systems, radiators, instrumentation,


United Technologies


Electrical, interior and exterior trim
systems, steering, w iring products


Robert Bosch Corp.


Communications technology, fuel
management systems, anti-lock
braking systems, electronics, starters,


The Budd Co.


Steel stampings and frames, truck
wheels, hubs and drums,
composite body-engine parts


Kelsey-Hayes Group


Anti-lock brake systems, brake
components, wheels, electronic


Lear Seating Corp.

1 ,1 0 0

Seating systems, door panels



Systems and components: powertrain, lighting, chassis, steering,
braking, HVAC, batteries, engine
Automotive glass, electronic controls
and systems, climate controls and
systems, engine accessories,
trim and plastics

Sources: Flem in g (199 3 a ), Payne and Payne (1990).

swept away with the fragmentation of the U.S.
auto market.1 Multiple regional assembly
plants were gradually replaced by plants that
produced one particular platform for the entire
Finally, suppliers that deal directly with
assemblers (so-called first-tier suppliers), pro­
viding especially large, complex, and highvalue components and services, have been
locating near their customers. In contrast,
lower-tier suppliers, who tend to produce low
value-added parts, relocated to low-wage areas
in order to reduce production costs.1



A sse m b le r-su p p lie r re la tio n s h ip s
w ith in lean m a n u fa c tu rin g

With the arrival of lean manufacturing, the
relationship between assembler and supplier
companies has changed considerably. Under
the Fordist system, U.S. auto manufacturers
procured most parts and components from their
own parts divisions (see figure 4). These
sourcing relationships were supplemented by
purchases from independent suppliers in armslength transactions. Typically, a car assembler
dealt with 1,000 to 2,500 suppliers directly.1
Contracts with independent suppliers usually



Assembler-supplier relationships
Fordist manufacturing

Assem bler

Lean manufacturing

Tier 1 suppliers

Tier 2 suppliers

Tier 3 suppliers

ran no longer than a year. The assembler relied
on hierarchical coordination of information and
control over technology in order to solve the
complex task of manufacturing cars.
The tier system
Today, rather than centrally coordinating
almost its entire supply structure, an assembler
deals directly with only a small number of
supplier companies, referred to as first-tier
suppliers. Most first-tier suppliers deliver
fairly aggregate parts or entire systems rather
than individual bits and pieces. Such an ar­
rangement has greater informational efficiency
and therefore appears to have a competitive
advantage over the Fordist system.1 Indicative
are the results of a study conducted in Japan in
1977 to establish the supply tiers for one par­
ticular auto assembler. While the company’s
supplier pyramid contained over 35,000 suppli­
ers, the company dealt directly with only 122
of them, its first-tier suppliers.1 The remain­
der fell into the second and third tiers.
U.S. assembler-supplier relationships have
also become organized in tiers.2 In 1980, for
example, Ford Motor Company dealt directly


with about 2,400 North American suppliers. It
has since reduced that to about 1,400 first-tier
suppliers and is committed to a target of 1,150
by 1995.2 Similar changes are occurring at the
individual platform level. For Ford’s recently
introduced world car, called Mondeo in Europe
and Contour/Mystique in the U.S., the company
is working with only 227 first-tier suppliers in
the U.S. That compares to 700 suppliers for the
Tempo/Topaz platform, which the Contour/
Mystique will replace.2 Chrysler produces its
Neon with 289 first-tier suppliers, down from
425 for the Sundance/Shadow which it replac­
es.2 Changes such as these have increased the
potential roles of full-service supplier compa­
nies such as Magna International, which pro­
duces entire systems for seating, bumpers, doors
and panels, engines and transmissions, and
metal bodies.2 The development of the tier
system has also forced changes in the relation­
ships between suppliers. For example, as re­
cently as 1985, Manchester Stamping, located in
Manchester, Michigan, obtained its steel supply
from more than 30 different companies. It has
since reduced that number to five. With bigger
orders it can now demand faster service.2
Mutual commitment
Compared to the Fordist system, lean man­
ufacturing requires a high degree of communi­
cation and interaction between manufacturers
and fist-tier suppliers, resulting in more closelyknit relationships to which both sides make
various commitments. Rather than carrying
large amounts of inventory for the downstream
customer, supplier companies change their orga­
nization of production so as to produce “just in
time.” In addition, they take on responsibility
for quality control and, often, research and
development, activities that were traditionally
the task of the assembler. Accordingly, suppli­
ers must invest in quality control training and
equipment and maintain their own product de­
sign staff. The assembler, in turn, uses single
suppliers rather than multiple suppliers for each
part of the platform. A recent study of the Big
Three showed that for a list of 30 automotive
parts, in 85 of the 89 observations the part was
single-sourced.2 In addition, the assembler
makes a commitment to longer-term relations
through both longer-term contracts and the
extension of informal contract-renewal promis­
es, contingent on continuous quality improve­
ment by the supplier.


The degree of mutual commitment be­
tween assembler and supplier cannot be ob­
served directly, but it becomes apparent in
various specific aspects of sourcing relation­
ships. A recent study measured this commit­
ment as the number of years during which
assembler and supplier work together before
actually starting production.2 During this
time, supplier and assembler must reach agree­
ment about the part’s technical features, quality
standards, price, and delivery schedules—an
undertaking requiring significant cooperation.
The more time spent on pre-production com­
munication between assembler and supplier,
the stronger the mutual commitment to the
relationship. For example, Chrysler’s new JA
platform is scheduled to go into production
later this year, yet by 1992 every major system
in it had already been sourced.2 Some supply
relationships in the automobile industry are
now so established that suppliers play a role in
designing the automobile.
The following shows the importance of
mutuality in the commitment to sourcing rela­
tionships. In the mid-1980s, Lucas PLC, a
British supplier of mechanical and electrical
components to the automotive and aerospace
industries, began adopting lean manufacturing
principles. As a result, the company reduced
lead times and in-progress inventories signifi­
cantly while vastly improving the percentage
of orders delivered on time. However, one of
Lucas’s electrical component factories soon
ran into problems because some of its large
customers had not converted to lean manufac­
turing and continued to place their orders in an
unpredictable manner.2
Knowledge transfer
Domestic suppliers are now more likely
to provide detailed information to their cus­
tomers than just a few years ago.3 This re­
flects the need for increased communication in
a lean manufacturing environment. Most
notable has been the dramatic increase in infor­
mation exchanged on statistical process control
(see table 3). Statistical process control is a
technique for generating continuous reductions
in defect rates. It involves taking samples of
output, recording the results, analyzing them
to determine the causes of defects, and rede­
signing product and process to eliminate
those causes.3 According to a survey of 964
first-tier suppliers, 16 percent of the 453




Suppliers providing the following
information to assemblers






Production scheduling



Breakdown of production steps



Statistical process control charts
Breakdown of production costs

Source: H elper (1991).

respondents provided that kind of information
to their customers in 1984, while in 1989 the
share had increased to 92 percent.3 There
had also been a significant increase in the num­
ber of visits by representatives from the assem­
bler to the supplier in order to provide technical
assistance. Finally, the majority of suppliers
had become responsible for at least part of the
design of their product, as opposed to using
customer-provided blueprints and specifications.
The specific arrangements varied from suppliers
performing all the research and design to the
customer and supplier contributing equally.
Only 5 percent of the respondents in the survey
said they had no design responsibility.
The importance o f quality
Much of the increased information exchange
between assemblers and suppliers is motivated
by the assemblers’ desire to reduce production
costs by having suppliers share the responsibility
for quality control. To this end, assemblers
have given suppliers the tasks of testing parts
and components and certifying that they meet the
assemblers’ specifications. In turn, suppliers
have retrained their employees, upgraded their
equipment, and worked to make their own sup­
pliers comply with the more demanding stan­
dards. Not surprisingly, quality has become
more important to the selection of supplier com­
panies; according to one study, it moved up from
the third most important criterion in awarding
contracts in 1984 to the first in 1989.3 Perfor­
mance to quality standards has become very
important for continuing a supply relationship
over time. Assemblers closely monitor their
suppliers’ quality records and dependability,
with the understanding that continuous high
production quality will lead to continuing rela­
tionships. Every major auto manufacturer now


bestows quality awards to recognize its top
supplier companies.3
Contract duration
In a lean manufacturing environment,
supplier contracts frequently extend over the
particular model’s lifetime. For example,
when Chrysler made sourcing decisions for the
production of its Neon, rather than putting
contracts out for bid, the company awarded
lifetime contracts to suppliers that met a given
target cost.3 In the five years between 1984
and 1989, the average length of written sourc­
ing contracts in the U.S. auto industry dou­
bled.3 During the same period the percentage
of contracts written for more than three years
rose from 4 to 40 percent. Helper also reports
that the percentage of suppliers doubled who
said their customers would help them rather
than switch if a rival supplier came up with a
superior product.3 This finding is consistent
with the reported increase in single-source
contracts. Not only does it make sense for an
assembler to strengthen its reduced number of
supplier relationships; a commitment to a long­
term contract also serves as an incentive for the
supplier company to take on the increased
responsibilities described earlier.

O u tlo o k and p u b lic p o lic y im p lic a tio n s

The above analysis suggests a compelling
momentum toward a system of longer supply
relationships based on mutual commitment.
However, evidence from individual companies
does not always square with that picture. That
is because complex adjustment is required to
change organizational structures and approach­
es that worked well in the past, as did the
Fordist system of production. There is ample
evidence of the stress this adjustment causes,
and not every company deals with such stress
equally well. For example, Helper (1991)
reports cases where a manufacturer threatened
to cut off suppliers that did not provide the
new services such as product design and justin-time delivery for free.4 It is unclear how
frequently such situations occur, but there is
ample evidence that auto assemblers and sup­
pliers can more smoothly implement this more
efficient way of doing business with each oth­
er. For example, Chrysler has integrated sup­
pliers into its planning process by making them
full-fledged members of its vehicle platform
teams. About 300 supplier personnel have
offices in Chrysler’s Tech Center, where the
company develops its vehicles. In September
1989 Chrysler began a program to reduce sup-

The new auto supplier: Lean m anufacturing
from a supplier’s point o f view
Lear Seating Corporation, based in Southfield, Michigan, is one of the largest independent
suppliers of seat systems in North America. The
company switched to lean manufacturing in 1984.
Its sophisticated just-in-time system enables it to
deliver products to a customer’s factory on as
little as 90 minutes’ notice. As soon as the vehi­
cle body leaves the paint shop in the assembly
plant, its seating specifications are electronically
sent to a Lear plant, where the seats are assem­
bled and loaded for delivery. The company
counts 16 auto assemblers among its customers.
It currently operates 25 plants, with three more
slated to open soon.3 All of these plants are
located near the customers’ assembly plants to
reduce tum-around time from order to delivery.3
Freudenberg-NOK was established in 1989
as a partnership between Freudenberg & Compa­
ny of Germany and NOK Corporation of Japan to
serve the North American market. Headquartered
in Plymouth, Michigan, the company employs


3,600 employees in its 14 North American facili­
ties and produces seals, molded rubber and plas­
tics, and vibration control products. Lean manu­
facturing techniques have given the company
significant competitive advantages in terms of
cost, quality, and service. Freudenberg-NOK
doubled sales during the past five years, while
North American auto production was declining by
20 percent. To pursue its lean strategy further, in
1992 the company launched a program called
GROWTTH (“get rid of waste through team
harmony”), which fosters ongoing, employeedriven efforts to use space, people, and materials
more efficiently without adding jobs or floor
space. According to the company’s president,
early results are encouraging. Cycle times have
fallen by 82 percent, product lead time by 46
percent, and inventories by 77 percent, while
productivity has risen 48 percent and the compa­
ny needs 44 percent less production space.4


plier-related production costs; it has since re­
ceived almost 6,000 ideas from suppliers that
generated $400 million in annual savings.4
Lean manufacturing sourcing relationships such
as these have developed throughout the manu­
facturing sector; in fact, they are also spreading
to areas such as retailing and services.4
From a public policy perspective, the intro­
duction of lean manufacturing raises the ques­
tion of whether the necessary skills will be
available at both assembler and supplier compa­
nies. Lean manufacturing seems to have raised
the educational requirements for jobs in the
auto industry. For example, 97 percent of
hourly employees that Ford hired between 1991
and 1993 were high school graduates. That
compares to about 81 percent for all of Ford’s
hourly employees.4 Changing demands for
workers’ skills might become more noticeable
soon, since the average age of an assembly
worker in today’s auto plants indicates retire­
ment shortly after the year 2000. A number of
assemblers are setting up their own supplier
support and training programs; here and there,
suppliers of one assembler have begun cooperat­
ing to pursue a competitive edge and share re­
search.4 Some have proposed state or regional
involvement, for example, to promote technolo­
gy centers that could transfer the required skills
to workers in parts and assembly plants.
Some have suggested building a local eco­
nomic development strategy around a lean
manufacturing scenario.46 For example, the
state of Alabama offered significant financial
incentives to attract Mercedes’ first North

American auto plant, suggesting that the state
expects to benefit from supplier employment it
assumes will be generated near the assembly
plant. However, one needs to analyze the
evidence carefully in order to evaluate the
regional distribution of benefits and costs of
lean manufacturing activity.
S u m m a ry

The previous discussion outlined in broad
strokes the current trends in the supplier indus­
try and the relationship of that industry to
downstream customers. The adjustment pro­
cess is still under way. The introduction of
lean manufacturing has brought with it an
increase in outsourcing, the elimination of
multisourcing in favor of single sourcing, tier­
ing of the supplier structure, a reduction in the
number of first-tier suppliers, and longer-term
contracts between suppliers and assemblers.
In a lean manufacturing environment, assem­
blers and first-tier suppliers tend to have close
working relationships.
Successfully implemented lean manufac­
turing sourcing relationships, as described
above, enable both parties to benefit from the
incentive advantages of longer-term contracts.
The assembler can save monitoring costs and
cut down on inventory; the supplier is no long­
er exposed to the risks and costs of annual
contract bidding. Under Fordism, assemblers
typically had short-term, arms-length relation­
ships with multiple suppliers, relationships not
designed to reward commitment.

'The Fordist system is named after Henry Ford, who
introduced interchangeable parts and the moving assem ­
bly line to the manufacturing process. Lean manufactur­
ing is also frequently referred to as just-in-time manufac­
2In developing the lean manufacturing system, Japanese
companies, most notably Toyota, were influenced by their
own analysis o f the Fordist system as w ell as by the
quality-enhancing ideas o f the American consultant W.
Edwards Deming.
3See, for example, Milgrom and Roberts (1990), Helper
(1991), Bechter and Stanley (1992), and Klier (1993).
The recent gains in market share by the Big Three may
w ell be related to strong gains in manufacturing produc­
tivity that occurred during the last few years. For exam­
ple, Chrysler’s remarkable recent success in developing



cars quickly and efficiently is reported to be the result o f
reorganization efforts patterned on development and
production techniques employed by Honda. In addition to
the automotive industry, applications o f lean manufactur­
ing are reported for the consumer and electronic goods,
metal products, aircraft, aerospace, and computer indus­
tries; see Hollingsworth (1991).
4The Midwest is defined as the states o f Illinois, Indiana,
Michigan, Ohio, and W isconsin. Currently, about
500,000 workers are employed in auto assembly in the
Midwest. When suppliers and related industries are added,
the number rises to over 1.25 million (Ballew and Schnorbus 1994).
5Ballew and Schnorbus (1994).
6U.S. International Trade Commission (1987), p. 3-2.


’Automotive products can be found in over 20 additional
four-digit SICs. In addition, not all output classified
within a particular SIC is necessarily produced for auto­
mobile assembly; for example, SIC 3519 encompasses all
internal combustion engines. Nor can census data distin­
guish between supplies to the assembly process and to the
so-called aftermarket— items sold to consumers through
retail or service outlets.
8For an overview o f the major changes since World War
II, see Ballew and Schnorbus (1994).
’These operations are either subsidiaries o f Japanese
supplier companies or joint ventures, usually o f U.S. and
Japanese companies.
l0Estall (1985), p. 130.

assembly plant: As work teams require workers to take on
wider roles, first-tier suppliers are required to play wider
roles as well.
25See Treece (1992).
26Klier (1994).
27Klier (1994). The study estimated an econometric
model; in it the variable measuring mutual commitment
was statistically significant in explaining a reduction in
the probability o f vertical integration. The average value
for that variable is reported as 2.68 years. Even though
no direct comparison to pre-lean manufacturing data is
possible, it seem s reasonable to expect that number to be
lower in a system that relied mainly on annual price

"Mair et al. (1988). The authors analyzed 12 transplant
assembly plants and about 250 transplant parts factories.
Practically all o f them were greenfield sites.

28Ward’s Communications (1992), p. 53.

l2This pattern is almost entirely absent from the Japanese
transplant system. See McAlinden and Smith (1993),
p. 38.

30Helper (1991).

l3Rubenstein and Reid (1987), Rubenstein (1988).

32Helper reports that the survey was mailed to “virtually
every domestically owned first-tier automotive supplier in
the U .S.”

l4Rubenstein (1988), p. 290.
l5The number o f distinctive platforms built in North
America increased considerably, reducing demand for
each particular model. Platform refers to the structural
underbody o f a car. The vehicles that share a particular
platform have the same wheelbase and other dimensional
characteristics and thus can be produced relatively easily
on a common line (Luria 1990, p. 143).

“ Womack and Jones (1994).

3lHelper (1991), p. 27.

“ Helper (1991).
34While these awards tend to favor large suppliers who are
able to muster sufficient resources to produce the very
best quality, see Treece (1992) for a brief description o f
four small suppliers that earned quality awards from at
least two o f the Big Three and also from one Japanese

l6See Glasmeier and McCluskey (1987).
“ Ingrassia and Lavin (1993).
l7Womack et al. (1990), p. 146.
36Helper (1991).
18Helper (1991), Aoki (1988).
“ Helper (1991).
l9Aoki (1988), p. 204.
20The tiering effect would not be detectable in the census
SIC data since those data do not distinguish different tiers
o f suppliers. In fact, a shrinking base o f first-tier suppliers
may well be consistent with the observed increase in the
overall number o f supplier establishments (see McAlinden
and Smith 1993, p. 29). The change toward a tier structure
might have led to an increase in the number o f secondand third-tier establishments, overcompensating the
reduction in first-tier supplier establishments.
’ 'Fleming (1993c).
22“Ford stands by CDW 27 program” (1994).
23Chappell (1994).
24In a way, this decentralized sourcing structure is similar
to the organization o f work in the lean manufacturing


38In April, Lear Seating announced its decision to build a
seat plant in Hammond, Indiana, to manufacture seats for
Ford’s Torrence Avenue auto plant in Chicago, less than
25 miles away (Maclean 1994).
“ “Supplier profile: Lear Seating targets European market”
(1993), and Simmons (1994).
40Fleming (1993b), “Supplier profile: Lean production
keys growth at FGNP” (1993), and Treece (1993).
4lIn a recent survey o f supplier companies, GM ’s supplier
relations were ranked worst among 12 auto manufacturers
with plants in North America. This fact seem s mostly
due to the aggressive cost-cutting approach taken by
GM ’s former purchasing czar, Jose Ignazio Lopez (Gard­
ner 1993).
42Bohn (1994).


43“T y in g th e k n o t” (1 9 9 4 ) .

45F o r e x a m p le , 2 4 m o s t ly sm a ll parts c o m p a n ie s fo r m e d
su c h a s tr a te g ic a llia n c e in M ic h ig a n ( s e e C h a p p ell 1 9 9 3 ).

^ T e m p lin (1 9 9 4 ) .
46M air ( 1 9 9 3 ) .

Aoki, Masahiko, Information, Incentives, and
Bargaining in the Japanese Economy, Cam­
bridge: Cambridge University Press, 1988.
Ballew, Paul D., and Robert H. Schnorbus,
“Realignment in the auto supplier industry:
The rippling effects of Big Three restructur­
ing,” Federal Reserve Bank of Chicago, Eco­
nomic Perspectives, Vol. 18, No. 1, January/
February 1994, pp. 2-9.
Bechter, Dan M., and Stephen Stanley, “Evi­
dence of improved inventory control,” Federal
Reserve Bank of Richmond, Economic Review,
Vol. 78, No. 1, 1992, pp. 3-12.
Bohn, Joseph, “Chrysler cuts costs by nurtur­
ing links with suppliers,” Automotive News,
January 17, 1994, p. 18.
Chappell, Lindsay, “As Big Three go, so go
suppliers,” Automotive News, April 4, 1994,
p. 3.
________________, “All together now—U.S.
suppliers forge their own keiretsu,” Automotive
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Estall, R. C., “Stock control in manufacturing:
The just-in-time system and its locational im­
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________________, “Lean and happy,” Auto­
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________________, “Ford to cut 400 more
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make the grade in survey of its suppliers,”



Chicago Tribune, September 5, 1993, Section
17, p. 7.
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Production, Work, Territory: The Geographi­
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es and C. Leys (eds.), London: Allen and Un­
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Can flexible niching modernize U.S. manufac­
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Simmons, Jacqueline, “Lear Seating, supplier
to auto industry, plans to make initial stock
offering,” Wall Street Journal, March 14,
1994, p. B5F.

Maclean, John N., “Failed factory bid blamed
on secrecy,” Chicago Tribune, April 14, 1994,
section 3, p. 1.

“Supplier profile: Lean production keys
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June 28, 1993, p. 4.

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No. 3, 1993, pp. 207-221.

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Does program trading
cause stock prices
to overreact?

Jam es T. M o ser

Program trading constitutes a
substantial fraction of the
trading activity in the New
York Stock Exchange. The
volume of stocks exchanged
in orders labeled program trades typically
averages 10 percent of total volume. This
article investigates the claim that program
trading causes stock prices to overreact. Stock
price overreaction is important because inves­
tors are thought to use stock prices as guides to
the best uses of their capital. If prices overre­
act to new information, they cannot provide
accurate guidance. Evidence of such stock
price overreaction would be indicative of ex­
cessive volatility.
Previous researchers have considered the
possible effect of program trading on volatility,
a proposition which requires a model for the
natural evolution of volatility. Because such a
model lacks general acceptance, this article
offers an alternative approach. I investigate
whether program trades increase the odds of
price reversions.
Prices reverse when previously encoun­
tered price decreases are immediately followed
by an increase in price; or when a previously
encountered price increase is immediately
followed by a price decrease. Price reversions
can be expected to occur when price changes
are larger than the value changes warranted by
new information, that is, when prices overreact
to new information. In instances of overreac­
tion, informed traders will find current prices
out of line with their valuations. The trades of
these informed traders will then bring prices



back toward their original levels. This depic­
tion follows that of Black (1985).
This article examines whether program
trading should be classified as a type of noise
trading or as a type of information trading. If
levels of program trading increase the likeli­
hood that a price reversal will occur, we can
conclude that program trading is a type of
noise trading. On the other hand, if program
trading is unrelated to the likelihood of en­
countering a price reversal, then program trad­
ing should be categorized as information trad­
ing. I examine a 34-month period of daily
program trading activity and stock prices and
use a logit specification to consider the propo­
sition that trading activity changes the proba­
bility of stock price reversals. The results do
not support the claim that program trading
causes stock price overreactions.
L it e r a t u r e r e v i e w

Much of the literature on program trading
considers its effect on stock price volatility.
Stoll and Whaley (1986, 1987, 1988, 1990)
examine the consequences of program trading
occurring on “triple-witching days,” that is,
dates when multiple derivative contracts on
stocks simultaneously expire. As heavy pro­
gram trading frequently occurs on these expira­
tion dates, Stoll and Whaley’s evidence of
higher volatility suggests that program trading
can be linked to increased volatility. Edwards
(1988) studies the impact of stock-index fu­
tures and finds that volatility does not increase
James T. Moser is a senior economist in the
research department at the Federal Reserve Bank
of Chicago.


after the introduction o f multiple derivative
contracts. Since these contracts are frequently
involved in program trading strategies, an in­
crease in stock price volatility would be consis­
tent with a program trading effect. Maberly,
Allen, and Gilbert (1989) note that this result
depends on the sample period. Harris (1989)
finds only a slight increase in volatility during
the 1980s, suggesting that the increased program
trading activity that was facilitated by futures
trading had, at most, a very modest effect on
volatility. Martin and Senchack (1989, 1991)
find that the volatility of stocks included in the
Major Market Index (MMI) rose after the MMI
futures contract was introduced. Their risk de­
composition indicates that the systematic risk of
these stocks rose. Since the MMI futures con­
tract is frequently involved in program trading,
this finding suggests that program trading led to
higher volatility.
Program trading grew rapidly during the
1980s. If this activity increases volatility, then
the 1980s should have shown higher than usual
volatility. Several investigators have examined
the period for changes in volatility. Froot, Perold, and Stein (1991) investigate returns on the
Standard and Poor 500 since the 1930s. They
find that changes in volatility are conditional on
the length of the holding period. There is strong
evidence of an increase in return volatility dur­
ing the 1980s for 15-minute holding periods.
When longer holding periods are examined, it is
much less evident that volatility has changed.
Miller (1990) suggests a conceptual distinction
between the volatility of price changes and
price-change velocity. While statistical tests
frequently demonstrate no change in volatility
levels, the speed of price adjustments does ap­
pear to have increased during the 1980s. Froot
and Perold (1990) decompose price changes into
bid-ask bounce, nontrading effects, and noncontemporaneous cross-stock correlations. They
demonstrate that price adjustments occurred
more rapidly during the 1980s.
Direct investigation of the effects of pro­
gram trading finds temporary increases in vola­
tility which are most prominent in index arbi­
trage activities. Much of this evidence is re­
viewed by Duffee, Kupiec, and White (1990).
Grossman (1988) regresses various measures of
daily price volatility on program trading intensi­
ty, finding no significant effect. A Securities
and Exchange Commission study (1989) finds a
positive association between daily volatility of


changes in the Dow Jones Index and levels of
program trading activity. Furbush (1989) finds
a significant relationship between price volatil­
ity and program trading activity in the three
days prior to the October 19, 1987, market
break. Harris, Sofianos, and Shapiro (1990)
and Neal (1991) investigate intraday program
trading, finding that responses to program
trades are similar to those found for block
trades. Using “GARCH” estimation proce­
dures, Moser (1994) finds a modest increase in
the volatility of returns for one-day holding
periods associated with sell program activity.
Thus, the evidence is inconclusive. The logit
specification developed in the next section
offers an alternative approach to examining
this question.
D a t a s e ts a n d s a m p le d e s c r ip t io n

Trading activity data for this study are
from the New York Stock Exchange (NYSE).1
The data set includes aggregate trading volume
and share volumes involved in programmed
trades. The sample consists of 717 daily obser­
vations from the period January 1, 1988,
through October 31, 1990. Program trades
are presently classified as buys, sells, and
short sales.
Program trading activity is the number
of shares included in orders identified as pro­
gram trades. The NYSE defines program
trades as orders involving 15 or more stocks
having a combined market value in excess of
one million dollars. The program trades of
this sample include shares exchanged through
Price reversals are constructed from a data
set of percentage changes, denoted /?, in the
Dow Jones Industrial Averages. This stock
index is useful in that it is computed from
prices for heavily traded stocks which are fre­
quently involved in program trades. Thus, if
program trading does lead to price overreac­
tion, this effect should be most pronounced in
these stocks. Reversals, denoted r , are com­
puted for the stock return sample as follows:

(1) rH - \

l 0 otherwise

( 2)

e, = R ,- E(R'

| <(>,).


Equation 1 specifies an indicator variable as­
signed a value of one on sample dates when the
unanticipated portion of the return at t - j - l has
the opposite sign as that of the unanticipated
return realized at t-j for the holding period
from t - j - l through t-j-, on other dates, the
indicator variable is set to zero. Equation 2
states that unanticipated returns are computed
as actual returns minus their corresponding
expectations. Expected returns are generated
assuming that stock prices can be described by
a martingale; that is, E(RJ = 0. As the next
section points out, considering various values
of the lagy permits longer intervals for prices
to correct following a price overreaction.
E s t im a t in g r e v e r s a l p r o b a b i l it i e s
c o n d itio n a l o n tr a d in g a c t iv it y

Let Z represent a vector of index values
with each element measuring the propensity of
the market to produce a reversal. The proposi­
tion that program trading encourages overreac­
tion as demonstrated by stock price reversals,
implies that the index should be related to
levels of program trading activity. If this is
true, the data should allow us to reject the null
hypothesis that program trading has no effect.
Defining X as a matrix of k measures of the
trading activity variables, we write

Equation 3 is estimated using the method of
maximum likelihood. The expression for the
log likelihood is

log / = £ r \og[F(x' b )\
+ d - r ) iog [i - F ( X;_.b)],
where T is the number of observed changes in
returns and x are the activity variables ob­
served at dates t-j. Lagging the activity vari­
ables coincides with the null under investiga­
tion. W heny=l, the null hypothesis under
investigation asks, does heavy trading activity
at date t - 1 consistently cause stock prices to
overreact? If program trading activity caused
an overreaction on this date, and if a price
correction occurred in the one trading period
since the overreaction, then a price reversal is
realized, provided the information arriving at t
does not overwhelm the amount of price cor­
rection. If these conditions hold, then the coef­
ficients on the activity variables will differ
from zero, reflecting the average impact from
trading activity. Thus, the test specification
jointly considers three questions:
1) Does overreaction occur?

z =x § ,

2) Are price corrections realized the
following day?

so that levels of the index are predicted by
activity levels and their coefficients. The over­
reaction null predicts that P will differ from
zero. The level of this index can also be de­
scribed as determining the probability of en­
countering a reversal conditional on trading
activity. The vector of these probabilities can
be written as P=F(Z). Taking F () to be the
cumulative logistic probability function, these
probabilities of reversals are given by

3) Is the amount of the price correction
masked by the value of newly arriving

P = F ( Z ) = -------- = ---------- .
1 + e zt
Taking logs and rearranging gives the follow­
ing logit specification:
(3) log — = X f i + Zt .
1- P t



The null hypothesis of no effect can be rejected
only if the answer to each of these questions
is yes.
The third of these conditions is addressed
a priori. Amounts of price corrections are
masked by valuations of new information only
if the value of new information is larger and
has the same price change implications as the
previous overreaction. As the distribution of
value changes based on new information is
likely to be symmetric, it is not likely that
more than half of the overreactions will be
masked by value changes attributable to new
information. Further, if price changes due to
overreactions are generally smaller than those
caused by value changes due to new informa­
tion, then the problem of overreaction may not
be as large as often portrayed. These consider­
ations reduce the problem of new information


19.69 per cent of the sampled trading days.
Taking this as the unconditional probability of
a reversal, the conditional probability of a
reversal increases by approximately .00037 for
each increment of 1,000 shares executed in buy
programs above the sample-average level of
8,044,000. At one standard deviation above
this average level of trading activity— 17.5
million shares—buy programs increase the
probability of a reversal by 3.49 percent, with
the reversal from this activity being realized
over the succeeding four trading days.
Comparing the coefficients across the
three categories of trading activity included in
these regressions, nonprogram trading appears
to be a more reliable cause of price reversals.
Coefficients on nonprogram trading differ
reliably from zero for the two-, three-, and
five-day correction intervals. Again the mag­
nitudes of these effects are small. At one stan­
dard deviation above average nonprogram
trading activity, the probability of a reversal
increases by 3.4 percent for the three-day cor­
rection interval. The magnitudes of impacts on
reversal probabilities for the four- and five-day
correction intervals are similar.
Pseudo R2 values are computed following
Judge et al. (1985) for each specification. The

masking overreactions to an efficiency concern
rather than a bias concern. This leaves two
conditions. As the inferences that can be
drawn regarding the primary question of over­
reaction depend on the answer to the second
question, I attempted to lessen the dependence
on the length of the correction interval. I did
this by examining longer correction intervals.
Specifically, I extended the hypothesis to con­
sider whether trading activity at t-j produces
overreactions on that date which are corrected
over the interval from t-j to t. Thus I consid­
ered the possibility that correction intervals last
longer than one day. This still left open the
possibility that corrections occur in less than
one day.
Table 1 reports estimates of the logit spec­
ification given in equation 3 for price correc­
tion intervals of one through five trading days.
Coefficients on the activity variables are gener­
ally small. Evidence of price reversals attribut­
able to buy program activity is present for
correction intervals of four trading days.
Though statistically significant, the impact on
price reversal probabilities is small. To gauge
the relevance of this coefficient, I evaluated it
at average levels of trading activity. Price
reversals for this correction interval occur in


Maximum likelihood estimates of logit specifications
for price correction intervals of one to five days
January 1, 1988 - October 31, 1990
Param eter

Price correction intervals






-1 8 ,8 2 3 **

-1 8 ,7 3 8 **







Sell program




N onprogram


Log /

















N o te : t-s ta tis tic s in p a re n th e s e s .
* p < .05.
* * p < .01.



-1 5 ,1 7 9 **

Buy program

Pseudo R2




low values of these R2values implies that trad­
ing activity explains a very small portion of the
overall variation in reversals. To consider the
explanatory power of our specifications, I con­
ducted a likelihood ratio test. Under the null
hypothesis of no effect, the maximum value of
the likelihood function is
l o g / = / ? lo g

(n/T) + ( T - « ) l o g ( T - n/T),

where n is the number of reversals and T the
number of sample dates. Specifications can be
tested using a likelihood ratio test for the differ­
ence between this maximum log likelihood and
the log likelihood obtained from the estimation
procedure. For the sample of one-period cor­
rection intervals, the maximum log likelihood
under the null hypothesis is —
^495.29, which is
only slightly smaller than the actual value of
-494.24. The critical value of twice this differ­
ence is 7.81 for the 95 percent level of confi­
dence. Thus, the data fails to reject the null
hypothesis; that is, the results for the one-day
correction interval do not support an association
between trading activity and price reversals.
These differences are 6.85, 7.85, 6.56, and 5.96
for the two-, three-, four-, and five-day correc­
tion intervals, respectively. The critical value
is exceeded only at the three-day correction
interval. This implies that trading activity does
lead to price overreactions which are subse­
quently corrected in three trading days. The
individual coefficients indicate that it is nonpro­
gram trading which produces these overreac­

tions rather than buy or sell trading activity.
Recall that the price correction intervals
considered in this paper are whole trading
days. Fractional trading days are not consid­
ered. Thus, overreactions with a subsequent
correction within the same trading day cannot
be detected using a sample of daily returns as
in this article. Previous research does investi­
gate within-day reversals. Harris, Sofianos,
and Shapiro (1990) and Neal (1991) find that
the price impact of an average program trade is
similar to that found for block trades. We
conclude that price reversals, where found, are
generally small. This implies that current
trading mechanisms are usually quick to re­
solve those price overreactions attributable to
program trading. Given the current effective­
ness of these mechanisms, changes such as the
imposition of transaction taxes or other institu­
tional arrangements appear to be unwarranted.
C o n c lu s io n

Descriptions of stock market results fre­
quently give the impression that program
trading causes prices to overreact to current
information. Some have proposed policy
changes intended to dampen the effects of the
extent of these overreactions. This article
introduces a procedure to test the proposition
that program trading causes price overreac­
tions. Given the evidence presented, it appears
that program trading activity does not cause
price overreactions.

'1 am indebted to Deborah Sosebee and her staff at the
NYSE. They provided the data on program trading and
patiently answered many questions.
2Most but not all program trades at the NYSE are routed
through SuperDOT, a computerized routing system.
Large brokerage houses can arrange to have their program
trades executed by floor brokers, but this method is more
costly and slower. The weekly summaries o f program

trading reported in the financial press include program
trades executed o ff the SuperDOT system. These data
are unavailable on a daily basis. Program trading reported
in the weekly summaries for the period 1/1/88 through
9/22/90 averaged 16.4 m illion shares per day. Program
trades in this sample over the same period averaged 15.9
million shares. This suggests that program trades execut­
ed o ff the SuperDOT system account for only about
3 percent o f program trading activity.

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