Purifying Japan’s Banks - Am MIT spezialisierte KI-Forschung

Purifying Japan’s Banks
Purifying Japan’s Banks

Purifying Japan’s Banks: Issues and
Implications*

Randall Morck
School of Business
University of Alberta
3-23 Business Building
Edmonton, Alberta
Canada T6G 2R6
randall.morck@ualberta.ca

Bernard Yeung
Stern School of Business
New York University
44 West 4th Street,
Suite 7-190
New York, New York 10012-1126
USA
byeung@stern.nyu.edu

Abstrakt
We use a simple real options framework and empirical data to
establish that although Japanese banks hold borrowers’ shares,
their interest is more along the lines of a contractual claimant than
a residual claimant of corporations. We then explain why the
Japanese model of corporate governance was useful during the
“catching-up” growth of that country’s postwar reconstruction
decades but became problematic subsequently. The interests
of shareholders, creditors, workers, and managers are more
readily aligned because such growth entails investment in known-
technology physical-capital-intensive projects with highly predict-
able cash flows. Once firms are on the technological frontier,
“keeping-up” growth requires risk taking and a tolerance for “cre-
ative destruction.” This is better accommodated by entrusting
corporate governance to firms’ true residual claimants, their share-
Inhaber.

1. Einführung

Japan is Asia’s greatest success story, and the ªrst major
country outside the West and Western colonies of settle-
ment to rank among the world’s richest. Yet when Admi-
ral Matthew Perry bombarded Japan in 1853 into opening
trade with America, its Tokugawa economy was mainly
traditional agriculture, and its society was largely frozen
in a feudal caste system. How did this stagnant Asian civi-
lization rise to world economic leadership?

Japan’s unique institutions—its banks, keiretsu corporate
groups, and unique governance and employment prac-

* This paper was presented at the Asian Economic Panel meeting
in Tokyo on 7 Marsch 2005. We are grateful for comments from
participants at that meeting, and especially from Eisuke
Sakakibara, Juro Teranishi, Wing Thye Woo, and Lin See Yan.

Asian Economic Papers 5:1

Institute of Technology

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Purifying Japan’s Banks

tices—are often proposed as explanations and as models for other countries. Noch
these institutions are quite recent, having developed only in the second half of the
20th century (Morck and Nakamura 2005). Japan arguably “caught up” with the
Westen, or at least its poorer regions, long before that—plausibly in the early 20th cen-
tury—and did so with an economy of family-controlled pyramidal groups and con-
ventional labor markets (Morck and Nakamura 2005). The institutions now associ-
ated with Japan are thus mainly of interest in explaining Japan’s most recent
“catching up” with the West—its reconstruction after World War II.

dennoch, how Japan’s banks, keiretsu, and other unique institutions of the time
achieved this feat is still of considerable interest. In 1945, Japan’s modern infrastruc-
ture was in ruins, and the success of its reconstruction is remarkable. What lessons
does this era of Japan’s economic history hold for other developing economies?

We argue that the governance role Japan gave its great banks was critical to its suc-
cessful and rapid postwar reconstruction. In a nutshell, this is because banks prefer
stability and Japan needed economic stability during this period. Once the “catch-
up” phase was complete, Jedoch, Japanese banks and their client ªrms were ill-
equipped to participate in “creative destruction,” that is, the turnover of ªrms that
takes place as creative new innovators rise and, in so doing, destroy staid older
ªrms. Bankers unintentionally misallocated the savings of middle-class Japanese
into more of the same kinds of investments that would have made perfect sense in
the 1950s but were ill-suited to the technological developments and markets of the
late 20th century. As the former sorts of investments dried up in the 1980s, bankers’
well-meaning inºuence over the governance of large ªrms in Japan’s great horizon-
tal keiretsu magniªed this misallocation problem into a macroeconomic crisis.

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Japan’s institutions are thus well worth study in any country reconstructing after
war or other similar disasters. The usefulness of such institutions in energizing long-
dormant economies is unclear, for they never served that purpose in Japan. Ihre
usefulness to economies whose growth opportunities lie mainly on the frontiers of
new technology is also unclear, for institutional fault lines appeared when Japan
reached this status, and Japanese institutions are now changing.

Japan’s ªnancial system is opening up, and banks’ control over matters outside
banking is passing. Traded bonds are now allowed, and other competition from for-
eign capital is displacing banks. These developments are sensible and are likely to
“purify” Japan’s banks—rendering them “just banks” by undermining their former
roles as “corporate governance advisors.” Japan’s academic, politisch, and business
elites now realize the need for another round of institutional “selective breeding.”

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Purifying Japan’s Banks

Since the Japanese are proven masters at this art, it would be arrogant for outsiders
(especially from the West) to proffer advice.

daher, this paper focuses on lessons that other economies with less successful
track records at importing and domesticating foreign institutions might draw from
Japan’s experience. Assigning large private sector banks a role in corporate gover-
nance may well encourage “catch-up” development in a way that mitigates the cul-
tural instability engendered by institutional transplants. But banks’ voices in corpo-
rate governance must eventually be muted, for they grow less helpful as the catch-
up process nears completion.

Abschnitt 2 discusses postwar Japanese institutions in more detail, and section 3 Verwendet
option-pricing theory to explain bank governance, how it accords with manager and
employee governance, and how it fails to accord with growth through creative de-
struction. Abschnitt 4 applies this view to the governance of Japanese ªrms. Abschnitt 5
considers the social welfare implications of creditors, employees, and managers
having dominant voices in corporate governance. Abschnitt 6 discusses how the ad-
vantages of these sorts of governance evaporate as a country approaches the tech-
nology frontier. Abschnitt 7 considers how institutions might evolve to deal with this
Problem, and Section 8 concludes.

2. The import of institutions

Institutions are both important and difªcult to import. Few economists now dispute
North’s (1990) emphasis on “institutions,” broadly deªned as the legal, regulatory,
religious, and social constraints that guide human behavior. Unique institutions, Zu
some extent, surely do underlie the continued prosperity of the Western world. Noch
Pistor et al. (2003), Romano (1993), and others show that institutions are also quite
difªcult to transplant and in foreign soil often either choke or develop into ungainly
weeds.

One might quip that Buddhism reveres inconsistency as the path to enlightenment
and that the Japanese energetically “Zenned” Western imports and cherished cus-
toms into new hybrid institutions that soon became uniquely Japanese. Jedoch, Ja-
pan’s postwar institutions developed haphazardly, as most institutions do.1

The post–World War II American military government disbanded the great family-
controlled pyramidal corporate groups, or zaibatsu, that dominated Japan’s large

1 This summary is from Morck and Nakamura (2005).

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corporate sector from the late 19th century until the prewar and wartime
militarization of the economy. Von 1952, when the U.S. occupation ended, Japan’s
large corporate sector was a mirror image of America’s—large, freestanding, widely
held ªrms run by professional managers. Over the next two decades, Japanese ªrms
experienced the same governance crises now associated with America—hostile take-
overs, greenmail, and takeover defenses. In contrast to American ªrms in the 1980s
and 1990s, which relied on poison pills, staggered boards, and antitakeover legisla-
tion to stymie raiders, Japanese ªrms in the 1950s and 1960s used the “keiretsu de-
fense.” Japan’s great commercial banks helped potential target ªrms swap individu-
ally small blocks of shares with each other. The resulting webs of small
intercorporate block holdings accumulated to majority voting control in the for-
merly vulnerable targets, rendering them immune to hostile takeovers. These webs
generally connected ªrms that had been members of the same prewar zaibatsu and
had retained ties to that group’s main bank. Freed of shareholder pressure (hostile
takeovers, greenmail, and the like) and grateful to the bankers who freed them, Ja-
pan’s corporate managers rebuilt their country.

But which, wenn überhaupt, of the institutions that emerged from this fracas were really essen-
tial to Japan’s postwar miracle? Institution parsing is a useful exercise but must be
conducted carefully. Zum Beispiel, Japan’s large banks played a central role in creat-
ing modern institutions. They continued to intervene in the corporate governance of
their client ªrms during much of the postwar period (Kaplan and Minton 1994) Und
presumably therefore affected capital allocation and economic growth. Banks and
their afªliated insurance companies held substantial equity blocks in their client
ªrms during those decades. Bankers joined the boards of troubled companies and
presumably inºuenced governance. Banks organized many of the great horizontal
keiretsu groups and played leading roles in all of them. But how can we distinguish
critical institutional architecture from historical baggage?

Japanese bankers’ professed decisive role in catching up with the West exposed
them to (probably excessive) derision when the economy faltered in the 1990s. Japa-
nese banks were told to divest themselves of their shares in client ªrms, keep their
noses out of those ªrms’ business, and deconstruct their keiretsu. Were the banks and
the keiretsu mere institutional baggage all along?

In our view, banks likely played a crucial role helping Japan “catch up” with the
West after the nearly complete destruction of its modern physical infrastructure in
World War II. But once this process was mostly complete, the banks lost their magic
because “catching up with the West” and “keeping up with the West” present differ-
ent corporate governance challenges.

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“Catching up” requires many things, but the most important are probably a trust-
worthy elite, technological skills, and extremely large amounts of capital. Japan’s
political and economic elites were seldom accused of the wholesale corruption that
blights many developing economies. Japanese students brought foreign technologi-
cal skills home, and Japanese universities acquired international status. Japanese
banks placed the country’s national savings at the disposal of largely honest, largely
technologically competent businesses. This institutional formula let Japan “catch
up.”

“Keeping up” requires sustained innovation. The technology frontier moves out-
ward as entrepreneurial ªrms vie to develop and apply new ideas. This too requires
honesty, skill, and large amounts of capital. But it also requires a tolerance for risk
and instability. Schumpeter (1912) describes the outward expansion of technological
capabilities as a process of “creative destruction.” Creative entrepreneurs devise
new products and production techniques. Many fail, but some succeed dramatically.
In succeeding, they destroy established but less innovative ªrms. Sustaining this
process of creative destruction, with all its tendencies toward instability, is perhaps
the West’s major institutional achievement.

Japanese business and political leaders show increasing signs of understanding this.
One might quip that, since “creative destruction” and “sustained instability” both
have a Zen-like ring, neither is irretrievably alien to Japan. Japan’s prospects of
eventual success in “keeping up” are probably good.

Many Japanese industries are already enthusiastic participants in the global process
of creative destruction. Sony led the world into miniaturized electronics, and Japa-
nese automakers reacquainted Detroit with creative destruction. The great postwar
horizontal keiretsu—Dai Ichi Kangyo, Fuji, Mitsui, Mitsubishi, Sanwa, Sumitomo,
and the others—in which bank inºuence was greatest (Morck and Nakamura 1999)
essentially rebuilt Japan from the ruins of World War II (Johnson 1982). Yet Japan’s
great modern innovators (z.B., Honda, Sony, and Toyota) Sind, at most, only very
loosely afªliated with the country’s great banks and horizontal keiretsu.2

In retrospect, this should hardly be surprising. Bankers rationally dislike risky bor-
rowers, and bank-inºuenced ªrms thus invest in proven technologies with easily

2 An issue arises here concerning the deªnition of keiretsu. Zum Beispiel, Toyota is listed among
Mitsui keiretsu ªrms, but Toyota also runs its own Toyota keiretsu of auto parts suppliers and
other afªliated ªrms. Debates about the proper boundaries of each keiretsu are tangential to
this discussion. What is germane is that Toyota avoids borrowing money from the Mitsui
bank and that no bank has signiªcant inºuence over Toyota’s governance.

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Purifying Japan’s Banks

auditable value as collateral. Large swathes of Japan’s economy, especially the large
ªrms central to the great horizontal keiretsu, are governed much as bankers every-
where would idealize good governance. Risk is avoided and assets are made of con-
crete and steel. Gleichzeitig, from the perspective of top corporate executives,
stable ªnancial support is a necessary condition for large-scale investment in the
commercialization of proven technologies. This double alignment of incentives per-
mitted Japan to “catch up.”

Success in ªnancing postwar reconstruction gave the banks great credibility (Tera-
nishi 1995). This locked in banks’ dominance. Lobbying by major banks probably
contributed to Japan’s severe restrictions on the use of traded debt and to the conse-
quent market power of the great keiretsu banks. Once a ªrm became dependent on
a bank, switching to another was rare. This probably reºected adverse-selection
problems—other bankers wondered why the ªrm was no longer borrowing from its
former bankers and suspected hidden ªnancial problems (Diamond 1991; Rajan
1992). But tacit collusion to limit competition cannot be ruled out. Regardless of its
origin, this dependence gave bankers substantial inºuence over the governance of
their client ªrms without corresponding exposure to the effects of that inºuence on
those ªrms’ residual cash ºows. Bankers pressed borrower ªrms to undertake low-
risk projects and shun high-risk ones (Morck, Nakamura, and Shivdasani 2000).
Soon, bank-dependent ªrms evolved low-risk governance cultures that precluded
risk-taking ex ante—a logical consequence of bank inºuence over their boards
(Morck and Nakamura 1999).

Bank inºuence over corporate governance was probably important to Japan’s suc-
cess nonetheless. The resulting stability let Japanese employees and consumers
spend the past half century buying wholeheartedly into modern lifestyles. Such sta-
bility is plausibly socially efªcient, because employees also dislike risk, especially if
large-scale low-risk/high-return investment opportunities existed during postwar
reconstruction.3 Lifetime employment, though never as pervasive as some Japan en-
thusiasts alleged, was not uncommon (Lincoln 1999). Aggregate supply rose
steadily, chasing an even more buoyant aggregate demand in a “big push” toward
development of the sort modeled by Murphy, Shleifer, and Vishny (1989). Factory
towns prospered, and Japanese consumers developed middle-class tastes. Diese
tastes—especially for democracy and the rule of law—accorded with the agenda of
Japan’s postwar political leaders.

3 This is not dissimilar from Gerschenkron’s (1952) explanation of the role of banks in early

German industrialization. These arguments apply more readily to postwar Japan than to pre-
vious high-growth episodes.

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Purifying Japan’s Banks

But once Japan caught up with the West, its banks, like ships suddenly without ac-
customed winds, did not know what to do next. Further debt-ªnanced investment
in steadily expanding the output of old-line industries, instead of being low risk, links
banks holding huge nonperforming loans (Hanazaki and Horiuchi 2000, 2001, 2003).
Yet keiretsu ªrms with closer main bank ties continued accumulating debts and in-
vesting in ever more physical capital (Morck, Nakamura, and Shivdasani 2000). Der
next section explores how this came to be.

3. Putting growth options in perspective

Firms are legal persons, usually capable of generating wealth, against whom vari-
ous claimants have various rights. The ªrm’s employees, managers, and creditors all
have contractual claims. These parties are contractual claimants, for their wages, bo-
nuses, and interest payment schedules are all set forth in contracts that deªne the
obligations of the ªrm in precise terms.

Once the ªrm has fulªlled those contractual obligations, all additional wealth it cre-
ates belongs to the ªrm’s shareholders—its residual claimants. Residual claimants
own this unpredictable residual cash ºow and so must be prepared to accept gains
or losses as the ªrm’s fate unfolds. Residual claimants share proportionately in the
fruits of good ªrm performance and in the costs of poor performance.

Employees, managers, and creditors can become residual claimants under rare cir-
cumstances, such as bankruptcies. In these circumstances, the ªrm lacks the re-
sources to make good on its contractual obligations, and contractual claimants to
some extent also share proportionately in the ªrm’s fate.

But empirical evidence (sehen, z.B., Morck and Nakamura 1999; Morck, Nakamura,
and Shivdasani 2000) shows that in Japan, as elsewhere, banks behave primarily as
contractual claimants and use such inºuence as they have to maximize the value of
their ªxed contractual claims, not to share eagerly in the uncertain residual claims
that customarily ºow to shareholders. It seems likely that Japanese managers and
employees act similarly, though direct evidence of this is not currently available.
Faleye, Mehrotra, and Morck (2005) show empirically how American employees
shun acting as residual claimants even if they directly own large blocks of stock.
John, Litov, and Yeung (2005) show that the managers of American ªrms likewise
behave like contractual claimants.

Upon reºection, this is sensible, for students of Japan acknowledge the importance
in postwar Japan of stable wage streams and lifetime employment guarantees—

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Figur 1. Shareholdings as an option

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Notiz: The horizontal axis plots the value of the ªrm, and the vertical axis plots the value of various claims on the ªrm. The value of share-
holders’ equity in the ªrm, E, is zero if the ªrm’s assets are worth D0 or less, where D0 is the wealth the ªrm promised to its contractual

claimants—its employees, customers, Lieferanten, and creditors. The value of those claims is D, which rises with the worth of the ªrm’s as-
sets, W, until the latter exceeds D0, after which point it remains constant.

essential characteristics of contractual, rather than residual, Ansprüche. Only recently
have merit-based raises, promotions, and layoffs started to replace rigid seniority-
based rules (Schmidt 1996). Likewise, Kubo (2005) shows that director “pay-for-
performance” in Japan is not structured to align directors’ incentives with share-
holder wealth. Japan cannot have offered corporate managers solid job and income
security while simultaneously making them residual claimants in their corporations’
risky residual cash ºows. While Japan was “catching up,” this inconsistency could
be ignored, for residual cash ºows grew steadily. Once Japan “caught up,” her
great corporations had to play the game of creative destruction. The increased risk
this inºicted on their residual cash ºows made the contradiction impossible to over-
look.

How all this happened can be illustrated with some simple diagrams of risk alloca-
tion, as commonly used in the ªnancial economics of risk management. Figur 1
zeigt, dass, in classical ªnance theory, a ªrm should relegate corporate governance
to its shareholders because only they have a clear interest in maximizing the wealth
it creates.

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Figur 1 shows that contractual claimants (z.B., employees, managers, and creditors)
obtain the full value of their claims, D, as long as the ªrm generates wealth W ≥ D0.
As long as W exceeds D0 by a safe margin, the contractual claimants see no immedi-
ate purpose in maximizing it further. The residual claimants, the shareholders, eigen
the remainder of the wealth the ªrm generates, E (cid:1) W (cid:2) D. Assuming efªcient mar-
kets, the value of the ªrm to all its stakeholders (contractual and residual claimants)
is E (cid:3) D (cid:1) W. As long as W (cid:4)(cid:4) D0, maximizing share value is equivalent to maxi-
mizing ªrm value. Folglich, to the extent that the presumptions of neoclassical
economics apply, letting shareholders govern the ªrm to maximize their own wealth
is economically efªcient.

Well-known inefªciencies arise if W falls close to D0. Under those circumstances, Die
ªrm’s equity value can be thought of as a call option. A call option is a claim that
gives its owner the right to buy an underlying asset at a predetermined exercise price,
regardless of the actual market value of the underlying asset. The ªrm’s share-
holders can buy continued ownership of the ªrm’s assets by exercising the option:
paying the contractual claimants their promised dues. If the shareholders elect not
to make those payments, they can walk away, but ownership of the ªrms’ assets
transfers to the contractual claimants, who must recoup what they can through
bankruptcy procedures. The underlying asset of the call option is the ªrm’s assets, its
exercise price is the wealth promised the contractual claimants, and to exercise the op-
tion is to pay the contractual claimants their due.

This sets the stage for tragedy if the value of the ªrm’s assets falls to, Zum Beispiel,
W0, a value only slightly greater than D0, the wealth due the contractual claimants;
ªgure 2 illustrates the situation. In dieser Situation, shareholders rationally undertake
inefªciently risky strategies because they get any upside and have little to lose. Das
Ist, if a project might generate W0 (cid:3) (cid:5) (cid:4)(cid:4) D0, the shareholders win big. They might
undertake such a project even if it has a greater probability of leaving the ªrm’s as-
sets worth W0 (cid:2) (cid:5) (cid:6)(cid:6) D0. This lost worth is inconsequential to the shareholders,
who really only lose W0 (cid:2) D0 (cid:1) 0.

This sort of inefªcient high-risk investment plays a role in many corporate gover-
nance crises. Zum Beispiel, American savings and loans banks, rendered nearly
bankrupt by interest rate swings associated with high inºation in the 1970s, unter-
took numerous high-risk investments, from real estate speculation like the White-
water Development in Arkansas to junk bonds. If these gambles paid off, the own-
ers of the savings and loan were back in the black. If they failed, as most did, Die
banks were near death anyway.

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Figur 2. Inefªciently adventurous governance

Notiz: The shareholders, entrusted with corporate governance, rationally undertake a project that is most likely to subtract
ªrm’s current worth, W0, but that might add

sowie. The shareholders gain from any upside risk and have little to lose from downside

von dem

risk.

Allgemein, shareholder value in a limited-liability company with debt outstanding
can be represented as

E (cid:1) E(D0, (cid:5)) ,

(1)

Wo (cid:7)E/(cid:7)D0 (cid:6) 0 Und (cid:7)E/(cid:7)(cid:5) (cid:4) 0, mit (cid:7)2E/(cid:7)(cid:5)(cid:7)D0 positive and growing larger as D0
approaches W from below. Das ist, all else equal, shareholder value falls with rising
nominal debt but rises as the standard deviation of the ªrm’s fundamental value
rises. The latter effect grows stronger as the nominal value of the ªrm’s debt rises to-
ward the ªrm’s fundamental value.

The above analysis is a ªxture in ªnance textbooks in the United States, Vereinigt
Kingdom, Kanada, Hongkong, and other countries that entrust corporate gover-
nance to shareholders or their professional ªduciaries. Jedoch, it must be turned
on its head to be applied to a country like Japan, if banks have a paramount
inºuence in the corporate governance of their client ªrms.

Suppose that a creditor-governed ªrm, initially worth W0, has a genuine growth op-
portunity: a project much more likely to increase the ªrm’s wealth by (cid:5) than to de-
crease it by that amount. The creditors see no immediate point in undertaking this
project because W0 currently exceeds D0, and they gain nothing if the ªrm’s value
rises by (cid:5). If the project does lower the ªrm’s worth to W0 (cid:2) (cid:5), the creditors get only
that amount, which is less than D0.

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Figur 3. Inefªciently conservative governance

Notiz: The contractual claimants, entrusted with corporate governance, rationally avoid undertaking a project that is most likely to add
to the ªrm’s current worth, W0, but that might subtract

stattdessen. They lose from any downside risk and have nothing to gain from upside

risk.

Figur 3 shows that the creditors’ claim, D, is not a simple option, but rather a com-
posite of a sure payment of D0 and a short position in a put option. A put option gives
its owner the right to sell a given underlying asset at a predetermined exercise price.
Taking a short position in a put option means being the party that stands ready to
buy the underlying asset on those terms. The creditors can be thought of as having a
sure claim of D0, represented by the horizontal line at D0, plus a short position in a
put option. This means that if the ªrm’s assets fall below D0, their claim becomes D0
less their obligations under that put option, which amount equals the value of the
ªrm’s assets. Mit anderen Worten, the creditors pay D0 to buy the ªrm’s assets, worth
W (cid:6) D0. This is represented by the hockey-stick-shaped line in the lower right quad-
rant of ªgure 3. When this and the horizontal line at D0 are added together, the re-
sult is the function D.

Standard option-pricing theory shows the value of a short position in a put option
to fall as the standard deviation of the value of its underlying asset rises—see any
standard reference on options, Zum Beispiel, Hull and White (1996). Daher, ªgure 3,
buttressed by more formal mathematical arguments in option-pricing theory, dem-
onstrates that creditors, entrusted with corporate governance, refuse to implement
economically efªcient growth opportunities.

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Purifying Japan’s Banks

More formally, the value of the creditors’ claims in a limited liability ªrm is

D (cid:1) D0 (cid:2) P(D0, (cid:5)),

(2)

Wo (cid:7)P/(cid:7)D0 (cid:4) 0 Und (cid:7)E/(cid:7)(cid:5) (cid:4) 0, mit (cid:7)2P/(cid:7)(cid:5)(cid:7)D0 positive and growing larger as D0
approaches W from below. Das ist, all else equal, the value of the creditors’ claims
rises with rising nominal debt and with the standard deviation of the ªrm’s funda-
mental value. The latter effect grows stronger as the nominal value of the ªrm’s debt
rises toward the ªrm’s fundamental value.

Natürlich, these are not the only problems that can arise from entrusting corporate
governance to either shareholders or creditors. Either can be incompetent or venal.
In beiden Fällen, powerful individuals can bend corporate policy to suit their own
wishes. But the problems outlined above are especially interesting because they
arise in otherwise well-governed ªrms. They result from fully rational and informed
behavior and often entail no violation of the law.

Endlich, these are microeconomic effects. Individual ªrms, endeavoring to reduce
risk, might not lead to low risks at the macroeconomic level. If low-risk investments
prevail throughout an industry, or even the whole corporate sector, productivity and
overall competitiveness can suffer. Other countries’ ªrms, investing in higher-risk
Projekte, can quickly outmatch competitors that play it “too safe.” This “fallacy of
composition in risks” means that low-risk microeconomic policies can put at risk the
competitive advantage of an industry, or even a nation.

4. The objective functions of large Japanese banks

Japanese banks hold both equity and debt claims on their client ªrms. This gives
them cause to value both the maximization of ªrm wealth, since this maximizes the
values of their shares in their client ªrms, and the curtailment of volatility in the
worth of their client ªrms’ assets, since this protects the value of their debt claims.

This means a Japanese bank’s situation is actually a composite of ªgures 2 Und 3.
Suppose the bank owns fraction (cid:8)
value of its total claim, as a function of the ªrm’s total worth, is V (cid:1) (cid:8)
D D,
where E and D are the values of the ªrm’s equity and debt, as shown in ªgures 1
durch 3. Figur 4 illustrates these relationships.

E of a ªrm’s equity and fraction (cid:8)

E E (cid:3) (cid:8)

D of its debt. Der

Whether Japanese banks act more like shareholders or more like creditors is an em-
pirical question that depends on the relative values of (cid:8)

E is near zero

E and (cid:8)

D. Wenn (cid:8)

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Figur 4. Main Japanese banks’ combination of stakes in their client ªrms

Notiz: Figure shows the value of a main bank’s claims on a claim ªrm, of whose equity, E, it owns fraction E, and of whose debt, D, Es
owns fraction D. The vertical axis gauges the value of each claim. The horizontal axis measures the fundamental value of the ªrm, its total
worth.

D near one, the bank is mainly a shareholder and can be expected to use its

Und (cid:8)
corporate-governance sway, obtained by holding (cid:8)
taking when the ªrm’s total worth, W, is not far above the face value of the ªrm’s
debts, D0. Natürlich, (cid:8)
corporate governance.

E must be large enough to give the bank a dominant voice in

E of the shares, to discourage risk

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E and (cid:8)

It is possible to estimate (cid:8)
D from readily available ªnancial data, and table 1
displays these estimates for 1985, a year prior to Japan’s most extreme bubble econ-
omy excesses and the subsequently stuttering economy. The average Japanese ªrm
Ist 4.23 percent owned by its main bank and owes 7.27 percent of its debt to its main
bank. The situation is slightly more lopsided for the median ªrm (4.48 Prozent
owned by its main bank and owing 11.30 percent of its debts to its main bank). Das
suggests that main banks should be two to three times more worried about their cli-
ent ªrms’ debt values as opposed to equity values.

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EE(D0, (cid:5)) (cid:3) (cid:8)

DD0 (cid:2) (cid:8)
V (cid:1) (cid:8)
V (cid:1) 0.113 D0 (cid:3) 0.0448 E(D0, (cid:5)) (cid:2) 0.113 P(D0, (cid:5)) .

DP(D0, (cid:5))

(3)

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Purifying Japan’s Banks

Tisch 1. Debt and equity stakes of Japan’s main banks in their client firms

Main banks’ equity as a percentage of total firm equity

Main banks’ debt as a percentage of total firm debt

(cid:8)

E
(cid:8)

Main banks’ equity as a percentage of claims

Main banks’ debt as a percentage of claims

(cid:10)
E
(cid:10)

Quelle: Data are from Morck, Nakamura, and Shivdasani (2000).

Mean

4.23

7.27

17.40

82.60

Erste
quartile

Median

Dritte
quartile

3.10

3.56

5.60

77.50

4.48

11.30

88.70

9.64

22.50

94.40

Notiz: The debt stakes of Japan’s main banks are much larger than their equity stakes in their client firms, both as percentages of the cli-

ent firms’ outstanding debt and equity and as fractions of the sum of the main banks’ debt and equity holdings. The sample is 322 groß

Japanese firms in 1985. Equity is estimated as the market value of equity in 1983, before the onset of the bubble economy, and is ad-

justed using subsequent years’ net retained earnings to provide a 1985 estimate. Debt is taken at book value.

We argued that a main bank’s preferences as to the level of risk in its client ªrms’
strategies depend on the relative values of (cid:8)
ªrm’s equity and debt, jeweils. This can now be made more precise. Taking
Black-Scholes pricing as an approximation for valuing the options in equation (3)
provides a functional form for equations (1) Und (2) and thus for equation (3).4

D, its proportional stakes in the

E and (cid:8)

E (cid:1) W(cid:9)(d1) (cid:2) D0e(cid:2)rt(cid:9)(d2) ,
P (cid:1) D0e(cid:2)rt(cid:9)((cid:2)d2) (cid:2) W(cid:9)((cid:2)d1) ,

(4)

ln(

W D
/

)
S

R
(

2
S

T
)

1
2

Und

ln(

W D
/

)
S

−

R
(

2
S

T
)

1
2

(5)

where r is the interest rate, t is the time until the ªrm’s debt is due, Und (cid:5) is the stan-
dard deviation of the rate of increase in the ªrm’s fundamental value. Given this,
equation (3) becomes

V (cid:1) (cid:8)
V (cid:1) (cid:8)

E[W(cid:9)(d1) (cid:2) D0e(cid:2)rt(cid:9)(d2)] (cid:3) (cid:8)
D)W(cid:9)(d1) (cid:2) ((cid:8)
DW (cid:3) ((cid:8)

(cid:2) (cid:8)

D)D0e(cid:2)rt(cid:9)(d2) .

DD0e(cid:2)rt (cid:2) (cid:8)

D[D0e(cid:2)rt(cid:9)((cid:2)d2) (cid:2) W(cid:9)((cid:2)d1)]

(6)

4 The Black-Scholes approach to option pricing is not necessarily valid here, especially as re-

gards the put option. This is because the approach ignores the possibility of early exercise of
the option. Das ist, it assumes that the ªrm’s debts are all pure discount bonds or loans, mit
no coupon or periodic interest payments. Default can occur at the maturity of the debt agree-
gen, but never before. This is clearly not realistic; Jedoch, the simpliªcation does not af-
fect the relationship between (cid:5) and the value of the main bank’s claims. It is also assumed
that all the ªrm’s debts come due at once. If the ªrm has different debt contracts with differ-
ent maturities, the algebra grows more complicated, but the basic intuition remains.

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Purifying Japan’s Banks

By substituting equation (5) into equation (6) and differentiating, it can be shown
Das

sign

(cid:7)
V⎡
⎣⎢
(cid:7)(cid:5)

⎤
⎦⎥

(cid:1) sign [(cid:8)
E

(cid:2) (cid:8)

D] .

(7)

Das ist, Japanese banks prefer, all else equal, that their client ªrms minimize the risk
in their fundamental values if (cid:8)
D. This condition holds for the typical Japanese
borrower ªrm—indeed, it holds for about 61 percent of our sample client ªrms for
main banks’ debt and equity stakes. This rises to 74 percent when we aggregate all
banks’ debt and equity stakes in each borrower ªrm.

(cid:6) (cid:8)

A more natural way to express Japanese banks’ overall attitude toward risk taking
by their client ªrms is to sum the value of the main bank’s debt and equity claims in
each client ªrm and then to ask what fraction of this total reºects equity as opposed
to creditor interest. This is done in the lower panel of table 1. The average bank has
4.75 times as much tied up in loans to its client ªrms as in equity holdings. For the
median ªrm, the ratio is nearly eight times as much debt as equity interest.

The statistics in table 1 probably understate the lopsided nature of Japanese banks’
ªnancial relations with their client ªrms. Hoshi, Kashyap, and Scharfstein (1990,
1991) argue that Japanese ªrms’ main banks, their largest lenders, often offer im-
plicit guarantees to other banks that lend to their client ªrms, and even to bond-
Inhaber. This greatly magniªes the banks’ vulnerability to their client ªrms’ insol-
vency. Zum Beispiel, if we take (cid:8)
E as the main bank’s equity stake in a given client
ªrm and (cid:8)
D as all its debts to banks, equation (7) holds for less than 16 percent of
our sample. Japanese banks are not thought to offer any comparable implicit prom-
ise to augment, or even safeguard, the values of other equity block holders’ invest-
gen.

Japanese main banks, despite owning equity, are likely to use what corporate gover-
nance suasion they have to protect the value of their claims as creditors. Their inter-
est in their equity holdings is clearly secondary.

That Japanese banks affect the governance of their client ªrms seems well docu-
mented in the literature. Kaplan and Minton (1994), Morck and Nakamura (1999),
and others show that bankers are inserted into the boards of borrower ªrms whose
performance sags, das ist, whose W falls toward their D0. It is far from clear that this
inºuence is to the long-run advantage of shareholders, for Morck, Nakamura, Und
Shivdasani (2000) show that larger bank equity holdings are actually associated
with lower Tobin’s average q ratios, although the authors also detect a signiªcant

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Figur 5. Main Japanese banks’ ownership and shareholder value, prebubble

Notiz: In 1986, the shareholder value of a typical Japanese ªrm falls with the ownership stake of its main bank at low levels of main bank

ownership but rises with the ownership stake of its main bank at higher levels of main bank ownership. Shareholder value is measured as

Tobin’s average q, adjusted for real estate and cross-holdings price inºation.

nonlinear trend. If the bank’s equity stake is very large, banks’ shareholdings do be-
come positively related to ªrm valuation. Figur 5 summarizes Morck and col-
leagues’ main result.

Most large Japanese ªrms fall on the left side of ªgure 5. Morck, Nakamura, Und
Shivdasani (2000) report that main bank ownership averages 3.59 Prozent, with a
standard deviation of 2.22 Prozent. These statistics, Jedoch, come from a distribu-
tion with a very thin right tail. Although the median of the distribution is 4.18 pro-
cent, the 75th percentile is 4.99 Prozent. Very few Japanese ªrms have main bank
block holdings larger than 5 Prozent. Japanese banks were historically permitted to
hold blocks of their client ªrms’ stock as large as 10 Prozent. But the 1977 Anti-
Monopoly Act required all banks to reduce their ownership positions to 5 percent or
less by 1 April 1987. Most Japanese banks had already complied by 1986. Conse-
quently, ªgure 5 primarily indicates a negative relationship between main bank
share ownership and ªrm value.

This is consistent with Japanese banks’ using the governance voice their equity
stakes provide primarily to lobby for policies that limit risk taking even though
these policies maximize neither shareholder value nor overall ªrm value (Hanazaki

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Purifying Japan’s Banks

and Horiuchi 2000, 2001, 2003). Reverse causality is unlikely, for when Morck,
Nakamura, and Shivdasani (2000) repeat their analysis using 1975 main bank own-
ership to predict 1985 average q ratios, they obtain similar results.

McGuire (2002) reports that the sensitivity of capital investment to q ratios is less for
Japanese ªrms more dependent on bank ªnancing. This is consistent with gover-
nance in these ªrms having goals other than shareholder value maximization, welche
would manifest in high q ratios.

Japanese banks’ involvement in their client ªrms’ corporate governance need not be
entirely inimical to shareholder value. Morck and Nakamura (1999), again looking
at 1980s data, ªnd that troubled horizontal keiretsu ªrms’ share prices rise signiª-
cantly when bankers join their boards. This is consistent with their banks’ having at
least some concern for shareholder value. Jedoch, they ªnd an insigniªcant de-
cline in the values of troubled client ªrms not in horizontal keiretsu when bankers
join their boards. This is consistent with horizontal keiretsu member ªrms’ having
main bank equity block holdings toward the right in ªgure 5 and highlights the dual
incentives under which such banks operate.

Morck, Nakamura, and Shivdasani (2000) delve further into the inºuence banks ex-
ert on the governance of their client ªrms. They discover that higher levels of main
bank ownership are associated with higher property, plant, and equipment spend-
ing. This might be consistent with main banks’ encouraging their client ªrms to in-
vest overly heavily in collateralizable assets, rather than intangibles such as technol-
ogy or improved ºexibility, even when investment in intangibles would add more to
ªrm value (Hanazaki and Horiuchi 2000, 2001, 2003). Bedauerlicherweise, Morck,
Nakamura, and Shivdasani (2000) do not directly test for a link between bank voice
in governance and risk taking.

5. Macroeconomic effects of microeconomic risk avoidance

Society as a whole might prefer ªrms to adopt strategies that are either more or less
risky than would maximize shareholder value or ªrm value. Economists usually
think of social welfare as a trade-off between economic efªciency and equality; Das
might reºect debates between liberals and socialists within the profession. A trade-
off of growth against stability might better reºect the polities of many countries,
which often contain liberal and conservative parties. Jedoch, we argue that this
cannot be pressed too far in a globalized economy. If domestic ªrms avoid risk too
thoroughly, they risk falling behind their foreign competitors in productivity growth
and putting their country’s living standard at risk. To see the intuition behind this,

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consider a good produced by both Japan and the rest of the world. If risk taking
were to raise the productivity of foreign producers, Japanese ªrms would have to
sell their output at a lower price to remain competitive. This would require paying
their workers less through lower domestic wages. A depreciating exchange rate
would also work, but that too would reduce domestic living standards by making
imports costlier. Zusamenfassend, excessive microeconomic risk avoidance can create macro-
economic risk as the economy is forced to adjust to reduced competitive strength.

Corporate sector employees’ claims against ªrms are quite similar to those of credi-
tors. Employees, like banks and bondholders, have contractual claims against ªrms
and share little of the upside or downside risk in their ªrms’ operations. Faleye,
Mehrotra, and Morck (2005) examine U.S. ªrms in which employee-controlled in-
vestment funds have equity stakes greater than 5 percent and in which no other
blockholder has a larger share. These ªrms have depressed values and follow decid-
edly lower-risk strategies than otherwise comparable control ªrms with no em-
ployee voice in corporate governance.

Assigning corporate governance powers to either shareholders or creditors might
actually let a country adjust corporate governance to reºect the risk tolerance of its
Menschen. Roe (2002) Und, more explicitly, Claessens and Klapper (2002) propose pre-
cisely such a policy choice. From the late 1940s through the 1960s, the Japanese peo-
Bitte, who were recovering from earthquakes, depressions, fascism, nuclear war, Und
defeat, were probably especially risk-averse. Unsurprisingly, that is when Japan’s
main banks and keiretsu assumed their now-familiar economic roles. Giving credi-
tors a role in corporate governance may not have reºected a deliberate policy objec-
tive of corporate governance that avoided risk taking, but the result was probably
not unpopular with Japanese politicians and voters at the time.

Blending “catch-up” growth with job stability might be a politically appealing insti-
tutional framework for many countries in the current-day developing world, even if
it necessitates further institutional changes as these countries draw abreast of those
in the developed world. Western institutions cannot be transplanted piecemeal into
developing countries, and the same is surely true of Japan’s unique institutions.

Jedoch, there are pitfalls in this strategy. We have stressed a sort of fallacy of com-
Position. Banks, intent on promoting low-risk microeconomic corporate strategies,
might inadvertently undermine their client ªrms’ competitive advantage in the
global economy and thereby create macroeconomic problems, such as low produc-
tivity and slow growth. We believe this to be an important factor in Japan’s recent
macroeconomic stagnation.

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Other pitfalls also merit notice. Erste, banks’ interests, although concordant with em-
ployees’ interests as regards risk taking, might diverge in other dimensions. Zum Beispiel-
reichlich, once a client ªrm is in ªnancial distress, its creditors and employees compete
for recompense. Ogawa (2003) shows that ªnancially distressed Japanese ªrms shed
jobs in the 1990s, whereas Morck and Nakamura (1999) ªnd this only for ªrms out-
side ªnancial keiretsu in the 1980s. Prolonged ªnancial distress has perhaps made
banks less able to accommodate employees’ claims to retain popular support for the
banks’ voice in corporate governance.

Auch, Rajan (1992) argues that banks might “capture” their client ªrms. Unable to
switch banks without signaling problems with their credit, borrower ªrms might be
trapped into paying above-market interest rates. Consistent with this, Morck,
Nakamura, and Shivdasani (2000) ªnd that higher main bank ownership is associ-
ated with higher interest costs per yen of borrowings. Caves and Uekusa (1976) Auch
show that main banks charge their client ªrms higher-than-market interest rates,
with the premium proportional to main bank dependence in horizontal keiretsu
ªrms. Despite these higher costs, Nakatani (1984) shows horizontal keiretsu ªrms to
be more leveraged than other ªrms. Weinstein and Yafeh (1998) discuss how Japa-
nese banks might pressure ªrms whose governance they inºuence to borrow. All of
these results are consistent with main banks’ using the governance voice their eq-
uity holdings provide to direct their client ªrms to borrow more at higher interest
Tarife. This might be thought of as a form of tunneling, in which banks use their gov-
ernance inºuence to extract wealth from their client ªrms.

What gives bankers so much power? Certainly, ªrms became locked into ªnancing
arrangements with their main banks—switching to another could easily have been
perceived as abandonment by the ªrst, perhaps signaling concealed ªnancial trou-
ble. Certainly, client ªrms had few alternative sources of ªnancing, given the severe
constraints on corporate bond ºotation in postwar Japan. Certainly, bankers wielded
considerable political inºuence—probably explaining the constraints on corporate
bond ºotation. But another possibility, implied by John, Litov, and Yeung (2005), Ist
that client ªrm managers submitted to bank inºuence because doing so maximized
their utility too. John, Litov, and Yeung (2005) show using U.S. data that entrenched
top managers behave like contractual claimants. Like banks, they seek to avoid risk
to protect their claims on corporate resources.

This makes the fallacy of composition, alluded to above, even more plausible. Top
managers of the large ªrms in Japan’s great ªnancial keiretsu and their main banks
typically have rather short careers (Kaplan and Minton 1994; Morck and Nakamura
1999). This might induce a myopia problem. Even if corporate and bank top execu-

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tives understand that avoiding risk in the short term creates greater danger in the
long run, they may shun risk nonetheless if their career considerations depend only
on short-term outcomes. Bankers and corporate executives may decide to continue
eschewing risks as long as the long-term costs of this strategy fall due long after
their retirement dates. By the time those costs become imminent, it may be too late
for the cohort of bankers and corporate managers who take charge at that time to
take corrective actions.

6. Success sows seeds of failure

This issue of myopia is actually a broader and more general concern if bankers affect
their client ªrms’ governance. In providing a functional form to the values of the op-
tions implicit in Japanese banks’ claims against their client ªrms, equation (6) Re-
quires that we specify a maturity date for the client ªrms’ debts. This underscores
another signiªcant difference between shareholders’ and creditors’ claims. Share-
holders’ claims are of indeterminate horizon, for shareholders can be thought of as
valuing an option to buy free and clear ownership of the ªrm’s assets and the cash
ºows those assets generate over a theoretically inªnite horizon. Creditors’ claims, In
Kontrast, are risk-free payments at predetermined points in time, compromised by
the possibility that shareholders might leave creditors with the ªrm’s assets by exer-
cising their option to default. The major part of the creditors’ claims is thus short-
term claims. Folglich, creditors might be expected to use such governance
voice as their shareholdings provide to lobby for strategies beneªcial to the ªrms’
short-term prospects, despite those policies’ inºicting long-term disadvantages.5

Consistent with this, Morck and Nakamura (1999) show that bankers join their cli-
ent ªrms’ boards when those ªrms have shortfalls in current earnings or current
liquidity—among the shortest of short-term performance measures. Measures of longer-
term performance are distinctly less useful in predicting bankers’ joining boards and
thus presumably banks’ exercising of their corporate governance voices.

“Catching up” with the most advanced economies involves relatively capital-
intense corporate investments with relatively predictable cash ºows. Japan’s post-
war reconstruction and “catching up” in the subsequent decades involved using ex-
isting technology to produce copies of goods made elsewhere for sale both in Japan
and abroad. These sorts of investments are well suited to bank ªnancing. They in-

5 The actual situation is probably somewhat more complicated. Short-term bank loans contin-
uously rolled over de facto imply long-term put options with indeªnite maturity, implying
that the bank would limit risk taking over the longer term.

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volve investment primarily in property, plant, und Ausrüstung (collateralizable as-
sets) and generate predictable returns suitable for funding interest payments. In einem (n
economy predominated by such investments, banks’ focus on generating short-term
cash ºows might incidentally generate high growth and rising standards of living.
Creditor myopia would not only stabilize the economy but also direct capital to
where it is needed to “catch up” fast.

Natürlich, fundamental asset values occasionally fall below nominal debts owed,
despite ªrms’ following fairly low-risk policies. Hoshi, Kashyap, and Scharfstein
(1990, 1991) and others show that main banks often orchestrate bailouts of their dis-
tressed client ªrms in such circumstances. This often involves directing other client
ªrms to buy equity in the distressed client. This might explain the positive stock
price reaction Morck and Nakamura (1999) report around bankers’ joining their cli-
ent ªrms boards, although this interpretation suggests that ªrms whose governance
is inºuenced by their main banks, and who consequently participate in such bail-
outs, should report correspondingly reduced performance.

Hoshi, Kashyap, and Scharfstein (1990) suggest that Japanese main banks orches-
trate such bailouts because they make implicit promises to “insure” their client
ªrms’ debts. Das ist, main banks are vulnerable not only to put options from share-
Inhaber, but also to other put options from other creditors. This effectively raises the
effective value of (cid:8)
D above the main bank’s explicit share of the ªrm’s debts, aggra-
vating the imbalance referred to above.

A more profound myopia, alluded to above, plausibly afºicts the top executives of
the main banks. These executives often come to top positions near the ends of their
careers and retire soon after taking charge. If they can delay the realization of prob-
lems at their client ªrms even a few years, they can bequeath their problems to their
successors (Hanazaki and Horiuchi 2000, 2001, 2003).

None of this need pose serious problems to the economy as long as an abundance of
value-creating investments remains. The costs of bailouts to stabilize troubled client
ªrms can be spread across ªnancially sounder client ªrms and ultimately recouped
through further proªtable, low-risk investments.

Jedoch, Aghion and Howitt (1992), Aghion, Howitt, and Mayer-Foulkes (2005),
Fogel, Morck, and Yeung (2005), and others argue that the investments underlying
“catch-up” growth and those required to “keep up” are fundamentally different.
Keeping up with other rich countries requires risk taking—investing in unproven
technologies and uncertain ventures. It also requires investing in intangibles, solch

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as research, process development, and productivity enhancement. All of this re-
quires a degree of instability, for Fogel, Morck, and Yeung (2005) link more extensive
turnover in countries’ ranks of top corporations with faster productivity growth in
high-income countries, but not low-income countries. Auch, John, Litov, and Yeung
(2005) and Faleye, Mehrotra, and Morck (2005) link low corporate risk-taking with
both low productivity growth and low per capita GDP growth.

Japanese ªrms are clearly capable of undertaking risky investments. Sony, Toyota,
and Honda lead the world in their respective industries precisely because of their
skill in choosing such investments. But these ªrms are unusual in Japan for their re-
moteness from major banks and their strictly limited use of debt ªnancing. All three
were clearly governed through recent decades by entrepreneurial shareholders who,
except in the case of Toyota, were their ªrms’ founders. Such exceptions prove the
rule that giving banks a dominant voice in corporate governance mixes poorly with
entrepreneurial risk-taking. Figur 6 shows that Japan drew abreast of the other six
countries in the G7 group of leading industrialized nations and then surpassed them
in per capita GDP, evaluated at purchasing-power parity, In 1990. The ªgure also
shows that this year marked the implosion of Japan’s bubble economy. The argu-
ments above suggest that this is no coincidence.

As Japan drew abreast of the world’s richest economies in the late 1980s, “catch-up”
investments ran out. Japanese ªrms could no longer grow through low-risk ªxed-
capital-intensive investments. Yet the governance structures of most large Japanese
ªrms, still entrusting a commanding voice to banks, encouraged just such invest-
gen. Though these traditional investments no longer paid off as before, diese
ªrms’ managers continued pouring capital into those investments as their bankers
nodded assent. Japanese industries that had prospered almost continually as the
country caught up now found themselves in increasingly dire straits. Wert-
destroying investments depressed the fundamental values of many ªrms toward the
nominal values of their debts. As W fell toward D0, banks would have grown in-
creasingly nervous about risk taking, using their governance voices to minimize the
put option implicit in their claims by preventing radical restructuring or dramatic
strategy shifts. Das, Natürlich, only further misallocated capital.

Japanese investors, accustomed to an abundance of low-risk but ªnancially sound
investments, continued to save at a high rate and to entrust their savings to the do-
mestic ªnancial system. The stock market and real estate bubbles that ensued, as in-
vestment managers sought uses within their traditional bounds for the funds at
their command, follow the classic pattern described by Kindelberger (1978) and are
discussed in Goyal and Yamada (2004) and elsewhere. Goyal and Yamada (2004) In

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Figur 6. Japan catches up with the West

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Purifying Japan’s Banks

particular show that effervescent share prices probably induced further misallo-
cation of capital during the bubble years, for they show substantial equity and con-
vertible debt issues corresponding to likely windows of share price excesses. Daher,
years of avoiding microeconomic risks triggered macroeconomic instability and
then a macroeconomic crisis.

7. Japan’s banks need puriªcation, not just cleansing

Friedman and Schwarz (1963), in their A Monetary History of the United States, 1867–
1960, contrast that country’s fragmented banks with Canada’s much larger, geo-
graphically and industrially diversiªed multibranch banks. They note that, while
waves of bank failures paralyzed the American ªnancial system during the Great
Depression of the 1930s, no single Canadian bank of any importance failed during
that decade. This has become a traditional argument among American students of
bank ªnance for multibranch banks, interstate banking, and the internationalization
of banking.

Jedoch, Kryzanowski and Roberts (1993) suggest a different lesson. They examine
Canadian archival ªles and show that all major Canadian banks were legally insol-
vent during the Great Depression. With the blessing of the Canadian government,
the banks simply ignored their insolvency and continued as if nothing were wrong.
Canada emerged from the depression with all its major banks intact and enjoyed
several decades of almost continual high growth thereafter. Perhaps one sensible
way to deal with a banking crisis is simply to pretend that it does not exist until it
goes away!

The Japanese government has tried this “Canadian cure” for over a decade now, Aber
another high-growth period has not materialized. There are several reasons for
doubting that the Canadian approach can work in Japan. Erste, the Great Depression
was almost certainly primarily exogenous to Canada.6 Trade barriers erected by
American protectionists were undoubtedly a proximate cause of corporate and in-
dustry collapses across the country, though speculative excesses in the 1920s bull
market clearly led to excess capacity in some industries, such as paper production.
The Canadian government’s mercantilist approach to combating deºation—the
mandatory cartelization of every industry in the country—also probably made
things worse. But Canada’s banks owned no block holdings in their client ªrms.
They were purely creditors but had no governance voice of any volume until their
client ªrms actually defaulted, either formally or informally, whereupon the banks

6 The following is summarized from Bliss (1987).

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organized speedy liquidations. Canadian banks had no power to press their solvent
client ªrms to eschew risk or over-invest in collateralizable assets.

Japan’s ongoing economic problems, in contrast to Canada’s situation in the Great
Depression, are most probably endogenous. No foreign inºuences, such as trade
barriers or a worldwide ªnancial crisis, can be identiªed as proximate triggers of the
1990 stock and real estate price collapses and ensuing banking crisis. Eher, the ar-
guments above suggest that the corporate governance voice Japan’s main banks had
previously used to inºuence the governance of many of the country’s great ªrms
was increasingly off-key.

Bailouts of some of a bank’s client ªrms could no longer be ªnanced by other client
ªrms, for too many had projects that turned out to be unproªtable. Yet Hamao, Mei,
and Xu (2003) show that banks continued their past policies of bailing out troubled
client ªrms, especially those in horizontal keiretsu. Peek and Rosengren (2003) pro-
suasively argue that Japan’s banking regulations also encouraged such bailouts by
promoting the evergreening of bad corporate loans but ªnd this especially true for
ªrms in horizontal keiretsu. If Hoshi, Kashyap, and Scharfstein (1990) are correct that
main banks implicitly guarantee their client ªrms’ debts to other creditors, main
banks’ implicit put options would be most dangerous in those ªrms, perhaps ex-
plaining this favoritism in forbearance. Neither did banks’ and ªrms’ attempts to
compensate with investments in stocks and real estate pay off. The central problem,
the increasing divergence of banks’ natural interests in corporate governance from
the corporate strategies needed for continued economic growth, requires a different
approach to “cleaning up” the banking system.

The Japanese bank regulators have orchestrated a series of mergers and other stabi-
lization programs, discussed by Hoshi and Kashyap (2004) and others. The banks’
major insolvent client ªrms can be reorganized or liquidated as Japanese laws and
regulations dictate. Jedoch, a “cleansing recession” of the sort described by Cabal-
lero and Hammour (1994) does not seem to have taken place. Hamao, Mei, and Xu
(2003) ªnd that the share prices of horizontal keiretsu display little of the idiosyn-
cratic volatility that such a re-sorting of ªrms would probably imply.

Stattdessen, Hoshi and Kashyap (2004) argue that continued weakness in Japan’s banks
and in their major client ªrms creates a self-reinforcing feedback, prolonging
ªnancial weakness. They argue that the continued access of many Japanese bor-
rower ªrms to bank credit is a sign of this continued weakness, not of an underlying
strength in the banking system. They assert that the banks’ continued attempts to
prop up their most important client ªrms and constrain their liabilities from their

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put options, shown in ªgure 3, leave the economy anematized by legions of “zom-
bie ªrms.” This leads to a productivity growth collapse without a credit crunch. Ja-
pan’s antirecessionary monetary and ªscal policies of low interest rates and expan-
sive deªcit spending exacerbate this problem by transfusing more funds into
zombie ªrms.

Hoshi and Kashyap (2004) argue convincingly that various aspects of Japan’s bank-
ing regulations encourage banks to sustain zombie client ªrms. This seems likely,
but the banks’ actual ability to sustain these ªrms for so long is remarkable. Der
number of perambulating zombie ªrms, some apparently sustained for well over a
decade by special access to bank capital, suggests that banks had substantial
ªnancial market power. Ansonsten, it is hard to see how better-managed banks
could have been restrained from driving out worse-managed ones.7

These arguments perhaps explain why Japan’s bank regulators are considering both
increasing competition in banking and muting banks’ voices in their solvent client
ªrms’ governance. Truly cleaning up Japan’s banks requires more than just eliminat-
ing the current crop of zombie ªrms by revising the rules under which banks calcu-
late capital adequacy requirements and dispose of nonperforming loans. The banks’
voice in corporate governance no longer accords with the needs of an economy as
advanced as Japan has become. A hermetic seal preventing further bank inºuence
over the corporate governance of solvent Japanese ªrms is in order. Japan’s banks
need to be pure banks—they can no longer moonlight as guardians of corporate
governance, for they are no longer qualiªed for what that job has become. The bank-
ing system needs to be puriªed, not just cleaned up.

The forceful voice that Japan’s system of corporate governance accorded its major
banks encourages a degree of risk avoidance inimical to entrepreneurial success, A
bias toward investments in tangible, collateralizable assets that leaves innovation
underfunded, and a bias toward short-term investments and short-term solutions to
ªnancial problems.

One option for institutional reform is to revisit the Anglo-American system of share-
holder primacy in corporate governance that was foisted upon Japan by the Ameri-
can occupation authorities in the immediate postwar period. John, Litov, and Yeung
(2005) link stronger protection for shareholder rights to greater corporate risk
taking. Claessens and Klapper (2003) report higher bankruptcy rates in market-

7 Capital market power is not unique to Japan. It seems to be commonplace in developed and

developing countries (sehen, z.B., Morck, Stangeland, and Yeung 2000; Rajan and Zingales 2003;
Morck, Wolfenzon, and Yeung 2005).

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oriented economies, suggesting that shareholder primacy in corporate governance
permits more risk taking. But Japanese corporate executives and bankers found that
system distasteful in the 1950s and early 1960s and actively undermined it. Perhaps
tastes have changed.

But Anglo-American shareholder primacy is clearly not the only option. Other
countries that grant banks loud voices in corporate governance, such as Germany,
confront analogous problems. Germany’s handful of major banks control most
large ªrms’ shareholder meetings through their proxy voting powers. Germany’s
largest ªrms have held to tried-and-true techniques and done acceptably well for
decades.

Fohlin (2005) argues that, in Germany, family-controlled ªrms are much more im-
portant, and banks are less important, than generally realized. Family control also
entails governance problems, but the controlling family (unlike a creditor) beneªts
primarily from raising the share price and so tolerates a degree of risk a bank would
prefer to avoid. Kleeberg (1987), Fohlin (2005), and others argue that banks’ role in
the governance of large German ªrms was not always beneªcial, or even benign.
Franzke, Grobs, and Laux (2001) argue that banks actively subverted ªnancial de-
velopment in Germany. Zum Beispiel, they argue that the paucity of initial public of-
ferings in Germany in part reºects banks’ lobbying of stock exchanges to prevent
the rise of competitors to their existing client ªrms.

La Porta et al. (1999) show that family-controlled corporate groups, similar to Ja-
pan’s great prewar zaibatsu, remain the predominant form of corporate organization
in most countries at all stages of economic development. Morck, Stangeland, Und
Yeung (2000) argue that these structures are vulnerable to a range of corporate gov-
ernance problems and that such problems may sometimes reach macroeconomic
proportions. Morck, Wolfenzon, and Yeung (2005) present a survey of the microeco-
nomic and macroeconomic resource allocation problems inherent in concentrated
control of a country’s corporate sector in modern countries with zaibatsu-like corpo-
rate governance arrangements.

Japan need not follow the Anglo-American model of large, widely held ªrms whose
controversially highly paid managers are disciplined by equally controversial corpo-
rate raiders and activist pension funds. Family ªrms might do the trick. But modern
Japan is an intensely egalitarian society (Kitamura, Suto, and Teranishi 2004). Der
inequality in economic power inherent in a Western European–style economy of
old-money family corporate empires might arouse unacceptable memories of the
prewar zaibatsu, which were organized along those lines.

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Japan’s past success at domesticating foreign institutions makes it likely that Japan
will ªnd its own solution. Perhaps a Japanese system of widely held ªrms with
modestly paid professional managers disciplined by equally modestly paid pension
fund managers might emerge as another Japanese model for other nations. It is too
soon to tell.

8. Conclusions

Japan is justly seen as a role model for other countries. It is the ªrst large country
outside the Western world to join the ranks of the world’s richest countries. The in-
stitutional development that let it do so is unique in the world and worthy of study
for purely academic reasons as well as practical ones.

We argue that the institutional innovations normally associated with Japan—its cor-
porations’ heavy reliance on bank ªnancing and its great banks’ involvement in
their client ªrms’ corporate governance—probably were important to the country’s
rapid postwar reconstruction in the mid-20th century and to its rapid economic as-
cent in the 1970s and 1980s. “Catching up” entailed large-scale low-risk investment
in physical assets—precisely the sorts of investments best suited to bank ªnancing.

Other countries in similar situations can learn from the Japanese experience. Coun-
tries recovering from wars, natural disasters, or other calamities that need to rebuild
physical assets quickly should consider bank-centered governance and bank
ªnancing. Perhaps decades of totalitarian socialism count as this type of calamity as
well, and transition economies might proªt from the Japanese model. An important
caveat remains, obwohl, for Japan had already experienced high-growth periods and
had a modern corporate sector prior to World War II. It clearly developed a range of
institutions capable of sustaining a modern economy in the late 19th and early 20th
centuries. Transition economies may well need those earlier institutions as well to
follow the Japanese example.

Jedoch, the Japanese postwar experience is perhaps of more value as a negative
example to countries in other situations. Certainly, many in 21st-century Japan no
longer ªnd its postwar system adequate and seem likely to move on to governance
models that entrust less power to banks (Hanazaki and Horiuchi 2000, 2001, 2003).
We have presented detailed explanations about why banks are ill-equipped either to
ªnance or to monitor the governance of ªrms whose assets are largely intangibles—
Ideen, Software, and the like. In der Tat, we have explained how banks are likely to try
to avoid risks of the sort they normally avoid, and in doing so, misdirect capital in
ways that undermine the macroeconomy and ultimately the stability of the banking
System selbst.

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If Japan’s postwar experience is of limited value to developed economies, what of
emerging markets? Most developing economies are not reconstructing the physical
infrastructure of their corporate sectors, but rather trying to develop modern econo-
mies for the ªrst time. Japan’s initial high-growth phase, prior to World War I, oc-
curred under markedly different institutions from those prevailing after World
War II. That earlier period might be a more valuable source of inspiration to policy-
makers in emerging economies seeking a Japanese model. Trotzdem, Japan’s lost decade
serves as a warning to other countries about the loss in economic versatility and
agility that bank-centered governance models can induce if they become overly en-
trenched.

This is no criticism of Japan. Every extant corporate governance system has prob-
lems. The dot.com bubble in the United States shows that that country’s stock mar-
ket-based system has its own set of problems. The weakness or, in some occasions,
the outright absence of high-tech sectors in many European countries demonstrates
that the zaibatsu-like systems still commonplace there fare perhaps even worse. Als
developed nations everywhere, including Japan, move forward with further institu-
tional reforms and experiments, it seems unlikely that future developments will
give banks the sorts of power they wielded in postwar Japan.

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