The J-System (Part One) - Main Bank

Introduction

Japan's economic performance after WW II till 1990 was exceptional. As measured by per Capita GNP and net holdings of foreign assets, in only three short decades, Japan managed to rise from a country decimated by a world war to arguably the wealthiest nation on earth.

In 1988, the Japanese economy was nine times larger than in 1955. During the same period, the United States’ economy had grown only about 2.5 times. Per capita GDP, de-nominated in U.S. dollars at the market exchange rate, had overtaken that of the United States by the late 1980s.  (Ito)

Especially the high-growth era between 1950 and 1973 had stunned many Japan observers. During that time Japan’s real GNP growth rate averaged more than ten percent per year. The high growth phenomenon was partly explained by Japan's quick recovery of the productive potential that had been destroyed during World War II. However, already in the 1960`s Japan surpassed its prewar potential trend and the economy kept on growing rapidly throughout that decade and into the beginning of the 1970s. The growth trend of the 1960's slowed abruptly after the first oil crisis in 1973-74, still the annual growth rate over 1975-90 was roughly half of that achieved in the previous two decades, it still exceeded 4 percent. (Ito)

The period was dubbed the "Japanese Miracle", whereby this terminology stems from the fact that economists, using a Solow growth model that analyzes total factor productivity, could not explain the large "Solow residuals" that they found.  (Ito)

The "Solow Residual" inspired a flurry of literature devoted to unraveling the factors behind Japan’s economic success. More and more a broad consensus emerged in academia, that Japan’s unique form of corporate governance, known as the main bank model, was a driving force behind its economic growth and a significant contributor to its competitive advantage over the United States.

Three fundamental elements to the Japanese main bank model exist:

• Strong long-term relationships between specific banks and specific firms

• A Keiretsu corporate structure

• Lifetime employment

The Main Bank

During the "Japanese Miracle" strong, long-term relationships between banks and firms were often cited as a source of the strength and efficiency in the Japanese economy.

During the high growth area of Japan, the stock and corporate bond markets were severely restrained by laws and regulations. Regulated interest rates more closely tracked market rates in Japan and regulation made the bond market a less cost-effective source of funds. Thus, firms in Japan were given more incentive to avoid market financing and rather use bank financing. (Ramseyer).

Corporate financing took place mainly through 20 banks. Those banks intermediated household saving and provided long-term as well as short-term funds to corporate Japan.  (Puchniak)

But Japanese banks are not simple intermediaries. They rather play a much broader role than that of lenders with monopoly power. Although Japanese companies usually borrow from many banks, they often have a special relationship with only one bank. That bank, in the great majority of cases, not only provides loans to a firm, but also holds a substantial share ownership at the same time. Thus, a firm developed a relationship with a particular financial institution and banks on its steady support in funding over the long term. In return, the firm uses the bank for major transactions from which the bank earns fees and profits. This type of primary relationship of a bank with a firm is called a main bank. (Ito)

As the main banks hold the major payment settlement accounts, and are both the largest single lenders and a principal shareholders of the company, with at least one board seat, main banks are believed to be the central repository of accurate real time information about corporations’ financial health and business ventures. (Puchniak)

The conventional view of the main bank advocates is that this main bank system contributes to the efficiency of the Japanese financial markets by solving the principle- agent problem and problem of asymmetric information with minimal friction costs. Information asymmetries and principle-agent problems are inherent in the separation of ownership and management. On the one hand because management of a firm possesses a wealth of "insider information", that is not readily available to the owners or creditors of a company. On the other hand because individual stock- or bondholders do not monitor management effectively. Furthermore, it was believed that in Japan institutional investors did not possess of and did not exercise the kind of monitoring and influencing power that investors had in the United States. (Ito)

Main bank theorist claim that, given that the cost-effective level of monitoring generally depends on the amount of money lent, a main bank is obviously going to monitor more extensively and cost efficient than other shareholders and creditors. (Miwa and Ramseyer)

Thus, the main banks are viewed as agents for investors and lenders to the firm by examining the viability of investment projects and monitoring the performance of management (= delegated monitor). (Ito) In addition, because banks would waste resources if they redundantly monitored the same firm, the main bank of a company serves as the "exclusive" monitor for the Japanese banking system in aggregate. The other banks, who might also hold an interest in a particular company, implicitly (they make none of these deals explicitly, even orally) “delegate” that job to the main bank and then abandon any further monitoring efforts. (Miwas and Ramseyer)

Since the main bank holds both equities (unsecured) and loans (secured) it is believed that conflicts of interest between banks and other investors are mitigated in this system. In addition, because the bank is involved in the business by being represented on the board of directors, it can distinguish a temporary cash-flow problem from more serious situations involving fundamental business misjudgment or solvency issues in a timely manner. (Puchniak) (Ito)

Although the main bank does not overtly intervene with the management of firms in normal times, the control right is expected to shift to the main bank in a critical corporate-value state. (Aoki) It is believed that the main banks’ substantial debt and equity positions with the client companies give them the leverage to use their information to influence managerial decisions and, when necessary, replace senior management and placing more members of the bank on company boards, or even liquidate the company (=contingent governance). But one has to keep in mind that the main bank would be extremely cautious about closing down a failing business by calling in loans. Often, it would first send in an extra management team, even including a replacement for the president of the firm, if necessary. (Pushniak) (Aoki)

Often it is argued that the main bank’s implicit promise to seriously attempt to restructure underperforming clients in times of financial or managerial crisis, allowed Japanese companies to pursue long-term goals and invest in human capital, which gave Japanese companies a significant advantage over U.S companies with their tendency to short term thinking. Furthermore, this promise was credible because of the government’s implicit guarantee to prevent main bank failures (=no-fail policy/Convoy System). (Pushniak)

During the high growth area in Japan many pundits, also in the west, were convinced that monitoring by a bank was in fact the most efficient way in overcoming agency problems and mitigating the problem of information asymmetries, They saw the main bank system of corporate japan as a central component of Japan’s competitive advantage and outperformance over corporate America.

How time has changed!

Keiretsu - The J-System (Part Two) 

Lifetime Employment - The J-System (Part Three)

Source:

Masahiko Aoki;  Whither Japan’s Corporate Governance?; Rock Center for Corporate Governance Working Paper No. 29; July 2006

Yoshiro Miwa and J. Mark Ramseyer; THE MYTH OF THE MAIN BANK: JAPAN AND COMPARATIVE CORPORATE GOVERNANCE; Discussion Paper No. 333; 9/2001

TAKATOSHI ITO;  Japan and the Asian Economies: A "Miracle" in Transition;  Brookings Papers on Economic Activity; 1996

Dan W. Puchniak; The Efficiency of Friendliness: Japanese Corporate Governance Succeeds again without Hostile Takeovers; Berkeley Business Law Journal; Vol.5; Issue 2; September 2008

Mark Ramseyer; Explicit Reasons for Implicit Contracts: The Legal Logic to the Japanese Main Bank System; The Law School The University Of Chicago; August 1993

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