2002 Japan Conference: A Summary of the Papers

The severe economic crisis in Japan, associated with the collapse of the Japanese stock and real estate markets and the dramatic deterioration in the health of the Japanese banking sector, represents one of the major economic events of the late twentieth century. It is even more striking because the second largest economy in the world remained stagnant for more than a decade, and even today shows no evidence of returning to the robust health that characterized most of its postwar history. One potential source of difficulty in implementing major corporate restructuring has been the web of corporate affiliations that encourages lenders and affiliated companies to support firms that otherwise would have been restructured, sold, or liquidated. We show that a primary driver of lending to troubled firms has been the strength of corporate affiliations, and that lenders without such affiliations are much less inclined to allocate additional credit to deeply troubled firms. Further, as banking problems worsened in the latter half of the 1990s, evidence of lending in support of troubled affiliated firms became particularly evident.

Two forms of corporate affiliations that have distinguished Japanese bank-firm relationships are key contributors to the pattern of Japanese lenders supporting troubled firms. The first, the keiretsu, is characterized by firms having substantial cross-shareholding and extensive business ties, both explicit and implicit. The second is the "main bank system," in which a firm has a strong relationship with its primary bank (the main bank) and the main bank has extensive shareholdings in the client firm, serving as a major source of short- and long-term financing and, in many instances, having a representative on the firm's board of directors.

Previous work has documented the importance of Japanese corporate affiliations. Many of these studies highlight the potential beneficial effects of these corporate affiliations, including the ability to reduce agency costs, maintain greater bank debt, and avoid restructuring through costly bankruptcy proceedings. A less benign view of these corporate affiliations is that they subvert corporate governance, insulating firms from the discipline that otherwise would come from outside directors, shareholders, and creditors, resulting in suboptimal business and financial decisions. By comparing affiliated and nonaffiliated firms, previous studies have examined how corporate affiliations affect investment decisions, stock returns, and corporate governance decisions, but they have not directly examined how affiliations affect the allocation of credit.

This study uses a unique database that enables us to examine the patterns of firm borrowing from banks and nonbank financial firms to determine the extent to which such lending is affected by corporate affiliations, including the main bank and keiretsu relationships. Any influence of such corporate affiliations on the allocation of credit should be particularly apparent during times of economic stress, as has been the case in Japan with the continuing banking crisis and the inability of the macroeconomy to recover from the adverse shocks at the beginning of the 1990s.

Although strong corporate affiliations encouraged economic growth during the boom times, for example by making credit more available and investment less sensitive to internal cash flows, these same affiliations might inhibit an economic recovery when the economy needs major restructuring. Firms whose tradition is protecting employees and maintaining relationships with affiliated companies clearly benefit from a lender willing to provide more flexibility and support than would be available in a more market-driven credit allocation process. However, the reality of banks placing relationships ahead of sound business practices that rely on credit risk analysis has contributed significantly to the lending policies that have resulted in bank failures, massive loan charge-offs, and the substantial volume of problem loans still remaining on Japanese bank balance sheets. Such behavior was reinforced by the perceived national duty of banks to support troubled firms, especially in favored industries.

In Japan, bank regulation and supervision policies provide banks with significant nonperforming loans and impaired capital and present little incentive to be strict with troubled borrowers. In fact, it is in the self-interest of banks to follow a policy of forbearance with their problem borrowers just to avoid pressure to increase their own loan loss reserves, further impairing their capital. This in turn leads to a policy of banks "evergreening" loans: banks extend additional loans to troubled firms to enable them to make interest payments on outstanding loans and to avoid or delay bankruptcy. By keeping the loans current, the banks can make their reported balance sheets look better; the bank is not required to report such problem loans as nonperforming loans. Finally, faced with a growing budget deficit and a voting public weary of funding bank bailouts, the government may prefer banks to continue their policies of forbearance in order to avoid the alternative scenario of massive firm, and perhaps bank, failure-- and, in particular, the associated costs, both financial and political.

We investigate the impact of main bank and keiretsu affiliations on credit allocation during periods of firm and/or bank distress. Our goal is to determine the extent to which credit has been misallocated because of the pressures emanating from such corporate affiliations. We find strong evidence that main bank and keiretsu affiliations have affected the allocation of credit in Japan during the 1990s, when both firms and banks were severely troubled. However, rather than lenders exploiting their superior information about affiliated firms to make additional loans to those firms with the best prospects, they were more likely than nonaffiliated lenders to provide additional loans to the weakest firms. We find that corporate affiliations, both from main banks and strong keiretsu ties, increase the likelihood of a firm receiving additional financing as its health deteriorates. Furthermore, this perverse effect does not occur when the lender is a nonbank without keiretsu ties to the firm. In addition, our results indicate that banks have practiced the evergreening of loans, particularly to affiliated borrowers. It also appears that Japanese banks may have been responding to government pressure to avoid a credit crunch or a precipitous decline in economic activity by extending credit to troubled firms. By supporting the weakest firms rather than those with the best prospects, these lenders have misallocated credit.

While many Japanese firms have been insulated from market pressures by their strong relationships with affiliated lenders, this is not necessarily good news for the Japanese economy. Just as forbearance by bank regulators has allowed the banks to be slow to restructure, bank support for troubled and noncompetitive firms has prevented the needed restructuring of nonfinancial firms. If scarce credit is allocated to uncompetitive and troubled firms, then Japan will not experience the natural cleansing that results from a major restructuring which typically occurs in an economic downturn. This will inhibit the ability of the Japanese economy to recover from the current economic malaise, and will adversely affect the longer-run growth potential of the economy.