Xueping WU City University of Hong Kong Jun YAO The Hong Kong Polytechnic University

1. Understanding the Rise and Decline of the Japanese Main Bank System: The Changing Effects of Bank Rent Extraction Xueping WU City University of Hong Kong Jun YAO The Hong Kong Polytechnic University

2. The Bank-Based Financial System (Japan Model):From the bright side…. • Stable equity holdings in business firms • Strong influences on corporate finance and governance (Aoki, Patrick and Sheard, 1994)  To mitigate the classic agency conflicts (Prowse, 1990; Berglof and Perotti, 1994).  To relaxfinancial constraints (Hoshi, Kashyap and Scharfstein, 1990a, 1990b, 1991)  To help in financial difficulties (Kaplan and Minton, 1994; Kang and Shivdasani, 1997)  Reasons for Japan’s rapid economic growth and success in early postwar years

3. To the dark side: • More non-bank financing due to financial deregulation in the 1980s (Campbell and Hamao, 1994)

4. Theoretical basis? • Banks’ ex post rent extraction due to their information monopoly (Sharpe, 1990) • Underinvestment due to bank rent extraction if funding competition is absent (Rajan, 1992) • Overinvestment due to rent extraction plus main bank control (Weinstein and Yafeh, 1998)

5. Empirical evidence • Overinvestment, especially in keiretsu firms vs. non-keiretsu peers (Nakatani, 1984, Weinstein and Yafeh, 1998; Morck, Nakamura and Shivdasani, 2000;Wu and Xu, 2005). • Rent extraction: Firms with main bank relationships have lower profitability and growth but higher interest payment than their counterparts (Weinstein and Yafeh, 1998) • Large keiretsu firms are problematic in adding firm value (Wu, Sercu and Chen, 2000)

6. A direct challenge to the system: • Business firms with more bank borrowings in the late 1980s suffer more losses of their equity value (Kang and Stulz, 2000)  Kang and Stulz (2000): Is the main bank system worth it?

7. Relevant issues in a longer time span: • Why was the main bank system beneficial when the main banks were at their most powerful (in the 1950s, 1960s and 1970s)? • Why did it become a burden during the 1980s that coincides with financial deregulation? • Why did the banking system become so vulnerable to the adverse shock of the late 1980s equity market bubble burst?

8. Rajan’s (1992) suggestion: The deterioration in the credit rating in Japan may partly reflect the deterioration in control that accompanies the movement from a relationship-oriented system to a transactions-based competitive system, but statements on the efficiency implications of this phenomenon requires an examination of the accompanying effect on corporate investment.

9. Summary of our predictions: • Types of investment inefficiencies are flipped under main bank control and rent extraction (from under- to overinvestment). • But bank capital shortage constrains bank controlled overinvestment (in the 1950s, 1960s and 1970s). • Conversely, overinvestment looms large as bank capital starts to flood (in the 1980s). • Financial deregulation toward a more market-based system is well intended but hurts the bank fundamentally. • When control rights are returned to firms (due to the deregulation) and the equity market is opened up, firms are able to reach investment efficiency, but the “equity for growth and bank debt for downside risk” bias works against the bank. Downside Risk: Suffer great loss if fails. e.g., high-flying real estate projects and aggressive production expansions in maturing industries

10. Predictions: (Cont’d) 6. This bias gets stronger during the equity market boom because asymmetric information costs of equity get even lower than the agency costs of bank debt  Banks are likely to pile up bad debt following adverse shocks.  The equity market boom that accompanies the deterioration in bank control fundamentally increases bank risk.

11. The model setup • A three-date, two-period model • At t=0: A=assets-in-place (AIP), a=bank equity holdings (%) • At t= 1: An investment opportunity, requiring an input of capital, I. • Financed by either bank borrowing (D), or new equity (e), or both (I=D+e) • At t= 2, I generates a non-negative return, rH, in the good state, or, a non-positive return, rL, in the bad state (-1 ≤ rL ≤ 0 ≤ rH )

12. The model setup (Cont’d 1) • q=the prob. of the good state • Asymmetric info. structure at t=1: --Insiders (managers and the bank) know: A, I, q, (rL, rH),and m (=% rent extraction) --The market knows: A, I, m, (rL, rH), and uniformly distributed q over [ql, qu] (0<ql<qu<1). --The range [ql, qu] reflects the range of guesses by the market about the quality of the project given (rL, rH).

13. The model setup (Cont’d 2) • r = the perfect market interest rate for risky debt will be rationally determined • m=rent extraction in terms of a bank’s share of profits in the good state --Rent depends on both m and D.  e.g., Rent and debt income in the good state: mD(rH-r)+D(1+r) --Always solvent in the good state: A+I(1+rH) > I(1+r)

14. Investment Policy: Definition • Firm value maximization at t=1: (1) • Definition 1: An investment policy which accepts a project for rH>rH0 = f(rL) will be denoted as investment policy [rH0], in which rH0 is a function of rL. See John and John (1993) and John, John, and Saunders (1994)

15. First best investment • The investment policy (with a hurdle rate in terms of rH) that maximizes the firm’s value can be expressed as [rH*] where • Example: Project=[0.14, -0.2] and q=0.6 • The decision rule: (Accept the project!)

16. Figure 1: Investment Policies in Scenario I (only bank financing)

17. Scenario 1: Bank debt only (D=I) • Case 1: Firms’ (Shareholders’) objective: (2) Risky debt pricing: or: Note ru is interest rate ceiling.

18. Proposition 1: With bank financing only, the manager, on behalf of the shareholders, chooses the investment policy [rHe], in which

19. Corollary 1: With bank financing only, the manager, on behalf of the shareholders, implements a sub-optimal investment policy [rHe], in which rHe is higher than rH* if and rHe is lower than rH* if . Underinvestment “a” in Fig. 1: Due to rent extraction. Different from the debt overhang problem (due to old debt). Overinvestment “b” in Fig. 1: Given the government regulation with a ceiling on r, limited liability or risk shifting enables the shareholders to benefit from even a negative NPV project.

20. Case 2: Bank control in scenario 1 (D=I), • Main bank’s objective function: (1) a (%) of the firm’s equity or residual value, (2) debt income, and (3) info. rent. • (9)

21. Proposition 2: With bank financing only, the manager, on behalf of the bank, will choose the investment policy [rHb], in which

22. Corollary 2: With bank financing only, the manager, working on behalf of the bank, implements a suboptimal investment policy [rHb], in which rHb is lower than rH* if and rHb is higher than rH* if . • Overinvestment “c” in Fig. 1: bank’s stake gives insufficient incentive to restrain overinvestment as long as the bank’s marginal income from debt is greater than its equity loss caused by overinvestment. Underinvestment “d” in Fig 1: the interest rate ceiling prevents the bank from charging a higher market interest rate to factor in the higher risk.

23. Scenario 2:Bank control and new equity is allowed • A mix of debt (D) and new equity (e): I=D+e • Bank takes up some new shares to keep a stable share, a, of the firm’s equity: • The bank’s total NPV comes from its equity holdings, debt and rent extraction: (13) • A, I, a, m, andq are given. • r is determined under risky debt pricing:

24. Bank controlled corporate finance: (14) s.t. (15) ae=a(I-D) Solve for the optimal financing policy, D*, and the investment policy [rHb], given NPVb>0.

25. Proposition 3: In the case of financing with new equity and debt, the manager, on behalf of the bank, will choose the optimal financing policy, D*, and the investment policy [rHb], such that

26. Proposition 3: (Cont’d 1) • The optimal financing policy, D*  All debt finance if downside risk is limited. (19)  Mixed debt and equity if downside risk is considerable and the upward potential is capped. (20)  The bank counts on the new equity investors to share the project’s downside risk, a risk that is too big for the bank to bear alone.  As long as the main bank controls the firm, the main bank is happy with the opening up of equity financing, because this risk-sharing is to the bank’s benefit.  Risk sharing here tends to cause overinvestment.  The costs of overinvestment are passed on entirely to the existing shareholders.

27. Proposition 3: (Cont’d 2) And Overinvestment: [rHb]--Curve B, is always above [rH*]--Curve O • Highly risky projects with +NPVs are less likely to be skipped because, despite of the interest rate ceiling, new equity is available. • The opening up of the equity market helps mitigate the underinvestment problem. But the overinvestment problem arises.

28. Figure 2: Main bank controlled investment policies in Scenario 2

29. Corollary 3: In the case of financing with new equity and debt, when the bank requires a higher cutoff level, X, on its payoff, i.e., NPVb>X>0, the manager, working on behalf of the bank, will choose the investment policy [rHbx], in which

30. Corollary 3: (Cont’d) A shortage of capital at the bank—a situation that reflects early postwar Japan coinciding with high economic growth  Bank capital shortage restrains main bank controlled overinvestment  Conversely, the overinvestment problem looms large, when banks accumulate sufficient capital.

31. Figure 3: Deposits in Japanese banking institutions (trillion yen) Source: Datastream

32. What happened until the 1980s? (our story) • War-torn economy  main bank hands-on governance (but with capital shortage)  mainly mitigating underinvestment (until the early 1970s) •  New equity helps the bank in risk-sharing  overinvestment looms large when bank capital abounds  deregulation to undercut the main banks’ influence is ex ante necessary. • Japanese financial deregulation towards a more market-oriented financial system was launched slowly in the mid-1970s and really took off in the early 1980s.  Equity market boom in the late 1980s  Deterioration in bank control during financial deregulation

33. Scenario 3: Control rights back to the firm • No investment efficiency problem (1) Overinvestment is absent in this setting. (2) Underinvestment due to bank rent extraction can be solved by firms’ use of outside new equity (3) Underinvestment due to adverse selection is also absent because there is no asym. info about AIP and asym. info about growth never hinders new equity issues. See Myers & Majluf (1984), Noe & Rebellio (1996),Wu & Wang (2005) • It comes down to financing decisions: a choice between debt (loan) and new equity

34. Scenario 3: Debt or Equity If bank financing • Rent extraction=mI(rH-r) if the good state occurs • The firm’s expected costs of using debt: qmI(rH-r) • r is determined according to  If equity financing (outside equity) • New investors require a share of total firm payoff, β (yet to be determined under asymmetric information) • Investors can under- or overestimate q

35. Proposition 4: When using either debt or new equity to finance a project, the manager, working on behalf of the existing shareholders, weighs the agency costs of debt and the asymmetric information costs of new equity. The firm’s expected agency costs of using debt are: The firm’s expected asymmetric information cost of new equity at time, t=1, is equal to the share, b, of the firm’s expected total value minus the new equity investors’ investment, namely,

36. bis determined in the market: • q obeys a uniform distribution over [ql, qu]—the range of guesses by the market about the project’s quality. • The lower bound (reflecting the most conservative guess by the market about q), ql, is exogenously given. • But the upper bound, qu, is endogenously determined. • E[q]= the expected value of q (and β is related to E[q])  Rational pricing: , or  The cost of new equity decreases with E[q]

37. Compare CBank and CEquity Decision rule: Choose new equity instead of loan if CEquity<CBank: • E[q], qu and b, are endogenously determined.

38. Proposition 5: When using either debt or new equity to finance a project, the manager, acting on behalf of the existing shareholders, may prefer new equity over debt. If so, the market can infer the best possible quality of the project as follows: Where (36)

39. Proposition 6: When using either debt or new equity to finance a project, the manager, acting on behalf of the existing shareholders, prefers new equity over debt as long as CBank >CEquity, namely, where E[q] is determined by the following implicit functions:

40. Numerical procedure: (rL, rH)-points that plot the indifference curve for the financing decisions: • Set parameters A, I, q, m, and ql; • pick a value for rL; • input the parameters along with the picked value for rL into conditions (37) to (40) so that there are only two unknown variables, rH and E[q]; • try a value of rH (from small to big); • input the value of rH into equations (39) and (40) to get the value of E[q]; • input the value of E[q] along with the value of rH into conditions (37) and (38); • if inequality in (37) and (38) holds, restart from Step (d) to try another value of rH; • if inequality in (37) and (38) becomes equality, we get a point of (rl, rH) on the indifference curve, restart from Step (b) to pick another rl. • For example, set A=4, I=25, m=0.2, q=0.6, and ql=0.4. • Try rL=(0, -0.1, -0.2, -0.3, -0.4, -0.5) consecutively •  a corresponding series, rH= (0, 0.21, 0.45, 0.71, 0.94, 1.15).

41. Fig. 4: The firm’s financing decisions with various inputs of ql (market confidence)

42. Fig. 4: Interpretation  Financing depends on project risk profile • The indifference curve varies with ql (market confidence) • e.g., given ql=0.3 • (IV) above the curve: equity • (I+I+III) below the curve: bank debt  The separation in risk profiles or bias works against the bank because of rent extraction plus loss of bank control, making the bank harder to diversify risks.

43. How an equity market boom hurts more? • Market confidence, ql↑, facilitates equity issues because holdup costs are more likely to overweigh asymmetric information costs. The equity market boom aggravates the “equity for growth and bank debt for downside risk” bias.  If adverse shocks occur to the economy, banks will be hit harder than ever and also than the business sector. Bank downside risk has already increased in the booming 1980s, foreshadowing the troubles of the Japanese banking system in the 1990s and beyond.

44. Conclusion • Types of investment inefficiencies are flipped under main bank control and rent extraction (from under- to overinvestment). • But bank capital shortage constrains bank controlled overinvestment • Conversely, overinvestment looms large as bank capital starts to flood. • Financial deregulation toward a more market-based system is well intended but hurts the bank fundamentally because bank holdup backfires. • When control rights are returned to firms (due to the deregulation) and the equity market is opened up, firms are able to reach investment efficiency despite bank holdup, but the “equity for growth and bank debt for downside risk” bias works against the bank. • This bias gets stronger during the equity market boom because asymmetric information costs of equity get even lower than holdup costs of bank debt  Banks are likely to pile up bad debt following adverse shocks.  The equity market boom that accompanies the deterioration in bank control fundamentally increases bank downside risk.

45. Thank You!

46. Fly away from bank financing • Listed Japanese Firms Excluding Financials, Utilities and Telecommunications

47. Fig. 5: m=the degree of rent extraction