Understanding the Rise and Decline of the Japanese Main Bank System: Corporate Investment and Financing under Bank Rent Extraction

Abstract

While a close firm-bank relationship mitigates market imperfections, recent research has suggested that insider banks often impose 'holdup' costs. This paper presents a model of how main bank rent extraction affects corporate decisions about investment and financing, and how the high-flying equity market during financial deregulation breeds trouble for the main bank system mainly through unfavourable investment risk profile but not necessarily through overinvestment. Our model predicts that main bank control tends to produce overinvestment by the client firm. This overinvestment, however, is contained by the shortage of bank capital, even when new equity is available to the firm. Abundant bank capital aggravates overinvestment to the detriment of firm profitability. The shift of control rights back to the firm thanks to the financial deregulation undercuts main banks only to erode banks' investment quality. The ex-ante rational bank is left financing projects with less upward potential but higher downside risk. The high-flying equity market aggravates the situation, making the bank's assets more sensitive to shocks. The model is able to show how changes in corporate governance affect investment efficiency and risk profiles especially related to ways of financing, shedding light on why Japan's main bank system was beneficial in the postwar (capital constrained) period, but became harmful during the (capital abundant and bubble-laden) 1980s, and why the adverse shocks of the post-deregulation 1990s had such severe effects on the banking system.