Understanding the Rise and Decline of the Japanese Main Bank System: The Changing Effects of Bank Rent Extraction

Abstract

This paper shows how main bank rent extraction affects corporate decisions about investment and financing and then the banking system itself under changing contracting conditions. Interestingly, during the transition from a relationship-oriented financial system to a transaction-based competitive system, an market boom can ominously increase bank risk. More precisely, our model predicts that main bank control tends to produce overinvestment by the client firm. This overinvestment, however, is initially contained by the shortage of bank capital, even when new is available to the firm. Abundant bank capital facilitates overinvestment to the detriment of firm profitability. The shift of control rights back to the firm thanks to the financial deregulation undercuts the bank influence only to erode its loan quality, because the ex ante rational bank is left financing projects with higher downside risk. The high-flying market further lowers the asymmetric information costs of new and aggravates the equity for growth and bank debt for downside risk bias. This makes the bank harder than ever to diversify its risk. The insights of this paper in a dynamic perspective help shed 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.