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Capital structure in Japan

Capital structure in Japan has been noted to be more highly leveraged than comparative North American firms which brings to mind the question: how is it that Japanese firms have been able to take on such high levels of debt? The answer lies in the environment that Japanese firms have been operating in. More specifically, the levels of debt are likely to have been induced by the lack of alternative sources of finance because of the effect of government regulations, and the different ownership structure in Japanese firms (with institutional lenders being major equity holders).

So, the higher leverage has been a consequence of the conditions that Japanese business face—with a more pronounced effect (due to relationships) in companies which are in corporate groups known as keiretsu. These conditions were characteristic of the past. As the benefits of debt are well known in finance theory (tax shields, signaling etc. ), the lack of independence and efficiency in decision making borne by Japanese managers seem to be the costs. The result for some firms has been a reduction in debt levels to those more resembling U. S. companies. The questions now have become: What is the optimal debt level for a Japanese firm?

Should firms still be taking advantage of the benefits of their keiretsu relationship that have allowed them to take on such levels of debt? Our analysis focuses on Mitsubishi Corporation, a core conglomerate that is part of the larger Mitsubishi Group keiretsu having the capital structure characteristics mentioned above. The report will first explore the circumstances that may have induced Mitsubishi to its present capital structure, then look at more recent events and trends that may affect future financing decisions, and conclude with the Mitsubishi capital structure/optimum debt level analysis.

Japanese corporations have outpaced rival firms in the US and Europe in terms of capital investment throughout the 1970’s and into the 1980’s. One of the main reasons behind the high level of investment is the better access to capital that Japanese firms have compared to their western counterparts-the result is that Japanese firms seem to have more debt than their U. S. counterparts. A common motive for taking on more debt is for the tax advantages, but there is little to suggest that there is much difference in the taxation systems between the two countries to support such a reason .

The most likely factor for this trend in Japan has been the result of the close relationships that Japanese firms have with each other in a keiretsu. In Japan the majority of companies are formed into enterprise groups called keiretsu (which translates as “series” or “group”. The basic features of a keiretsu are as follows: cross-share holding agreements, interlocking directorates, intra-group financing, joint investing, and a consistent pattern of dealing among group members.

The largest of the keiretsu are Mitsubishi, Mitsui, Sumitomo, Fuji, Daiichi Kangyo, and Sanwa (the latter three are centered around Japan’s largest commercial banks. Together, these six corporate groups account for a quarter of total Japanese business assets. History/Background Prior to the Second World War, several large monopolistic companies dominated Japanese industry. They were known as zaibatsu – the dominant four were Mitsubishi, Mitsui, Sumitomo and Yasuda. During the post-war Occupation the holding companies of the zaibatsu that controlled member firms were dissolved.

Many firms subsequently regrouped to create the keiretsu we see today. Types of keiretsu: Vertical and Horizontal Vertical keiretsu are arranged hierarchically along production and distribution lines and organized under a principal manufacturer. The benefits of this network include increased efficiency and customer service, decreased distribution costs, simplified marketing channels, rationalized inventory controls and the facilitation of effective information sharing between members.

Also, the principal manufacturers receive the benefit of being in a dominant position, which creates a high degree of bargaining power. Horizontal keiretsu are large groups of Japanese companies in a wide range of industries, organized around a commercial bank. Direct competition is avoided between member firms by only having one company in any line of business. The success of this type of keiretsu is attributed to their cross- shareholding and the availability of bank loans to their members.

This is supplemented with personnel exchanges and consensus decision making between member firms. Being in a horizontal keiretsu also means that a stable core of long-term shareholders is in place for a company. For our purposes we will be focusing on the capital structure and other features of firms in a horizontal keiretsu. The economic environment that Japanese firms operated in favored highly leveraged capital structures. The following are some of the factors, besides belonging to a keiretsu, that have had an effect on a Japanese firm’s capital structure.

Equity Markets The reluctance of Japanese managers to raise equity capital stems from the operations of the Japanese stock markets. Firstly, the Tokyo Stock Exchange is less stringent on disclosure requirements as compared to the NYSE, for example, which causes sharp asymmetric information differences between corporate insiders and the market. The result of this asymmetry is a severe underpricing of new share offerings and a reluctance to issue on management’s part. Firms, therefore, had a preference for bank debt which was less likely to suffer from such pricing effects.

Secondly, equity has been an expensive form of finance in the past. The notion of issuing shares at market value is a recent phenomenon whereas traditionally firms issued equity at a historical par value of 50 yen with a fixed dividend. Investors typically demanded a 20 to 30 percent annual dividend on the par value (in essence the instrument was a preferred share), which were paid out of after-tax cash flows. Loans on the other hand were easily obtained through an affiliated bank at reasonable interest rates, and provided a tax shield through the deductible interest payments.

Government Regulations and the Bond Market Table 1 shows how the domestic bond market in Japan began to open up during the 1980’s. Until that time, strict bond issuing criteria that applied internationally kept most firms out of the domestic and foreign bond markets. Government regulations worked against issuing corporate bonds. The government saw corporate bonds as a competitive threat to the its own bonds since interest rates would have to be raised in order for the government’s bonds to compete with those of the top corporations.

It wasn’t until 1985 that unsecured straight-debt corporate bonds were even issued. These conditions meant that firms had a reliance on their bank for debt financing; and as a result of their close relationships to banks, had a lower cost of capital and the ability to invest more than those who did not. Structure of Corporate Ownership in Japan The structure of corporate ownership in Japan is quite different compared to their counterparts in the West, with ownership being highly concentrated in Japan.

Japanese laws allow institutional investors to exert more control over firms and their management inducing them to seek higher levels of share ownership. Indeed, there is a striking difference between Japanese and US corporate ownership. Ownership by financial institutions (particularly commercial banks) is far greater in Japan than in the US. Japanese commercial banks and insurance companies hold approximately two to three times the number of outstanding shares of public firms than their US counterparts do.

On top of being a predominant shareholder, financial institutions play the simultaneous roles of also being the largest creditors of the firms as well being an important long-term commercial business partner. For example, it has been shown that out of 344 manufacturing corporations, financial institutions own 34. 48% of the common equity and individuals own 29. 53% . Therefore, many Japanese firms have access to more debt since financial institutions have highly concentrated ownership in firms.

Ownership concentration does not differ significantly between keiretsu and independent Japanese firms . With high ownership concentration and cross-share holding by banks, suppliers and customers, keiretsu firms are better able to monitor decisions of firms within the group and direct management’s actions to benefit the whole and to act as a collective rather than just being contractual business partners. The Role of Banks During the high growth era, the government of Japan’s Ministry of Finance directed investment to high growth industries.

To ensure that investment capital was available to firms in these industries, implicit guarantees on the liabilities of financial and non-financial corporations were given to lenders. The provision of a safety net for the loans made the banks eager to lend money to finance rapid expansion in these industries, and the corporations willing to borrow it. Banks were also threatened by market bonds since they posed direct conflict to their business in two ways. First, there was a fear that interest rates on bank deposits would have to be raised from their artificially low rates to keep funds from migrating to other investment instruments.

Second, banks did not want to lose their traditional customers for loans to the capital market. Because of their presence in the management and the board of directors in firms within the keiretsu structure, they were able to effectively keep these companies financing their operations with loans. This was relatively easy since most firms could not issue bonds anyhow until recently. Information Effects The keiretsu system helped to reduce many of the direct and indirect costs faced by Western firms, which may have allowed firms to raise their debt levels.

Costs of Financial Distress A major benefit arising from keiretsu affiliation is the reduction in costs of financial distress for member firms thus allowing them to take on a higher debt to equity ratio than otherwise possible. This is mainly attributed to keiretsu banking relationships and the consequent high levels of share ownership by financial institutions. Since a Japanese keiretsu is primarily financed by its main bank, to which a firm has close ties to, the extent of financial distress is greatly reduced.

Hypothetically, when a firm within a keiretsu is entering financial distress, its main bank will coordinate rescue efforts by arranging loans from other banks as well as itself. In extreme cases, the bank will even find a company within the same keiretsu to merge with the distressed firm. In the event of a bankruptcy, the main bank will bail out the keiretsu firm by absorbing all losses by taking a subordinated position to other debt holders, eliminating the need for squabbling between the other claimants.

The other features of the keiretsu, namely cross-ownership of shares and intra-group financing, also decrease the cost of financial distress. Since all firms within a keiretsu have some sort of stake in the distressed firm, it is in their best interest to try to keep that firm in operation . Aid from companies in the keiretsu can come in the form of stretched receivables, favorable transfer pricing and direct management incentives. To decrease the probability of bankruptcy and to increase the likelihood of recovery by a financially distressed firm, it would be ideal to expand, invest, and allow their organizations to grow.

This is consistent among keiretsu firms since in times of financial distress, they tend to invest 46 percent more compared to non-keiretsu firms . Firms in financial distress generally have problems in raising capital, which may be in part due to a free rider problem. Firms with diffuse groups of creditors are faced with this problem because individual debt holders would not be willing to refinance the firm or renegotiate debt claims even though it would be in their collective best interests to do so. This problem is absent however, when a keiretsu firm is primarily financed with bank loans from a single creditor.

Free rider problems are less severe or eliminated in keiretsu organizations. In addition, keiretsu firms tend to stay out of Japanese bankruptcy courts. Since financially distressed keiretsu firms are bailed out internally, the direct costs of bankruptcy such as legal and advisory fees, are vastly reduced. American firms on the other hand see the majority of disputes, arising from financial distress, ending up in bankruptcy courts. This problem in the US corporate system can be partially attributed to the wide use of bond financing.

A multitude of bondholder claims are more difficult to restructure than a single bank loan and US bankruptcy legislation prevents companies from changing the principal, interest, and maturity without unanimous consent from bondholders. Therefore, keiretsu firms do not incur these large costs of financial distress, which can reach up to five percent of firm value, incurred by their US counterparts. In the end, the lower costs of financial distress is another reason why Japanese firms can take on more debt and thus lower their costs of capital even more with increased utilization of their tax shields.

Monitoring A financial keiretsu, through its network of corporate cross-shareholdings and strong relationship with a main bank, serves as an effective system for monitoring the actions of a member firm. Member firms are in unique positions to serve as mutual monitors because the success of a single firm is in the best interests of the entire keiretsu. As keiretsu firms typically have seats on other member firm’s board of directors, they can make sure that the actions of management are in accord with the interests of the entire group.

The main bank acts as the primary lender and as a major shareholder, also tends to have its own executives sit on the board. This dual role ensures that the banks will be looking out for the interests of both bond and equity holders of the firm. The costs of monitoring are not as high as they are in the US system for any one party since the ownership is not as diluted. Hence, each member has a signficant interest in monitoring the firm’s activities and the free rider problem is alleviated. This system of corporate governance effectively makes sure that management pursues long run value creation.

Agency Costs Agency costs are reduced in a keiretsu because of the unique relationships within the group. Shareholders cannot participate in moral hazard activities such as transferring risk to debt holders or transferring wealth from them by encouraging management to take on negative NPV projects. Both the higher level of debt and the structure of ownership, i. e. the bank being a creditor-owner and the high proportion of shares being cross-held within a keiretsu, serve the purpose of keeping managerial interests in accord with the group.

The lower agency costs also results from the fact that most of the debt is short-term and secured. Asymmetric Information. Asymmetric information is a problem faced by many firms that need capital, whether it is from equity, bonds or loans. The less stringent reporting rules that Japanese companies face means that companies have problems letting investors know their true prospects when planning an equity issue. Since these investors cannot accurately measure a firm’s prospects, the equity will likely be undervalued and thus not pursued by the firm.

For rational lenders, asymmetric information problems arise out of managerial moral hazard incentives for managers to pursue activities which transfer risk to debt holders (i. e. the shareholder’s put option) or transfer value from debt holders, which inevitably causes them to demand higher rates of return. The result is a higher cost of capital for firms. Since keiretsu firms do not have as much of an asymmetric information problem, the conflict can be relieved. The lender and the owner are embodied in the same entity, the bank, resulting in the reduction of any asymmetric information premium.

The resulting condition is that firm’s have an increased propensity for debt because it is relatively cheaper than any alternative for financing. As Japanese corporations began to experience slower growth in the early 1980’s, the trend in capital structure was away from the traditional model of high levels of bank debt. Firms began to lower their leverage rates, following more of a mix that was similar to their American counterparts. Another factor contributing to this trend was the stockpile of cash that Japanese firms had accumulated during the high growth era with which they were increasingly depending on to finance new projects.

Deregulation of Japanese capital markets was also increasing the accessibility of direct financing for many firms. Equity issues at market price, with the increasingly high P/E ratios, made issuing stock very attractive for the first time. With the funds, firms paid down their debt resulting in greater discretion and flexibility in decision making without having their bank scrutinizing management and being directly involved in major decisions. Successful firms felt that there was no longer a need to rely so heavily on costlier, intermediated debt so they loosened their banking relationships.

For management, direct financing was certainly preferrable since greater independence was obtained with a diffuse group of claimants whereas having one large creditor meant that the main banks constantly had their nose in the firm’s day-to-day operations. The trend towards direct financing during the 80’s was largely due to the deregulation of the capital markets in Japan. Large manufacturing firms in particular, are heading towards becoming as independent of their main banks as their US counterparts. The process is coming to a conclusion with the implementation last April of a reform program known as the “Japanese Big Bang”.

For the lack of originality, the Japanese have acquired this name from a similar movement that swept the financial industry in Great Britain. As table 2 shows, when the Big Bang is completed in the year 2001, Japanese firms will have an even wider choice of financing available from banks, securities firms and insurance companies that will finally be competing on equal terms. As the number of large corporations going to the international capital markets increased with deregulation, Japanese banks looked elsewhere for new customers in their traditional lines of business.

Government measures, particularly Article 65 of the Securities and Exchange Act constrained commercial banks from entering new lines of business such as bond and equity underwriting activities that were still reserved for investment banks. Consequently, as seen in figures 1 and 2, banks were forced to look for new borrowers which they found in small and medium sized companies whose assets were heavily weighted in real estate. With the decline in property prices in Japan since the bubble collapse in 1990, these loans constitute a large part of the bad loan problem shown in figure 3.

In addition, with bank loans still accounting for 90 percent of nominal GDP in Japan compared to 37 percent in the US in 19916, the current trend towards direct financing means that the Japanese banking industry faces a massive contraction in size in order to eliminate this excess capacity. The movement towards a more western capital structure for Japanese firms began in the early 1980’s. Up until 1980, the Bond Issuance Committee’s criteria for firms wishing to issue bonds in any capital market was so strict that only Toyota Auto and Matsushita Electric qualified.

During that year, the Foreign Exchange and Trade Control Act was reformed, opening up foreign bond markets to Japanese companies. A year after that, a new type of bond with options to buy shares called warrant bonds were legalized. These bonds proved to be immensely popular with investors in foreign markets and Japanese firms issued substantial amounts of them during the decade. Japanese firms were especially attracted to foreign bond markets since they had less stringent requirements than at home and they also did not require any collateral securing the debt.

The creation of the commercial paper market in 1987 gave companies another alternative to borrowing from banks and in 1996, all requirements regarding bond issues were abolished. By this time, the number of firms that could issue unsecured bonds grew to over 500. Empirical evidence, Hoshi and Kashyap (1999), suggests that deregulation has allowed the largest and most successful Japanese firms to become just about as independent of their main banks as their counterparts in the US. Tables 3 and 4 clearly show that large Japanese firms in the manufacturing sector have reduced their bank borrowings the most.

Intuitively, this supports the notion that successful firms are better able to obtain financing in capital markets and the most successful Japanese firms are manufacturers whose names are recognized around the world. It is also evident that most of the transition to capital markets took place between 1983 and 1988 when the bond markets opened up. It is also clear from the tables that small firms have became more bank dependent with the progress of deregulation. Relationship financing is common even outside of Japan for small firms that have trouble obtaining direct financing.

To see whether the capital structure of Japanese and American firms is converging to some sort of global norm, similar data on bank borrowing by US firms was collected by the US Census Bureau in a survey called the “Quarterly Financial Report for Manufacturing, Mining, and Trade Corporations”. A compilation of the data in table 5 shows that bank dependency for firms has not changed significantly during the time span from 1979 to 1999 compared to the transition seen in the Japanese data.

Still, a slight increase in the bank dependency of large firms as well as for the major corporations in table 6 is evidence that the borrowing behaviors of US and Japanese companies are in fact coming closer together. To expand on this a little further, borrowing patterns should be converging at the industry level to take into account the differences in leverage that exist from one industry to the next depending on the “riskiness and collateral of different industries7.

Figure 4 shows the difference between Japanese bank debt to asset ratio with those in the US in 1980 and 1998 for firms in thirteen industries spanning food, textiles, pulp/paper, printing/publishing, chemicals, stone/clay/glass, iron/steel, nonferrous metals, fabricated metal products, machinery, electrical/electronic machinery, transportation equipment, and precision machinery. As you can see, the differences are more concentrated around zero in 1998. “By 1998, for ten out of thirteen industries, the Japanese bank debt ratios are within 10 percentage points of the US ratios8.

Not surprisingly, the three industries in which Japanese firms still retained a high bank debt ratio in 1998 were those in which many Japanese companies did poorly. This adds credibility to the notion that the more successful firms were better able to go to capital markets for financing than poor performers were. The remaining differences in the ratios are probably due to cross-country differences in the respective industrial structures and to the slow pace of deregulation; capital markets in Japan are not as liberal as those in the US quite yet.

We have decided to call the former, the keiretsu effect, and the latter, the deregulation effect, on a firm’s capital structure. These two effects are working against each other. The keiretsu effect should theoretically lead to a higher bank debt to total assets ratio since a firm belonging to a keiretsu would presumably have a higher propensity to turn to a commercial bank for its financing. In contrast, the deregulation effect should lead a firm to have more market debt and/or equity in its capital structure since the costs of doing so are lower for large corporations than it is for them to borrow from banks.

Therefore, any differences in capital structure in Japanese and American firms in the same industry, with similar operating risks, can be attributed to these two factors. The convergence is mostly seen in large manufacturing firms so we decided to compare and contrast the capital structure of Japanese and American consumer electronics companies. In order to isolate the keiretsu effect, a comparison between Sony, an independent firm, and Mitsubishi, a keiretsu firm, is done first. According to the data in table 4, we would expect these differences to be quite small.

Next, a comparison between Sony and GE should reveal the effects of the differing nature of capital markets in the two countries since both firms are independent of any corporate grouping. Figure 6 shows the results of this comparison of bank debt to total assets ratios for the three companies; Mitsubishi Electric is at 11. 66 percent, Sony is at 3. 52 percent and General Electric is at 0. 20 percent. These results show that there is a dominant keiretsu effect and a significant deregulation effect. Figure 5 also shows the trend in capital structure for the Mitsubishi Corporation at the consolidated level.

When combined, these two exhibits seemingly show that Mitsubishi is headed towards a western style capital structure. So as corporations are seemingly headed towards an American style corporate structure with less reliance on their traditional main bank, questions arise as to the potential effects of such a trend. The benefits of the Japanese keiretsu system were highlighted earlier in this report, mainly with regards to how it effectively dealt with the agent-principal problems inherent in U. S. companies. Higher efficiency and greater independence are compelling reasons for management to loosen the banking relationship.

With such a trend in mind, it will be interesting to see how the eminent principal-agent problems, which are typical in Western systems, are addressed by Japanese firms. Japanese companies are surely aware that the benefits of going to capital markets come with their own costs that at the very least include the absence of a keiretsu-safety net. With the relaxation of listing requirements for the Tokyo Stock Exchange accompanied by the deregulation of commissions, more companies have the choice of equity financing as well.

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