The Latest Report on Corporate Governance Reform: "Progress in Corporate Governance Reforms and the Revitalization of Japanese Companies" by the Ministry of Finance's Policy Research Institute

Senior Fellow, RIETI

Corporate governance reform is drawing attention as one of the keys to reviving Japanese firms. How far has the reform of governance structure progressed, what factors decide a company's reform efforts, and do reforms actually contribute to an improvement in corporate performance? In an attempt to find the answers to such questions, the Policy Research Institute of the Ministry of Finance conducted a questionnaire survey last December of listed and over-the-counter non-financial firms regarding their recent governance structure reforms. (Responses came from 876, or 34%, of the firms surveyed.) The results of the survey were combined with the firms' financial data in an attempt to conduct a qualitative and quantitative analysis of governance structure reforms at Japanese companies(1). The results were released on June 20 in the form of a report entitled "Progress in Corporate Governance Reforms and the Revitalization of Japanese Companies."(2) This report is the most recent survey to date on the progress in corporate governance reform at Japanese companies. It is also a comprehensive survey in view of the fact that it even covers labor relationships. In this column I would like to briefly introduce the contents of this report.

What kind of changes are occurring?

The report approached this issue through a comparative analysis of the questionnaire survey in question with a survey conducted in November 1999. As a result, the following points were confirmed as conspicuous changes in corporate governance.

(1) There has been a dramatic rise in the number of companies that place greater priority on markets. There were remarkable increases in the percentage of firms that said they place priority on their customers (from 37.9% in the 1999 survey to 50% in the 2002 survey) and shareholders (from 25.5% to 31.3%) as important stakeholders. The percentage of companies that placed weight on such stakeholders was greater than that of firms that said they place weight on their creditor banks, which have traditionally been important stakeholders for Japanese companies (down from 27.9% to 16.6%). However, the percentage of firms that place importance on employees remained comparatively stable (rising from 27.3% to 28.5%), indicating that the greater priority placed on markets is not the result of any reduced emphasis on employees.

(2) Reforms of the board of directors system are gathering speed. Thirty-three percent of the firms said they have introduced an executive officer system, while 35.8% said they have outside directors. Compared to the survey conducted three years ago, the figures rose by 20.2 percentage points and 5.7 percentage points, respectively. Looking at major corporations capitalized at ¥30 billion or more, more than 50% of the firms responding said they have introduced such systems. The characteristics of the Japanese corporate board, which in the past was comprised of executives who were promoted through the ranks and lacked separation between supervision and execution, have greatly diversified.

Do corporate governance structure reforms affect performance?

In approaching this problem, the report used a comprehensive index, the Corporate Governance Score (CGS), based on the results of the questionnaire survey to show how actively a firm was pursuing governance reforms. The relationship between the CGS and corporate performance (Tobin's q Ratio and Return on Total Assets) was then tested by means of a simple model. As a result, the CGS and corporate performance are, in statistical terms, in a significant positive relationship, and it is highly plausible that corporate governance reforms are contributing to improved performance. Furthermore, it was discovered that among various governance reform measures, active information disclosure (investor relations activities) was especially influential on corporate performance, and it was demonstrated that information disclosure has the potential to reduce the agency problem between shareholders and business managers, and improve corporate performance by increasing tension on the part of the management. These findings imply that, given the environment in which major Japanese corporations have been increasingly under a market-oriented external pressure, active information disclosure (investor relations activities) can be a universal model for reform.

On the other hand, analysis showed no significant relationship between corporate performance and the introduction of such systems as the executive officer system or the utilization of outside directors. However, such is the present situation that even at firms that have introduced such systems, there are cases in which they have not been introduced in a manner consistent with the company's own business and organizational structures; or there are many cases in which companies have just perfunctorily introduced U.S.-style reform models. Of course, there are firms that are attempting to improve the independence and roles of outside directors, and at such companies proof can be found of the potential for improving corporate performance through board reforms.

What decides corporate governance reform efforts?

In the report, we approached this issue by estimating a simple model regarding the determinates for governance reforms by putting the CGS as dependent variables. First, as might have been reasonably expected, we discovered that companies with a high ratio of foreign ownership and high dependence on capital markets were active in reforming their governance structures. While in contrast, companies with a high ratio of strong stockholders and more dependent on borrowings to procure funds were passive toward governance reforms.

This report also highlights the effect employee involvement in management has on governance reforms. It is generally considered that corporate governance reforms and management that places priority on employees are in an antagonistic relationship. However, as far as we can tell from the employee involvement index formulated through the questionnaire survey, this is not necessarily the case. If anything, similar to firms that depend on markets to procure most of their funds, the greater the extent to which employees were involved in management at companies under the strong monitoring pressure of capital markets, the more active those firms were toward corporate governance reforms.

Finally, we also attempted to analyze the relationship between wage and employment structures, and corporate governance reforms. We found that companies which maintained the long-term employment and seniority-based wage systems (characteristic of major firms in the past) were less active in governance reforms, while companies that did not guarantee long-term employment and introduced merit-based pay were active in reforms. What was especially interesting here was that firms which maintained long-term employment, while attempting to introduce a merit-based wage system, actively pursued reforms and enjoyed high performance. This combination of long-term employment, merit-based wages and active information disclosure can be seen as a model for rejuvenating Japanese companies.

The focus of revitalizing Japanese corporations

Analysis of the report showed that a rapid diversification is going on among Japanese firms in terms of corporate governance. On the one hand, there is a group of firms that increasingly depend on capital markets, while their shares are held highly by foreign investors. These firms are positive toward reforms, dealing with changes in the external environment, and their performance is relatively high. However, at the opposite end, there is a group of firms that keep in cross-shareholding relationships and depend on bank borrowings, while at the same time maintaining traditional employment practices. These firms are passive toward reforms and their performance is significantly low.

When revitalizing Japanese firms, the focus of major reforms should be those companies that are in this balance of disadvantage. Moreover, what should be noted is that these companies are in this balance of disadvantage as a result of the rational choices of their stakeholders. This is all the more the reason why external pressure is indispensable for getting them out of this situation. The policy implication presented by this report is that in order to achieve Japanese corporate revitalization, it is of the utmost importance that such firms escape this balance of disadvantage through strong policy promotion measures, the cultivating of banks' supervisory capabilities, and the securing of new external monitors (domestic institutional investors).

September 9, 2003
  1. This report is the result of joint research by Kenji Haramura, senior researcher at the Policy Research Institute (currently with the Financial Services Agency), institute researcher Kenichi Inagaki (currently with Sumitomo Mitsui Banking Corp.) and special researcher Hideaki Miyajima.
  2. The full text of the report can be obtained from the Ministry of Finance home page (Japanese Only). Results of the 1999 survey as well as other research on corporate governance conducted by the institute can also be found here.

September 9, 2003