Developing the Research Frontier in Corporate Governance Analysis: Economic Analysis of M&As and Governance

Fellow, RIETI

In the latter half of the 1990s, as the macroeconomic environment changed drastically and the government rapidly implemented deregulation and regulatory reforms, Japanese companies embarked on dynamic experiments in business strategy, organizational structure, and corporate governance scheme. The consequences of these experiments have been drawing much attention both in Japan and abroad. RIETI's research team on corporate governance, headed by myself and joined by leading researchers and practitioners in this field, has been undertaking research primarily focused on how the governance structures of Japanese companies have been reformed since the latter half of the 1990s and the resulting impacts on their corporate performance. I would like to outline the progress we have thus far made in our research.

The primary interests in our research to date have been to explore how the governance structure of Japanese companies - which used to be popularly referred to as Japanese-style corporate governance - is changing and whether the ongoing changes are meant to be convergence toward Anglo-American-style governance or an overhaul of Japanese-style governance (hence, continuing diversity of capitalism). Thus, in our analysis, we have focused on 1) changes in the relationships between companies and their creditor banks (widely known as the "main bank" system); 2) determinants and implications of the unwinding of cross-shareholding; and 3) determinants and performance impacts of reform of the board of directors. One of our results will appear as edited volume by Masahiko Aoki (former president of RIETI), Gregory Jackson and myself: Corporate Governance in Japan: Institutional Change and Organizational Diversity (Oxford University Press).

Also, as another research theme for the past few years, we have taken up the issue of mergers and acquisitions (M&As), the number of which has been rapidly increasing in Japan, to analyze their determinants and economic roles. We have launched new empirical research on this topic after consulting with individuals concerned and developing a new database. Some of the result of this project on M&A will be published as RIETI discussion paper and Miyajima ed., Nihon no M&A [M&As in Japan], Toyo Keizai Inc. will come out soon.

Exploring research frontier in corporate governance analysis: Four key issues

Building on these research streams, we have recently sought to explore a new frontier of research in the analysis of corporate governance, while continuing on our research on M&As. Of the range of issues relevant to corporate governance, internal governance mechanisms (board of directors, compensation scheme) and external governance mechanisms (shareholder/creditor discipline, market for corporate control through M&As) have already been subjected to extensive study. However, there still remain quite a few problems concerning the governance of Japanese companies. Thus, the current objective of our project is to identify these crucial problems and explore this new frontier of research in the analysis of corporate governance. In doing so, we will address the following key issues:

1) Ownership structure of Japanese companies with cross shareholding on the decline
The 1990s witnessed a significant reduction in cross shareholdings between Japanese companies and their creditor banks. Conversely, the percentage of shares held by non-affiliated shareholders has increased substantially. This in turn has raised awareness among Japanese companies for the need to defend against hostile takeovers and led to some rethinking of the "unwinding of cross shareholding." Given these significant changes, it is of urgent importance to identify the desirable ownership structures of Japanese companies and the type of legal framework needed to regulate them.

2) Governance problems with emerging companies and listed subsidiaries
Analysis of Japanese companies from the viewpoint of corporate governance has until now focused mostly on two issues: 1) control of public companies - agency problems resulting from the diffusion of stock ownership; and 2) discipline imposed by debt (creditor and bond holder), - agency problems associated with the issuance of debt. Meanwhile, little attention has been paid to yet another aspect of agency problems; the exploitation of minority interests by controlling shareholders (founders, parent companies, holding companies), which is common in South Korean chaebol (family-owned conglomerates) and the formerly state-owned enterprises in Russia. However, in the face of the rapid growth of newly emerging companies (Rakuten, Livedoor, etc.) starting around the year 2000, particularly in the IT sector, there is increasing need to examine the governance structure of these companies and their impacts. Furthermore, following the lifting of the ban on holding companies, more companies are adopting a vertical organizational structure with a holding company at the top. At the same time, the continuing presence of listed subsidiaries, a practice said to be unique to Japan, poses the potential problem of conflicting interests between parents and subsidiaries. These changes point to the need to reexamine the governance of Japanese companies from the viewpoint of the exploitation of minority interests by controlling shareholders. Also, looking at these problems in Japan would lead to examination of the possible leveling of corporate governance standards in East Asian countries.

3) Interrelationships between corporate governance and inter-company competition (complementary/substituting relationships)
In Economics, corporate governance is defined as a mechanism for maintaining corporate efficiency. Given this, how does corporate governance relate to competition in the product market as a traditional mechanism? The importance of interrelationships between corporate governance and inter-company competition has been pointed out by Aghion et al. (1997, 1999) and Nickell (1996), who did carry out some pioneering research. However, no sufficient follow-up research has been conducted. Empirical study on Japan is no exception; few research studies have been conducted apart from those reexamining the roles of main creditor banks in corporate governance. Yet in reality, the functioning of fund providers' involvement and the effect of selections of the board of directors are closely related to the environment in which companies operate. For instance, in an environment where either external governance or internal governance functions effectively, corporate managers may choose to utilize rents generated by restrictions on competition and industrial policies for the development of new technologies as well as for R&D. In other words, to understand the actual function of the governance structure of Japanese companies, it is not enough to simply look at the disciplinary effect of debt and large shareholders such as institutional investors (external governance) and the effect of incentive mechanisms for the board of directors independently. We should consider the complimentary or substitute relation between conventional governance device and products market competition. Consideration of this issue also has significant implications for the designing of laws and institutions concerning business combinations as the resulting findings will affect the function of industrial organizations.

4) Comprehensive understanding of external governance (finance), internal governance (board directors and compensation systems), and corporate structures (business portfolios and organizational structures)
Corporate governance is structured around multiple factors including the involvement of investor and debtor (external governance), supervision by the board of directors, and compensation systems (internal governance). Each factor's function is affected by other or exogenous factors including the aforementioned competition in the product market. For instance, choice and functions concerning internal governance - such as the composition of the board of directors and the selection of compensation systems as mentioned above - are dependent on each company's business portfolio and internal organizational structure (internal company system, holding company system, etc.). In recent years, some researchers, including Harris and Raviv (2004), have begun to examine the relationships between business portfolios and internal organizational structures. In the context discussed above, seeking a comprehensive understanding of the three key aspects of corporate governance - internal governance, external governance, and corporate structures - appears an important issue to consider in our endeavor to explore the new frontier of research in the analysis of corporate governance.

Opening of RIETI website area, "Developing the Research Frontier in Corporate Governance Analysis"

This covers just a small portion of the issues that are of interest to our research team. Our team defines the two fiscal years from April 2006 through March 2008 as a phase in which to carry out basic studies toward exploring the new frontier of research in the analysis of corporate governance. Working together with the Ministry of Economy, Trade and Industry (METI) and, more specifically, with those at the Competition Enhancement Office of the Industrial Organization Division, we aim to identify key issues concerning corporate governance and to provide new directions for relevant empirical analyses as well as for data development to enable us to achieve this end.

As part of our initiatives in this project, in a special section on the RIETI website, "Developing the Research Frontier in Corporate Governance Analysis," we will periodically introduce findings from our research on corporate governance and their implications on government policies.

March 6, 2007

Aghion, P., M. Dewatripont and P. Rey (1997), "Corporate Governance, Competition Policy and Industrial Policy," European Economic Review 41: 797-805.

Aghion, P., M. Dewatripont and P. Rey (1999), "Competition, Financial Discipline and Growth" Review of Economic Studies 66: 825-852.

Harris, M. and A. Raviv (2004), "A Theory of Board Control and Size," CRSP Working paper No. 559.

Nickell, S. J. (1996), "Competition and Corporate Performance," Journal of Political Economy 104(4): 724-746. 

March 6, 2007