Policy Update 015

Emerging Patterns of Corporate Governance in Japan

Visiting Fellow, RIETI

The Japanese firm is now facing a fundamental challenge and transformation of its postwar corporate governance institutions. The main bank system, cross-shareholding, lifetime employment, and Japanese-style management appear to be eroding, but have not disappeared. New patterns of corporate governance have also been enabled through legal reforms, innovations in corporate finance, and shifting boundaries of firms.

However, little consensus exists among experts about the true extent and impact of reforms. Do these changes mean that Japan now converging on the U.S. model? Or has Japan made progress in developing a new and distinct approach to corporate governance? The RIETI online editorial team recently interviewed RIETI Visiting Fellow Gregory Jackson about current issues for Japan's corporate governance and its future prospects. Dr. Jackson was a presenter at a RIETI policy symposium entititled "Emerging Patterns of Corporate Governance among Japanese Firms - Converging to Any Specific Model?" held on October 20, 2004.

RIETI Editorial Team: What fundamental challenges and changes do Japanese firms now face with respect to their postwar institutions of corporate governance?

Jackson: Japan's postwar model of corporate governance had numerous competitive strengths. Today, the challenges to that model are diverse, and fall under at least four sets of issues. First, internationalization has exposed Japanese firms to new types of social norms and values. Cross-border mergers, FDI and exposure to foreign and international regulatory standards are all things that call for a greater focus on capital markets and different management cultures. The most direct pressures come from the growing numbers of foreign institutional investors, which exert a tremendous influence on the Japanese market. These investors have championed corporate governance reform in the name of shareholder value in the U.S. and present a major clash of culture with traditional Japanese management. Of course, not all firms in Japan are strongly exposed to such international pressures, and so we have to look beyond that for the full story.

Second, the deregulation of Japan's capital markets has had a huge impact. The bright side has been the greater access of large firms to bond markets, but the dark side has been the banking crisis. The "main bank" system, which was a central feature in the postwar business structure, has lost much of its capacity to be an effective corporate monitor. This again underlines the need for urgent policy measures to break the downward spiral of "evergreen" loans to bad borrowers while elsewhere, worthy firms cannot get credit. Smaller firms will continue to need banks, and restoring the monitoring capacity of banks is therefore key.

Third, corporate governance is increasingly challenged by what can be called the lifecycle of companies - their transitions through birth, growth, maturity and death or transformation. Different phases place different demands on governance. Japan is currently dealing with a large number of mature sectors in need of restructuring, but at the same time new enterprises need to be supported in emerging sectors. The knowledge, resources and capacities needed for, say, corporate restructuring and venture capital are quite different.

A fourth related issue is what can be called organizational architecture, or the characteristics of information-sharing and knowledge needed for coordination or innovation in different types of economic activity. IT and modular production are changing how knowledge is distributed, and this also affects governance by changing the boundaries of organizations.

RIETI Editorial Team: What are the impacts on Japan's corporate governance of recent legal reforms and public policy measures?

Jackson: The extent of legal reform in Japan has not been well appreciated by most foreign observers. Policy has been incremental, but it has opened many new options. Most measures have been enabling legislation, namely removing constraints on behavior and thus allowing management more flexibility, particularly in how corporate equity is used - such as stock options, share swaps, buybacks and so on. While these freedoms may support corporate restructuring, they also carry dangers. For one, more power goes into management's hands. Another issue is related to the international market for corporate control. If Japan allows foreign firms to buy Japanese firms through stock swaps, the threat of hostile takeovers in Japan may become real very quickly. As we see in Europe, U.S. or British firms tend to be valued highly by the stock market given their existing equity culture and the sheer size of pension funds that invest in blue chip firms. Greater valuations could also help U.S. firms leverage takeovers of their competitors in Japan too. While takeovers are often promoted as an effective governance mechanism, many target firms will not be the poor performers, but successful firms that are quite viable on their own.

On the issue of board reform, legal measures have also aimed to increase the role of outsiders, in particular outside directors. This issue remains controversial, and has been resisted strongly in Japan. But international experience suggests that we should not expect too much from outside directors - good or bad. In most cases, I doubt if outside board members are tough monitors of the CEO. If board members do not represent some stakeholder interest such as banks, employees or other investors, those outsiders are usually chosen by the CEO. A trade-off thus seems to exist between to two different meanings of independence - independence from so-called special interests of stakeholders, or independence from existing management. Japan's approach has been gentle - to enable but not mandate outsiders. So existing outsiders such as those dispatched from banks may continue playing a role, but newly appointed outsiders will probably be more important for advice and consultation than as true watchdogs. That role may nonetheless be valuable at many firms. A final word should also be said about statutory auditors (kansayaku). Little social science research has been done on their role, and whether recent moves to strengthen their independence from the firm have made it easier for them to play their legally prescribed role in corporate monitoring.

RIETI Editorial Team: Do you think Japan's corporate governance is now converging on the U.S. model, or has Japan made progress in developing a new approach to corporate governance?

Jackson: Corporate governance in Japan is becoming much more diverse, but it is not converging on the U.S. model. A most obvious example is that the commitment of Japanese managers to providing long-term employment has remained quite strong. So I think the emerging new Japanese model, if you like, is one that tries to blend a stakeholder orientation with greater transparency to the outside and greater "tension" within. Many latent issues will have to be discussed more openly, but few businesspeople in Japan seem to believe that the corporation should solely serve the interests of its shareholders, and that markets will take care of the rest. In this sense, I think Japan continues to have much in common with countries like Germany, where they are also trying to find a new balance within the stakeholder model. Meanwhile, the U.S. model has gone into a deep crisis since the Enron scandal. Many core features of the U.S. model have proved highly problematic. The Sarbanes-Oxley law may improve things at the margins, but it does not address many of the deeper underlying issues. Meanwhile, it makes more red tape.

In our academic recent studies, we use survey evidence to identify the major patterns of corporate governance among Japanese firms. Three main ones emerge. First, the traditional Japanese model continues to account for nearly 70% of firms. Within this large group, different segments of firms exist, and some are doing very badly in the context of the banking crisis. Others who are in stable, domestically-oriented businesses or part of successful, internationally-oriented business groups remain successful. Second, about 17% of Japanese firms are rather independent from old-style Japanese corporate governance. This group includes both some younger venture firms that are quite oriented to capital markets, but also firms with strong family legacies. Legacies of family control remain a neglected topic in Japan.

But among the largest and most important Japanese firms, corporate governance is moving increasingly to a hybrid model. What is a hybrid? Hybrids recombine distinct elements from different governance models, such as transparency and internal information sharing, or capital market orientation and commitment to stakeholders, or even lifetime employment with merit-based pay. These companies make up around 13% of those in Japan, but employ about half of the corporate workforce. Only a few of these firms have moved in a very strongly "Anglo-Saxon" direction, whereas about 80% of this group has been very selective in which new practices it adopts and how they are adapted to the existing company culture. So we may see stock options being picked up by many firms, but these are not the same stock options you find in the United States - luckily, I might add! The encouraging thing about these hybrid patterns is that many of the firms are performing very well, and seem very successful in slowly bringing their distinctive competitive strengths based on cooperative business relationships and strong corporate culture forward into a changed, more open, and internationalized world. But only time will tell if such experiments prove durable in the long term, or if investor pressures and generational change among top managers will erode these commitments to the stakeholder model. Much may depend on shareholders and employees learning to work together to increase the accountability of management.

The original text in Japanese was posted on October 19, 2004.

October 22, 2004

Interview conducted by Akiko Kumagai, online editor, on October 19, 2004.

October 22, 2004