JOURNAL OF THE JAPANESE AND INTERNATIONAL ECONOMIES 12, 167–170 (1998)ARTICLE NO. JJ980402

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Paul Sheard, Ed., Japanese Firms, Finance and Markets, Addison–Wesley,Melbourne, 1996. 308 pp. A$44.95.

If your initial reaction to an edited volume is ‘‘not another collection oflow quality conference papers,’’ this is entirely inappropriate for the volumeunder review. Sheard has brought together an excellent set of high qualityand thought-provoking papers that make an important contribution to thegrowing literature on corporate organization and finance in Japan.

There are some important similarities between the role of the main bankand the role of the editor of a set of papers. Both provide costly ‘‘publicgoods.’’ Since the benefits to good editorship (and main bank monitoring)typically accrue to the paper writers (nonmonitoring banks) rather thanthe editor (monitoring banks), we might expect these editorial (monitoring)services to be underprovided. In this volume, the contrary is the case.Sheard has provided an excellent introduction that not only summarizesthe essence of all the other chapters but also indicates how each paper fitsinto the broader literature and how they all fit together. He also oftendraws out implications in addition to those suggested by the paper writersthemselves. As in the typical main bank story, Sheard has put his reputationon the line by including three of his own papers in the volume (a significantshare given there are only ten papers in addition to the editor’s intro-duction).

It is impossible to do justice to the wide variety of topics and issuesraised in the book so I will focus on just four chapters that I found particu-larly interesting. Sheard’s chapter 5 provides a theoretical justification forthe interpretation of the main bank system as a system of reciprocal dele-gated monitors. Two outcomes are compared: a normal bank contract wherebanks decide to monitor noncooperatively, and a main bank arrangementwhere one bank monitors a firm on behalf of all the other banks. By havinglower priority when the firm defaults, the main bank bears more of therisk when default occurs. Sheard shows that nonmonitoring banks do betterunder the main bank case than under the normal contract case, as they getthe public goods benefit of monitoring at no cost; monitoring banks doworse under the main bank contract, as they bear the full cost of monitoring

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but only get part of the benefit; but overall monitoring banks are betteroff under the main bank regime. Although not discussed by Sheard, thebiggest winner would, however, appear to be the firm itself as it appearsto get monitoring at no cost! Sheard does not show that the main bankcontract is the ‘‘best’’ arrangement or the only arrangement ‘‘better’’ thanthe normal contract. (Why not just internalize the public good aspect ofmonitoring by one bank providing 100% of the loan?) Since the event ofa firm defaulting is assumed to be independent of any other firm defaulting,banks can rely on a law of large numbers in sharing out the firms to monitor.It would be interesting to determine the robustness of Sheard’s resultswhen the probability of default is not independent (because of firm ties ormacro shocks such as a burst bubble).

While Sheard provides a theoretical justification for the existence ofthe main bank, Gower seeks to provide a theoretical explanation forthe anecdotal evidence that bank monitoring activity was less intensiveduring the bubble period. He shows, contrary to some earlier claims byAoki, that the deposit rate paid to monitoring banks does not affectshirking incentives. The factors that affect shirking incentives are shownto include ex post monitoring costs, the probability that a firm will faildue to bank neglect in monitoring, the probability of failure regardlessof monitoring, and the cost of funds for non-main-bank intermediaries.Gower suggests that shirking by main banks will strongly depend onthe pricing behavior of nonmain banks. He essentially argues thatincreased competition as a result of financial deregulation reduced theincentives for main banks to monitor. What is needed here is an empiricalstudy to try to distinguish this theoretically plausible explanation fromother explanations for the less intensive bank monitoring during thebubble period (including those explanations that rely on self-fulfilling(rational or irrational) expectations). Measuring the intensity of monitor-ing for an individual bank or for banks as a whole is an importantproblem for this empirical work.

Horiuchi’s study of the public safety net to protect financial institutionsin postwar Japan is extremely topical given the recent collapse of financialinstitutions such as Hokkaido Takushoku Bank and Yamaichi Securities.Horiuchi argues that the public safety net relied heavily on (or in its extremeform was) a safety net provided by private financial institutions with guid-ance and incentives provided by the Ministry of Finance and the Bank ofJapan. Large banks were main banks for firms and for other financialinstitutions. In the regulated financial system, the rents accruing to strongbanks were reflected in their balance sheets and could be used to savefailing firms. In addition, the authorities could use administrative guidance(with the threat of future penalties; Horiuchi provides some illustrations)to attempt to induce private financial institutions to provide ‘‘private’’

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assistance to failing financial institutions. Of course, financial institutionshave suffered the double whammy of financial deregulation significantlyreducing whatever rents accrued to them and the burst bubble which forsome banks has eliminated (or more than eliminated) whatever rents theyhad accumulated. Where the private safety net runs into problems is whenthe main banks themselves face a liquidity or credit crisis. In 1998, themain bank for the main banks would appear to be the Ministry of Financeand the Bank of Japan (or really Japanese taxpayers).

It is well known that one form of main bank intervention in Japanesefirms is the provision of managerial support, which leads to ‘‘outside’’directors. What is perhaps less well known is that about 25% of the directorsof Japanese firms are ‘‘outside’’ directors, that is, directors who are notinternally promoted long-term employees of the firm. Sheard’s empiricalcross-section study shows that variations in the proportion of ‘‘outside’’directors in Japanese firms are not random but can be partially explainedby factors suggested by the corporate governance literature. Does the dis-tinction between ‘‘inside’’ and ‘‘outside’’ directors really matter? By choos-ing to focus on the proportion of external directors, Sheard obviously thinksthe distinction matters. What is missing in his analysis is a story about whythe incentives facing ‘‘inside’’ and ‘‘outside’’ directors are actually differentonce both are appointed. Sheard does not touch on the issue of in whoseinterests the inside and outside directors operate. Sheard tells us that ‘‘direc-tors are generally full-time officers of the corporation’’ (p. 169) and arepresumably paid by the firm, but there is no discussion of any differencesin the ex ante or ex post incentive structures facing ‘‘inside’’ and ‘‘out-side’’ directors.

Other chapters focus on the question of keiretsu and market access(Sheard); the responsiveness of prices to input price shocks across differenttypes of firms (Ariga and Ohkusa); the impact of deregulation on corporatefinance (Hoshi); causality among domestic and Euro interest rates (deBrouwer); differences in corporate governance and employment incentivesin Japan and the United States (Garvey and Swan); and the competitivenessof Japanese firms (Ide).

Despite some of the papers having been presented at a conference in1993 (exactly which ones is not clear), most have been updated as far aspossible to include material from 1994, 1995, and in one case 1996 (anexception is de Brouwer, who for some reason chooses to focus on deregula-tion and interest rate causality only in the period 1988–1990). The valueadded in the volume is reduced somewhat by the presence of severalchapters that have already appeared as journal papers, either as is or inan earlier form.

Despite my criticisms, this volume is a welcome addition to the literatureand should be read by anyone with an interest in the Japanese economy and

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also by those with an interest in corporate governance issues. Researchers orgraduate students looking for Japan-related topics to work on would benefitgreatly from reading this volume.

Colin McKenzie

Osaka School of International Public PolicyOsaka University