December 01, 1996
Editor's note: This article is based on a speech that Macey delivered at the Nobel Symposium on Law and Finance in Stockholm on August 19, 1995. An expanded version, coauthored with Prof. Geoffrey P. Miller of the New York University School of Law, will appear in the Stanford Law Review (© 1996 by Jonathan R. Macey).
In recent years legal scholars have frequently criticized America's system of corporate governance.1 They have argued that America's mechanisms for monitoring and controlling corporate managers are grossly inferior to those of Japan and Germany, where commercial banks are able to monitor and influence the business affairs of borrowing corporations in ways that American banks cannot. American law has traditionally limited the size of banks and the scope and geographical range of their activities. At present, American banks lack both the power and the incentive to monitor their corporate borrowers. Critics have argued that without major changes in American banking law that would allow American banks to play a role similar to German universal banks and Japanese main banks, "the United States is likely . . . to lag behind its European and Japanese competitors."2
The desirability of commercial bank involvement in corporate governance has been greatly overstated. Proponents of bank involvement not only fail to address the significant costs of the Japanese and German systems of bank-dominated corporate governance but ignore important benefits of the American system of equity-dominated corporate governance as well. Advocates of bank influence also ignore critical differences between the incentives of risk-averse, fixed claimants, such as bankers who make loans, and residual claimants, such as shareholders who invest risk capital. For those reasons, America would be better off repairing the flaws in its own corporate governance system than adopting an entirely new system, with all its attendant problems.
The Conflict between "Pure" Equity Claimants and Banks
Modern corporate finance scholars have formalized the conflict of interest that exists within the publicly held corporation between the interests of fixed claimants (such as banks) and the interests of shareholders who hold residual claims to the firm's earnings.3 When choosing how to allocate assets, firms that increase risk will transfer wealth from the fixed claimants to the residual claimants. Because fixed claimants, unlike residual claimants, do not capture the upside potential gain from risky projects, they prefer asset allocations that result in more certain cash flows and minimize the risk of nonpayment of fixed claims. While that is a rational preference, it results in suboptimal asset allocation from a societal perspective, because the fixed claimants will discourage the asset uses that have the greatest present value to the firm as a whole.
Two important insights emerge from the conflict of interest between fixed and residual claimants. First, banks are not ideal institutions to monitor corporate performance on behalf of shareholders. Second, in a properly functioning capital market, an equilibrium emerges among the disparate interests of all claimants such that claimants who want less risk pay for it with lower returns. However, legal and structural problems—such as corporate managers' risk-averse behavior when their compensation is fixed and the high cost of contracting—raise transaction costs, thereby impeding the operation of capital markets and making it more difficult to resolve the inherent conflicts between fixed and residual claimants.
Romanticizing the Role of German and Japanese Banks
The critical distinction between the American model of corporate governance and the German and Japanese models is that in Germany and Japan large-block shareholders take an active management role to mitigate managerial shirking and misconduct. German and Japanese commercial banks are at the center of their respective corporate governance models. In contrast, the American structure of corporate governance focuses power in management, particularly in the chief executive officer. For that reason, American shareholders are relatively powerless to affect management decisions, as they are too disaggregated to monitor management's activities, much less to galvanize into effective political coalitions to oppose those activities.
The Japanese system of corporate governance is characterized by a complex network of intercorporate equity holdings, known as keiretsu, with Japanese banks at the center of the network.4 The banks either have or can obtain seats on the boards of directors of keiretsu firms, particularly when cash flows become unstable. Management gains from the Japanese pattern of bank domination and cross-ownership because the system allows incumbent management to insulate itself from takeovers and thus avoid the strict discipline imposed by the takeover market. Banks gain because they are able to influence the degree of internal risk taking by firms and thereby control risk that would otherwise benefit shareholders at the banks' expense. While Japanese banks do have substantial equity holdings in keiretsu firms, the available evidence indicates that banks intervene in keiretsu firms to increase the certainty of cash flows and profitability.5 That suggests that Japanese banks intervene to promote their interests as fixed claimants rather than as residual claimants.
German universal banks play an even greater role in corporate governance than their Japanese counterparts. Commentators argue that in sharp contrast with American banks but similar to Japanese banks, the German banks have "the position, information, and power to effectively monitor the activity of management and, when necessary, to discipline management."6 Like Japanese banks, German banks own only modest shares of the firms to which they lend money. Though German banks own only about 6 percent of large share stakes in Germany, they tend to exert effective control over a majority of the shares voted in annual meetings.7 For example, as of 1988, Deutsche Bank and Dresdner Bank directly owned 28.2 percent and 1.6 percent, respectively, of Daimler-Benz's outstanding shares. In comparison, in 1986 those banks held voting rights in Daimler-Benz of 41.8 percent and 18.78 percent, respectively.8
The disparity between small equity holdings and the large voting power of German banks is attributable to two factors. First, German banks vote bearer shares that they hold as custodians for shareholder-clients of the banks' brokerage operations. Second, German banks augment their voting rights by voting the shares owned by mutual funds they operate. Like Japanese banks, German banks have a substantial economic stake in corporations as a result of lending; German and Japanese firms borrow about $4.20 from banks for every dollar they obtain in capital markets, whereas American firms borrow $0.85 for every dollar they raise in capital markets. Clearly, the prominent role of German banks in corporate governance, like that of the Japanese banks, creates significant conflicts between the banks as fixed claimants and the residual claimants.
Commercial Banks as Fixed Claimants: The Moral Hazard
Although German and Japanese banks are better able to monitor and control the "adverse selection" problem (the danger that bad borrowers will seek loans from banks in disproportionate numbers) and the "moral hazard" problem (the tendency of debtors to divert borrowed money to riskier investments) than American banks, excessive risk avoidance in effect prevents the development of robust primary and secondary capital markets in Germany and Japan. While the evaluation processes that a firm must undergo before it obtains funds either in the capital markets or from a bank are essentially the same, banks are superior monitors of the firm. That is, commercial banks like those in Germany and Japan can both monitor and control the use of borrowed funds by a firm.
Arguably, equity claimants and fixed claimants should negotiate to pursue the higher valued but riskier investment and split the proceeds. That is not the case in Germany and Japan. To reach that efficient bargaining solution, commercial banks would have to threaten not to maximize shareholder value unless granted concessions. Because German and Japanese bank representatives sit on the boards of many borrower firms, and because German banks owe a fiduciary duty to the owners of the shares the bank holds in trust and votes, that sort of bargaining would unmask serious problems in the keiretsu system and in the German universal bank system, if not expose the banks to legitimate charges of extortion. In addition, a more fundamental obstacle to efficient bargaining is that banks, with their highly leveraged capital structures, are risk-averse; even considering potential side payments, banks' expected utility loss on the downside exceeds their expected utility gain on the upside.
Given their capacity to control adverse selection and moral hazard problems, German and Japanese banks are more successful than American banks and therefore play a larger role in their respective economies. Moreover, their superior ability to control moral hazard suggests that, at the margin, German and Japanese firms should find bank financing more attractive than capital market financing. As banks exert greater control over firms, the cost of raising equity capital increases, because potential equity investors demand compensation for the risk-averse firm behavior that results from bank domination.
Implications for American Corporate Governance
This analysis does not establish that the American system of corporate governance is necessarily superior to its German and Japanese counterparts. It does show, however, that the advantages of the German and Japanese systems have been exaggerated, while the costs have been underemphasized. Those costs come not only in the form of excessive risk aversion, which stifies innovation, but also in the form of illiquid, undeveloped, and poorly functioning capital markets.
While the level of control in the Japanese and German bank-dominated systems is probably too high, the level of control in the American system is probably too low. Three sets of problems contribute to that conclusion. First, the American system may cause firms to undertake excessively risky projects, because weak banks in the United States are unable to monitor and control excessive risk effectively.
Second, seemingly minor rules in the United States impede the ability of fixed claimants to monitor and control borrowers. For instance, several American legal doctrines have limited the enforcement of contracts written to protect lenders from borrowers' moral hazard, have changed substantive contractual provisions, and have even placed massive liability on banks for environmental harm caused by the borrower.
Third, market forces in the United States have a declining capacity to discipline managers and improve corporate performance. In particular, politics has reduced the efficacy of the market for corporate control. Thus America's corporate governance problem may stem not from a lack of concentrated share blocks and powerful financial intermediaries but from American courts' unwillingness to enforce contractual provisions on which financial intermediaries and borrowers agree, and from American legislatures' willingness to emplace legal obstacles to a free and efficient market for corporate control.
Economies with the best corporate governance structures will outperform rival economies at the margin.
The "continuous and textured" monitoring that characterizes relational investing in Japan and Germany is not a panacea, however. In those systems the interests of equity investors are insufficiently represented in corporate governance. On the other hand, the American system of corporate governance is also imperfect. In the U.S. system fixed claimants are unable to protect themselves from the moral hazard posed by the equity-dominated corporate borrowers. Rather than investing resources in copying each others' systems, each system would be better off focusing on, and repairing, its own problems.
* Professor Jonathan Macey is a professor at Cornell Law School and Chairman of the Financial Institutions Practice Group.
- See, e.g., Ronald T. Gilson & Reinier Kraakman, "Investment Companies as Guardian Shareholders: The Place of the MSIC in the Corporate Governance Debate," 45 Stan. L. Rev. 985, 989 (1993).
- Anthony Saunders & Ingo Walter, Universal Banking in the United States: What Could We Gain? What Could We Lose? 236 (1994).
- See, e.g., William A. Klein & John C. Coffee Jr., Business Organization and Finance: Legal and Economic Principles 225_26 (5th ed. 1993). For further discussion, see Jonathan R. Macey & Geoffrey P. Miller, "Bank Failures, Risk Monitoring, and the Market for Bank Control," 88 Colum. L. Rev. 1153 (1988).
- Randall Morck & Masoa Nakamura, "Banks and Corporate Control in Japan" 4_5 (Institute for Financial Research, Faculty of Business, University of Alberta, Working Paper No. 6-92, rev. July 26, 1993). In keiretsu, each member firm generally owns less than 2 percent of the stock in other member firms. However, between 30 and 90 percent of the stock in each firm is owned by other keiretsu members.
- Id. at 36_37.
- Gilson & Kraakman, supra note 1, at 988.
- "Those German Banks and Their Industrial Treasures," Economist, Jan. 21, 1995, at 71.
- Arno Gottschalk, "Der Stimmrechtseinfiuss der Banken in den Aktionärsversammlungen der Grossunternehmen," 5 WSI Mitteilungen 294, 298 (1988)