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Corporate shareholding in Japan Nakano, Katsura 1999

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CORPORATE SHAREHOLDING IN JAPAN by KATSURA NAKANO B . A . , K y o t o University, 1988 M . P . A . , I n t e r n a t i o n a l C h r i s t i a n U n i v e r s i t y , 1990 M . A . , T h e U n i v e r s i t y o f B r i t i s h C o l u m b i a , 1992  A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMANETS FORT H EDEGREE OF in DOCTOR OF PHILOSOPHY  THE FACULTY OF GRADUATE STUDIES (Department of Economics)  We accept this thesis as conforming to t h e / r e q u i r e d s t a n d a r d  THE UNVERSITY OF BRITISH COLUMBIA  S e p t e m b e r 1999  © NAKANO  Katsura  In presenting this thesis  in partial fulfilment  of  the  requirements  for  an advanced  degree at the University of British Columbia, 1 agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for department  or  by  his  scholarly purposes may be granted by the head of my  or  her  representatives.  It  is  understood  that  copying  or  publication of this thesis for financial gain shall not be allowed without my written permission.  Department of  ^oonorhtoS  The University of British Columbia Vancouver, Canada  Date  DE-6 (2/88)  Oct  7 ,  /9?9  Abstract This dissertation investigates why a substantial number of common stocks is held by companies in many countries, especially in Japan. Chapter 1 gives an overview of historical and legal issues regarding corporate shareholding in Japan. Chapter 2 reviews how researchers have, theoretically and empirically, approached corporate shareholding issues. Chapter 3 elaborates on a corporate shareholding model which incorporates a standard principal-agent model with Aoki's managerial risk sharing argument (Aoki, 1988). The model finds that a risk-averse manager of a firm invests in other firms if managerial reward is linked with the value of the firm she manages, and if the operating profits of investing and investedfirmsare negatively correlated. Corporate stock investment is larger if the invested (and/or investing) company's operating profit is less volatile and/or if the covariance in the operating profits of the companies is more strongly negative. Although a stronger link between corporate performance and managerial reward increases managers' incentive to exert efforts, it also increases the risk that managers must bear. If the risk is too high, managers would leave their companies. Corporate stock investment reduces the risk, and enables shareholders to offer a higher incentive to the managers and to earn a higher (expected) income. Chapter 4 examines three major arguments concerning the rationale behind the practice of corporate shareholding: the competitive-effect, risk-sharing, and control-rights arguments. Predictions drawn from those arguments are tested using panel data of 186 Japanese corporate group firms from 1980 to 1988. The main findings of this study are as follows. (1) The competitive-effect argument is clearly supported by the data. Firms in the same industry do tend to invest more in one another. (2) The evidence in favor of the risksharing argument is weaker — although firms with less risky operating profits tend to attract more investment, the relationship between investment and the covariance in the firms' operating profits is ambiguous. (3) The strongest empirical support is given to the control-rights argument. Indeed, the evidence confirms that afirmis more likely to invest in otherfirmsthat hold more of its own shares. Chapter 5 concludes this dissertation.  ii  Table of Contents  Abstract  ii  List of Tables  v  List of Figures  vi  Acknowledgements  vii  Dedication  viii  CHAPTER 1 Introduction 1.1  1  Definition of Corporate Groups in Japan  1  1.2 A Brief History of Japanese Corporate Groups  2  1.3  Modern Japanese Corporate Groups  7  1.4  Corporate Shareholding  11  1.5  Legal Issues on Corporate Shareholding  13  CHAPTER 2 Review of the Literature  22  2.1  Theories  23  2.2  Empirical Studies  29  2.3  Concluding Remarks  32  CHAPTER 3 Corporate Shareholding and Agency Cost  35  3.1  Introduction  35  3.2  P-AModel with Unilateral Stock Investment Opportunity  37  3.3  P-AModel with Bilateral Stock Investment Opportunities  53  3.3.1  The Model  53  3.3.2  The Solution  55  3.4 Concluding Remarks  64  CHAPTER 4 Corporate shareholding in Japan: Empirical Testing  67  4.1  Introduction  67  4.2  Hypotheses  6 8  4.3  Data  80  4.3.1  Raw Data  81 iii  4.3.2  Constructed Variables I  84  4.3.3 Constructed Variables II: Control Rights Indices  86  4.3.4  89  Constructed Variables III: Portfolio Choice Indices  4.3.5 Summary Statistics for the Variables  94  4.4 Models and Tests  96  4.5 Empirical Results  99  4.6 Concluding Remarks  103  CHAPTER 5 Conclusion  120  Bibliography  124  iv  List of Tables Table 1.1  Intra-group Shareholding (Mitsui Group)  20  Table 4.1  Comparative Static on Corporate Investment (a* )  108  Table 4.2  Data Items  109  Table 4.3  Constructed Variables i n Estimations  109  Table 4.4  Summary Statistics of the Explanatory Variables  110  Table 4.5  Summary Statistics of the Dependent Variables  Table 4.6.1  Tbbit Estimation Results: Control Rights Model ( A y )  112  Table 4.6.2  Tobit Estimation Results: Control Rights Model (B,,)  114  Table 4.6.3  Tobit Estimation Results: Portfolio Choice Model (PF )  116  Table 4.6.4  Tobit Estimation Results: Portfolio Choice Model (IPF y)  118  ;j  Ill  ;j  V  List of Figures Figure 1.1  Number of Stocks by Holder in Japan  17  Figure 1.2  Firm's Asset (10 year Growth Rates from 1977 to 1986)  18  Figure 1.3  Distribution of 410 Japanese Firms in Cross Shareholding  19  Figure 1.4  Average Cross Shareholding by Group  21  Figure 3.1  A,/ as Function of r : Model (1-1)  41  Figure 3.2  w / as Function of r : Model (1-1)  43  Figure 3.3  Shareholder's Expected Income as Function of r : Model (1-1)  Figure 3.4  Shareholder's Expected Income as Function of r : Comparison  52  Figure 3.5  Firm i's Reaction Function  58  Figure 3.6  a*^ as Function of p at Symmetric Equilibrium: Bilateral Model  Figure 3.7  w\ as Function of r at Symmetric Equilibrium: Comparison  x  x  x  ±  x  vi  43  60 62  Acknowledgements  I would like to extend my thanks to the members of my supervisory committee: Dr. Margaret Slade, Dr. John Cragg, Dr. Keneith Hendricks (Department of Economics), and Dr. Masao Nakamura (Faculty of Commerce). Their very patient and thoughtful advice contributed substantial improvements at each stage of my work on this thesis. I also acknowledge grately the helpful comments of seminar participants at Hosei University, Nanzan University, Shiga University, and the University of British Columbia. Discussions with many visiting scholars at the Centre for Japanese Research, UBC, were equally important for the improvement of this thesis. I wish to thank all of my friends, especially Jeff Kuypers, David Mcintosh, Janette Mcintosh, Alex Munteane, Toshikatsu Noma, and Yoshihiko Wada, for their heartfelt support. Finally, this thesis would have never been completed without the support of my families, especially Kazuko and Jiro.  vii  To Kazuko and Jiro  viii  Chapter 1 Introduction  T h i s dissertation addresses the issues o f corporate s h a r e h o l d i n g , p a r t i c u l a r l y a m o n g f i r m s w h i c h b e l o n g to corporate groups i n Japan. W e first p r o v i d e , i n the rest o f this chapter, some b a c k g r o u n d r e g a r d i n g corporate groups a n d corporate s h a r e h o l d i n g structure i n Japan. The s e c o n d chapter r e v i e w s h o w researchers have approached Japanese corporate g r o u p issues, e s p e c i a l l y corporate shareholding. It is f o l l o w e d b y the presentation o f a corporate s h a r e h o l d i n g m o d e l w i t h risk-sharing. I n the fourth chapter, v a r i o u s m o t i v e s , i n c l u d i n g the r i s k - s h a r i n g m o t i v e , for corporate s h a r e h o l d i n g are e m p i r i c a l l y e x a m i n e d . T h e last chapter c o n c l u d e s the dissertation.  1.1  Definition of Corporate G r o u p s in Japan  To b e g i n w i t h , the n o t i o n o f a "corporate g r o u p " used i n the c o n t e x t o f the Japanese e c o n o m y must be c l a r i f i e d because issues o f corporate s h a r e h o l d i n g a n d corporate groups are i n d i v i s i b l e i n Japan. D e f i n i t i o n s for "corporate g r o u p s " v a r y b e t w e e n studies ( M i w a , 1990). F o r the purpose o f this dissertation, w e w i l l f o l l o w a c o n v e n t i o n a l d e f i n i t i o n that a corporate g r o u p is a cluster o f firms w i t h i n w h i c h the presidents o f those f i r m s participate i n a m o n t h l y presidents' c l u b m e e t i n g , s o - c a l l e d (shacho-kai ).' T h i s type o f "corporate g r o u p " is sometimes c a l l e d a f i n a n c i a l keiretsu group, because f i n a n c i a l institutions s u c h as banks often p l a y a central role. T h e y are also referred to as " h o r i z o n t a l " keiretsu groups.  1  T h e functions o f the presidents' c l u b meetings w i l l be d i s c u s s e d later.  1  H o r i z o n t a l here means that each corporate g r o u p i s u s u a l l y made u p o f a representative from different industries a n d that m e m b e r s are m o s t l y o f the s i m i l a r size. N o t e that there is another type o f corporate g r o u p c a l l e d " p r o d u c t i o n " o r " v e r t i c a l " keiretsu, w h i c h consists o f a major c o m p a n y a n d a n u m b e r o f its subsidiaries and/or parts s u p p l i e r s . F o r e x a m p l e , 2  Toyota b e l o n g s to a f i n a n c i a l keiretsu, M i t s u i group, but is also a leader o f a v e r t i c a l keiretsu, Toyota group. I n this paper, the w o r d "corporate g r o u p " w i l l a p p l y strictly to the f i n a n c i a l keiretsu groups, unless otherwise noted. T h e m o d e r n Japanese corporate groups w e r e f o r m e d i n the late 1940s a n d the early 1950s. B e f o r e the S e c o n d W o r l d War Japan h a d a different corporate g r o u p system. I n the f o l l o w i n g part o f this i n t r o d u c t i o n , a b r i e f history o f b o t h pre- a n d post-war corporate groups as w e l l as the current situation o f corporate s h a r e h o l d i n g i n J a p a n is presented.  1.2  A Brief History of Japanese Corporate Groups  3  M o s t Japanese corporate groups o r i g i n a t e d i n the early 1900s ( T a m a k i , 1976, p3). T h e y were c a l l e d zaibatsu groups ( o r concerns). I n each o f the zaibatsu groups, u s u a l l y a f a m i l y o w n e d a h o l d i n g c o m p a n y a n d , t h r o u g h the h o l d i n g company, the f a m i l y c o n t r o l l e d the other m e m b e r s o f the group.  T h e members w e r e f r o m v a r i o u s industries a n d f o r m e d a  conglomerate. A f i n a n c i a l crisis w h i c h o c c u r r e d i n 1926 brought a restructuring o f the b a n k  2  S o m e f i r m s i n a " h o r i z o n t a l " keiretsu are subsidiaries and/or part suppliers o f other  m e m b e r f i r m s a n d have " v e r t i c a l " t r a d i n g relationships. T h e w o r d , " h o r i z o n t a l " is sometimes m i s l e a d i n g . H e n c e the author believes that the w o r d s , " f i n a n c i a l " a n d " p r o d u c t i o n " keiretsu, s h o u l d be u s e d to describe the types o f different keiretsu. 3  T h i s f o l l o w i n g b r i e f history o n zaibatsu i s m o s t l y b a s e d o n the w o r k s o f A r i s a w a  (1976), M a s a m u r a ( 1 9 8 5 ) , a n d T a m a k i (1976).  2  industry, a n d m a n y s m a l l e r banks were m e r g e d into b i g g e r ones. U n t i l S a n w a B a n k w a s established i n 1933, M i t s u i , M i t s u b i s h i , S u m i t o m o , a n d Yasuda. b a n k s w e r e the f o u r largest banks ( A r i s a w a ed., 1976, p30). T h e n u m b e r o f price a n d p r o d u c t i o n cartels, b a c k e d u p b y the government, increased after the G r e a t D e p r e s s i o n . M i t s u i a n d M i t s u b i s h i groups w e r e the largest a m o n g the corporate groups, a n d the group c o m p a n i e s a c q u i r e d a n d e n j o y e d their o l i g o p o l i s t i c p o w e r s w i t h i n v a r i o u s industries ( A r i s a w a , p p 6 6 - 7 1 ) . T h i s situation c o n t i n u e d u n t i l the e n d o f the S e c o n d W o r l d War. A f t e r the war, the S u p r e m e C o m m a n d e r for the A l l i e d P o w e r s ( S C A P ) i n Japan i m p l e m e n t e d v a r i o u s p o l i c i e s to p r o m o t e Japanese d e m o c r a t i z a t i o n . T h e d i s s o l u t i o n o f zaibatsu w a s one o f them. A s Zaibatsu groups, together w i t h the Japanese military, w e r e b e l i e v e d to have i n c i t e d J a p a n to start the war, the G e n e r a l H e a d Quarters o f A l l i e d P o w e r thought it important to break u p the zaibatsu groups. I n 1946, the h o l d i n g c o m p a n i e s , their subsidiaries, a n d the o w n e r f a m i l i e s w e r e ordered to sell the shares w h i c h they o w n e d i n their g r o u p c o m p a n i e s to the H o l d i n g C o m p a n i e s L i q u i d a t i o n C o m m i s s i o n ( H C L C ) . T h e c o m m i t t e e then r e s o l d the shares to the e m p l o y e e s o f those c o m p a n i e s o r to the p u b l i c . T h e total v a l u e o f shares subject to this order w a s 4 2 % o f total shares i s s u e d i n J a p a n at the t i m e ( T a m a k i , p 4 5 3 ) , a n d , as a consequence, a p p r o x i m a t e l y 7 0 % o f the total shares outstanding, i n number, were o w n e d b y i n d i v i d u a l s . T h e h o l d i n g c o m p a n i e s w e r e d i s s o l v e d b y the c o m m i s s i o n . A m o n g a l l the zaibatsu c o m p a n i e s , M i t s u i & C o m p a n y a n d M i t s u b i s h i C o r p o r a t i o n , w e r e accused o f p l a y i n g c r u c i a l roles d u r i n g the w a r and, as a result, w e r e segmented into a f e w h u n d r e d s m a l l c o m p a n i e s . H o w e v e r , banks  3  such as M i t s u i and M i t s u b i s h i B a n k s were not split a n d therefore retained their p o w e r w i t h i n the Japanese economy. T h i s w a s one o f the reasons w h y the b a n k s w e r e p o s i t i o n e d i n the center o f each corporate group after the war. A s a c o m p e n s a t i o n for their shares s o l d to the H C L C , the o w n e r zaibatsu f a m i l i e s r e c e i v e d g o v e r n m e n t bonds w i t h 10 years maturity. H o w e v e r , the f a m i l i e s ' f i n a n c i a l p o w e r s were d i m i n i s h e d b y the series o f orders a n d l a w s i m p l e m e n t e d after the w a r ( T a m a k i , p453). F o r e x a m p l e , t h r o u g h the O r d e r o f Purge f r o m P u b l i c P o s i t i o n s i n 1946 and Z a i b a t s u F a m i l y P o w e r E l i m i n a t i o n L a w i n 1948, m o s t o f the zaibatsu f a m i l y m e m b e r s w h o w o r k e d as managers o f major Japanese c o m p a n i e s were forced to leave their positions. E v e n t u a l l y , they lost c o n t r o l o f the zaibatsu c o m p a n i e s a n d have never been able to r e g a i n their p o w e r s . A l o n g w i t h the series o f orders to d i s s o l v e zaibatsu, the A n t i M o n o p o l y A c t a n d the P r e v e n t i o n o f E x c e s s C o n c e n t r a t i o n o f E c o n o m i c P o w e r A c t w e r e enforced. M o s t o f the regulations t r i e d to prevent f i r m s f r o m f o r m i n g a z a i b a t s u - l i k e corporate group. F o r e x a m p l e , each f i r m was l i m i t e d to h o l d i n g n o m o r e t h a n one quarter o f the total shares o f other firms. A l s o , f i n a n c i a l institutions were not a l l o w e d to h o l d m o r e than 5 % o f shares i n any other c o m p a n y a n d j o i n t appointments o f a n e x e c u t i v e t o t w o or m o r e c o m p a n i e s w e r e prohibited. B y 1949, most o f the d e m o c r a t i z a t i o n p o l i c i e s had been i m p l e m e n t e d . H o w e v e r , the resurrection o f "zaibatsu " h a d also b e g u n at this t i m e e v e n t h o u g h its o w n e r s h i p structure h a d totally changed after the war. T h e n e w type o f groups are n o w c a l l e d keiretsu groups. S o m e o f the major characteristics o f a keiretsu g r o u p are; p r o v i s i o n o f b a n k loans w i t h i n  4  the group, s h a r e h o l d i n g o f the b o r r o w i n g c o m p a n i e s b y b a n k s , a n d appointments o f bank e m p l o y e e s to the boards o f those c o m p a n i e s . T h e b a n k s , w h i c h w e r e not subject to the d i s s o l u t i o n p o l i c i e s h a d already b e c o m e the center o f post-war zaibatsu. U n d e r g r o u n d meetings w i t h the presidents o f former zaibatsu c o m p a n i e s h a d also b e g u n . I n 1949, the A n t i M o n o p o l y A c t w a s r e v i s e d to ease the restrictions o n merger a n d corporate shareholding. T h i s r e v i s i o n w a s f o l l o w e d b y a series o f events w h i c h accelerated the f o r m a t i o n o f corporate groups, the keiretsu groups. W h e n the S a n F r a n c i s c o Peace Treaty b e t w e e n Japan a n d the A l l i e s b e c a m e effective i n 1952, the orders issued b y S C A P h a d e x p i r e d . A n order o f 1948 w h i c h p r o h i b i t e d the use o f zaibatsu names as part o f a c o m p a n y n a m e was one o f them. O n c e this b a n w a s lifted, m a n y o l d group c o m p a n i e s r e v i v e d their pre-war names. T h e demands f r o m the K o r e a n w a r w h i c h b r o k e out i n 1950 h e l p e d the Japanese e c o n o m y to r e c o v e r faster. M o s t k e y industries w e r e o l i g o p o l i s t i c w i t h m e m b e r s o f former zaibatsu. T h e y earned huge profits f r o m demands o f this war. T h e s e c o n d r e v i s i o n o f the A n t i M o n o p o l y A c t i n 1953 p e r m i t t e d s o m e cartel, and lifted the l i m i t o n s h a r e h o l d i n g b y n o n - f i n a n c i a l institutions. T h e bank's percentage l i m i t o n s h a r e h o l d i n g was r e l a x e d f r o m 5 % o f other f i r m s ' shares to 1 0 % , a l t h o u g h it was r e d u c e d to 5 % a g a i n i n 1977.  Other  changes m a d e i n this r e v i s i o n i n c l u d e d ; the p e r m i s s i o n o f j o i n t appointment o f executives, a n d the l e g a l i z a t i o n o f the p r i c e retail maintenance system for certain products. A l l o f these events h e l p e d the o l d zaibatsu , n o w keiretsu, c o m p a n i e s to r e g a i n strength. The divided trading companies o f former M i t s u b i s h i and M i t s u i & C o . were unified again i n 1954 and i n 1959, respectively. W h e n "Vbwa R e a l Estate ( n o w M i t s u b i s h i Estate)  5  was threatened to be t a k e n over, M i t s u b i s h i g r o u p c o m p a n i e s bought b a c k the shares o f the c o m p a n y f r o m the potential raider. T h i s w a s one o f the first incidents w h e r e g r o u p firms fought against a threat o f takeover. M i t s u i , M i t s u b i s h i , and S u m i t o m o were the first groups that emerged their post-war shapes.  F u j i C & s u d a or F u y o ) , S a n w a , a n d D a i - I c h i  K a n g y o h a d started f o r m i n g their o w n groups later. T h e y r a p i d l y increased ties w i t h their 4  m e m b e r f i r m s d u r i n g the 1950s, although the ties between the n o n - f i n a n c i a l firms w i t h i n these groups r e m a i n weak. T h i s was the b e g i n n i n g o f the current corporate groups i n Japan. I n 1965 Japan's c a p i t a l m a r k e t w a s o p e n e d to f o r e i g n investors. B e c a u s e o f the fear o f b e i n g taken o v e r b y foreigners, m a n y Japanese firms have started to m a k e cross-shareholding arrangement ( O k u m u r a , 1992a, p p l 6 - 1 7 ) .  T h e stock investments w e r e done c r o s s w i s e  because s h a r e h o l d i n g o f its o w n were p r o h i b i t e d . T h e amount o f corporate s h a r e h o l d i n g steadily increased u n t i l the first o i l shock. A f e w years after the o i l s h o c k , b a n k s ' shareh o l d i n g started to increase a g a i n , a n d kept i n c r e a s i n g throughout the 1980s. S h a r e h o l d i n g b y n o n - f i n a n c i a l institutions, o n the other hand, remains fairly constant i n the late 1970s a n d the early 1980s. I n recent years, there were t w o important changes i n Japan's e c o n o m y w h i c h have affected the corporate b e h a v i o r towards i n v e s t i n g i n the stock market; the b u b b l e e c o n o m y a n d the B I S (the B a n k for International Settlements) regulation. A r o u n d 1986, Japan's e c o n o m y g r a d u a l l y m o v e d towards the s o - c a l l e d " b u b b l e e c o n o m y . " A s interest rates d e c l i n e d , asset prices s u c h as l a n d a n d stock prices b e g a n to soar.  4  T h e name o f banks are u s e d to identify each group. N o t e that F u j i B a n k is the m a i n  bank for "Vasuda (or F u y o ) group.  6  These p r i c e increases w e r e s a i d to be m o r e t h a n the l e v e l s w h i c h w e r e theoretically predicted f r o m the d e c l i n e i n the interest rates ( N o g u c h i 1992). T h e h i g h p r i c e d stocks c h a n g e d the f i r m s ' w a y o f f i n a n c i n g ; m a n y c o m p a n i e s i s s u e d c o n v e r t i b l e bonds a n d stocks instead o f b o r r o w i n g m o n e y f r o m banks. F i n a n c i a l institutions, i n c l u d i n g b a n k s , w e r e major b u y e r s o f those stocks (Suto, 1995). A s a result, b a n k s ' shareholding kept i n c r e a s i n g d u r i n g the b u b b l e p e r i o d . T h e presence o f f o r e i g n investors b e c a m e noticeable i n this p e r i o d as w e l l . I n the 1980s, the B a n k for International Settlements ( B I S ) set a m i n i m u m requirement for owners equity-total assets value ratio for the b a n k s w h i c h m a k e international settlements. S i n c e a part o f u n r e a l i z e d profits, a difference b e t w e e n the b o o k a n d current market values, o f h o l d i n g stocks are c o n s i d e r e d to be a part o f owner's equity, banks h a d n o trouble a c h i e v i n g the requirement w h e n stock prices w e r e steadily i n c r e a s i n g . B a n k s w e r e also able to keep the owners equity-total asset value ratio h i g h t h r o u g h equity f i n a n c i n g . H o w e v e r , once the stock m a r k e t c o l l a p s e d i n 1990, it b e c a m e a c o n c e r n for m a n y banks to a c h i e v e the B I S requirement. A n e w B I S r e g u l a t i o n r e q u i r e d banks to m a i n t a i n the ratio at least 8% o f its total asset v a l u e b y the e n d o f M a r c h 1993. S t o c k s obtained at a h i g h price d u r i n g the b u b b l e p e r i o d b e c a m e a b u r d e n to m a n y Japanese banks. S h a r e h o l d i n g b y banks, i n terms o f the n u m b e r o f shares, started d e c l i n i n g i n 1990.  1.3 M o d e r n Japanese C o r p o r a t e G r o u p s  M i t s u i , M i t s u b i s h i , S u m i t o m o , F u j i , S a n w a , a n d D a i - I c h i K a n g y o are the s o - c a l l e d s i x major corporate groups. T h e s i x major groups, e x c l u d i n g banks a n d insurance c o m p a n i e s ,  7  accounted for 3 . 7 9 % o f the number o f e m p l o y e e s , 11.89% o f the total asset v a l u e , 1 3 . 2 7 % o f sales v a l u e , a n d 2 3 . 8 2 % o f net profits, o f a l l the l i s t e d 2044 c o m p a n i e s , a g a i n e x c l u d i n g b a n k s and insurance c o m p a n i e s , for the 1993 fiscal year {Kigyo Keiretsu Soran, T o y o K e i z a i S h i n p o S h a , 1994). A s m e n t i o n e d , a corporate g r o u p is defined as a cluster o f f i r m s w i t h i n w h i c h their presidents participate i n a m o n t h l y presidents' c l u b meeting.  T h e f u n c t i o n o f the presi-  dents' clubs i s c o n t r o v e r s i a l a m o n g a c a d e m i c and business people a l i k e .  See O k u m u r a  (1994, p p l 1.2-131) for e x a m p l e . O f f i c i a l l y , the presidents' c l u b meetings are j u s t i n f o r m a l s o c i a l i z i n g meetings a n d are not intended for any managerial d e c i s i o n - m a k i n g . I f this is true, b e i n g a m e m b e r o f a presidents' c l u b s h o u l d not have any e c o n o m i c bearings for the c o m p a n i e s i n v o l v e d . I n reality, however, the participants o f the meetings often d o exchange m a n a g e r i a l i n f o r m a t i o n a n d sometimes m a k e m a n a g e r i a l d e c i s i o n s , w h i c h c o u l d , as a result, have s i g n i f i c a n t e c o n o m i c r a m i f i c a t i o n s . A n e x a m p l e o f m a n a g e r i a l d e c i s i o n s m a d e at the presidents' meetings is that, i f any o f the affiliate c o m p a n i e s wants to use a trade name, say " M i t s u b i s h i " , i n the corporate name, p e r m i s s i o n is r e q u i r e d at the presidents' meeti n g . H a v i n g a b i g name s u c h as " M i t s u b i s h i " i n the corporate name c o u l d b r i n g v a r i o u s e c o n o m i c benefits to f i r m s . F o r e x a m p l e , people already r e c o g n i z e the c o m p a n y a n d their beliefs o n the r e l i a b i l i t y o f the product w o u l d be favorable. A s e x p l a i n e d before, i n a Japanese corporate group, u s u a l l y o n l y one f i r m f r o m each major industry is c h o s e n as a m e m b e r i n order to c o v e r the w h o l e industry area. T h i s is c a l l e d one-set principle.  8  T h e Japanese f i n a n c i a l corporate groups are often characterized b y v a r i o u s e c o n o m i c ties b e t w e e n f i r m s w i t h i n the same group. T h e four major ties are; first, loans f r o m the m e m b e r f i n a n c i a l institutions; second, i n t e r l o c k i n g shareholding; t h i r d , i n t e r l o c k i n g directorships; a n d fourth, t r a d i n g relations. L o a n s are p r o v i d e d to m e m b e r c o m p a n i e s o f a corporate group b y the central  financial  institutions, w h i c h are u s u a l l y the s o - c a l l e d main banks. A l t h o u g h m o s t major corporations b o r r o w m o n e y also f r o m f i n a n c i a l institutions outside the group, the amount o f loans prov i d e d inside the g r o u p is u s u a l l y largest. O n e p o s s i b l e e x p l a n a t i o n for this p h e n o m e n o n is that b e i n g members o f the same presidents' c l u b the f i n a n c i a l institutions have better access to m a n a g e r i a l i n f o r m a t i o n o f the b o r r o w i n g c o m p a n i e s . M a n y c o m p a n i e s , e s p e c i a l l y f i n a n c i a l institutions, o f a group h o l d shares o f other m e m ber c o m p a n i e s . T h e investment relations are sometimes r e c i p r o c a l a n d m u l t i p l e , w h i c h creates a w e b type o f shareholding relationships. A s discussed i n the later chapters, there are m a n y possible reasons w h y c o m p a n i e s i n the same g r o u p invest w i t h i n the m e m b e r s . T h i s c o u l d be because f i r m s have access to m a n a g e r i a l i n s i d e i n f o r m a t i o n o f m e m b e r c o m p a nies t h r o u g h personal connections at the presidents' meetings. F u r t h e r m o r e , s o m e p e o p l e c l a i m that companies w i t h i n a group i m p l i c i t l y agree to defend a m e m b e r c o m p a n y against a take-over b y outsiders, as m e n t i o n e d earlier r e g a r d i n g the "fowa R e a l Estate case. A l o n g w i t h these i n t e r l o c k i n g shareholding relationships, m a n y major corporations often send representatives as directors to other m e m b e r f i r m s ' boards. T h e sender c o m p a n i e s have direct access to m a n a g e r i a l i n f o r m a t i o n .  9  T h e forth major tie w i t h i n m e m b e r s o f a corporate group is s a i d to be a t r a d i n g tie. W h e n a c o m p a n y has access to detailed i n f o r m a t i o n o f product/services t h r o u g h c o n n e c t i o n at presidents' m e e t i n g , it is natural for the c o m p a n y to procure goods/services f r o m other m e m b e r c o m p a n i e s , e s p e c i a l l y i f their prices are the same as those o f other c o m p e t i t o r s outside the g r o u p .  5  A c c o r d i n g to L i n c o l n , G e r l a c h , and A h m a d j i a n (1993), the p r o p o r t i o n  o f a f i r m ' s trade w i t h firms i n a g r o u p w h i c h accounts for the largest share o f the  firm's  trade is 2 5 . 8 % o n average for 87 Japanese f i n a n c i a l corporate g r o u p firms a n d 2 3 . 5 % o n average for 110 other independent firms. Unfortunately, w e d o not k n o w i f these numbers are s i g n i f i c a n t l y different, one t h i n g true is that h a v i n g a c o m p l e t e set o f firms, the one-set principle  a l l o w s m e m b e r c o m p a n i e s to procure g o o d s a n d services o n l y f r o m other m e m b e r  firms. These ties are inter-related. F i n a n c i a l institutions m a y h o l d the shares i n b o r r o w i n g c o m p a n i e s i n order to better m o n i t o r the c o m p a n i e s . I f a c o m p a n y has a stock investment relationship w i t h another m e m b e r company, then the i n v e s t i n g c o m p a n y has a n i n c e n t i v e to increase t r a d i n g ties w i t h the invested c o m p a n y because a part o f profits o f the i n v e s t e d c o m p a n y w i l l be p a i d out to the i n v e s t i n g company. T h e focus o f this dissertation is o n corporate shareholding. T h e f o l l o w i n g s e c t i o n exp l a i n s the current situations o f corporate s h a r e h o l d i n g a n d some significant issues surroundi n g them.  5  I n A u g u s t 1997, M i t s u i group d e c i d e d to h e l p a m e m b e r company, M i t s u i C o n s t r u c t i o n ,  w h i c h is i n a management crisis w i t h large debts. O n e o f the group's restoration plans for the c o m p a n y i n c r i s i s is to procure m o r e f r o m the c o m p a n y (Kigyo Keiretsu Soran, T o y o K e i z a i S h i n p o S h a , 1999).  10  1.4 Corporate Shareholding  I m m e d i a t e l y after the d i s s o l u t i o n zaibatsu, the amount o f stocks h e l d b y private corporations i n Japan w a s about 3 0 % . T h e r e m a i n i n g 7 0 % was o w n e d by, mostly, i n d i v i d u a l s . A t i n y fraction was o w n e d b y governments. C o r p o r a t e shareholding, however, has steadily increased since then. B y 1991, the figure for financial institutions a n d other business c o r porations h a d increased to 6 7 % , w h i l e the amount o w n e d b y i n d i v i d u a l s h a d decreased to 2 3 . 2 % o f the total n u m b e r o f shares outstanding.  6  T h e rest is o w n e d b y g o v e r n m e n t sec-  tors and f o r e i g n investors, w h i c h i n c l u d e i n d i v i d u a l s a n d other institutions. See figure 1.1. M i c r o data estimated b y H a y a s h i a n d Inoue ( 1 9 9 1 ) also s h o w the strong trend o f Japanese firms i n v e s t i n g i n other f i r m s t h r o u g h stocks. T h e data used w e r e o n the average market values o f v a r i o u s assets s u c h as instruments, t o o l s , l a n d , inventory, o r m a c h i n e r i e s o f 6 8 7 Japanese m a n u f a c t u r i n g c o m p a n i e s f r o m 1977 to 1986. Japanese f i r m s i n the sample had increased f i n a n c i a l assets, e s p e c i a l l y the stocks o f affiliates, b y 5 1 4 . 4 % i n v a l u e o v e r the ten years period. See figure 1.2. I n contrast, most o f the other asset items o n l y increased b y 2 0 - 1 0 0 % i n v a l u e o v e r the same t i m e p e r i o d . I n 1 9 8 6 , 2 3 . 3 % o f the total assets v a l u e o f a n average firm was c o m p r i s e d o f the stocks o f affiliate companies. A part o f corporate shareholding, e s p e c i a l l y w i t h affiliate c o m p a n i e s , is i n the f o r m o f cross (or mutual) shareholding. A c c o r d i n g to a survey c i t e d i n a Japanese E c o n o m i c 6  T h e same statistics are a v a i l a b l e for some other countries s u c h as K o r e a , T a i w a n , and  the U n i t e d States. F o r e x a m p l e , i n K o r e a , 5 0 . 2 % o f stocks w e r e o w n e d b y i n d i v i d u a l s i n 1991 a n d this percentage is f a i r l y stable since early 1970s (Korea Statistical Yearbook, N a t i o n a l Statistical O f f i c e , R e p u b l i c o f K o r e a , v a r i o u s years). A c c o r d i n g to A o k i (1988), i n d i v i d u a l s i n the U n i t e d States o w n e d 5 1 . 1 % o f total shares outstanding i n the U n i t e d States i n 1980.  11  P l a n n i n g A g e n c y A n n u a l R e p o r t (1992), 7 7 . 5 % o f 4 1 0 Japanese f i r m s admitted that at least 1 0 % o f its shares were h e l d c r o s s w i s e b y other f i r m s a n d 5 1 . 5 % o f the f i r m s are i n the range between 1 0 - 4 0 % . See figure 1 . 3 . 1 8 . 7 % o f the f i r m s say that m o r e than 4 0 % o f their shares 7  are o w n e d i n the f o r m o f cross-shareholding, w h i l e o n l y 8% o f the f i r m s say n o n e .  8  Table 1.1 shows an e x a m p l e o f corporate shareholding i n a Japanese corporate group, M i t s u i group. There are a f e w p r o m i n e n t features to be o b s e r v e d i n this table. F i r s t , a cross s h a r e h o l d i n g arrangement u s u a l l y i n v o l v e s m o r e than t w o f i r m s w h i c h forms a " w e b " relation. A l t h o u g h e a c h f i r m o w n s a relatively s m a l l p o r t i o n o f other participants' shares, the total amount h e l d b y other participants tends to be large. I n the e x a m p l e g i v e n i n table 1.4, the total percentage o f shares h e l d b y affiliates amounts to about 2 0 % i n m o s t f i r m s w h i c h is consistent w i t h earlier m e n t i o n e d survey results. Secondly, there are v a r i o u s i n d i r e c t o w n ership relations t h r o u g h the w e b structure. F o r instance, suppose f i r m 1 does not o w n any o f f i r m 2. H o w e v e r , i f f i r m 3 o w n s some shares i n f i r m 2 a n d i f f i r m 1 possesses f i r m 3's shares, then f i r m 1 o w n s a part o f f i r m 2 indirectly. T h i s indirect o w n e r s h i p issue w i l l be addressed i n detail later. T h e t h i r d o b s e r v a t i o n is the s o - c a l l e d one-set  principle—although  there m i g h t be some o v e r l a p i n their business fields o r business relations s u c h as a supplier-  7  T h e d e f i n i t i o n o f cross-shareholding used b y the survey is unclear. T h e statistics are  sensitive to the d e f i n i t i o n itself. A possible d e f i n i t i o n o f the f i r m ' s rate o f cross h o l d i n g is the total percentage o f shares h e l d b y other f i r m s w h o s e shares are o w n e d b y the f i r m . 8  C r o s s - s h a r e h o l d i n g has been practiced i n some other countries. F o r e x a m p l e , N y b e r g  (1995) refers to a study done b y D s l (1986) w h i c h shows that i n S w e d e n almost one-third o f the f i r m s w i t h equity e x c e e d i n g ten m i l l i o n S w e d i s h K r o n o r have cross-shareholding relationships to some extent. A c c o r d i n g to the A s a h i N e w s p a p e r (February 1 8 , 1 9 9 7 ) , Japan's F a i r Trade C o m m i t t e e c l a i m e d i n a recently p u b l i s h e d report that a one d i r e c t i o n a l c i r c u lar type o f corporate shareholding had d r a w n attentions because o f the corporate c o n t r o l p r o b l e m s it has created i n France.  12  b u y e r relationship w i t h each other, f e w o f the participants are i n e x a c t l y the same industry. I n other w o r d s , those participants i n a g r o u p are, usually, not c o m p e t i n g i n the same product market. F i g u r e 1.4 presents the average fractions o f shares h e l d b y other m e m b e r f i r m s i n each o f the s i x major groups f r o m 1982 to 1992. I n the M i t s u b i s h i g r o u p , about 2 6 - 2 7 % o f a f i r m ' s shares are o w n e d b y the other m e m b e r f i r m s o n average, w h i c h is highest a m o n g the s i x groups. D a i - I c h i K a n g y o group exhibits l o w e s t 1 1 - 1 2 % o n average. T h e s e averages are fairly stable o v e r the time.  1.5 Legal Issues on Corporate Shareholding N o w let us e x a m i n e some l e g a l issues w i t h regard to corporate shareholding. I n m a n y countries corporate shareholding is subject to regulation s u c h as anti-trust l a w s . I n K o r e a , cross s h a r e h o l d i n g has been p r o h i b i t e d since 1987 for 511 c o m p a n i e s w h i c h b e l o n g to any one o f 33 major c o m p a n y groups ( O k u m u r a , 1992b). I n m a n y E u r o p e a n countries, m u tual shareholding, at least direct m u t u a l s h a r e h o l d i n g , is p r o h i b i t e d b y l a w ( N y b e r g , 1995). I n the U n i t e d States cross s h a r e h o l d i n g is not i l l e g a l , but there does not s e e m to be any e x a m p l e o f cross shareholding. I n Japan, there are s o m e restrictions o n corporate shareh o l d i n g , w h i c h i n d i r e c t l y result i n regulating cross-shareholding. A s stated earlier, b a n k s are p r o h i b i t e d f r o m o w n i n g m o r e than 5 % o f a f i r m ' s share by Japan's a n t i - m o n o p o l y l a w s ( A r t i c l e 11). N o n - f i n a n c i a l institutions m a y possess other f i r m s ' shares o v e r 5 % w i t h c o n 9  9  B a n k s i n Japan c a n h o l d corporate shares o n their o w n account, w h i l e b a n k s i n the  U n i t e d States cannot b y the G l a s s - S t e a g a l l A c t .  13  ditions that it w i l l not reduce market c o m p e t i t i o n a n d that, for the f i r m w h i c h is c a p i t a l i z e d at m o r e than 10 b i l l i o n y e n o r o w n s net assets i n excess o f 30 b i l l i o n y e n , the v a l u e o f the obtained shares w i l l not e x c e e d the m a x i m u m o f either the net asset or capital o f i t s e l f ( A n t i M o n o p o l y A c t , A r t i c l e 10 and 9 . 2 ) .  10  T h e F a i r Trade C o m m i t t e e is g i v e n the authority to  j u d g e whether or not a c o m p a n y ' s stock investment w o u l d reduce the market c o m p e t i t i o n . I f the c o m p a n y ' s practice is f o u n d to be i l l e g a l , the c o m p a n y and/or the executive(s) w i l l be f i n e d and/or i m p r i s o n e d ( A r t i c l e 1 0 , 9 1 , a n d 95.2). I f m o r e than a h a l f o f f i r m 1 's shares are o w n e d b y f i r m 2, f i r m 1 is not a l l o w e d to o b t a i n f i r m 2's shares ( C o m m e r c i a l L a w A c t , Article 211.2).  11  I f m o r e than a quarter o f f i r m l ' s shares are o w n e d b y f i r m 2 and/or f i r m  2's subsidiaries, f i r m 1 is not a l l o w e d to exercise its v o t i n g rights i n f i r m 2 e v e n i f f i r m 1 o w n s firm 2's shares ( C o m m e r c i a l L a w A c t , A r t i c l e 241.3). W h y is cross s h a r e h o l d i n g restricted o r e v e n p r o h i b i t e d i n m a n y countries? O k u m u r a (1992a, 1992b) p r o v i d e s one explanation. H e believes cross s h a r e h o l d i n g creates a m o n i t o r i n g p r o b l e m ; that is, w i t h a sufficient amount o f cross-shareholding, the managers c a n do a n y t h i n g they want to b y c o l l u d i n g w i t h each other. S u p p o s e b o t h managers 1 and 2, the managers o f f i r m 1 a n d 2, are not m a x i m i z i n g the values o f the firms i n their charge. I f these t w o f i r m s have a cross shareholding relation, manager 1 c a n support manager 2 i n the d e c i s i o n m a k i n g process, or, m o r e precisely, a p p r o v e the d e c i s i o n s made b y manager 2  1 0  U n t i l 1997, Japan's A n t i - m o n o p o l y A c t p r o h i b i t e d the establishment o f a shareholding  c o m p a n y w h o s e p r i m a r y purpose is to c o n t r o l other f i r m s t h r o u g h the shares they o w n e d ( A r t i c l e 9). T h i s p r o h i b i t i o n is n o w r e m o v e d 1 1  R e p u r c h a s i n g o f its o w n shares is also i l l e g a l i z e d b y the C o m m e r c i a l L a w A c t , A r t i c l e  210.  14  at the shareholders meeting. I n the stock market, manager 1 m a y n o t sell F i r m 2's stocks to prevent manager 2 f r o m b e i n g r e p l a c e d w i t h s o m e b o d y else e v e n i f it i s against the i n d i v i d u a l shareholders' interest. I f manager 1 does not support manager 2 , manager 2 w i l l be r e p l a c e d b y s o m e other manager w h o i s c o n s i d e r e d to m a x i m i z e the shareholders' i n terest. T h e n e w manager w i l l f i n d out that the v a l u e o f shares i n f i r m 1 c a n b e increased b y r e p l a c i n g manager 1 w i t h s o m e other efficient manager. I n s u c h a case, it is r a t i o n a l for manager 1 to support manager 2 because manager 1 is essentially s u p p o r t i n g h i m / h e r s e l f I f this happens, the shareholders' interests w i l l b e reduced. O k u m u r a ' s argument is a m b i g u o u s a n d i s r e q u i r e d to b e w o r k e d out m o r e rigorously. H o w e v e r , i t i s suggestive a n d seems to b e consistent w i t h s o m e other observations. A c c o r d i n g to K a p l a n ( 1 9 9 4 ) , the n u m b e r o f outside directors i s o n l y 0.86 out o f a total, 22.29 directors, o n average i n Japanese f i r m s .  1 2  T h e same figure for U S c o m p a n i e s is 9.57 out  o f 14.88. M a n a g e r s i n the Japanese firms i n w h i c h c r o s s - s h a r e h o l d i n g i s c o m m o n l y pract i c e d s e e m to have a free hand. It i s d o u b t f u l that those directors i n the Japanese f i r m s are perfectly representing the shareholders' interests. Shareholders meetings i n J a p a n are also b e l i e v e d to be distorted (See for e x a m p l e H i g a s h i , 1993). M o r e than 9 5 % o f the l i s t e d f i r m s i n Japan, conventionally, h o l d shareholders' meetings o n the same day. T h i s p h y s i c a l l y l i m its i n d i v i d u a l shareholders to attend m o r e than one m e e t i n g . H o w e v e r , the managers o f the  1 2  I n this figure, s o m e o f the people w h o are sent f r o m affiliated c o m p a n i e s to the b o a r d  o f directors are c o u n t e d as insiders. C o n s i d e r i n g t h e m as outsiders, a study finds that 3 1 % o f directors o f 1985 l i s t e d Japanese f i r m s are outside directors i n 1988 (Kigyo Keiretsu Soran, 1990). I m p l i c a t i o n o f this study i s t w o - f o l d . F i r s t , the n u m b e r o f outside directors i n Japanese firms i s s m a l l e r than i n U S firms e v e n under a broader d e f i n i t i o n . i n t e r l o c k i n g d i r e c t o r s h i p is v e r y c o m m o n i n Japanese c o m p a n i e s .  15  Secondly,  c o m p a n i e s w i t h cross s h a r e h o l d i n g ties d o often send their e m p l o y e e s , as representatives o f their c o m p a n i e s , to other c o m p a n i e s ' shareholders' meetings. S i n c e they have a n u m b e r o f e m p l o y e e s , they d o m i n a t e the shareholders' meetings b y numbers. T h e i r r o l e i s , u s u ally, to support the m a n a g e r s ' d e c i s i o n s at the meetings. It is b e l i e v e d that the managers i n m a n y c o m p a n i e s also p a y people c a l l e d sokai-ya to be supportive o f the managers at the shareholders' meetings. Often, s o k a i - y a prevent other i n d i v i d u a l shareholders from a s k i n g u n w a n t e d questions to the m a n a g e r s ' side at the m e e t i n g s .  13  Payoffs to sokai-ya are p r o -  h i b i t e d b y the C o m m e r c i a l L a w A c t , but is b e l i e v e d to be w i d e l y p r a c t i c e d i n the Japanese firms.  14  A s a result, shareholders' meetings take less than h a l f an h o u r o n a v e r a g e .  15  T h e next chapter discusses theoretical a n d e m p i r i c a l studies o n corporate s h a r e h o l d i n g .  1 3  Sokai-ya  often threaten corporate managers that they w i l l disrupt their shareholders'  meetings b y a s k i n g embarrassing questions about c o m p a n y finances and/or scandals i f the managers d o not g i v e s o m e payoffs to them. H e n c e , Sokai-ya  is s o m e t i m e s translated as  corporate extortionist or racketeer. O n c e a sokai-ya g r o u p receives s o m e payoff, however, they w i l l usually cooperate w i t h the managers so that the shareholders' meetings w i l l go s m o o t h l y w i t h o u t any obstructions. See, for e x a m p l e , O k u m u r a ( 1 9 9 8 , p p l 6 5 - 1 6 6 ) . 1 4  F o r e x a m p l e , i n v o l v e m e n t o f sokai-ya  i n Takashimaya, Ajinomoto, D a i - i c h i K a n g y o  b a n k , a n d N o m u r a S e c u r i t y c o m p a n i e s b e c a m e p u b l i c recently. T h e C E O o f D a i - i c h i K a n g y o B a n k , one o f the w o r l d largest b a n k s , h a d c o m m i t t e d s u i c i d e after their case b e c a m e p u b l i c . See O k u m u r a ( 1 9 9 8 , p p l 6 4 - 1 6 5 ) . 1 5  T h e s e statistics are reported i n most n a t i o n a l papers every year. J a p a n m u s t be the o n l y  country t a k i n g s u c h d e t a i l e d statistics o n an annual basis.  16  ro TO0) k_ c  cn o  Ke ye Nat  .N  |  our  iho  va  o w <D o 1b di c o  z c CO ro ai o cg> o p  c  ke  (0  a ra -»  CO  I-  o I  u o </>  o  n E 3  2  3 O)  "3"  o oo  o  o co  o  o •sr  17  o co  o  CN  O  f  4—  o a>  CO  ro o r- "a  >  -»—i  cn a> cn i  0  00  CD  E  O C  c  md  0 O) CD  CD cn CD >» CO  r-  o> E o  0  S6U|ABS  o cn  XB} JO  i  co CD CM  g ro ro c CD E CO LO  E  4—>  o CO z a)  O CO  Q>  3  0  ca £ >.0 -o CD I "CD  t  0  1s  >  CO  ai o  g  £ | s co o ro  CD CD CD  X  |  2 5  CD  o  £  % c  CD  CD  cu  £  E  AojjueAU|  puei  cd  . 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CO  CO  jaqiunN  crCNJ  crO  o> 2  o c  CD  i-  JS 5  (0  p o o  0)  «o  CM CM o CO CM CM CO cri LO T— cn CM T— CM  =3 LU  CO cn CO CO CM CO LO o CM O o Tt CM CO o d d d d d d d d d  o  cn cn co _c CO  I  CO CO N  2  I  I-  c co ! o CO CO -#—•  {2 OhC0 00  s a: 00  13 O CO  i  P | X O  «S  rr: LU CL < CL  Q_ -1 Z) Q_  LU  cn Tt CO o CM CO CM o d d d  o o d  o o d  o o d  o r-- CO 00 C oO d d d  o o d  o o d  LO o Tf o d d  cn ci  & £ OC  p  z >  o 5  LO cn LO o LO co o d d d d ~ T  LO Tt LO CD Tt CM CO T— o d d  t- CO  d  CO o o o d d l  1  o o d o o d  o o d  LL  T _  DJ  T _  o o d  o o d  Tt  o IO o d  i  o o d  CO o o o d d  CO  o o d  o o d  o o d  o o d  CO d  LO CO Tt CO CO d d d  o o d  d  o cn d  o o d  Tt  d  00  i_ CD o CD O  °  cn  o C CO O CM  O V  CD  CD  _I <  LU Q-  O O  cn o LO CO 00 C CM D LO CM CM CO  *C co  >rr: ico o z  d  CM CO cn CM CO o CO d d d d  ci  O o CM CM d d d  Tt  co 12 zo o CD  CO Tt LO CO LO ci CO  o  o o CM d  00  o8 -  LU  => 2  «  -  CC L U fc < rr: M  E2 £  LU  LL  ji I £ §  t- m<  CC  CO co o  1  T— o CM T— LO CO LO  o  cvi  LO CO CO o LO CM T— o C D CM d d d CO o CM Tt o LO d  CM CO CM LO  (D CD 00 CO CM LO TT cn LO CM CO 00 cb o> LO Tt Tt Tt CO 00  TT  cn cn CO CO CO CO 00 LO CM CO CM LO CO o cn Tt CO LO CO CD Tt CO LO  CO CM T ~  5  CM  Tt  CM Tt CD CO cn o CO CD LO CO LO CO cn CM CO L O cn TT Tt Tt CM Tt •<* CO Tt Tt  z < c< co m  < CD  z < m iw cr  LL o8 LU  z CC  <  CC LU  Z  LU CC  m o  o I-  C5  z Q  o  3 CC I-  w z o o  >-  CC  I-  W  I  Q  8  >-  UL  CO O)  oo  20  LU X  Q.  —  => CL  LU X  «S  CC  LU CL < CL  ••-  o o  CC ILU CL  T-  21  Chapter 2 Review of the Literature  Three major categories o f the theoretical literature o n corporate s h a r e h o l d i n g are (1) c o m p e t i t i v e effect arguments ( R e y n o l d s a n d S n a p p , 1986; F l a t h , 1989, 1 9 9 1 ; R e i t m a n , 1994), (2) r i s k - s h a r i n g m o t i v e arguments ( A o k i , 1988) and (3) c o n t r o l l i n g rights arguments (Perotti, 1992; B e r g l b f a n d P e r o t t i , 1994; N y b e r g , 1995; O s a n o , 1 9 9 6 ) .  16  Besides  these arguments, there is a separate argument o f corporate s h a r e h o l d i n g s p e c i f i c to f i n a n c i a l i n s t i t u t i o n s — f i n a n c i a l institutions h o l d the shares i n b o r r o w i n g c o m p a n i e s i n order to better m o n i t o r the c o m p a n i e s ( N a k a t a n i , 1984; Sheard,1989; P r o w s e 1989, 1990). T h i s is sometimes d e s c r i b e d as " m a i n b a n k " a r g u m e n t .  17  It, however, does not p r o v i d e any i n -  sights for corporate s h a r e h o l d i n g between industrial f i r m s . H e n c e this thesis focuses o n the three major arguments. T h e list o f e m p i r i c a l research studies o n the Japanese corporate groups is v e r y l o n g . C l a s s i c a l w o r k s b y C a v e s a n d U e k u s a (1976) a n d N a k a t a n i (1984) are, s t i l l , the most frequently c i t e d a m o n g the literature. T h e list, however, becomes short i f it is o n l y i n regards to corporate shareholding.  1 6  T h e r e are s o m e other arguments as w e l l . F o r e x a m p l e , T a n i g a w a ( 1 9 8 6 ) s h o w s that  cross s h a r e h o l d i n g c o u l d benefit i n d i v i d u a l shareholders under the then Japan's tax system that c o m p a n i e s need not p a y corporate tax for r e c e i v e d d i v i d e n d , w h i l e d i v i d e n d tax is l e v i e d o n net d i v i d e n d payment. 1 7  H o s h i , K a s h y a p , a n d Scharfstein (1990 a n d 1991) p r o v i d e s o m e p o s i t i v e s u p p o r t i n g  e v i d e n c e for the argument. A f t e r the burst o f the s o - c a l l e d b u b b l e economy, however, the argument h a d also b e g u n to receive a lot o f questions. See for e x a m p l e M o r c k a n d N a k a mura(1999).  22  T h e next t w o sections r e v i e w the theoretical a n d e m p i r i c a l papers f o c u s i n g o n corporate shareholding.  2.1  Theories  Competitive Effect A r g u m e n t R e y n o l d s and S n a p p (1986) p r o v i d e d the first a n a l y t i c a l m o d e l i n regard to corporate s h a r e h o l d i n g between f i r m s i n the same industry. T h e y argue that, under a C o u r n o t m o d e l , a f i r m w i t h s h a r e h o l d i n g i n its r i v a l reduces product market c o m p e t i t i o n because the f i r m ' s total profit is l i n k e d to that o f the r i v a l t h r o u g h d i v i d e n d payments. A s a consequence o f this h o r i z o n t a l s h a r e h o l d i n g , the e q u i l i b r i u m p r i c e (or quantity) is higher ( l o w e r ) than the c o m p e t i t i v e p r i c e (quantity). F o r e x a m p l e , i f there are n identical f i r m s i n a market a n d i f each f i r m o w n s 1/n fraction o f shares o f every other f i r m , then the industry w i l l produce the m o n o p o l y l e v e l o f output i n e q u i l i b r i u m . U n d e r this c i r c u m s t a n c e , as the a m o u n t o f corporate shareholding increases, the industry's output m o v e s f r o m n f i r m s ' o l i g o p o l y l e v e l to the m o n o p o l y l e v e l .  1 8  C o n v e n t i o n a l market concentration ratios s u c h as H e r f i n d a h l i n d e x  d o not p r o p e r l y reflect the true state o f market c o m p e t i t i o n .  1 8  T h i s is true u n t i l the amount o f investment reaches 1/n.  19  I n their s y m m e t r i c e x a m p l e ,  i f each invest m o r e than 1 / n , e q u i l i b r i u m output is less than the m o n o p o l y l e v e l . I f investment is at the feasible m a x i m u m l e v e l , l / ( n — 1) > 1/n, e a c h f i r m produces n o t h i n g at e q u i l i b r i u m . T h i s o u t c o m e c a n be c h a n g e d i f each f i r m ' s p a y o f f p r o p e r l y includes r e c u r s i v e effects o f corporate s h a r e h o l d i n g o n d i v i d e n d payments.  C h a p t e r 4 discusses this issue a  little m o r e . 1 9  E x a m p l e s h o w n b y t h e m is as f o l l o w s . I f each o f ten f i r m s , w i t h no s h a r e h o l d i n g ties,  h a d a ten percent market share, a four f i r m concentration ratio w o u l d be 4 0 % . H o w e v e r , i f e a c h h a d a ten percent interest i n each o f the other f i r m s , then their m o d e l suggests that the industry w o u l d produce the m o n o p o l y l e v e l o f output.  23  F l a t h (1991) questioned w h y there seem to be f e w e x a m p l e s o f h o r i z o n t a l corporate s h a r e h o l d i n g e v e n i n Japan w h e r e corporate s h a r e h o l d i n g are c o m m o n b e t w e e n the firms. H e creates a t w o - f i r m two-stage N a s h m o d e l , w h e r e each f i r m decides the amount o f stock investment i n the other f i r m i n the first stage a n d the f i r m s c o m p e t e i n product m a r k e t i n the s e c o n d stage. A c c o r d i n g to the m o d e l , a f i r m actually invests into the other f i r m s o n l y i f the f i r m k n o w s that investment results i n a n increase o f its o w n profits rather than the j o i n t profits o f the i n v e s t i n g and invested f i r m s .  2 0  T h e first stage necessary c o n d i t i o n c a n  be d e c o m p o s e d into t w o effects; "strategic effect'' a n d " d i r e c t effect". T h e strategic effect is the effect o n the i n v e s t i n g f i r m ' s profit o f the stock investment t h r o u g h the change i n the i n v e s t e d f i r m ' s c h o i c e s i n the product market. T h e direct effect is the change i n the i n v e s t i n g f i r m ' s profit b y the stock investment t h r o u g h the change i n its o w n choices i n the product market. F l a t h says that, for b o t h C o u r n o t a n d B e r t r a n d c o m p e t i t i o n i n the p r o d u c t market, the direct effect is negative because the firm has to g i v e u p a part o f its o w n operating profit to o b t a i n a p a r t i a l o w n e r s h i p i n the other firms. H e n c e the strategic effect has to be, at least, p o s i t i v e i n order to have stock investment i n e q u i l i b r i u m . S i n c e the investment i n t o the other firms makes the i n v e s t i n g f i r m react softly, for the f i r m to m a k e stock investment, c h o i c e variables i n the product market have to be strategic c o m p l e m e n t s (fat cat p l o y ) . I n other w o r d s , for the existence o f a sub g a m e perfect e q u i l i b r i u m , the p r o d u c t market c o m p e t i t i o n cannot be C o u r n o t c o m p e t i t i o n , but c o u l d be B e r t r a n d . F l a t h s h o w s that, under B e r t r a n d duopoly, there c a n be a N a s h e q u i l i b r i u m w i t h cross-shareholding, i f the products o f r i v a l s 2 0  A n important a s s u m p t i o n is that the f i r m s acquire the stocks o f the r i v a l t h r o u g h a n ef-  ficient stock market w h e r e the stock prices reflect correct a n t i c i p a t i o n o f the product market equilibrium.  24  are imperfect substitutes. I f the products are perfect substitute, it w o u l d not be rational to acquire the shares o f the other f i r m . U s i n g a conjectural v a r i a t i o n m o d e l , R e i t m a n (1994) s h o w s that a l l o f the f i r m s i n the industry do not necessarily agree to participate i n a cross s h a r e h o l d i n g r e l a t i o n s h i p at a N a s h e q u i l i b r i u m . It m a y be rational for some f i r m s to stay outside the cross s h a r e h o l d i n g arrangement because there is a p o s i t i v e externality for the f i r m s w h i c h d e c i d e not to participate i n the arrangement. R e i t m a n finds that it is not rational f o r any f i r m to participate i n any cross s h a r e h o l d i n g r e l a t i o n , i f the n u m b e r o f f i r m s i n the industry is three a n d i f they are c o m p e t i n g i n C o u r n o t o r less r i v a l r o u s way. O n the other h a n d , i f the f i r m s are competi n g i n m o r e r i v a l r o u s t h a n C o u r n o t , s u c h as B e r t r a n d , there exists a n i n d i v i d u a l l y rational cross s h a r e h o l d i n g arrangement. F l a t h (1989) l o o k s at the vertical s h a r e h o l d i n g ties, instead o f h o r i z o n t a l ones, w i t h n  u  i d e n t i c a l upper stream f i r m s a n d n  d  i d e n t i c a l d o w n stream firms. A s G r e e n h u t a n d O h t a  (1979) f i n d , there w i l l be a d o u b l e m a r g i n a l i z a t i o n p r o b l e m under a C o u r n o t o l i g o p o l y i f they are not v e r t i c a l l y integrated. I n s u c h a case, the f i n a l g o o d p r i c e that c o n s u m e r s face is h i g h e r than it w o u l d be i f there were n  u  o r n integrated f i r m s operating. A r a m i f i c a t i o n o f d  this is a b e l i e f that integration t h r o u g h increased s h a r e h o l d i n g w o u l d decrease the c o n s u m e r p r i c e as w e l l .  F l a t h , however, shows that m o r e stock investments b y upstream f i r m s i n  d o w n s t r e a m firms w i l l l o w e r the c o n s u m e r p r i c e , but m o r e investments b y d o w n s t r e a m f i r m s i n upstream f i r m s does not l o w e r a n d m a y e v e n raise the price. H e says this a s y m m e t r y arises because upstream f i r m s are the first m o v e r s . U p s t r e a m firms w i l l reduce the price  25  to d o w n s t r e a m f i r m s i f their o w n e r s h i p interests i n the d o w n s t r e a m f i r m s are increased. I f d o w n s t r e a m f i r m s increase their interests i n upstream firms a n d i f the upstream f i r m does not o w n any share i n the d o w n stream firm(s), the upstream f i r m s w i l l not change the sale price. I f the upstream f i r m s o w n s o m e o f shares i n the d o w n stream firm(s), the upstream f i r m s m a y e v e n increase the sale price.  Risk Sharing Argument A o k i ' s ( 1 9 8 8 ) argues that a f i r m w h i c h is e x p o s e d to i d i o s y n c r a t i c s h o c k s c a n reduce r i s k b y i n v e s t i n g i n other c o m p a n i e s .  21  W i t h s u c h investments, the i n v e s t i n g c o m p a n y ' s  profits, after r e c e i v i n g d i v i d e n d s , b e c o m e less v o l a t i l e . A c c o r d i n g to A o k i , those w h o m o s t benefit from this type o f inter-corporate stock investments are non-saleable stakeholders o f c o m p a n i e s s u c h as employees. I n d i v i d u a l shareholders, w h o are saleable stakeholders, c a n  2 1  A o k i ( 1 9 8 8 ) also p r o v i d e s a s e c o n d argument—  transactional risk-sharing arrange-  m e n t between transacting partners. Suppose that there are t w o v e r t i c a l l y related firms. T h e prices o f a p r i m a r y resource a n d the final product are a s s u m e d to be stochastic, w h i l e the p r i c e o f the intermediate product is d e t e r m i n e d i n a perfectly c o m p e t i t i v e market. I f the t w o c o m p a n i e s are r i s k averse, say i n C A R A class, then the t w o c o m p a n i e s c a n w r i t e a p r o f i t s h a r i n g agreement i n order to reduce risk. A n e x a m p l e o f the agreement is that the upstream (or d o w n s t r e a m ) f i r m receives a p o r t i o n a (or 1 — a ) o f the j o i n t p r o f i t plus (or m i n u s ) a f i x e d amount (3. W i t h this agreement, the c o m p a n i e s c h o o s e the same l e v e l o f o p e r a t i o n as they w o u l d w i t h o u t the agreement because the intermediate product m a r k e t is perfectly c o m p e t i t i v e . A l t h o u g h total profit is the same w i t h o r w i t h o u t the agreement, r i s k is reduced. U n d e r certain regularity c o n d i t i o n s , the share parameter a is d e t e r m i n e d b y the c o m p a n i e s ' degree o f absolute risk a v e r s i o n . T h e transfer parameter (3 is d e t e r m i n e d b y the their relative b a r g a i n i n g powers. I n the context o f a " m a i n b a n k " system, the upstream f i r m is the bank a n d the d o w n s t r e a m is an affiliated c o m p a n y i n the f i n a n c i a l corporate group. I f the b a n k is less r i s k averse, it s h o u l d bear a large p o r t i o n o f the risk. T h e b a n k uses the f i x e d p a y m e n t as c o m p e n s a t i o n for r i s k b e a r i n g . I n this e x a m p l e , the affiliated c o m p a n y enjoys less v a r i a b l e , but somewhat lower, profit. S h a r e h o l d i n g p l a y s o n l y a secondary role i n this argument, a l t h o u g h A o k i says that cross s h a r e h o l d i n g is r e q u i r e d as a m u t u a l m o n i t o r i n g d e v i c e f o r c i n g e a c h firm to c o m p l y w i t h a n arrangement that m a y not necessarily be i n its short-term interest.  26  reduce their risk t h r o u g h corporate stock investment, but they d o not necessarily rely o n this m e c h a n i s m to d i v e r s i f y their p o r t f o l i o because they c a n d i r e c t l y invest i n v a r i o u s c o m p a nies. Workers i n a company, o n the other h a n d , accumulate their w e a l t h i n the c o m p a n y and part o f their w e a l t h is p a i d out as a retirement payment, w h i c h u s u a l l y is neither portable n o r marketable. I n most Japanese f i r m s , where q u a s i - l i f e - t i m e a n d s e n i o r i t y - p a y m e n t systems p r e v a i l , w o r k e r s bear h u m a n c a p i t a l investment costs and receive l o w wages i n the first years o f their career, w h i l e they are compensated i n later years. T h e w e a l t h retained i n a c o m p a n y i n these forms depends o n the performance o f the c o m p a n y a n d there is n o w a y for e m p l o y e e s to diversify these h o l d i n g s . S i n c e m a n a g e r i a l c o m p e n s a t i o n is u s u a l l y l i n k e d to the performance o f the company, managers also h o l d non-saleable stakes i n the company. F o r this reason employees and/or managers want the f i r m to h o l d the shares o f other c o m p a n i e s to reduce the v o l a t i l i t y o f the c o m p a n y ' s performance. A n important a s s u m p t i o n i n the above t w o classes o f arguments—the c o m p e t i t i v e effect a n d  risk-sharing  arguments—is that o b t a i n i n g stocks i n a c o m p a n y o n l y means ac-  q u i r i n g rights to c l a i m d i v i d e n d s . H o w e v e r , shareholders have rights to c o n t r o l the f i r m as w e l l . T h e y c a n t y p i c a l l y exercise the rights at annual shareholders' meetings. T h i s is also a n important characteristic o f c o m m o n stocks. O u r f i n a l category, the c o n t r o l l i n g rights argument, sheds l i g h t o n this aspect o f stock investment. Control Rights Argument Perotti (1992) and B e r g l o f and P e r o t t i (1994) say that cross s h a r e h o l d i n g is a sort o f hostage exchange to support c o l l a b o r a t i o n a m o n g managers. I n their m o d e l , managers m a k e  27  t w o decisions: collaborate o r not; a n d exert effort or not. A manager's effort, say R & D effort, increases the profit, not o n l y o f her f i r m , but also o f the other f i r m s i f those f i r m s collaborate w i t h each other, say i n a R & D project. T h i s externality does not exist i f they d o not collaborate. T h e r e is a certain range o f payoffs for w h i c h the managers f a l l i n a prisoner's d i l e m m a w h e n a cross s h a r e h o l d i n g arrangement does not exist. I n a one shot game, they d o not collaborate but exert effort for their o w n sake. I n a repeated-game setting, a p u n i s h m e n t for d e v i a t i o n is to e n d c o l l a b o r a t i o n i f there is n o cross s h a r e h o l d i n g arrangement.  The  punishment, however, m a y not be strong e n o u g h to force the managers to collaborate. T h e i r m o d e l suggests that i f the f i r m s exchange sufficient shares p r i o r to the game, they m i g h t be able to attain a better e q u i l i b r i u m . W i t h a cross s h a r e h o l d i n g arrangement, a manager w h o deviates w i l l be ousted b y the other managers, a n d this threat o f j o b l o s s , w h i c h is a m o r e sever punishment, c a n i n d u c e every manager t o c o m p l y w i t h the agreement. H e n c e profits are higher for the f i r m s w h i c h participate i n the cross s h a r e h o l d i n g arrangement. U n l i k e Perotti ( 1 9 9 2 ) a n d B e r g l o f a n d P e r o t t i ( 1 9 9 4 ) , N y b e r g ( 1 9 9 5 ) i n t r o d u c e d a p o tential raider outside a cross s h a r e h o l d i n g arrangement as a source o f t a k e o v e r threat. I n his m o d e l , managers b u y shares o f other c o m p a n i e s c r o s s w i s e i n order to protect themselves from a takeover.  22  A c c o r d i n g to N y b e r g , the managers' resistance to takeover induces a  h i g h e r p r e m i u m w h i c h c a n p o s s i b l y benefit the i n d i v i d u a l shareholders i f the takeover act u a l l y occurs. H e also s h o w s that, i f the p r o b a b i l i t y o f t a k e o v e r is h i g h , a h i g h l y inten-  2 2  N o t e that s h a r e h o l d i n g ties i n this m o d e l are not b e t w e e n corporations, but b e t w e e n  managers.  28  s i v e cross s h a r e h o l d i n g arrangement m a y increase b a r g a i n i n g p o w e r o f the managers and, thereby, the m a n a g e r i a l rewards. O s a n o (1996) s h o w s that a manager, w h o w o u l d invest i n a risk-free l o w - r e t u r n project w i t h o u t a cross s h a r e h o l d i n g arrangement because o f a threat o f takeover, m a y invest i n a h i g h - r i s k high-return project w i t h s u c h a n arrangement. Suppose that a manager's utility is c o m p r i s e d o f two parts; a fraction o f total p r o f i t o f the f i r m a n d some fixed v a l u e f o r s t a y i n g w i t h the f i r m . T h e r e is a potential raider w h o c a n better manage the r i s k y project i n a b a d state t h a n the i n c u m b e n t manager can. T h e manager w o u l d choose the risk-free project i f the threat o f takeover is large enough. W i t h a cross s h a r e h o l d i n g arrangement, however, the potential raider c a n b e b l o c k e d , i f the i m p r o v e m e n t w h i c h w i l l be b r o u g h t b y the potential raider i n a b a d state is smaller, a n d i f managers' gains f r o m staying w i t h their f i r m s are large c o m p a r e d to the v a l u e o f stakes that the manager has i n the f i r m . T h i s means that raiders cannot i m p r o v e the performance o f the c o m p a n y i n the b a d state e n o u g h to m a k e a tender offer. I n s u c h a case, the cross s h a r e h o l d i n g arrangement is sustainable a n d the managers w i l l choose a h i g h - r i s k high-return project. T h e next section r e v i e w s the e m p i r i c a l literature o n w h y c o m p a n i e s h o l d shares i n other companies.  2.2  E m p i r i c a l Studies  A n u m b e r o f e m p i r i c a l studies address Japanese corporate group issues from v a r i o u s perspectives s u c h as s h a r e h o l d i n g ties, debt ties, director ties, a n d trade ties. M u c h o f the  29  literature stresses the existence o f s o m e " i n s u r a n c e " m e c h a n i s m a m o n g the g r o u p affiliated companies. F o r e x a m p l e , N a k a t a n i (1984) finds, f r o m a sample o f 3 1 7 n o n - f i n a n c i a l c o m p a n i e s for the p e r i o d o f 1 9 6 6 - 1 9 7 4 , that o v e r - t i m e f l u c t u a t i o n o f business p r o f i t rates o v e r total assets is s m a l l e r for g r o u p affiliated f i r m s than for n o n - g r o u p firms.  I n a d d i t i o n to this  l o w e r volatility, N a k a t a n i also finds that business profit rates are s i g n i f i c a n t l y l o w e r i n g r o u p f i r m s than i n n o n - g r o u p f i r m s .  23  H e tries to e x p l a i n these observations w i t h a r i s k - s h a r i n g  m e c h a n i s m t h r o u g h interest payments: U n d e r n o r m a l circumstances, a g r o u p f i r m p a y s a higher interest rate, a sort o f " i n s u r a n c e p r e m i u m " , to its m a i n bank; once a d o w n t u r n occurs, the m a i n bank charges l o w e r rates to its g r o u p f i r m s so that they c a n get t h r o u g h the b a d t i m e ; a n d , as a consequence, profit rates are l o w e r but stable o v e r t i m e i n g r o u p firms. B e h i n d this argument is C a v e a n d U e k u s a ' s (1976) d i s c o v e r y that the g r o u p f i r m s , e s p e c i a l l y s m a l l peripheral f i r m s , bear h i g h e r cost o f interest to be p a i d to the " m a i n b a n k ( s ) " o f the group. T h i s insurance m e c h a n i s m w o r k s o n l y b e t w e e n banks a n d borrowers. O n a broader basis, however, m a n y studies indicate a negative c o r r e l a t i o n b e t w e e n corporate shareholdi n g a n d v o l a t i l i t y i n c o m p a n i e s ' profits. A m o n g t h e m are C a v e s a n d U e k u s a ( 1 9 7 6 ) , H o s h i a n d Ito (1992), a n d L i n c o l n , G e r l a c h , a n d A h m a d j i a n (1996). B a s e d o n a s a m p l e o f 243 large m a n u f a c t u r i n g c o m p a n i e s o v e r the p e r i o d o f 1961— 1970 i n Japan, C a v e s a n d U e k u s a f i n d that rates o f after-tax return o n assets ( R O A ) o f 2 3  T h e g r o w t h rate o f sales values i s also f o u n d to be l o w e r for the g r o u p f i r m s than for  n o n - g r o u p f i r m s . N a k a t a n i says the rate o f g r o w t h o f the f i r m ' s output a n d o f its total assets e x h i b i t the same k i n d o f results.  30  corporate g r o u p f i r m s are negatively related to the amount o f shares h e l d b y their affiliated companies.  24  H o s h i a n d Ito ( 1 9 9 2 ) replicate a s i m i l a r result based o n a sample o f 178 group  affiliated c o m p a n i e s f r o m 1 9 7 8 - 1 9 8 8 .  25  L i n c o l n , G e r l a c h , and A h m a d j i a n (1996) f i n d ,  u s i n g a sample o f 197 m a n u f a c t u r i n g c o m p a n i e s o v e r a n extended p e r i o d o f 1 9 6 7 - 1 9 8 5 , that a c o m p a n y w i t h stronger shareholding ties, measured b y the total amount o f shares h e l d b y its affiliates, tends to earn a higher ( l o w e r ) profit rate i n the subsequent periods i f it earned a l o w e r (higher) profit rate i n the p r e v i o u s periods. N o t e that there are s o m e studies w h i c h indicate n o r e l a t i o n b e t w e e n corporate shareh o l d i n g and v o l a t i l i t y i n c o m p a n i e s ' profits. L i n c o l n , G e r l a c h , a n d A h m a d j i a n states, i n their study, that the o v e r t i m e " r e d i s t r i b u t i o n " effect disappears i n the late 1980s. U s i n g a s a m p l e o f 118 Japanese companies i n 1 9 8 9 - 9 0 , B e a s o n (1998) finds that m o r e stock investment b y other industrial c o m p a n i e s o r f i n a n c i a l institutions does not i m p l y a l o w e r v o l a t i l i t y i f the v o l a t i l i t y is measured b y standard deviations i n the invested c o m p a n y ' s stock prices. B a s e d o n the same v o l a t i l i t y measurement, he a l s o finds that affiliated c o m p a n i e s d o not necessarily e x h i b i t a l o w e r volatility. A l t h o u g h it has n o t h i n g to d o w i t h the " i n s u r a n c e " argument, F l a t h ' s (1996) e m p i r i c a l research must be n o t e d here because it l o o k s at the determination o f f i r m s ' stock invest-  2 4  T h e explanatory variables used i n the a n a l y s i s are; m a r k e t concentration rate i n the  m a i n product o f each f i r m , advertisement-sales ratio, total asset v a l u e , product s p e c i a l i z a t i o n rate, sales g r o w t h rate, v a r i a n c e i n sales v a l u e s , the percentage o f shares h e l d b y the affiliated c o m p a n i e s a n d the corporate g r o u p d u m m i e s . 2 5  A d i s t i n c t i v e feature o f their study is that their indices for s h a r e h o l d i n g a n d directorship  ties i n c l u d e b o t h direct a n d indirect relations. T h e reason w h y they i n c l u d e indirect ties into their analysis is that direct ties ignore indirect relations s u c h as a parent-grandchild r e l a t i o n o f companies.  31  merits i n other f i r m s . T h i s is a huge departure f r o m the above class o f literature. T h e purpose o f his study is to f i n d e v i d e n c e that supports his argument that corporate s h a r e h o l d i n g i n trading partners deters opportunistic b e h a v i o r o f the partners. U s i n g a regression m o d e l , s h a r e h o l d i n g b y e a c h f i r m i n other affiliates is e x p l a i n e d b y the characteristics o f b o t h i n v e s t i n g a n d invested f i r m s . A m o n g the explanatory variables are p r o x i e s o f t r a d i n g relations b e t w e e n i n v e s t i n g a n d invested c o m p a n i e s . T h e percentage o f i n v e s t i n g (or invested) c o m p a n y ' s industry's purchases o f intermediated inputs that are f r o m invested (or investi n g ) c o m p a n y ' s industry are the proxies. It is f o u n d that s t o c k investment is larger b e t w e e n c o m p a n i e s w i t h stronger trading ties. I n summary, a l t h o u g h there are some exceptions, m a n y e m p i r i c a l studies f i n d that c o m panies w h i c h are m o r e c l o s e l y t i e d together w i t h corporate s h a r e h o l d i n g t e n d to e x h i b i t l o w e r but less v o l a t i l e profit rates. T h i s is often regarded as a " s t y l i z e d " fact for corporate s h a r e h o l d i n g a m o n g Japanese c o m p a n i e s .  2.3  Concluding Remarks  Aoki's  risk-sharing  argument is a n attempt to e x p l a i n this " i n s u r a n c e "  phenomena  a m o n g g r o u p f i r m s . I n his stock-swap m o d e l , the v a l u e o f shares o w n e d b y affiliates s h o u l d be equal to the v a l u e o f shares that a c o m p a n y o w n s i n the affiliates. W i t h d i v i d e n d payments/receipts, the m o r e a c o m p a n y invests i n other c o m p a n i e s , the less v o l a t i l e the p r o f i t rates o f the company. A o k i ' s argument consistently p r o v i d e an e x p l a n a t i o n for the l o w e r v o l a t i l i t y a m o n g g r o u p c o m p a n i e s , as w e l l as the " i n s u r a n c e " m e c h a n i s m . H i s m o d e l , h o w -  32  ever, c a n not e x p l a i n the l o w e r profit rates o f those c o m p a n i e s . W i t h respect to the " i n s u r a n c e " a m o n g g r o u p f i r m s , the other theories p r o v i d e n o e x p l a n a t i o n , or e v e n suggest the opposite. T h e competitive-effect argument predicts that the profits o f the f i r m s s h o u l d be r a i s e d w i t h r e d u c e d c o m p e t i t i o n . S i n c e those c o m p a n i e s are i n the same industry a n d their profit rates are l i k e l y to be correlated, r i s k r e d u c t i o n effect o f s u c h investment must be s m a l l , i f any. T h e control-rights arguments, except N y b e r g , also predict h i g h e r profit rates i n firms w i t h cross shareholding. M o r e o v e r , Osano's m o d e l says that a cross s h a r e h o l d i n g arrangem e n t a l l o w s p r e c i p i t a t i n g firms to invest i n a r i s k project, w h i c h cause m o r e v o l a t i l i t y i n the c o m p a n i e s ' ex-post profits. T h i s contradicts the f i n d i n g o f most e m p i r i c a l researches. I n most o f the e m p i r i c a l literature, the total fraction o f shares h e l d b y other g r o u p m e m bers is the o n l y v a r i a b l e to describe the shareholding structure. A firm's stock investment i n other firms, w h i c h determines the p o r t f o l i o o f the company, is not c o n s i d e r e d i n those analyses. It also r e m a i n s a mystery h o w shareholding b y affiliates c a n reduce v o l a t i l i t y o f the f i r m ' s profits. T h e e m p i r i c a l studies discussed above are intended to describe functions o f corporate groups, a n d are not d e s i g n e d to, specifically, test the theories o f corporate s h a r e h o l d i n g , except F l a t h (1996). F o r e x a m p l e , w e still d o not k n o w i f there actually is corporate shareh o l d i n g w i t h the competitive-effect m o t i v e . I n chapter 4 , w e try to find e v i d e n c e w h i c h supports each o f the three major arguments.  33  T h e next chapter is dedicated to a construction o f a r i s k - s h a r i n g m o d e l w i t h agency costs, w h i c h e x p l a i n s not o n l y the l o w e r v o l a t i l i t y but also the l o w e r l e v e l o f profit rates i n c o m p a n i e s w i t h corporate shareholding.  34  Chapter 3 Corporate Shareholding and Agency Cost  3.1  Introduction  Today a substantial amount o f corporate stocks are h e l d b y other c o m p a n i e s i n m a n y countries. There are m a n y arguments for w h y c o m p a n i e s invest i n other c o m p a n i e s . A s d i s c u s s e d i n chapter 2, A o k i ' s illustrative r i s k sharing m o d e l p r o v i d e s one o f the insight ( A o k i , 1988, p p . 2 2 5 - 2 3 4 ) . Suppose that there are t w o f i r m s (i =  1,2) a n d their  operating profits are subject to t w o independent states (j = 1,2). T h e operating profits for e a c h f i r m at each state are g i v e n b y 7r] s u c h that f i r m 1 performs better i n state 1 a n d f i r m 2 does better i n state 2; n\ > -K[ a n d ix\>  I f b o t h firms c o u l d issue n e w shares a n d swap  t h e m w i t h each other, each f i r m ' s profit, after d i v i d e n d payments a n d receipts, b e c o m e s less volatile. A o k i argues that non-saleable stakeholders o f a c o m p a n y are the p e o p l e w h o benefit from s u c h exchanges o f stocks because, otherwise, they cannot reduce their r i s k s . E x a m p l e s o f non-saleable stakeholders are e m p l o y e e s and managers. E m p l o y e e s o f a c o m p a n y accumulate their w e a l t h i n their c o m p a n y a n d part o f their w e a l t h is p a i d out as a retirement payment. T h u s they have an incentive to support corporate shareholding. M a n a g e r s also are often stakeholders o f the f i r m they w o r k for. A s standard p r i n c i p a l agent m o d e l s suggest, m a n a g e r i a l c o m p e n s a t i o n i s u s u a l l y l i n k e d to the performance o f their company. S t o c k o p t i o n is one w a y to l i n k manager's performance a n d rewards, a l t h o u g h it was i l l e g a l i n Japan u n t i l 1997. T h e r e are some other w a y s to l i n k m a n a g e r i a l r e w a r d to the  35  c o m p a n y ' s performance. I n fact, K a p l a n (1994) finds l i n k s between m a n a g e r i a l rewards a n d f i r m ' s performance e v e n a m o n g Japanese f i r m s i n w h i c h stock o p t i o n has not b e e n practiced. W h a t is important is that managers are not o n l y non-saleable stakeholders but also p r i m a l investment d e c i s i o n m a k e r s o f their f i r m s , w h i l e e m p l o y e e s are n o t M o d e l s presented i n this chapter c o m b i n e the principle-agent issue w i t h the r i s k - s h a r i n g argument. S u p p o s e that a risk-neutral shareholder is the p r i n c i p l e a n d a risk-averse manager the agent. N o n - o b s e r v a b l e m a n a g e r i a l effort is the p r i m a r y input for a company. M a n a g e r i a l p a y m e n t s c h e m e consists o f a performance-based r e w a r d a n d a f i x e d w a g e , w h e r e the performance o f a c o m p a n y is measured b y the v a l u e o f that company. T h i s performancebased p a y m e n t scheme m a k e s the managers non-saleable stakeholders o f the company. A stronger l i n k between the c o m p a n y ' s performance a n d the m a n a g e r i a l r e w a r d w o r k s i n t w o different directions. F i r s t , i t increases the risk that the managers have to face, as is d i s c u s s e d i n A o k i (1988). S e c o n d l y , it increases the manager's i n c e n t i v e to exert effort, as i n any stand a r d p r i n c i p l e - a g e n t m o d e l . G i v e n the contract, managers try to m a x i m i z e their expected utility b y c h o o s i n g the l e v e l o f their effort a n d the amount o f corporate stock investments. Shareholders, o n the other h a n d , try to extract a l l the rent f r o m the managers b y c h o o s i n g a p a y m e n t scheme w h i c h w i l l keep the managers i n the company. O n e o f the purposes o f this study is to see i f o u r m o d e l c a n p r o v i d e a consistent e x p l a n a t i o n for the " s t y l i z e d " facts that, i n Japan, c o m p a n i e s w h i c h are m o r e i n v o l v e d i n intercorporate s h a r e h o l d i n g e x h i b i t l o w e r but less v o l a t i l e p r o f i t rates m e a s u r e d by return o n assets. A o k i ' s r i s k sharing argument suggests the l o w e r v o l a t i l i t y o f profits, but not the l o w e r  36  l e v e l o f profits i n c o m p a n i e s w i t h cross-shareholding. A s discussed i n chapter 2 , none o f other arguments seem to p r o v i d e a n e x p l a n a t i o n for the " s t y l i z e d " facts. T h e structure o f this chapter is as f o l l o w s . In the s e c o n d section, the effects o f unilateral stock investment under a standard principal-agent m o d e l w i l l be considered. A s i m p l e m o d e l e x p l a i n s w h e n a n d h o w a manager c a n reduce r i s k b y i n v e s t i n g i n another company. I n this m o d e l , the i n v e s t e d c o m p a n y is a n entrepreneurial c o m p a n y — t h a t is a f i r m w i t h o u t agency p r o b l e m — a n d does not h o l d any shares i n the i n v e s t i n g company. T h e t h i r d section extends the m o d e l to bilateral investment m o d e l s , b y a s s u m i n g that the invested c o m p a n y also has the same principle-agent p r o b l e m . T h i s adds n e w tiers to the m o d e l — m a n a g e r s (and shareholders) o f the t w o c o m p a n i e s interact strategically w h e n they choose their v a r i ables. T h e fourth s e c t i o n draws c o n c l u s i o n s f r o m the s e c o n d a n d t h i r d sections.  3.2 P-A M o d e l with Unilateral Stock Investment O p p o r t u n i t y  L e t us start w i t h a standard principal-agent m o d e l . A f i r m , say firm 1, is o w n e d b y a risk-neutral i n d i v i d u a l shareholder a n d r u n b y a risk-averse m a n a g e r . 7Ti, is generated b y a manager's non-observable effort, e  7Ti  2 6  l 5  26  T h e f i r m ' s profit,  w i t h a disturbance, e i :  = e i + Ci  I n d i v i d u a l shareholders are a s s u m e d to be r i s k neutral, due to m a i n l y a t e c h n i c a l reason.  I f i n d i v i d u a l shareholders are r i s k averse, determination o f stock p r i c e becomes extremely c o m p l i c a t e d because i n d i v i d u a l shareholders intervene the m a n a g e r s ' investment d e c i s i o n s b y affecting the stock price. S i n c e the focus o f this study is o n the risk sharing b e h a v i o r o f non-saleable stakeholders (i.e. managers), i n d i v i d u a l shareholders, w h o c a n d i v e r s i f y their portfolio directly, are a s s u m e d to b e h a v e as i f they were  37  risk-neutral  i n this m o d e l .  where  61 ~  N(0,crf).  T h e r e is a cost o f effort to the manager, w h i c h i s \e\.  T h e manager's net i n c o m e is denoted  b y yi a n d the manager's utility f u n c t i o n is — exp(—r yi) x  where r  x  is the manager's degree  o f absolute r i s k a v e r s i o n . T h e t i m i n g o f the g a m e is as f o l l o w s . I n the first stage, the shareholder w r i t e s a c o n tract. S i n c e m a n a g e r i a l effort is n o n - o b s e r v a b l e , the shareholder has to w r i t e a contract o n o b s e r v a b l e v a r i a b l e s . M a n a g e r i a l r e w a r d c a n be l i n k e d to either the o p e r a t i n g p r o f i t o r the v a l u e o f the company. T h e shareholder c a n a l s o p a y a wage. I f the w a g e i s negative, it is a transfer p a y m e n t f r o m manager to shareholder. T h e manager's e x p e c t e d u t i l i t y m u s t be non-negative so that the m a n a g e r w i l l participate i n the contract. I n the s e c o n d stage, g i v e n the contract, the m a n a g e r decides o n her effort. I f opportunities to invest i n other f i r m s exist, the m a n a g e r a l s o decides o n the firm's i n v e s t m e n t .  27  S i n c e firms i n this m o d e l d o not  h a v e any fund at this stage yet, o n l y the d e c i s i o n is m a d e i n the this s t a g e .  28  F i n a l l y , the  m a n a g e r exerts effort, a n d the stochastic elements are revealed. Shares are transacted at the p r e - d e t e r m i n e d p r i c e a n d quantity as d e c i d e d i n the s e c o n d stage. P r o f i t s are distributed to the m a n a g e r a n d the shareholder a c c o r d i n g to the m a n a g e r i a l contract a n d the o w n e r s h i p structure. 2 7  I n this case, it is a s s u m e d that the manager decides o n the a m o u n t o f investment a n d  the l e v e l o f effort simultaneously. T h i s a s s u m p t i o n is different from the one u s e d i n F l a t h (1991).  I n F l a t h , managers decides o n the a m o u n t o f investment a n d , then, m a k e s their  product market decision. 2 8  B o n d financing c o u l d be i n c l u d e d i n the m o d e l . It, h o w e v e r , does n o t change the nature  o f o u r argument as l o n g as the p o s s i b i l i t y o f b a n k r u p c y is not c o n s i d e r e d .  38  W h a t f o l l o w s s h o w s that; (1) operating-profit-based a n d value-of-the-firm-based payment schemes i n the i n c e n t i v e contract are equivalent for b o t h i n d i v i d u a l shareholder a n d manager i f there is n o investment opportunity; (2) w i t h the operating-profit-based p a y m e n t scheme, a manager c a n never reduce r i s k i n her i n c o m e b y i n v e s t i n g i n another c o m p a n y a n d ; (3) w i t h the f i r m - v a l u e - b a s e d payment scheme, a manager c a n reduce r i s k b y i n v e s t i n g i n another company, w h i c h eventually benefits the shareholder. (1-1) Operating-Profit-based Payment Scheme with No Investment Opportunity S u p p o s e that the m a n a g e r i a l r e w a r d is a fraction A i o f the operating profit p l u s a w a g e wi.  T h e n the manager's net i n c o m e , y ,  is Ai7Ti + w\ — e f / 2 .  x  G i v e n that the manager's  u t i l i t y f u n c t i o n is — e x p ( — n y i ) , the certainty equivalent i n c o m e for the manager, z\, is  zi  =  XiEfoi] -  =  A  l C l  +  W l  ^-Var[yi]  -ie?-^A?<jf.  (3.1)  T h e last t e r m is the r i s k p r e m i u m . In the s e c o n d stage, the manager m a x i m i z e s the certainty equivalent i n c o m e , z\, w i t h respect to her o w n effort, e . x  H e n c e the o p t i m a l l e v e l o f effort i s e* = A j . T h e manager  exerts m o r e effort w h e n the m a n a g e r i a l r e w a r d is m o r e strongly l i n k e d to the operating profit o f the f i r m . A s y o u see i n the a b o v e equation, a h i g h e r A i increases not o n l y m a n a g e r i a l effort but a l s o the degree o f r i s k that the manager is e x p o s e d to.  39  Shareholder's net i n c o m e , u\, i s (1 — Ai)7Ti — w\. B e i n g r i s k neutral, the shareholder is c o n c e r n e d w i t h his e x p e c t e d i n c o m e , E[ui] = (1 — A ^ e ! — wi. I n the first stage, the shareh o l d e r m a x i m i z e s his expected i n c o m e subject to the manager's p a r t i c i p a t i o n constraint:  m a x ( l — AiJ-EfTTi] —w\=  max(l  — w\  (32)  subject to  i + i~2  x  w  1  _  T  l<Tl  A s s u m i n g that the p a r t i c i p a t i o n constraint i s b i n d i n g , the s o l u t i o n i s  and  I f the manager is r i s k averse (i.e. r  x  > 0 ) , a higher l i n k to the operating p r o f i t (i.e.  larger A i ) assigns m o r e r i s k to the manager. A l t h o u g h the shareholder h i m s e l f is risk neutral, a large risk p r e m i u m for the manager means that less c a n be extracted f r o m the manager w h i l e k e e p i n g the manager i n the f i r m . H e n c e the shareholder has t o set A j s m a l l at the expense o f manager's i n c e n t i v e so that the r i s k p r e m i u m for the manager w i l l be s m a l l . See F i g u r e 3.1. N o t e that <j\ is assumed to be one i n a l l o f the figures i n this chapter.  40  I  0  ,  .  .  ,  1  1  .  .  ,  .  1  1  .  2  •  ,  1  .  1  3  .  1  4  F i g u r e 3 . 1 : A * as F u n c t i o n o f r  x  41  .  .  !  •  1  1  •  5  : M o d e l (1-1)  1  P• ,  6  F i g u r e 3.2 s h o w s that as the manager's degree o f risk a v e r s i o n rises, the w a g e increases, initially, a n d then d e c r e a s e s .  T h e i n c r e a s i n g part is associated w i t h the gradual w e i g h t  29  shift f r o m a performance-based r e w a r d towards a f i x e d wage. A s is s h o w n a b o v e , w h e n the manager's degree o f risk a v e r s i o n is s m a l l , the shareholder g i v e s h i g h e r i n c e n t i v e to the manager. W i t h the h i g h e r incentive, the expected profit o f the c o m p a n y is large, a n d the shareholder asks the manager to pay a higher " f r a n c h i s e ' ' fee (i.e. negative wage). T h e m i d d l e part o f the f u n c t i o n s h o w s the case w h e r e , i f the manager is moderately risk averse, the shareholder has to p r o v i d e a p o s i t i v e w a g e to keep the m a n a g e r i n the company. I f the manager is h i g h l y risk averse, the risk p r e m i u m is h i g h , but not so h i g h because the m a n a g e r i a l p a y m e n t is w e a k l y l i n k e d to the performance o f the c o m p a n y b y a l o w e r A i value. T h e w a g e c a n be l o w e r e d accordingly. T h i s is s h o w n i n the decreasing part o f the function. I n e q u i l i b r i u m , the shareholder's expected p a y o f f is  £  ' " ' l = 2(TT^!)-  (  3  '  5  >  F i g u r e 3.3 depicts the shareholder's e x p e c t e d i n c o m e , w h i c h decreases as the manager's degree o f r i s k a v e r s i o n increases. T h i s m a k e s a b e n c h m a r k case for the f o l l o w i n g argument.  (1-2) Value-of-the-Firm-Based Payment Scheme with No Investment Opportunity 2 9  w* is i n c r e a s i n g i f ra  2  < 3, w h i l e decreasing i f ra  2  d  ra  dra  2  2  - 1  3 -  2(1+rcr ) 2  2 (1 +  2  42  > 3 because  ra  2  ra f 2  Suppose that e v e r y t h i n g is the same as i n m o d e l 1-1, except that the m a n a g e r i a l r e w a r d is a fraction A i o f the v a l u e o f the f i r m plus a wage, w\. T h e v a l u e o f the f i r m , v\, is d e f i n e d after w a g e payment. It i s , therefore, -K\ — w , i f there is no outside investment opportunity. x  T h e n the manager's i n c o m e , y  u  is Ai(7Ti — wi)  i n c o m e for the manager, z\, is A i l ? [7^ — wi\-\-wi  + w  x  — \e\,  a n d the certainty equivalent  — \e\ — y A f t r . T h e certainty equivalent 2  i n c o m e is m a x i m i z e d , as before, w h e n e\ — \ \ . T h e shareholder's expected i n c o m e is (1 — \\)E\K\  — w\] i n this setup. T h e sharehold-  er's m a x i m i z a t i o n p r o b l e m is m a x ( l — Ai)i?[7ri — w\\ = m a x ( l — Ai ) ( A i — w ) x  subject to A i ( A i - Wi) + w i -  -Aj  T h i s f o r m u l a appears different f r o m the p r e v i o u s m o d e l . H o w e v e r , a s s u m i n g the part i c i p a t i o n constraint to b i n d and m a n i p u l a t i n g the expression to e l i m i n a t e the w a g e , the red u c e d f o r m o f the m a x i m i z a t i o n p r o b l e m is the same i n the t w o m o d e l s . T h u s , the o p t i m a l choices o f A i , a n d hence the l e v e l o f effort, is the same as i n m o d e l 1-1: A J = 1/(1 + n trf). T h e w a g e is different,  2(1 + n c r ^ r i c r .2' ?  44  (3.6)  because the v a l u e o f the f i r m i s d e f i n e d b y the operating profit m i n u s f i x e d wage. D e s p i t e the change, w\ has the same property as i n the p r e v i o u s m o d e l — i t i s i n c r e a s i n g i n r a n d a x  i f b o t h r i a n d a are s m a l l , w h i l e decreasing i f they are l a r g e .  30  A l t h o u g h w\ i s different, the shareholder's expected p a y o f f is the same as i n m o d e l 1-1.  T h i s i s because the shareholder p a y o f f is the operating profit m i n u s the manager's cost o f effort m i n u s the risk p r e m i u m , w h i c h are a l l the same as i n m o d e l 1-1. T h i s s h o w s that the t w o payment schemes i n m o d e l s 1-1 a n d 1-2 are equivalent. T h e f o l l o w i n g subsections s h o w that the e q u i v a l e n c y o f the t w o p a y m e n t schemes does n o t h o l d w h e n there i s a n outside investment opportunity. (2-1) Operating-Profit-Based Payment Scheme with Investment Opportunity S u p p o s e that there i s a n entrepreneurial company, f i r m 2 , w h i c h generates 7T2 = e2 + e2  (3.8)  w h e r e e i s a the first-best effort l e v e l w h i c h is fixed, w h i l e firm l ' s operating p r o f i t i s the 2  same, 7Ti = e + x  3 1  e is a r a n d o m variable w i t h t  e - M 0 , S ) a n d E =  3 0  °  x  G  v  i  M o r e precisely, w* is i n c r e a s i n g i n r or a i f ra < 1 + V2, w h i l e decreasing i f ra > 2  2  l + y/2 because d  _  r<r -l 2  1 ( r c r ) - 2r<T - 1 o V it . o\2 / o\o 2  dra 2(1 + ro- )ra 2  3 1  2  2  2  2 (1 + ra )  2  v  2  2  (ra ) 2  2  '"  e does not have to b e the first-besteffort l e v e l f o r the f o l l o w i n g argument to h o l d . 2  45  F r o m c o n v e n t i o n , cn stands for the standard d e v i a t i o n o f shocks, tr^ is the c o v a r i a n c e bet w e e n 6i a n d €j. F i r m 1 is o w n e d b y a n i n d i v i d u a l shareholder. T h e total n u m b e r o f shares is one for each f i r m . U n d e r this c i r c u m s t a n c e , f i r m l has a n opportunity to invest i n f i r m 2. Suppose that, i n the s e c o n d stage, f i r m 1 asks f i r m 2's o w n e r to s e l l s o m e fraction c*i o f f i r m 2's shares. T h e v a l u e o f the shares is  w h i l e the cost is ct\pi w h e r e p% is the share price. A risk-neutral  owner, w h o o r i g i n a l l y h a d 1 0 0 % o f f i r m 2 , is entitled to (1 — a i ) 7 r after this transaction 2  while receiving 1991).  i n cash. T h e share p r i c e is determined b y an " e f f i c i e n t m a r k e t " ( F l a t h ,  I n a n efficient market, the p r i c e o f a share is equal to its e x p e c t e d v a l u e ; p  2  =  W h a t f o l l o w s s h o w s that n o t h i n g changes b y the existence o f outside investment opportunity, as l o n g as the manager's r e w a r d i s b a s e d o n operating profits. U n d e r a n operatingprofit-based p a y m e n t scheme, the manager's net i n c o m e , yi, a n d hence the certainty e q u i v alent i n c o m e , z\, is the same as i n m o d e l 1-1 (equation 3.1). Therefore the manager's c h o i c e remains the same as w e l l : e\ = \\. S i n c e z\ is independent o f a\, the a m o u n t o f investment is indifferent to the manager. G i v e n the a b o v e , the p a y o f f to f i r m 1 's shareholder, u , i s d e f i n e d b y f i r m 1 's operating x  profit plus d i v i d e n d i n c o m e f r o m f i r m 2 m i n u s p u r c h a s i n g cost o f f i r m 2's share m i n u s m a n a g e r i a l compensations: u\ = E[n } 2  3 2  TTI +  OLYRI  —aie  2  — \i~ni — w\.  Since  = e i n the equation, the e x p e c t e d p a y o f f to the shareholder is E[ui\ 2  E[TX\]  = e* and  = (1 — A ^ e * —  O b v i o u s l y this is a strong a s s u m p t i o n because, for this to be true i n general, e v e r y b o d y  i n stock market has to be r i s k neutral w i t h n o t i m e preference. T h i s a s s u m p t i o n , h o w e v e r , a l l o w s us to s i n g l e out the m a n a g e r i a l risk sharing issue, w h i c h is the f o c u s o f o u r study.  46  w\, w h i c h is the same as i n m o d e l 1-1. H e n c e the shareholder's m a x i m i z a t i o n p r o b l e m is i d e n t i c a l w i t h the one i n m o d e l 1-1, as is the s o l u t i o n . I n s u m , the existence o f a n investment opportunity does not change the e q u i l i b r i u m c h o i c e s o f b o t h manager a n d shareholder i f the m a n a g e r i a l c o m p e n s a t i o n is b a s e d o n the operating profit o f the f i r m . (2-2) \ & l u e - o f - t h e - F i r m - B a s e d P a y m e n t S c h e m e w i t h I n v e s t m e n t O p p o r t u n i t y T h e next s h o w s that, i f the m a n a g e r i a l r e w a r d is p a i d based o n the v a l u e o f the f i r m , i n t r o d u c t i o n o f outside investment opportunity benefits the shareholder. W h e n f i r m 1 holds a fraction a  x  o f f i r m 2 , the v a l u e o f f i r m 1 i s ,  f 1 = 7Tj -f Ct\V — C*lP2 — IV1 2  where v  2  i s the v a l u e o f f i r m 2. T h e terms o n the right h a n d side o f the equation are; the  operating profit o f the f i r m ; the m a r k e t value o f the shares purchased f r o m an i n d i v i d u a l shareholder o f f i r m 2; the m o n e y that is p r o m i s e d to be p a i d to the i n d i v i d u a l shareholder; a n d the f i x e d w a g e p a i d to the manager. These four items define the market v a l u e o f f i r m 1. S i n c e f i r m 2 does not o w n any f i r m ' s shares, the v a l u e o f f i r m 2 is s i m p l y e q u a l to its operating profit: v  2  — ir . 2  W i t h a value-of-the-firm-based payment scheme, the manager's i n c o m e is Vi = A i « i + 1 0 1 - ^ e . 2  W i t h the efficient market a s s u m p t i o n (i.e. p  2  — E[v ]), 2  the expected v a l u e o f the f i r m is  equal to the l e v e l o f effort m i n u s w a g e p a i d to the manager, E[vi] — E\K  X  T h u s , certainty equivalent i n c o m e for the manager, z\, is  47  — w\ x  — e\ — w\.  zi = Xi(e! -  )  Wl  +  W  l  -  -e\ - -^(ai  + 2a a 12  x  + ^af).  (3.9)  G i v e n the p a y m e n t scheme, the manager i n the s e c o n d stage m a x i m i z e s z\ w i t h respect to ej a n d « j subject to 0 < a  x  < 1. T h e s o l u t i o n is e^ = A  a  and a*  = 0  if  0  =  if  -CT|<CT  = 1  if  <T < —cr|.  <  C T  1  2  <  1  1  2  <0  (3.10)  12  W h a t is f o u n d here i s as f o l l o w s . F i r s t , a * is independent o f the first stage c h o i c e s , A  x  a n d wi. S e c o n d l y , the c o v a r i a n c e must be negative for the o p t i m a l a m o u n t o f investment to be p o s i t i v e . T h i s is because cash, w h i c h is a risk-free asset, is p r o m i s e d i n exchange for a profit c l a i m i n the outside project, w h i c h i s a r i s k y asset. A r a m i f i c a t i o n o f the s e c o n d f i n d i n g is that f i r m l ' s standard d e v i a t i o n , a , x  has to be p o s i t i v e for the o p t i m a l amount  investment to be p o s i t i v e , because the c o v a r i a n c e is a l w a y s zero i f o~i is zero. T h i s means that o n l y a manager o f a r i s k y f i r m invests i n other companies. T h i r d l y , i n its interior, stock investment is larger i f the c o v a r i a n c e i n operating profits is s m a l l e r (i.e. m o r e strongly negative) and/or i f the target c o m p a n y ' s l e v e l o f r i s k is s m a l l e r . T h e degree o f risk that f i r m 1 o r i g i n a l l y faces (i.e. <ri > 0) does not affect the e q u i l i b r i u m l e v e l o f i n v e s t m e n t .  3 3  33  Lastly,  T h e reason for this is, again, that cash is p r o m i s e d i n exchange o f another c o m p a n y ' s  stocks i n o u r m o d e l a n d that i n v e s t i n g f i r m ' s d e c i s i o n is m a d e s o l e l y based o n the m a r g i n a l cost and benefit o f s u c h a n exchange.  48  i f the invested c o m p a n y is v e r y safe, the o p t i m a l l e v e l o f investment reaches the boundary,  al =  1.  T h e manager's p a r t i c i p a t i o n constraint, a n d therefore the m a x i m i z a t i o n p r o b l e m i n the first stage, depends o n the m a n a g e r i a l investment c h o i c e i n the s e c o n d stage. W h e n there is n o stock investment (i.e. a * = 0), the m a x i m i z a t i o n p r o b l e m , and the s o l u t i o n , is the same as i n m o d e l 1-2. W i t h p o s i t i v e investment, the p a r t i c i p a t i o n constraint i s  A  l  (  A  l  _  W  l  )  +  W  _ I 2 _ I l M ^ l Z Z  l  _  A  > 0 c r  i f 0 < al < 1  l 2 t T  or  A (A -^ )+ 1  1  1  -^A -^i(cT 2  W l  2  + 2cT  12  + cr|)>0  ifaj = l ,  d e p e n d i n g o n the e q u i l i b r i u m l e v e l o f investment. In order to further a n a l y z e these t w o cases, let us define a f u n c t i o n s u c h that 0"i, o- , t r ) 2  12  = ntT (l 2  ^gSr)  = r i ( t r f + 2tTi + o%) 2  - CT| < <7i2 < 0  if if  tr  12  <  -of.  It is straightforward to s h o w that fx is i n c r e a s i n g i n n , <TI, rr , and c r , as l o n g as c r 2  S i n c e the r i s k p r e m i u m is Af fx/2,  12  12  < 0.  this means that the r i s k p r e m i u m increases as either the  manager's degree o f r i s k aversion, the variances i n i n v e s t i n g or invested f i r m ' s operating profit, or the c o v a r i a n c e i n operating profit increases. N o t e also that fx is p o s i t i v e as l o n g as the parameters, r 3 4  l 5  o\, o^, a n d t r , stay i n their feasible r e g i o n s .  34  12  T h i s c a n be easily s h o w n , r e m e m b e r i n g the c o r r e l a t i o n coefficient, p, is a l w a y s be-  t w e e n m i n u s one a n d one; — 1 < p = a^/ciO-j < 1. (1) r t r ( l — o-^/afa?,) > 0 since 2  and r ,  ax >  ^ ) 0102  =  0.  49  r o i ( l - V )  Suppose that the p a r t i c i p a t i o n constraint is b i n d i n g . T h e n a r e d u c e d f o r m o f the shareholder's m a x i m i z a t i o n p r o b l e m is  max(l - Ai)Ai + A - ^ A 2  i \ ? / i ( n , (T < T , a ) .  2  U  2  (3.11)  l 2  T h e s o l u t i o n is  K^T^-T 1 + /:  (3.12)  and  ™ = wrm;  (313)  T h e shareholder's e x p e c t e d p a y o f f i s  E  K  = HTTTT) = 3 ^ -  1  (  3  1  4  )  T h e f u n c t i o n a l forms o f A* a n d w* i n this m o d e l are the same as those s h o w n i n m o d e l 1-2. R e p l a c e ji i n the a b o v e equations w i t h r a\  reproduces the s o l u t i o n s for m o d e l 1-  x  2.  3 5  E q u a t i o n 3.12 s h o w s that X\ is decreasing i n f  u  (2) r(o-f + 2(7i2 + t r | ) > CT + 2tT  0  2  s  i  n  c  + <T  2  12  2  w h i l e e q u a t i o n 3.13 s h o w s that w\ i s  e  = (  - C T ) + 2(1 + ^ ) C T C T 2  ( 7 1  2  1  = (<Tl - C T ) + 2 ( l + p ) c T 2  2  1 C  T  2  2  and r, <7\,o > 0. Q . E . D . 2  3 5  I n m o d e l s , 1-2 a n d 2-2, the value-of-the-firrn b a s e d p a y m e n t scheme is e m p l o y e d . I n  m o d e l 1-1, o n the other h a n d , the operating-profit-based p a y m e n t s c h e m e is used. T h i s is w h y the w a g e function i n m o d e l 1-1 is not c o m p a r a b l e to the ones i n m o d e l s 1 - 2 , 2 - 2 a n d the bilateral m o d e l i n the next section.  50  i n c r e a s i n g for a s m a l l e r v a l u e o f / i a n d decreasing for a larger value. A p p l y i n g the c h a i n rule, w e c a n study the c o m p a r a t i v e statics o f n , o\, tr a n d <r o n AJ a n d w J . A J is decreasing 2  12  i n a l l o f these variables. A s w e have discussed, m a r g i n a l effect o f those variables o n w\ depends o n the v a l u e o f f\. F o r a s m a l l fi, w J i s i n c r e a s i n g i n r i , 0 1 , t r a n d c r , w h i l e for 2  12  a large f\, it is decreasing. A n important fact is that fi is a l w a y s s m a l l e r than r\o~\ as l o n g as the c o v a r i a n c e is negative.  36  T h i s means that the shareholder w o u l d choose a larger A i than he w o u l d w i t h o u t  outside investment opportunity as i n m o d e l 1-2. T h e h i g h m a n a g e r i a l i n c e n t i v e m a k e s the shareholder better o f f as is s h o w n i n F i g u r e 3.4.  T h e upper line is w i t h the investment  opportunity ( m o d e l 2-2), a n d the l o w e r one is w i t h o u t it ( m o d e l 1-2) w h e n o\ = <r and 2  o~i2 =  -0.5.  T h i s figure c l e a r l y s h o w s that, w i t h outside investment opportunity, the f i r m - v a l u e based p a y m e n t scheme i m p r o v e s the shareholder's expected i n c o m e . U p to this point, w e o n l y a l l o w e d one c o m p a n y to invest, unilaterally, i n the other c o m pany. I n the next section, w e c o n s i d e r what happens i f b o t h c o m p a n i e s c a n invest. It adds  3 6  T h e p r o o f is as f o l l o w s . (1) r t r f (1 - o- /a\al) 2  2  — ra\(l  - p) 2  < ra\  since  «r?(l--^)=«7?(l-V) a n d - 1 < p < 1. (2) r ( c r + 2 t r 2  + t r | ) < ra  2  12  since  2tri2 - f o r < - 2 o - + o f < 0 2  2  f r o m er  12  < - o f < 0. Q . E . D .  51  0  1  2  3 r 1  4  5  6  ;ure 3.4: Shareholder's E x p e c t e d I n c o m e as F u n c t i o n o f r i : C o m p a r i s o n  52  n e w layers to the m o d e l , representing strategic interactions o f managers and shareholders in t w o companies.  3.3 P-A M o d e l with Bilateral Stock Investment Opportunity  3.3.1 T h e M o d e l  S u p p o s e that there are t w o f i r m s , and one shareholder and one manager for each o f the f i r m s . I n the first stage, each shareholder, independently, writes a m a n a g e r i a l i n c e n t i v e contract. I n m e a s u r i n g the performance o f manager, the v a l u e - o f - t h e - f i r m is e m p l o y e d . I n the s e c o n d stage, managers n o n - c o o p e r a t i v e l y d e c i d e o n the a m o u n t o f stock investment a n d the l e v e l o f their e f f o r t .  37  C o r p o r a t e stock investments c a n be m u t u a l .  T h e r e m a i n i n g assumptions are the same as before: Initially, there is n o corporate shareh o l d e r i n the e c o n o m y a n d none o f the i n d i v i d u a l shareholders h o l d s the shares o f m o r e than one f i r m ; the n u m b e r o f shares for e a c h f i r m i s e q u a l to one; managers are risk-averse, w h i l e i n d i v i d u a l shareholders are risk-neutral. T h e operating profit o f f i r m i (i = 1,2) is 7Tj -  3 7  6 j " j - 6j  It m a y require s o m e d i s c u s s i o n whether managers i n Japanese c o m p a n i e s are coopera-  t i v e or non-cooperative. F o r m a n y o f o u r eyes, they are s e e m i n g l y cooperative. Various ties, i n c l u d i n g s h a r e h o l d i n g ties, between the c o m p a n i e s m a y be used as " e v i d e n c e " for their c o operative nature. H o w e v e r , the " e v i d e n c e " c o u l d be s i m p l y the outcomes o f i n d i v i d u a l l y rational behavior. O n e o f the purposes o f this chapter is to s h o w that cross s h a r e h o l d i n g c a n happen e v e n under non-cooperative e n v i r o n m e n t .  53  where e~JV(0,£).  T h e m a r k e t v a l u e o f f i r m i after corporate s h a r e h o l d i n g a n d w a g e payments is  Vi — 7Ti + CUVj - CXiPj - Wi w h e r e an is a fraction o f firm j's shares h e l d b y f i r m i a n d p^- is f i r m fs the above equations for v  it  Vi = —  T h e value o f the f i r m , v  it  share p r i c e . S o l v i n g  w e obtain  {ui 4- otiKj - a y ^ - a ^ p * -  ctiWj  - Wi).  is distributed a m o n g the residual c l a i m a n t s ;  (3.15)  to the manager,  cxjVi to the corporate shareholder, a n d (1 — Aj — <Xj)vi to the i n d i v i d u a l shareholder o f f i r m i. U n d e r the efficient market a s s u m p t i o n (i.e. pi = E[vi\), the expected v a l u e o f the f i r m is equal to the l e v e l o f effort m i n u s the w a g e , E[vi] = E[iTi] - Wi = ei - w .  (3.16)  t  H e n c e manager i ' s certainty equivalent i n c o m e , under the v a l u e - o f - t h e - f i r m based paym e n t scheme, is  Z l  = Xi (ei - Wi)+Wi - -e  {  2  (  i  _  a  ^  )  2  (3.17)  T h e r i s k p r e m i u m is c o n c a v e i n the a m o u n t o f the firm's investment, cti. It is also a function o f counter-investment, aj. T h e counter-investment increases the risk p r e m i u m as l o n g as ai is p o s i t i v e . T h i s is because, w i t h h i g h e r counter-investment, m o r e o f f i r m i's  54  investment into f i r m j is re-invested i n f i r m i, thereby r e d u c i n g the effectiveness o f f i r m z's investment i n f i r m j. We m o d e l the game as a two-stage game. I n the first stage, shareholders % and j s i m u l taneously c h o o s e their m a n a g e r s ' c o m p e n s a t i o n schemes b y setting (A;, Wi) a n d (\j,Wj)  re-  spectively. I n the s e c o n d stage, manager % and j s i m u l t a n e o u s l y choose their efforts l e v e l s , ei a n d ej, a n d investment shares, ai a n d <x,. We s o l v e for the subgame perfect e q u i l i b r i u m b y w o r k i n g b a c k w a r d s f r o m the s e c o n d stage.  3.3.2  T h e Solution  T h e Second Stage M a n a g e r i's objective is to m a x i m i z e its certainty equivalent i n c o m e , z ; , taken as g i v e n the strategy o f manager j. aiaj  T h e constraints o n its c h o i c e s are (i) 0 < a*, ex, < 1 a n d ( i i )  ^ 1. T h e last constraint e x c l u d e s the case w h e r e ai a n d a , are b o t h equal to 1, w h i c h  w o u l d be the case i f the r i s k p r e m i u m is infinite. W i t h o u t loss o f generality, w e c a n assume 0~i > (Tj.  F r o m the first order c o n d i t i o n , the l e v e l o f effort for manager i is e*  =  M a n a g e r i ' s best reply to manager j ' s investment c h o i c e is  a  ^  H  -  ^  55  ^  M  (3.18)  a s s u m i n g a n interior s o l u t i o n . T h e c o n d i t i o n f o r ai € ( 0 , 1 ) for a l l values o f <x, is —o < 2  Oij < 0 .  3 8  I f the c o v a r i a n c e i s s o s m a l l that  < —o , the o p t i m a l v a l u e o f ai i s equal 2  to one f o r l o w values o f ex,. I f the c o v a r i a n c e is positive, m a n a g e r z's best reply i s n o t to invest i n f i r m j. T h e a b o v e c o n d i t i o n s are the same as those f o r the u n i l a t e r a l investment m o d e l (i.e. m o d e l 2-2, hereafter) to have a n interior solution. I n the f o l l o w i n g a n a l y s i s , w e assume that these c o n d i t i o n s are satisfied f o r i = 1,2. T h e best reply functions for the investment c h o i c e i n the bilateral m o d e l has several interesting properties. F i r s t , a is independent o f the first stage c h o i c e s , As a n d ws. E a c h {  shareholder i n the first stage faces a s i m p l e o p t i m i z a t i o n p r o b l e m , that is, there i s n o strateg i c interaction between shareholders. a n d i n standard d e v i a t i o n , o j . investment, <x,, i s n o t z e r o . 3 8  Secondly, a , i s decreasing i n the c o v a r i a n c e , t  a  iJ7  T h i r d , ai is decreasing i n Oi > 0 as l o n g as the counter  3 9  T h i s is because, g i v e n other things constant, a part o f f i r m  4 0  T h e first inequality c o n d i t i o n i s d e r i v e d f r o m a fact that a* i s a decreasing f u n c t i o n o f  « j , as w i l l be p r o v e d later i n another footnote. B a s e d o n this property, the upper b o u n d i s  g i v e n b y a* \ =o=  < 1-  aj  3 9  T h e proofs are as f o l l o w s .  da* _ -a) + a a 2  2  is negative since  -cT| + cT a 2  2  < <  -a +<j aJ ^=a <- ^ 2  2  i  2  (  ij  j  (Tin  0 < = - 1 < — ^ < 0. CiCTj  Oa*  da* do)  doi  do  2  doj  ffij+pZgj (a  2  {  + ajCTij)  2  ^ 3  is negative since, for 0 < <Xj < 1, o-y -I- o f a,- < cry + o- (—(Tij/o ) 2  Q.E.D. 4 0  The p r o o f is;  56  2  — 0.  i's investment i n f i r m j returns to firm i t h r o u g h recursiveness o f cross s h a r e h o l d i n g a n d thereby, i f firm i is riskier, the stock investment i n f i r m j b e c o m e s less effective. F o u r t h , ai is d e c r e a s i n g i n the opponent's investment a m o u n t at a n i n c r e a s i n g rate (i.e. ai a n d aj are strategic substitutes).  41  T h e i n t u i t i o n is that counter-investment decreases the m a r g i n a l  effectiveness o f stock investment to reduce risks. F o r e x a m p l e , suppose w e ignore the adj u s t m e n t o f a counter-investment b y o m i t t i n g (1 — a ^ t x , )  i n c o m p u t i n g the v a r i a n c e o f the  - 2  f i r m ' s v a l u e . T h e n f i r m i's reaction f u n c t i o n b e c o m e s a» = —tr^/tr . T h e investment l e v e l 2  i n this case is independent o f the other c o m p a n y ' s c h o i c e , a n d is the s a m e as i n a u n i l a t e r a l investment m o d e l . T h i s amount o f investment a l w a y s exceeds the a m o u n t w i t h p r o p e r adj u s t m e n t f o r the counter-investment, w h i c h i s s h o w n b y equation 3.18. I n other w o r d s , the stock investment under cross s h a r e h o l d i n g situation is not as effective as it is under n o n cross s h a r e h o l d i n g . F i g u r e 3.5 a representative best r e p l y f u n c t i o n for m a n a g e r i.  da* _ da* do? c9<7; is negative since cr? + ajO^  _  aj  do- do-j  a  2  > cr + ( - ^ J C T ^ 2  investment stays i n t e r i o r (i.e. 0 < aj <  ^  + ajOij  2  1  > 0 for  —).  Q.E.D. 4 1  T h e first order d e r i v a t i v e , da*(aj)  +  =  daj  is negative because — 1 < p = aijJGiCTj  (CT + ajOij 2  oftr  2  4 )  2  > tr?- > 0.  S i m i l a r l y , the s e c o n d order d e r i v a t i v e , d aj 2  is negative for a  tj  l J  < 0.  57  ^  (cr? + ocjO-ijY  < 0 as l o n g as the counter  -a.. / a. U  J  a. J  F i g u r e 3.5: F i r m i's R e a c t i o n F u n c t i o n  58  N o t e that a* = —aij/a , w h e n ex, = 0, and the r i s k p r e m i u m for manager i is smallest 2  at ^ A < r ( l — a j/a a ), 2  2  2  2  2  w h i c h is the same as the e q u i l i b r i u m risk p r e m i u m under t h e  unilateral m o d e l . T h e r i s k p r e m i u m becomes larger as aj increases. A t the other b o u n d a r y s o l u t i o n (i.e. w h e n aj = —a^/a ), ai — 0, a n d the r i s k p r e m i u m is the largest at y A c r , 2  2  2  w h i c h is the same as the e q u i l i b r i u m risk p r e m i u m under m o d e l s 1-1, 1-2, a n d 2 - 1 . A s w i l l be d i s c u s s e d later, this has a n important i m p l i c a t i o n f o r the first stage outcome. A N a s h e q u i l i b r i u m to this s e c o n d stage g a m e is a p a i r (a*, a*,) w h i c h lies o n b o t h best r e p l y functions. Interestingly, the best r e p l y functions i n this b i l a t e r a l m o d e l c o i n c i d e , w h i c h means that w e have c o n t i n u u m o f e q u i l i b r i a . T h i s result does n o t require the f i r m s to b e s y m m e t r i c , that i s , ai a n d aj c a n differ.  This phenomenon is due to our specific  utility f u n c t i o n , w h i c h generates a certainty equivalent i n c o m e i n a mean-variance f o r m . O t h e r types o f utility f u n c t i o n m a y p r o d u c e a u n i q u e s o l u t i o n to this stage. B e c a u s e o f the existence o f m u l t i p l e e q u i l i b r i a , w e have t o i m p o s e a n a d d i t i o n a l a s s u m p t i o n to s o l v e the first stage. B e f o r e d o i n g so, let us define a function, / » , as w e d i d i n the p r e v i o u s section: =  r (o? + 2ai a* + a*af) i  j  (1 - a*a*f  U  T h i s f u n c t i o n a l w a y s takes a non-negative v a l u e for a* a n d a* e [0,1), since a + 2oija* + a)af 2  = (a - aja*) + 2a*(aij + t^cr,) > 0 , 2  t  a n d (1 - a*a*) > 0 a n d r» > 0. U s i n g this f u n c t i o n , the risk p r e m i u m b e c o m e s A / i / 2 . 2  2  The F i r s t Stage  59  ki.8 HJ.6 HJ.4 h0.2  -O.B  -0.6  -0.4  -0.2  F i g u r e 3.6: a* as F u n c t i o n o f er^ at S y r n m e t r i c E q u i l i b r i u m : B i l a t e r a l M o d e l  In order to s o l v e the first stage, w e need to select a n e q u i l i b r i u m to the s e c o n d stage game.  L e t us assume f i r m s are s y m m e t r i c (i.e.  =  tr, =  e q u i l i b r i u m for the s e c o n d stage game (i.e. a* = a*[ = a*).  <r) a n d select a s y m m e t r i c T h e shareholders anticipate  this e q u i l i b r i u m . F r o m equation 3.18, s u c h investment c h o i c e s are, CT?, \  a  T h e constraint o n a* b i n d s i f  l + \ n-^r  /a  2  CT  2  —  i f - l < ( 7^^ < 0 .  > 0 or tr^/cr = —1. F i g u r e 3.6 s h o w s the s y m m e t r i c 2  e q u i l i b r i u m investment as a function o f the c o v a r i a n c e , a^, w h e n a — 1. T h e / j f u n c t i o n under this s y m m e t r i c e q u i l i b r i u m is  7-jof (1 + 2tT -q* + a* ) 2  i3  /•? =  (1 - a* ) 2  60  2  A s e x p l a i n e d above, it i s important t o note that the r i s k p r e m i u m i n this case lies between the r i s k p r e m i u m s i n m o d e l  2-2 a n d  1-1,1-2, a n d 2-1:  i n models  |A CT (1 - ^ ) < | / / < | A a . 2  2  2  2  (3.19)  T h e shareholder's expected p a y o f f i s (1 - A i - a*)(e* - Wi) + a*pi.  R e m e m b e r i n g pi = e i — w a n d e* = A i f r o m the s e c o n d stage, the shareholder's expected t  p a y o f f can be s i m p l i f i e d to (1 — Aj) (Ai — Wi). T h e p a r t i c i p a t i o n constraint i n the first stage is Ai(Ai-  W  ™i-lA -^/;>0. 2  i) +  A s s u m i n g a b i n d i n g p a r t i c i p a t i o n constraint, w e c a n derive a r e d u c e d f o r m o f the shareholder's m a x i m i z a t i o n p r o b l e m s i m i l a r to the one i n m o d e l  2-2  (equation  3.11). T h e s o l u t i o n  is  K =<= The s e c o n d order c o n d i t i o n is s a t i s f i e d .  42  (3-20)  A s before, a p p l y i n g the c h a i n r u l e , it is easy  to f i n d that the o p t i m a l A i i s decreasing i n the manager's degree o f r i s k a v e r s i o n , 7 \ , a n d the degree o f r i s k ,  w h i l e i n c r e a s i n g i n the c o v a r i a n c e , tr^. T h e e q u i l i b r i u m l e v e l o f  effort i s l o w e r than i n the unilateral investment m o d e l w i t h outside investment, but h i g h e r than i n the m o d e l w i t h o u t the investment opportunity. T h i s c a n b e easily p r o v e d because ritr (l 2  CT2/CT ) 4  <ff<  ncr  2  f r o m equation  3.19.  T h e s e c o n d order c o n d i t i o n , —1 — / / , is negative for the d o m a i n s i n c e / / is p o s i t i v e i n the d o m a i n . 4 2  61  bilateral investment model  W 1  -0.2  without investment (model 1-2)  -0.3  F i g u r e 3.7: w\ as F u n c t i o n o f n  : C o m p a r i s o n ( w h e n o~\ — <J<I a n d  =  —0.8)  T h e o p t i m a l w a g e is  (3.21) 2(1+  //)#'  F i g u r e 3.7 shows the o p t i m a l wages as a function o f the manager's degree o f r i s k a v e r s i o n , r for m o d e l s 1 - 2 , 2 - 2 , a n d the bilateral investment m o d e l w h e n <ri = a  2  = 1 a n d tr^ =  —0.8.  N o t e that the relative p o s i t i o n o f the functions totally changes d e p e n d i n g o n the parameters. F o r e x a m p l e , the function for m o d e l 2-2 c a n be located to the left o f the function for m o d e l 1-2 i f \<Tij\ is s m a l l . T h e shareholder's expected p a y o f f is  2(1 + //)'  62  (3.22)  In figure 3.4, this shareholder's expected p a y o f f is depicted as a function o f r. It lies bet w e e n the upper a n d l o w e r l i n e s , w h i c h , respectively, represents the expected p a y o f f w i t h the investment opportunity ( m o d e l 2-2), and w i t h o u t it ( m o d e l 1-1, 1-2, a n d 2-1). T h i s i s , again, s i m p l y because r j c r ( l — a j/afa ) 2  2  2  < f? < r^af from equation 3.19. H e n c e it is  true for any v a l u e o f parameters, CTJ = cr, = a a n d a^, as l o n g as those parameters k e e p the s o l u t i o n interior. N o w let us extend the above d i s c u s s i o n . Suppose that the anticipated e q u i l i b r i u m i n vestment c h o i c e s are not s y m m e t r i c (i.e. a* / ^  a*) a n d the f i r m s are not s y m m e t r i c (i.e.  aj) either. I n this case, shareholders' d e c i s i o n o n A s a n d ws are n o longer the same:  A* ^ Xj a n d w* ^ Wj. C o n s e q u e n t l y shareholders' expected payoffs are different. H o w ever, the expected p a y o f f for b o t h shareholders is b o u n d e d b y the t w o lines i n figure 3.4 as l o n g as the s o l u t i o n is interior. T h i s is o b v i o u s since r i £ r ( l — tr?-/cr?cT?) < f 2  t  < r^af i n  general. To c o n c l u d e , shareholders benefit from the i n t r o d u c t i o n o f stock investment opportun i t y e v e n i f the managers a n d shareholders o f the t w o c o m p a n i e s strategically choose their o w n variables. T h e shareholder's benefit, however, is less c o m p a r e d to the situation w h e r e the investment is s i n g l e sided. T h i s is because, w h e n it is m u t u a l , the r i s k reduction effect o f the stock investment declines. A s a consequence, i n order to obtain the participation o f managers w h o face a greater uncertainty, the shareholders must w e a k e n the l i n k between the c o m p a n y ' s performance and m a n a g e r i a l reward. T h e existence o f outside investment opportunity itself, however, s h o u l d s t i l l benefit the shareholders because s u c h investment  63  reduces the r i s k p r e m i u m . We must also bear i n m i n d that this happens o n l y w h e n the i n c e n t i v e contract is based o n v a l u e - o f - t h e - f i r m a n d not o n operating-profit.  3.4  Concluding Remarks  T h e m o d e l s presented i n this chapter incorporate the agency p r o b l e m w i t h the r i s k s h a r i n g argument f o r corporate shareholding. T h e y are different f r o m A o k i ' s m o d e l i n m a n y respects.  First, operating profits d e p e n d not o n l y stochastic events, but also the l e v e l o f  effort w h i c h is e n d o g e n o u s l y d e t e r m i n e d b y managers, g i v e n the i n c e n t i v e contract. Secondly, investment decisions are also m a d e n o n - c o o p e r a t i v e l y i n each f i r m . U n l i k e A o k i ' s s w a p m o d e l , the investment does not have to be r e c i p r o c a l . L a s t l y , but m o s t importantly, the degree o f m a n a g e r i a l reward's l i n k to the c o m p a n y ' s performance, as w e l l as a f i x w a g e , are e n d o g e n o u s l y d e t e r m i n e d b y the shareholders, w h i l e these factors are not i n A o k i ' s m o d e l . W i t h a unilateral investment m o d e l , w e f i n d that i f manager's degree o f risk a v e r s i o n is s m a l l , shareholder offer h i g h w o r k i n c e n t i v e s w i t h a negative w a g e to the manager. I n the extreme, i f a manager is risk-neutral, the manager b e c o m e s the r e s i d u a l c l a i m a n t a n d pays a h i g h "franchise fee" (i.e. negative w a g e ) to the shareholder. F o r managers w i t h a m e d i u m degree o f risk a v e r s i o n , shareholders l o w e r the rate o f m a n a g e r i a l r e w a r d w h i c h is l i n k e d to the f i r m ' s performance, a n d m a y have to pay a p o s i t i v e f i x e d w a g e to keep the managers i n the company. I f managers are h i g h l y risk averse, shareholders l o w e r the l i n k to the performance further. T h e r i s k p r e m i u m remains h i g h because the managers are h i g h l y risk averse, but i s not so h i g h because the m a n a g e r i a l r e w a r d is l i n k e d w e a k l y to  64  the performance o f the company. H e n c e the w a g e does not h a v e to be so h i g h to keep the managers i n the company. W i t h s u c h factors s e r v i n g to l o w e r i n c e n t i v e , the p r o f i t o f the c o m p a n y w i t h h i g h l y risk averse managers is low. C o n d i t i o n s f o r a p o s i t i v e stock investment i n the unilateral m o d e l are; (1) the manager is risk averse, (2) her m a n a g e r i a l r e w a r d is l i n k e d w i t h the v a l u e o f the f i r m she manages, a n d (3) the operating profits o f i n v e s t i n g a n d i n v e s t e d c o m p a n i e s is negatively correlated. C o r p o r a t e investment is larger i f the i n v e s t e d c o m p a n y ' s operating p r o f i t is less v o l a t i l e and/or i f the c o v a r i a n c e i n the o p e r a t i n g profits o f the c o m p a n i e s is m o r e strongly negative. W i t h the bilateral investment d e c i s i o n m o d e l , w e f i n d — i n a d d i t i o n to the above results— that corporate investment tends to be larger i f the i n v e s t i n g c o m p a n y ' s operating p r o f i t is less v o l a t i l e and/or i f there is less counter investment f r o m the invested f i r m to the investi n g f i r m . W e also f i n d that shareholders' payoffs are l o w e r than i n the unilateral investment m o d e l , because the m u t u a l i t y o f investment reduces the r i s k r e d u c t i o n effect o f stock i n vestment i n the bilateral investment m o d e l . W h a t is the relevance o f these outcomes to the e x i s t i n g e m p i r i c a l literature? A c c o r d i n g to K a p l a n (1994), m a n a g e r i a l c o m p e n s a t i o n i n m a n y c o m p a n i e s i n Japan a n d the U n i t e d States is l i n k e d m o r e strongly to o v e r a l l performance measures s u c h as the rate o f return o n total assets o r stock returns than to sales-performance measures s u c h as the g r o w t h rate o f sales. O u r m o d e l s i n this chapter p r o v i d e a n e x p l a n a t i o n w h y the i n c e n t i v e contract is m o r e l i k e l y to be based o n o v e r a l l performances w h i c h i n c l u d e s investment i n c o m e , rather t h a n sales performance w h i c h does not. T h e r i s k - s h a r i n g argument says that  65  corporate s h a r e h o l d i n g reduces the risk borne b y managers c o m p a r e d to the case w h e r e n o corporate s h a r e h o l d i n g is a l l o w e d . I n o u r m o d e l , this benefits shareholders w h o extract a l l the rents f r o m the managers. A s w e have seen, for this to happen, the performance p a y m e n t m u s t be based o n the v a l u e o f the f i r m rather than o p e r a t i n g profit. I f shareholders choose the operating-profit-based payment scheme instead, they must offer l o w e r w o r k i n c e n t i v e s to managers a n d e n d u p r e c e i v i n g l o w e r payoffs. A n o t h e r r a m i f i c a t i o n o f our theoretical m o d e l is that c o m p a n i e s w i t h corporate stock investments e x h i b i t l o w e r but less v o l a t i l e profits after d i v i d e n d s than c o m p a n i e s w i t h o u t t h e m . A o k i ' s m o d e l s h o w s that profits after d i v i d e n d s are less v o l a t i l e i n the f i r m s w i t h stock investment. W h a t i s m i s s i n g i n his m o d e l is the l i n k b e t w e e n corporate s h a r e h o l d i n g a n d performance o f the company. I n o u r m o d e l , a p o s i t i v e investment i s a n i n d i c a t i o n o f risk-averse managers. T h e m o r e risk-averse are the managers, the e q u i l i b r i u m l e v e l o f effort, and hence the profit, is lower. I n summary, c o m p a r e d to other arguments for corporate s h a r e h o l d i n g , the r i s k s h a r i n g m o d e l e x a m i n e d here p r o v i d e s a m o r e consistent e x p l a n a t i o n f o r the " s t y l i z e d " facts that c o m p a n i e s w h i c h are m o r e i n v o l v e d i n inter-corporate shareh o l d i n g e x h i b i t l o w e r but less v o l a t i l e p r o f i t rates measured b y return o n assets.  66  Chapter 4 C o r p o r a t e S h a r e h o l d i n g i n J a p a n : E m p i r i c a l Testing  4.1  Introduction  T h e r e are v a r i o u s reasons w h y c o m p a n i e s h o l d the shares o f other c o m p a n i e s . W h e n a c o m p a n y tries to enter a new, e s p e c i a l l y risky, business, the c o m p a n y sometimes creates a subsidiary. B e c a u s e o f shareholders' l i m i t e d liability, the parent c o m p a n y c a n , i n this way, reduce the risk o f the n e w business. A l t h o u g h this k i n d o f investment contributes to the increase o f corporate s h a r e h o l d i n g i n Japan, this i s not, strictly s p e a k i n g , a n investment i n a different c o m p a n y because the s u b s i d i a r y c a n be c o n s o l i d a t e d w i t h the parent company. T h i s chapter studies stock investment b e t w e e n different, i n the strict sense o f the w o r d , c o m p a n i e s . A s w e have d i s c u s s e d i n chapter 2 , three major arguments have b e e n m a d e i n the literature c o n c e r n i n g the rationale b e h i n d s u c h corporate shareholding: the c o m p e t i t i v e effect,  risk-sharing,  a n d control-rights arguments.  T h e purpose o f this chapter is to test a n u m b e r o f hypotheses that have been d r a w n f r o m these arguments, a n d to e x a m i n e the extent to w h i c h their m o t i v e s are supported b y the data. M o r e precisely, this chapter, first, discusses exogenous factors r e q u i r e d for the arguments, a n d , then, studies h o w w e l l the a m o u n t o f stock investment between t w o c o m p a n i e s is e x p l a i n e d b y those e x o g e n o u s factors u s i n g a regression analysis. D e p e n d i n g o n the purpose o f stock investment, t w o different types o f dependent v a r i a b l e , the p o r t f o l i o - c h o i c e i n d e x a n d the control-rights i n d e x , are e m p l o y e d i n the analysis.  67  E m p i r i c a l tests i n this chapter focus o n Japanese f i r m s because o f the p r e v a l e n c e o f this practice a m o n g Japanese corporations, as w e l l as the a v a i l a b i l i t y o f data. T h e s a m p l e u s e d i n this a n a l y s i s is o f 186 Japanese c o m p a n i e s that b e l o n g to s i x major f i n a n c i a l keiretsu groups d u r i n g 1 9 8 0 s .  43  T h e reason w h y o n l y the keiretsu g r o u p c o m p a n i e s are c h o s e n i s ,  a g a i n , due to the a v a i l a b i l i t y o f data. T h e f o l l o w i n g are the m a i n results o f this chapter. (1) T h e competitive-effect argument is reasonably supported b y the data. (2) T h e e v i d e n c e i n f a v o r o f the r i s k - s h a r i n g argument is somewhat w e a k e r — although f i r m s w i t h less r i s k y operating profits t e n d to attract m o r e investment, contrary to p r e d i c t i o n , the r e l a t i o n s h i p between investment a n d the c o v a r i a n c e i n the t w o f i r m s ' operating profits is a m b i g u o u s . (3) T h e strongest e m p i r i c a l support is g i v e n to the control-rights argument.  Indeed, the e v i d e n c e c o n f i r m s that a f i r m is m o r e  l i k e l y to invest i n other f i r m s that h o l d m o r e o f its o w n shares. T h i s m u t u a l i t y is a necessary c o n d i t i o n for the v a l i d i t y o f the control-rights argument. T h e structure o f this chapter is as f o l l o w s . T h e next section s h o w s h o w the hypotheses are d e r i v e d f r o m e x i s t i n g literature.  T h e t h i r d section presents the data used to test the  hypotheses. I n the forth section, the t w o m o d e l s u s e d i n the analysis are presented. T h e fifth section covers the results obtained, w h i c h is then f o l l o w e d b y some c o n c l u d i n g remarks.  4.2 Hypotheses  T h e Competitive-Effect Motive  4 3  T h e y are M i t s u b i s h i , M i t s u i , S u m i t o m o , F u j i ( F u y o or Yasuda), S a n w a , and D a i ' i c h i  K a n g y o u groups.  68  T h e competitive-effect argument w a s i n t r o d u c e d b y R e y n o l d s a n d Snapp (1986) a n d further d e v e l o p e d b y F l a t h (1991) a n d R e i t m a n (1994). See chapter 2 f o r m o r e detail. A c c o r d i n g to this class o f literature, b e i n g i n the same industry does not a l w a y s lead t o stock investments i n t o other f i r m s i n the industry. I n order to have corporate s h a r e h o l d i n g i n e q u i l i b r i u m , the product market c o m p e t i t i o n must b e B e r t l a n d ( R e i t m a n , 1994), a n d p r o d ucts m u s t b e imperfect substitutes ( F l a t h , 1991). S o m e o f the literature o n the competitive-effect argument have a c o m m o n p r o b l e m i n d e f i n i n g a f i r m ' s profit after corporate shareholding. R e y n o l d s a n d Snapp (1986) a n d R e i t m a n (1994) define a f i r m ' s profit after d i v i d e n d s b y a s i m p l e linear c o m b i n a t i o n o f operating profits o f firms: F i r m i ' s profit after d i v i d e n d s i s d e f i n e d , i n their m o d e l s , as (1 -a )'KT  +^2  sratin9  2  e r a U n g  >  w h e r e  e r a t i n g i  s f  i  r  m  * ' operating profit a n d a is the fracs  t i o n o f f i r m fs shares h e l d b y f i r m i.  t  u  T h i s s p e c i f i c a t i o n puts too m u c h w e i g h t o n the r i v a l ' s  operating profit a n d too little o n its o w n operating profit. A s a consequence, w h e n m a k i n g a p r o d u c t i o n d e c i s i o n , a f i r m tends t o produce less t h a n w h a t it w o u l d i f profits after d i v i d e n d s w e r e defined i n the w a y t o reflect the recursive structure o f c r o s s - h o l d i n g . i f t w o firms m u t u a l l y o w n 1 0 0 % o f the other's shares (i.e. a  x  = a  2  45  F o r example,  — 1), f i r m s care o n l y  about their r i v a l s , a n d neither o f the f i r m s produces a n y t h i n g under C o u r n o t c o m p e t i t i o n . T h e p r o b l e m rises d u e to ignorance o f the recursive structure o f cross-shareholding. Tanig a w a (1986) presented a w a y to take the recursive structure o f cross-shareholding into c o n -  4 4  F o r s i m p l i c i t y , cost o f p u r c h a s i n g stocks are o m i t t e d i n the f o l l o w i n g d i s c u s s i o n .  4 5  F o r e x a m p l e , i f t w o f i r m s m u t u a l l y o w n 1 0 0 % o f the other's shares (i.e. a  x  = a  2  = 1),  f i r m s care o n l y about their r i v a l s , a n d neither o f the firms produces a n y t h i n g under C o u r n o t competition.  69  sideration i n d e f i n i n g f i r m ' s p r o f i t after d i v i d e n d : j^iir?™ ™ 1  9  + a  l 7  rf  e r a t i n 9  ).  This  is also a standard f o r m u l a used i n adjustment for d o u b l e c o u n t i n g w h i c h is i n v o l v e d i n cross-shareholding ( M c D o n a l d , 1989; F r e n c h a n d Poterba, 1991 and; F e d e n i a , H o d d e r a n d Triantis, 1994). T h e f o r m u l a reflects true o w n e r s h i p interests o f the i n v e s t i n g f i r m i n the i n vested f i r m . W i t h this s p e c i f i c a t i o n , the above f u l l y integrated f i r m s s h o u l d independently realize that "the best for m e is the best for y o u " e v e n under N a s h conjecture—the total output s h o u l d be equal to the m o n o p o l y l e v e l o f output. T h i s illustrates that, i n R e i t m a n , the external benefit o f staying outside a cross s h a r e h o l d i n g arrangement is overstated because members i n the arrangement cut their p r o d u c t i o n too m u c h under C o u r n o t c o m p e t i t i o n . I n s u m , under some c o n d i t i o n s , c o m p a n i e s i n the same industry c a n earn h i g h e r profits t h r o u g h integration b y means o f stock investments. A s i m p l e , but most important, h y p o t h esis w h i c h c a n be d r a w n f r o m this argument i s ,  C E - H 1 : A f i r m , ceteris paribus, tends to h o l d m o r e o w n e r s h i p interest i n other f i r m s that b e l o n g to the same industry.  T h e literature o n the c o m p e t i t i v e effects o f corporate shareholding assumes that investi n g c o m p a n i e s are " s i l e n t " stakeholders, w h o take a n interest i n the profit o f the invested c o m p a n y but d o not exercise their v o t i n g p o w e r as shareholders. T h e r e d u c t i o n o f c o m p e tition, i f any, w o r k s through this p r o f i t sharing m e c h a n i s m . There i s , however, another w a y to i n f l u e n c e market c o m p e t i t i o n — b y h o l d i n g the stocks o f c o m p e t i n g companies. W i t h their v o t i n g rights, the shareholders o f the c o m p a n y c a n affect m a n a g e r i a l d e c i s i o n s o n such issues as p r i c e , quantity, or sales locations. A c c o r d -  70  i n g to O k u m u r a (1992a), before 1988 w h e n the Securities and E x c h a n g e L a w were r e v i s e d , m a n y Japanese c o m p a n i e s h e l d meetings w i t h large shareholders p r i o r to their a n n u a l general meetings o f s h a r e h o l d e r s .  46  T h i s practice w a s a b o l i s h e d because it w a s considered to  v i o l a t e the n e w l a w w h i c h prohibits i n s i d e r t r a d i n g m o r e strictly than before.  Okumura  c l a i m s that, e v e n today, the presidents' meetings ( s o - c a l l e d shacho-kai) p l a y the same role as the large shareholders meetings. I n a d d i t i o n , there are m a n y other chances for large corporate shareholders to meet the managers o f the invested c o m p a n y and express their c o n cerns to the managers. It is also c o m m o n for i n v e s t i n g f i r m s to m a k e their e m p l o y e e s b o a r d m e m b e r s o f the c o m p a n i e s i n w h i c h they have invested. W i t h this practice, m a n a g e r i a l dec i s i o n s o f a c o m p a n y tend to reflect the interests o f its corporate shareholders m o r e clearly. A s a result o f these i n f o r m a l institutions o f d e c i s i o n m a k i n g , a n n u a l general shareholder's meetings o f the Japanese f i r m s u s u a l l y have a c e r e m o n i a l f u n c t i o n o n l y .  4 7  A l t h o u g h the  m e c h a n i s m i s different f r o m profit sharing, this c o u l d be another reason for f i r m s to invest i n other corporations i n the same industry. T h e competitive-effect hypothesis has not yet been e m p i r i c a l l y r e s e a r c h e d .  48  A s far as  the Japanese e c o n o m y is concerned, there m a y be t w o reasons for this o m i s s i o n . O n e is that  4 6  I n Japanese corporate g r o u p c o m p a n i e s , i f a c o m p a n y o w n s 5 % o f other c o m p a n y ' s  shares, the c o m p a n y is u s u a l l y r a n k e d as one o f top ten shareholders a n d c o n s i d e r e d to be a " l a r g e " shareholder. 4 7  T h e managers u s u a l l y s o l i c i t p r o x i e s f r o m other i n v e s t i n g c o m p a n i e s , a n d v o t e for  themselves. Japanese corporate shareholders s e l d o m exercise their v o t i n g rights against the board's d e c i s i o n s , or ask a question at the annual shareholders' meetings. 4 8  P r o d u c t i o n keiretsu groups s u c h as T o y o t a group or H i t a c h i g r o u p have f i r m s f r o m  the same industry a n d have been studied extensively. T h o s e c o m p a n i e s are, however, u s u a l l y subsidiaries o f a parent c o m p a n y a n d d o not have s h a r e h o l d i n g r e l a t i o n b e t w e e n the subsidiaries.  71  Japanese a n t i - m o n o p o l y l a w s p r o h i b i t corporate s h a r e h o l d i n g w h i c h reduces market c o m petition. T h e F a i r Trade C o m m i t t e e is g i v e n the authority to j u d g e whether o r not a c o m p a n y ' s stock investment reduces market c o m p e t i t i o n . Theoretically, i f the c o m p a n y ' s practice is d e e m e d i l l e g a l , the c o m p a n y and/or its e x e c u t i v e ' s ) w i l l be f i n e d and/or i m p r i s o n e d .  4 9  Secondly, Japanese f i n a n c i a l corporate groups are s a i d to e m p l o y the s o - c a l l e d one-setprinciple. T h e one-set p r i n c i p l e refers to the fact that each Japanese f i n a n c i a l corporate g r o u p consists o f a n u m b e r o f f i r m s f r o m the entire range o f industries, s u c h that, usually, o n l y one f i r m f r o m e a c h industry participates i n the group. S i n c e m o s t e m p i r i c a l research p a i d attent i o n to w i t h i n - g r o u p data, corporate s h a r e h o l d i n g w i t h i n the same industry has not d r a w n m u c h attention f r o m researchers. T h e existence o f l a w s , however, does not guarantee that there is n o stock investment for the purpose of r e d u c i n g c o m p e t i t i o n . Rather, s u c h investments c o u l d exist across different groups i n spite of the one-set p r i n c i p l e . Consequently, it is w o r t h testing whether o r not f i r m s have a tendency to invest i n other f i r m s i n the same industry.  The Risk-Sharing Motive A o k i ( 1 9 8 8 , p p 2 2 6 - 2 3 0 ) presents a m o d e l of r i s k - s h a r i n g t h r o u g h d i v i d e n d payments. A c c o r d i n g to the m o d e l , a f i r m w h i c h i s e x p o s e d to i d i o s y n c r a t i c s h o c k s c a n reduce the after-dividend risk b y i n v e s t i n g i n other companies. N o n - s a l e a b l e stakeholders o f c o m p a nies s u c h as e m p l o y e e s a n d managers benefit m o s t f r o m inter-corporate stock investment.  4 9  See A r t i c l e s 1 0 , 9 1 , a n d 95.2 of the A n t i - m o n o p o l y A c t .  72  I n chapter 3, w e d e v e l o p a  risk-sharing  m o d e l w i t h principal-agent relations.  With  performance-based m a n a g e r i a l rewards, managers are non-saleable stakeholders o f their f i r m s . T h e y decide o n t h e i r effort and corporate investment so as to m a x i m i z e their utilities. S i n c e shareholders c a n extract a l l the rent from managers w i t h a p r o p e r l y d e s i g n e d p a y m e n t scheme, shareholders are the ones w h o benefit f r o m corporate shareholding i n o u r m o d e l . I n regard to stock investment, o u r unilateral investment m o d e l y i e l d s a p r e d i c t i o n that a f i r m tends to invest m o r e i n another f i r m w i t h l o w e r standard d e v i a t i o n and/or l o w e r c o v a r i a n c e i n operating profits (equation 3.10 i n chapter 3 ) .  5 0  See table 4 . 1 . I n a d d i t i o n to  the p r e d i c t i o n o f the unilateral m o d e l , o u r bilateral investment m o d e l f i n d s that, g i v e n the a m o u n t o f counter investment, a f i r m w i t h l o w e r standard d e v i a t i o n i n its o p e r a t i n g profit tends to invest m o r e i n the other f i r m (equation 3.18). T h i s is because, g i v e n other t h i n g s constant, part o f a f i r m ' s investment i n the other f i r m returns to the i n v e s t i n g f i r m t h r o u g h the recursive structure o f cross s h a r e h o l d i n g a n d thereby, i f the i n v e s t i n g f i r m is riskier, the stock investment i n the other f i r m becomes less effective. T h e m o d e l a l s o finds that a f i r m is l i k e l y to invest m o r e i n another f i r m w h e n the i n v e s t e d c o m p a n y o w n s fewer shares i n the i n v e s t i n g company. T h i s reflects the fact that it is less effective, i n terms o f risk r e d u c t i o n , to invest i n a f i r m w h i c h o w n s a large n u m b e r o f shares i n the i n v e s t i n g f i r m . T h i s is also due to the recursiveness o f cross shareholding. T h e f o l l o w i n g hypotheses c a n be inferred f r o m o u r theoretical m o d e l s i n chapter 3.  5 0  T h e p r e d i c t i o n s m a y change i f f i n a n c i n g m e t h o d is different from the one assumed i n  the m o d e l . .  73  R S - H 1 : A f i r m , ceteris paribus, tends to invest m o r e i n other f i r m s w i t h a l o w e r c o variance i n operating profits.  R S - H 2 : A firm, ceteris paribus, w i t h a l o w e r standard d e v i a t i o n i n its o p e r a t i n g p r o f i t tends to be a target o f m o r e investment b y other f i r m s .  R S - H 3 : A firm, ceteris paribus, w i t h a l o w e r standard d e v i a t i o n i n its operating p r o f i t has a tendency to invest m o r e i n other f i r m s to reduce risk.  R S - H 4 : A f i r m , ceteris paribus, is l i k e l y to h o l d a larger p o r t i o n o f another  firm's  stocks w h e n the invested c o m p a n y o w n s fewer shares i n the i n v e s t i n g company.  I n regard to the t h i r d hypothesis, there m a y be an opposite argument—a firm w i t h a h i g h e r standard d e v i a t i o n i n its operating p r o f i t has a stronger i n c e n t i v e to reduce r i s k , a n d hence to invest m o r e i n t o other f i r m s . It is true that r i s k i e r f i r m s have a stronger i n c e n t i v e for investment. T h e q u e s t i o n is i f s u c h f i r m s a c t u a l l y invest m o r e o r not. A s e x p l a i n e d a b o v e , o u r t w o - f i r m m o d e l finds, because o f the r e c u r s i v e structure o f cross s h a r e h o l d i n g , c o m p a n i e s w i t h h i g h r i s k have d i f f i c u l t y i n v e s t i n g i n other c o m p a n i e s i f c a s h is p r o m i s e d i n exchange o f another f i r m ' s stocks. I n case o f stock swaps, n o f i r m wants b e c o m e a partner o f h i g h risk c o m p a n i e s . I n s u m , h i g h r i s k i n e s s g i v e s h i g h i n c e n t i v e f o r corporate investment, but it is also a n obstacle f o r it. T h e last hypothesis is not v a l i d i f t w o c o m p a n i e s arrange to exchange each other's shares w i t h o u t actual m o n e y transaction ( s w a p o r kara-uri transaction) as illustrated b y A o k i . A s w a p transaction requires b o t h c o m p a n i e s to invest i n e a c h other a n d hence the  74  amounts o f shares o w n e d b y e a c h firm s h o u l d be p o s i t i v e l y c o r r e l a t e d .  51  S t o c k swaps, h o w -  ever, are u n c o m m o n as a means o f o b t a i n i n g stocks a m o n g l i s t e d Japanese firms, although it m a y be p r a c t i c e d a m o n g s m a l l unlisted firms. O n the other h a n d , a l l o c a t i o n o f n e w stocks to its affiliates is c o m m o n l y practiced. I n this case, the last hypothesis is s t i l l v a l i d because c a s h is p a i d i n to s t o c k - i s s u i n g firms. Unfortunately, it is i m p o s s i b l e to identify i n o u r data w h i c h shares w e r e o b t a i n e d t h r o u g h a s w a p o r other types o f transaction s u c h as market transaction and t h i r d party a l l o c a t i o n .  The Control-Rights Motive T h e r e are t w o types o f the control-rights arguments i n the literature, as s h o w n i n chapter 2. Perotti (1992) a n d B e r g l b f a n d Perotti ( 1 9 9 4 ) discuss the w a y i n w h i c h corporate shareh o l d i n g b e c o m e s a m u t u a l m o n i t o r i n g / d i s c i p l i n a r y d e v i c e w h e n the c o m p a n i e s o w n each other's shares. T h e essence o f their argument is as f o l l o w s .  52  w h i c h requires R & D efforts o f its p a r t i c i p a t i n g managers.  C o n s i d e r a n R & D project A free-rider p r o b l e m is i n -  v o l v e d i n the project. N o n e o f the managers exerts her effort i n a one-shot game, although a better p a y o f f c a n be o b t a i n e d for e v e r y manager w h e n a l l the managers put their efforts (prisoner's d i l e m m a ) . I n a repeated g a m e f r a m e w o r k , managers c a n p u n i s h , b y not putting their efforts i n the future, a manager w h o d i d not exert her effort. It m a y l e a d to the better outcome ( F o l k theorem). H o w e v e r , i f discount rates are large, the punishment m a y not  5 1  I f a n u m b e r o f firms c a n m a k e s u c h a stock exchange arrangement, they c o u l d a v o i d  to have a direct m u t u a l investment r e l a t i o n a n d the hypothesis remains v a l i d . 5 2  See chapter 2 for their o r i g i n a l argument.  75  be strong e n o u g h to p r o d u c e the desirable outcome. W h e r e a s , w i t h a cross s h a r e h o l d i n g arrangement, a d e v i a t i n g manager c a n be ousted b y the other managers, a n d this threat o f j o b loss, w h i c h is a m o r e severe punishment, c a n i n d u c e every manager to c o m p l y w i t h the agreement to a l w a y s exert their efforts. N y b e r g (1995) and O s a n o (1996) focus o n the fact that managers i n a cross shareholdi n g ( C S H ) arrangement c a n defend themselves against a takeover threat w h i c h c o m e s f r o m outside the arrangement.  N y b e r g argues that managers c a n b u y the shares o f other c o m -  panies a n d ask the managers o f those c o m p a n i e s to support e a c h other i f threatened b y a takeover.  T h i s means that the managers h o l d the shares o f their o w n c o m p a n i e s .  53  Os-  a n o ( 1 9 9 6 ) argues that a manager c a n act m y o p i c a l l y due to the threat o f a takeover. M o r e specifically, w h e n there are t w o projects, a risk-free l o w - r e t u r n a n d a h i g h - r i s k high-return project, managers m i g h t invest i n the risk-free project i f the return o f the risky project i n a b a d state is v e r y l o w a n d thus generates a h i g h p r o b a b i l i t y o f a takeover. T h e managers, however, m i g h t invest i n a r i s k y project i f they c o u l d establish a C S H r e l a t i o n a n d r e m o v e the threat o f a takeover. These arguments are not necessarily m u t u a l l y e x c l u s i v e . A m i n i m u m requirement for the arguments is that, i n order to participate i n a C S H relationship, a f i r m has to possess shares i n at least one o f the other C S H m e m b e r f i r m s , a n d , at the same t i m e , has to be p a r t i a l l y o w n e d b y at least one o f the m e m b e r 5 3  firms.  N y b e r g (1995) s h o w s that b o t h managers and i n d i v i d u a l shareholders c a n want a h i g h e r  l e v e l o f C S H . T h e managers' resistance to takeover w i l l i n d u c e a higher p r e m i u m w h i c h benefits the i n d i v i d u a l shareholders i f the takeover actually occurs. O n the other h a n d , i f the p r o b a b i l i t y o f takeover is h i g h , a higher rate o f C S H c a n increase the b a r g a i n i n g p o w e r o f the manager i n the d e c i s i o n m a k i n g process a n d , hence, the r e w a r d to the manager.  76  Various arrangements are possible for a C S H relationship w i t h n > 1. C o n s i d e r t w o examples w i t h n s y m m e t r i c f i r m s f o r m i n g a C S H group. I n one e x a m p l e , a f i r m o w n s at least a fraction, 0 . 5 / ( n — 1), o f every other f i r m s ' shares so that the total o f shares i n the former company, h e l d b y the latter n — 1 f i r m s , exceeds the m a j o r i t y needed to c o n t r o l that f o r m e r c o m p a n y (or defend that f i r m f r o m takeover b y outsiders). I n this case, every c o m b i n a t i o n o f f i r m s i n the g r o u p is i n v o l v e d i n a m u t u a l stock investment relationship. I n the other e x a m p l e , the f i r m s f o r m a c i r c l e o f stock investment relationships, and each f i r m o w n s a h a l f o f the shares o f the f i r m sitting next to it. W i t h this arrangement, there is n o m u t u a l or m u l t i p l e shareholding relationship b e t w e e n the f i r m s i n a direct way, a l t h o u g h there is indirectly.  54  T h e s e are t w o extreme examples. Various other arrangements are p o s s i b l e and,  i n the real w o r l d , a c o m b i n a t i o n o f these t w o extreme scenarios is m o r e l i k e l y to occur. W h e t h e r directly, indirectly, o r b o t h , any C S H arrangement w i l l l e a d to m u t u a l a n d m u l t i p l e shareholding. T h e first hypothesis is;  C R - H 1 : A f i r m , ceteris paribus, tends to invest m o r e i n f i r m s w h i c h o w n m o r e o f the i n v e s t i n g f i r m ' s shares, d i r e c t l y and/or indirectly.  N o t e that this hypothesis m a i n l y deals w i t h the mutuality, but not the m u l t i p l i c i t y o f C S H arrangements. A l t h o u g h i n c l u s i o n o f indirect investment relationships reflects one o f the features o f m u l t i p l i c i t y , the a b o v e hypothesis applies o n l y to bilateral relationships. I n the control-rights argument, it is important what fraction o f shares is o w n e d b y the other 5 4  A c c o r d i n g to a report submitted to the F a i r Trade C o m m i t t e e o f Japan, this type o f  c i r c u l a r investment becomes a p u b l i c c o n c e r n i n F r a n c e . A l t h o u g h c i r c u l a r share investment relations c a n be v i r t u a l l y the same as direct cross shareholding, it is not c o n s i d e r e d to be i l l e g a l i f l a w s p r o h i b i t o n l y direct cross shareholding.  77  m e m b e r f i r m s c o l l e c t i v e l y , but not i n d i v i d u a l l y . T h e greater the n u m b e r o f f i r m s i n v o l v e d i n a C S H relation, the s m a l l e r the fraction o f shares e a c h f i r m is r e q u i r e d to o w n i n the other f i r m s i n order to m a i n t a i n the total amount o f shares h e l d as a C S H group.  One  p r o b l e m is that w e d o not k n o w h o w m a n y c o m p a n i e s and/or w h i c h s p e c i f i c c o m p a n i e s are p a r t i c i p a t i n g i n a C S H relation. O n e o f the w a y s to deal w i t h the m u l t i p l i c i t y p r o b l e m is to use p r o x y to identify the m e m b e r s o f a C S H arrangement. A s far as the Japanese e c o n o m y is c o n c e r n e d , a corporate g r o u p c a n be u s e d as the proxy. I f the C S H arrangement is a corporate g r o u p , then w e s h o u l d expect control-rights investments a m o n g m e m b e r f i r m s regardless o f the amount o f direct counter investments f r o m the f i r m s to be invested i n . H e n c e a hypothesis c a n be i n t r o d u c e d s u c h as;  C R - H 2 : A f i r m , ceteris paribus, is l i k e l y to invest i n f i r m s w h i c h b e l o n g to the same corporate g r o u p .  A l t h o u g h this hypothesis is not a perfect treatment o f the m u l t i p l i c i t y issue o f C S H arrangements, it p r o v i d e s a supplementary test for the strength o f the argument. I n Japan, m o s t corporate shareholders are referred as "stable shareholders" w h i c h means that they keep h o l d i n g shares as l o n g as the i n v e s t e d f i r m s p e r f o r m reasonably. O s ano(1996)'s argument i m p l i e s that c o m p a n i e s i n a C S H arrangement are able to invest i n a h i g h - r i s k high-return project because the f i r m s i n the arrangement w i l l not sell t h e i r shares a n d support managers e v e n i f a b a d state occurs. T h e last hypothesis i s ;  78  C R - H 3 : F i r m s ' stock investment d e c i s i o n s , ceteris paribus, are not affected b y shortt e r m performance, s u c h as sales g r o w t h rates o r operating profit rates o f target f i r m s .  T h e f o l l o w i n g sections w i l l e x a m i n e w h i c h hypotheses are supported b y the data. M o r e concretely, the amount o f stock investment b e t w e e n t w o c o m p a n i e s is e x p l a i n e d b y characteristics o f the c o m p a n i e s , u s i n g a regression analysis. T h e r e are t w o different aspects o f c o m m o n stocks; c o n t r o l rights a n d p r o f i t c l a i m s . E a c h o f the above hypotheses is associated w i t h one o f these aspects.  F o r e x a m p l e , the  control-rights argument, o b v i o u s l y , is based o n the f o r m e r characteristic o f c o m m o n s t o c k s , w h i l e the r i s k - s h a r i n g argument is rooted i n the latter. A c c o r d i n g l y , t w o different types o f dependent v a r i a b l e , the control-rights i n d e x a n d the p o r t f o l i o - c h o i c e i n d e x , are e m p l o y e d i n order to test these hypotheses.  O u r analysis focuses o n direct investment relations. We, however, present a w a y to i n c l u d e i n d i r e c t investment relations i n the analyses as w e l l . A l t h o u g h f i r m s p r i m a r i l y choose o n l y their direct amount o f investment i n other f i r m s , they m a y not determine o n l y their o w n direct investment amount. U n d e r c o o p e r a t i v e e n v i r o n m e n t , f i r m s coordinate their i n vestment a m o n g themselves. F o r e x a m p l e , a cross s h a r e h o l d i n g arrangement is f o r m e d as a c o l l e c t i v e d e c i s i o n . E v e n under n o n - c o o p e r a t i v e e n v i r o n m e n t , f i r m s s h o u l d , or at least try to, c o n s i d e r their true o w n e r s h i p interests, w h i c h c a n be correctly m e a s u r e d o n l y b y t a k i n g i n d i r e c t investment relations into account. T h i s is important for the competitive-effect a n d the r i s k - s h a r i n g arguments.  79  A l t h o u g h there is a statistical difficulty, as w e describe later, to incorporate indirect i n vestment relations into the analyses, one advantage o f indirect investment indices is that they r e v e a l covert investment relations between firms. F o r e x a m p l e , a o n e - d i r e c t i o n a l c i r c u l a r t y p e o f " c r o s s " s h a r e h o l d i n g arrangement cannot be detected o n l y b y l o o k i n g at direct investment relations. F i r m s m a y invest i n d i r e c t l y for competitive-effect reason, but this is i g n o r e d i f o n l y direct investment indices are e m p l o y e d . I n regard to the r i s k - s h a r i n g argument, the p o r t f o l i o indices w h i c h consider indirect investment represent true a l l o c a t i o n s o f f i r m s ' assets. N o t e that the degree o f r i s k i n v o l v e d i n a stock c a n o n l y be c a l c u l a t e d c o r rectly w i t h the use o f b o t h direct a n d indirect investment i n f o r m a t i o n . B e f o r e presenting the m o d e l s , the data used i n the analysis is e x p l a i n e d i n the next section.  4.3  Data  T h e subjects o f this analysis are 186 f i r m s b e l o n g i n g to s i x major corporate groups i n the 1980s.  T w e n t y - n i n e o f t h e m are f i n a n c i a l institutions s u c h as banks, trust b a n k s ,  a n d life or marine-fire insurance companies.  T h e f i n a n c i a l institutions e m p l o y different  a c c o u n t i n g methods and, often, d o not p r o v i d e c o m p a r a b l e data. F u r t h e r m o r e , consistent data are not a v a i l a b l e for three o f the n o n - f i n a n c i a l institutions w h i c h were not l i s t e d at the b e g i n n i n g o f the s a m p l e p e r i o d .  55  D u e to these o m i s s i o n s , the analysis is based m o s t l y  o n the observation o f 154 n o n - f i n a n c i a l companies. H o w e v e r , s t o c k h o l d i n g data o f a l l 186  5 5  Itoki Trading, Mitsubishi A u t o , and Mitsubishi Construction.  80  c o m p a n i e s , i n c l u d i n g f i n a n c i a l institutions, are used to identify indirect stock investment relation o f the c o m p a n i e s . T h e f o l l o w i n g subsections e x p l a i n the r a w a n d constructed data used i n the analysis. A s i n g l e subscript j signifies f i r m j, w h i l e d o u b l e subscripts ij means that it i s a r e l a t i o n a l variable b e t w e e n f i r m s i a n d j. Superscript / indicates variables w h i c h refer to both f i n a n c i a l a n d n o n - f i n a n c i a l institutions. A l l monetary variables are c o n v e r t e d to real values u s i n g the Japanese w h o l e s a l e p r i c e i n d e x for d o m e s t i c products ( 1 9 9 0 = 1.00). M o s t o f the f i n a n c i a l data o n n o n - f i n a n c i a l c o m p a n i e s w e r e d i r e c t l y d r a w n f r o m the y e a r l y Kaisha Zaimu Karute, p u b l i s h e d b y T o y o K e i z a i S h i n p o Sha. T h e s h a r e h o l d i n g i n f o r m a t i o n was retrieved f r o m the a n n u a l p u b l i c a t i o n s o f Kigyo Keiretsu Soran also b y Toyo K e i z a i S h i n p o S h a . References to other sources are p r o v i d e d throughout this chapter as the data are presented.  4.3.1 Raw Data T h e r a w data items are s h o w n i n table 4.2. T h e sample p e r i o d extends f r o m 1980 to 1988 for most o f the data items. T h e values are as o f the e n d o f each c o m p a n y ' s a c c o u n t i n g year, unless otherwise indicated. F i s c a l year ends at the e n d o f M a r c h for a majority o f the s a m p l e f i r m s , the t i m i n g o f w h i c h i s consistent w i t h that o f o u r stock investment data. ASSETj  (total asset v a l u e , o r soshisan ) is the s u m o f equity a n d debt taken f r o m the  balance sheet o f each company. EMPj SALEj  i s the n u m b e r o f e m p l o y e e s . represents sales revenues i n m i l l i o n y e n .  81  SGROWj  (sales g r o w t h rate) is the annual rate o f g r o w t h i n sales revenue f r o m the  p r e v i o u s year; this year's sales revenues m i n u s the previous year's sales revenues d i v i d e d b y the p r e v i o u s year's sales revenues. ADj  a n d RDj are a d v e r t i s i n g a n d R & D expenditures, respectively, as they appear  i n the o f f i c i a l f i n a n c i a l statement o f each c o m p a n y .  56  I n the a n a l y s i s , these data have b e e n  n o r m a l i z e d b y d i v i d i n g b y the sales revenue: ADj/SALEj, KLj,  and  RDj/SALEj.  capital-to-labor ratio, is p r o v i d e d as tangible fixed asset value m i n u s construc-  tion prepayment d i v i d e d b y the number of employees and executives. A b r i e f d e f i n i t i o n o f the tangible asset i s ; asset w h i c h are u s e d for p r o d u c t i o n , f o r e x a m p l e , b u i l d i n g s , l a n d , v e h i c l e s , a n d p r o d u c t i o n facilities. T h e p r e p a y m e n t made for c o n s t r u c t i o n i n process i s i n c l u d e d as a part o f the tangible asset v a l u e i n a c c o u n t i n g . I n order t o measure the s i z e o f tangible assets w h i c h are currently used for p r o d u c t i o n , c o n s t r u c t i o n prepayments are subtracted. I n c o m p u t i n g this v a r i a b l e , the y e a r l y data b o o k uses the averages o f each o f the a b o v e components at the b e g i n n i n g a n d the e n d o f the a c c o u n t i n g year. A l t h o u g h w e s h o u l d use the end-of-year values f o r consistency, unfortunately, they are not a v a i l a b l e . OPEj  ( O p e r a t i n g p r o f i t rate, uriagedaka eigyo rieki ritsu ) is d e f i n e d as operating  profits d i v i d e d b y sales revenues t i m e s 100, w h e r e the operating profits (eigyo rieki ritsu) are d e f i n e d as sales revenues m i n u s input costs m i n u s sales costs m i n u s management c o s t s .  5 6  57  A w e l l k n o w n d r a w b a c k o f these data items is that some o f the c o m p a n i e s d o not report  these expenditure figures i n the o f f i c i a l f i n a n c i a l statement since they are not r e q u i r e d to d o so b y law. 5 7  T h e s a m p l e p e r i o d o f this data i t e m starts from 1978. T h e data before 1980 h a v e b e e n  o b t a i n e d from the issues o f Japan Company Handbook, T o y o K e i z a i S h i n p o S h a , f r o m vari o u s years. T h e s e data have b e e n used i n c a l c u l a t i n g standard d e v i a t i o n s a n d correlations,  82  EYEARj  is each c o m p a n y ' s y e a r o f establishment.  These data are obtained f r o m  Kaisha Sikiho (1994, fall), T o y o K e i z a i S h i n p o S h a . T h e c o m p a n y ' s date o f establishment has been u s e d to assess the age o f the company. T h e f o l l o w i n g three v a r i a b l e s are characteristics o f e a c h f i r m that r e m a i n constant o v e r the years. FDUMj  i s a f i n a n c i a l institution dummy. Value 1 has b e e n assigned to f i n a n c i a l i n -  stitutions s u c h as banks, trust banks, life a n d n o n - l i f e insurance c o m p a n i e s , a n d 0 has been assigned to the o t h e r s .  58  Gl — G6 are g r o u p (shacho-kai) d u m m i e s for each o f the s i x major corporate groups, Mitsui, Mitsubishi, Sumitomo, Fuyo, Sanwa, and Dai-Ichi Kangyo.  S i x f i r m s b e l o n g to  t w o different groups at the same time. SICj is a 3 d i g i t industry code for each f i r m p r o v i d e d b y Gyoshu-betsu Rankingu, T o y o K e i z a i S h i n p o S h a . A c c o r d i n g t o their c l a s s i f i c a t i o n , the 186 s a m p l e f i r m s have been categorized into 53 different i n d u s t r i e s .  59  Aij is the fraction o f f i r m j ' s shares w h i c h are d i r e c t l y h e l d b y f i r m i at the e n d o f M a r c h i n respective y e a r s .  60  F o r instance, A  12  = 0.1 means f i r m 1 h o l d s 1 0 % o f f i r m 2's  outstanding shares. H e n c e Aij is the amount o f control-rights that f i r m i h o l d s d i r e c t l y i n  as e x p l a i n e d b e l o w 5 8  T h i s is used t o identify f i n a n c i a l institutions.  5 9  T h i s c l a s s i f i c a t i o n seems to be appropriate for the purpose o f our analysis. A broader  c l a s s i f i c a t i o n s u c h as 2 d i g i t code m i g h t i n c l u d e c o m p a n i e s w h o produce totally different products, w h i l e a narrower c l a s s i f i c a t i o n e x c l u d e c o m p a n i e s w h o produces c o m p e t i t i v e products, b u t not as their m a i n products. 6 0  T h i s is ^ i n our theoretical m o d e l s , o r aij i n table 4.1. F o r c o n s i s t e n c y o f notations  w i t h the other v a r i a b l e s , \j  i s used i n this chapter.  83  firm j .  Kigyo Keiretsu Soran, w h i c h i s p u b l i s h e d annually b y T o y o K e i z a i S h i n p o S h a ,  p r o v i d e s the stock investments b e t w e e n c o m p a n i e s (i.e. A j ) i n a m a t r i x f o r m for e a c h o f s i x i n d i v i d u a l corporate groups. A l t h o u g h the matrices d o not c o n t a i n the i n f o r m a t i o n o n the percentage stock investment b e t w e e n c o m p a n i e s i n t w o different groups, the b o o k i n c l u d e s lists o f names a n d percentage shares o f the top 20 largest shareholders for e v e r y listed company. F r o m the lists, i n f o r m a t i o n o n the stock investment b e t w e e n c o m p a n i e s i n t w o different groups have b e e n retrieved for f i v e years (1980, 82, 84, 86 a n d 88). I n m o s t p r e v i o u s studies o f Japanese corporate s h a r e h o l d i n g , o n l y the o r i g i n a l i n f o r m a t i o n p r o v i d e d i n m a t r i x f o r m i n Kigyo Keiretsu Soran has been used. O u r data present the advantage o f i n c l u d i n g stock investments between f i r m s i n t w o different groups.  4.3.2  Constructed Variables I  Table 4.3 s h o w s constructed independent variables used i n the analysis. SGRPDUMij  is the same g r o u p d u m m y , w h i c h is e q u a l to 1 i f b o t h i n v e s t i n g a n d  i n v e s t e d f i r m s are i n the same group, a n d 0 otherwise. SICDUMij  is the same industry d u m m y , w h i c h is 1 i f b o t h i n v e s t i n g a n d invested  f i r m s are i n the same industry and 0 otherwise. AGEj, is the age o f f i r m j , w h i c h is c a l c u l a t e d f r o m the year o f establishment,  EYEAR.  N o t e that some o f the y o u n g e r f i r m s i n o u r sample were created as subsidiaries or j o i n t v e n tures o f the e x i s t i n g c o m p a n i e s .  84  B e f o r e c a l c u l a t i n g the variance a n d b e t w e e n - f i r m c o v a r i a n c e o f operating profits, a n adjusted operating profit rate, DOPEj,  needs to be introduced. F i r s t , w e c a l c u l a t e d w e i g h t e d  average operating profit rates for each year, OPE , t  b y a d d i n g the operating profits, w e i g h t e d  b y the sales v a l u e , o f n - f i r m s , a n d d i v i d i n g it b y the n u m b e r o f f i r m s , n .  6 1  S e c o n d l y , w e cre-  ated n e w operating profit rates for each f i r m b y subtracting the e c o n o m y ' s y e a r l y average f r o m the o r i g i n a l operating p r o f i t rates.  DOPE^  t  where OPEj  it  DOPEj  = OPE  jJt  -  OPEt  is the operating profit rate o f f i r m j at t i m e t.  T h e reason w h y w e u s e d  i s because OPEj m a y i n c l u d e the effect o f shocks t o the w h o l e economy. A c c o r d -  i n g to the risk s h a r i n g argument, t h r o u g h stock investments i n other f i r m s i n the e c o n o m y , the i n v e s t i n g f i r m can protect i t s e l f f r o m c o m p a n y - s p e c i f i c s h o c k s but not f r o m the s h o c k s to the e c o n o m y as a w h o l e . F o r this reason, f i r m s must b e c o n c e r n e d w i t h the v a r i a n c e a n d c o v a r i a n c e o f the f i r m - s p e c i f i c shocks w h e n they m a k e stock investment decisions. T h i s is also the reason w h y operating profit rate has b e e n c h o s e n instead o f other indicators for profit rates, such as return o n assets, w h i c h i n c l u d e s investment i n c o m e s . T h e standard deviations o f f i r m j's operating p r o f i t rates, DSDOPEj,  over previous  years have been c a l c u l a t e d based o n a l l o f the p r e v i o u s observations o f DOPEj. a m p l e , DSDOPEj  at 1982 is c o m p u t e d w i t h DOPEj  F o r ex-  f r o m 1978 to 1981. T h e standard  deviations indicate the degree o f r i s k faced b y a company.  6 1  T h e estimation results w i t h the use o f s i m p l e averages are q u a l i t a t i v e l y the same as the  ones s h o w n i n this paper.  85  T h e c o v a r i a n c e o f the operating profit rates o f t w o firms, f i r m % a n d j , have also been c a l c u l a t e d f r o m past observations o f DOPEi  a n d DOPEj,  w h i c h is denoted as  DCOVOPEi  F o r the purpose o f the a n a l y s i s , w e are interested i n direct, as w e l l as indirect, measures o f the fraction o f f i r m fs  shares h e l d b y firm i ( c o n t r o l rights i n d i c e s ) a n d the fraction o f  f i r m i's s h a r e h o l d i n g i n v e s t e d into f i r m j ( p o r t f o l i o - c h o i c e indices). T h e f o l l o w i n g sections e x p l a i n the w a y to construct those indices.  4.3.3 Constructed Variables II: Control Rights Indices A s e x p l a i n e d i n the p r e v i o u s section, A  {j  measures the fraction o f firm j's shares d i -  rectly h e l d b y f i r m i a n d c a n be u s e d to measure f i r m i's direct c o n t r o l o v e r firm j .  How-  ever, c o m p a n i e s sometimes c o n t r o l other c o m p a n i e s indirectly. S u p p o s e that f i r m s 1 a n d 2 , respectively, h o l d 0 % a n d 1 0 % o f f i r m 3's shares, w h i l e firm 1 o w n s 5 0 % o f f i r m 3's shares i n d i r e c t l y t h r o u g h its subsidiary. W i t h the direct investment measure, the a m o u n t o f f i r m 1 's c o n t r o l rights o v e r f i r m 3 is regarded as 0 a l t h o u g h firm 1 seems to be able to c o n t r o l f i r m 3 w i t h the i n d i r e c t investment. T h i s m a y be a n extreme case. W h a t i f b o t h f i r m s 1 a n d 2 d i r e c t l y o w n 1 0 % o f f i r m 3 ' shares, w h i l e f i r m I's subsidiary o w n s 5 0 % o f f i r m 3's shares? T h e direct investment measure ranks the amounts o f c o n t r o l rights i n f i r m 3 h e l d b y firms 1 a n d 2 as the same. It, h o w e v e r , s h o u l d be natural to t h i n k that f i r m 1 has m o r e  86  i n f l u e n c e i n firm 3 than f i r m 2 d o e s .  62  Ito a n d H o s h i (1992) introduce a w a y to construct  a n i n d e x w h i c h includes indirect o w n e r s h i p s as f o l l o w s . F i r s t , c o n s i d e r mn  x n m a t r i x , A, w h i c h s h o w s direct o w n e r s h i p relations a m o n g n  f i r m s . T h e element i n r o w i a n d c o l u m n j o f this m a t r i x is Aij.  A s i m p l e e x a m p l e is used  i n order to e x p l a i n the construction o f control-rights indices w h i c h i n c l u d e indirect c o n t r o l . S u p p o s e f i r m 1 o w n s two-thirds o f f i r m 2's shares, firm 2 o w n s o n e - t h i r d o f f i r m 3's shares, a n d firm 3 o w n s one-third o f f i r m 1 's shares. T h i s o w n e r s h i p structure between the f i r m s is represented b y 0  A =  2/3  0  0  0  1/3  1/3  0  0  F i r m 1 o w n s two-thirds o f firm 2's control-rights directly, f i r m 2 a n d 3, respectively, o w n s o n e - t h i r d o f f i r m 3's and f i r m 1 's control-rights directly. I n this case, it c a n be s a i d that f i r m 1 i n d i r e c t l y o w n s a fraction o f f i r m 3's shares t h r o u g h f i r m 2 a n d that the amount o f o w n e r s h i p is g i v e n b y A A 3 12  A  2  2  — ( 2 / 3 ) ( l / 3 ) = 2 / 9 . L e t us c a l l it second order indirect investment.  represents the s e c o n d order indirect investment relationships o f a l l the f i r m s . I n general,  kth order indirect investments c a n be expressed b y A . H e n c e , a n e w m a t r i x k  B = A + A + A + • • • = A[I 2  6 2  3  - A}'  1  T h e readers m a y w o n d e r h o w the i n v e s t i n g c o m p a n y c a n i n f l u e n c e the management  o f the invested c o m p a n y i n d i r e c t l y i f the amount o f shares h e l d b y the i n v e s t i n g c o m p a n y is not large. O b v i o u s l y , it cannot be done at general meetings o f the shareholders. H o w e v e r , as m e n t i o n e d before, corporate shareholders c o u l d be i n f o r m a l l y i n v o l v e d i n the d e c i s i o n m a k i n g o f invested companies. T h r o u g h this m e c h n i s m , corporate shareholders c a n affect i n d i r e c t l y - i n v e s t e d companies.  87  c a n be d e f i n e d to i n c l u d e a l l the direct (first order) and indirect (second or h i g h e r order) o w n e r s h i p relations. T h e element i n r o w i a n d c o l u m n j o f this m a t r i x is denoted B y .  6 3  T h i s is the i n d e x w h i c h indicates the amount o f control-rights i n f i r m j h e l d , d i r e c t l y and/or indirectly, b y f i r m i. I n order to save space, let us c a l l this, s i m p l y , the indirect control-rights i n d e x , although the i n d e x actually takes b o t h direct a n d i n d i r e c t investments into account. W i t h our numerical example,  B  —  A[I - A]" = 1  2/25  18/25  6/25  3/25  2/25  9/25  9/25  6/25  2/25  M a t r i x B generally has the f o l l o w i n g three properties. F i r s t , every element i n m a t r i x B is greater than or equal to its counterpart i n m a t r i x A because o f its a d d i t i v e construction. Secondly, the d i a g o n a l elements o f m a t r i x B are no longer necessarily zero, w h i c h m e a n s that f i r m s c o u l d i n d i r e c t l y o w n some o f their o w n shares. T h e t h i r d property is that the s u m o f the elements i n each c o l u m n c a n never be greater than 1 i n m a t r i x A, but m a y e x c e e d 1 i n m a t r i x B.  T h i s is because m a t r i x B does not c a n c e l out m u t u a l o w n e r s h i p relations  t h r o u g h s h a r e h o l d i n g a n d is c l o s e l y related w i t h the first property. It c a n be s a i d that the c o n t r o l rights i n d i c e s , Aij and By, i's i n f l u e n c e i n f i r m j.  measure the degree o f f i r m  W i t h these i n d i c e s , h o l d i n g 5 0 % o f shares i n a l a r g e — i n terms o f  v a l u e — f i r m a n d a s m a l l f i r m are treated as the same. T h e y m a y not be, however, equivalent  6 3  F u t a t s u g i (1982 and 1984) is the first w h o studied the effects o f indirect s h a r e h o l d i n g  b y an operation o f shareholding matrices. Ito a n d H o s h i ( 1 9 9 2 ) discuss the relation b e t w e e n Futatsugi's measure and theirs. F l a t h (1992) proposes another measure o f indirect shareholding based o n ( / — A ) . - 1  H i s measure, however, does not exhaust a l l o f the p o s s i b l e  routes o f the indirect investment.  88  i n terms o f the values. T h e next subsection e x p l a i n s d e r i v a t i o n o f p o r t f o l i o c h o i c e i n d i c e s w h i c h represent a l l o c a t i o n o f a f i r m ' s stock investments a c c o r d i n g to their values.  4.3.4  Constructed Variables H J : Portfolio C h o i c e Indices  P o r t f o l i o c h o i c e i n d i c e s represent a relative degree o f o w n e r s h i p interest i n other c o m panies. T h e w o r d " r e l a t i v e " has t w o meanings. U n l i k e the c o n t r o l rights i n d e x , the portf o l i o i n d i c e s d i s t i n g u i s h the investments i n a large a n d a s m a l l f i r m , since investments are measured b y v a l u e , not b y a fraction. T h e p o r t f o l i o i n d i c e s also treat the same v a l u e o f i n vestment i n a c o m p a n y from t w o different size c o m p a n i e s differently. T h e i n d e x is s m a l l e r for the investment f r o m a larger company. P o r t f o l i o c h o i c e indices are c a l c u l a t e d u s i n g a m a t r i x i n t r o d u c e d by T a n i g a w a (1986). D e r i v a t i o n o f a p o r t f o l i o c h o i c e i n d e x w i t h o n l y direct investment is, first, s h o w n , w h i c h is f o l l o w e d b y d e r i v a t i o n o f a p o r t f o l i o c h o i c e i n d e x w i t h b o t h direct a n d indirect investment. T h e n u m e r i c a l e x a m p l e o f the p r e v i o u s section is presented to illustrate the i n t u i t i o n b e h i n d the indices. L e t Si denote the (market) v a l u e o f f i r m  i's operating  assets w h e r e  i = {1,n}.  This  v a l u e m a y v a r y w i t h a stochastic element. I n the context o f r i s k - s h a r i n g argument, this is the source o f uncertainty. Construct a diagonal matrix, A , 1  ones. T h e ith d i a g o n a l element o f A  1  such that ['(A  1  + A)  is the p o r t i o n o f f i r m i's  89  =  I' where / is a v e c t o r o f shares d i r e c t l y h e l d b y the  i n d i v i d u a l shareholders o f f i r m i. I n our e x a m p l e , [2/3  A = 1  0  0  0  1/3  0  0  0  2/3  T h e first d i a g o n a l element, for e x a m p l e , is two-thirds because one-third o f firm 1 's shares are o w n e d b y firm 3 and, hence, the rest, t w o - t h i r d s , are o w n e d b y i n d i v i d u a l shareholders o f f i r m 1. B y adding A and A , 1  the entire direct o w n e r s h i p structure is represented. D e n o t e this  n e w m a t r i x as m a t r i x G. T h e ith c o l u m n o f m a t r i x C s h o w s the d e c o m p o s i t i o n o f o w n e r s h i p o f f i r m i, w h i l e the ith r o w s h o w s f i r m «'s stock investment portfolio. N o t e that, b y its c o n s t r u c t i o n , m a t r i x C has a property that the s u m o f the elements i n each c o l u m n is a l w a y s e q u a l to one. I n our e x a m p l e , the m a t r i x is g i v e n b y 2/3  2/3  0  1/3  1/3  1/3  0  2/3  C = A+A = 1  0  T h e first c o l u m n c a n be r e a d that two-thirds o f f i r m 1 's shares is o w n e d b y i n d i v i d u a l shareholders o f f i r m 1 a n d one-third o f t h e m is o w n e d b y f i r m 3. H e n c e , i g n o r i n g i n d i r e c t investments, two-thirds o f the firm 1 's operating asset belongs to the i n d i v i d u a l w h i l e one-third o f it belongs to firm 3, a c c o r d i n g to the o w n e r s h i p structure. O n the other h a n d , the  first  r o w o f this m a t r i x indicates that f i r m 1 's total asset consists o f t w o - t h i r d o f f i r m 1 's operati n g asset a n d t w o - t h i r d o f f i r m 2's operating asset. N o n e is f r o m firm 3 since f i r m 1 does not o w n any shares o f f i r m 3.  90  A n i n d e x for direct p o r t f o l i o c h o i c e , PFij, is d e f i n e d b y the f i r m z' direct investment v a l u e i n f i r m j d i v i d e d b y the total direct investment v a l u e o f f i r m i.  Qj * AS SET j  „  p  J2(C * ik  ASSET,)  k=l  M a r k e t v a l u e s o f f i r m s ' total assets are u s e d as the weights s i n c e w e d o not have data o n the o p e r a t i n g assets. A s w i l l b e c o m e c l e a r later, the (expected) v a l u e o f a f i r m ' s operating asset is e q u a l to the (expected) v a l u e o f the f i r m ' s total assets, i f the p r i c e o f every f i r m ' s stocks i s e q u a l to the (expected) v a l u e s o f the f i r m .  6 4  I n o u r e x a m p l e , f i r m 1 's total investment i s 2 / 3 * s i + 2 / 3 * S 2 + 0 * s . I f the v a l u e s 3  o f the o p e r a t i n g assets are the same across the f i r m s (i.e. s\ ( 2 / 3 ) / ( 2 / 3 + 2 / 3 + 0) = i , PF  12  =  s  2  =  S3), t h e n PF\i  = ( 2 / 3 ) / ( 2 / 3 + 2 / 3 + 0) = \ a n d P F  1  3  -  =  (0)/(2/3 +  2 / 3 + 0) = 0. T h e f o l l o w i n g s h o w s the c a l c u l a t i o n o f an i n d e x for the p o r t f o l i o - c h o i c e m o d e l that i n c l u d e s i n d i r e c t investments. CV, does not offset the stock investments w h i c h are, d i r e c t l y and/or indirectly, made b y f i r m j i n f i r m i. I n order to compensate for this s h o r t c o m i n g , s o m e a d d i t i o n a l steps are required. U s i n g m a t r i x A, the market v a l u e o f f i r m i w i t h corporate s h a r e h o l d i n g is expressed b y the z'th factor o f v e c t o r u:  u = s — Ap + Au  6 4  I f there is n o uncertainty, the p r i c e o f shares m u s t be equal to the (market) v a l u e o f the  f i r m . I n this case, the (market) v a l u e o f the f i r m is also the same as the v a l u e operating assets. W i t h uncertainty, however, these relations m a y not h o l d because o f r i s k p r e m i u m s .  91  w h e r e p is a v e c t o r o f the prices per fraction o f shares. T h e first terms i n the r i g h t h a n d side o f the equation are the o p e r a t i n g assets o f f i r m i m i n u s the p u r c h a s i n g cost o f shares i n other f i r m s .  6 5  T h e s e c o n d t e r m is the (market) values o f those shares h e l d b y the company.  S o l v i n g the above equation for u, w e o b t a i n  u = [I- A\- [s-Ap\. X  (4.1)  It is w e l l - k n o w n that aggregate market c a p i t a l i z a t i o n is i n f l a t e d because o f d o u b l e c o u n t i n g p r o b l e m w h i c h is i n v o l v e d i n corporate shareholding. See for e x a m p l e , M c D o n a l d ( 1 9 8 9 ) , F r e n c h a n d P o t e r b a ( 1 9 9 1 ) a n d F e d e n i a , H o d d e r , a n d Triantis (1994). T a n i g a w a ( 1 9 8 6 ) seems to be the first w h o r e a l i z e d this fact. H e m u l t i p l i e d u f r o m its left h a n d side by A  1  to d e r i v e a true c a p i t a l i z a t i o n o f the f i r m s :  A'll-A^ls-Ap]. T h i s is what is c a l l e d outside v a l u e o f the f i r m s . Therefore f i r m s ' true p o r t f o l i o c h o i c e s are represented b y a n e w m a t r i x ,  D = A [I 1  A]' . 1  T h i s m a t r i x , D, takes into account b o t h the i n d i r e c t investment effects a n d the offsetting effects o f m u t u a l i n v e s t m e n t .  6 5  T h i s m a t r i x D has the same characteristics as m a t r i x C : the  66  T h e operating assets, s, are a s s u m e d to be large enough so that the p u r c h a s i n g cost  o f the shares c a n be f i n a n c e d f r o m it. F i r m s c a n issue bonds to finance the cost, but it w i l l not change the situation—the M o d i g l i a n i - M i l l e r theorem is a p p l i c a b l e to intercorporate s h a r e h o l d i n g ( K u r a s a w a , 1989). 6 6  A p o r t f o l i o i n d e x d e f i n e d b y F e d e n i a , H o d d e r , and Triantis (1994) is b a s e d o n m a t r i x  [I — A]~  x  instead o f A [I — A]' . 1  1  It is, however, essentially the same as o u r i n d e x because  A{ w h i c h appears o n b o t h numerator a n d d e n o m i n a t o r cancels out i n o u r i n d e x . t  92  ij element o f m a t r i x D , Dij, represents the fraction o f firm j ' s operating profit that goes to f i r m i; a n d the s u m o f elements i n e a c h c o l u m n i s a l w a y s e q u a l to o n e .  67  I n m a t r i x D,  not o n l y the indirectness b u t also the c a n c e l i n g - o u t effect o f cross-shareholding are t a k e n i n c o n s i d e r a t i o n . H e n c e , a n e w p o r t f o l i o i n d e x w h i c h includes i n d i r e c t investments,  IPFij,  c a n be obtained as before: r  „„  D-*  ASSET,  J2(D *ASSET ) fc=i ik  k  In our example, " 18/25 12/25 4/25  £> = A^I-A}-  =  1  [  1/25  9/25 3/25  6/25  4/25 18/25  and, i f the operating asset i s the same across the f i r m s , IPFu 4/25) =  IPF12 = £ a n d IPF  13  =  IPF  12  — (18/25) / ( 1 8 / 2 5 + 1 2 / 2 5 +  i s s m a l l e r w h i l e IPF  a n d IPF  n  13  are  b i g g e r c o m p a r e d t o the P F indices. I n constructing actual indices used i n o u r analysis, o n e a d d i t i o n a l step is r e q u i r e d i n order to deal w i t h the 2 9 f i n a n c i a l institutions a n d the 3 m a n u f a c t u r i n g c o m p a n i e s m e n t i o n e d before, w h o s e shareholding i n f o r m a t i o n i s a v a i l a b l e but f i n a n c i a l data are not. F i r s t , a 1 8 6 - b y - 1 8 6 A m a t r i x , w h i c h contains s h a r e h o l d i n g i n f o r m a t i o n o f a l l 186 f i r m , i s used to construct matrices B , C a n d D. A f t e r the c o n s t r u c t i o n o f these matrices, the entries for the f i n a n c i a l institutions a n d the m a n u f a c t u r i n g c o m p a n i e s are r e m o v e d f r o m the matrices so that each o f t h e m i s r e d u c e d to 154-by-154 matrices. T h e n Bij, C^, PFij a n d IPFij, are d e r i v e d , as d e s c r i b e d above, based o n those s m a l l e r matrices. A s a result, a f i r m ' s invest6 7  T h e p r o o f for the latter statement is: I'(A + A) = / ' b y d e f i n i t i o n . M u l t i p l y i n g b o t h 1  side o f t h i s equation b y ( 7 - A ) - f r o m t h e r i g h t , / ' ( A ( / - A ) - + A ( / - A ) - ) = 1  /  1  M o v i n g l'A(I - A)~ t o the right h a n d side, I'A (I - A)' l  1  93  1  = I'. Q . E . D .  1  l'(I-A)-\  ment into those o m i t t e d corporations are not i n the d e n o m i n a t o r w h e n c a l c u l a t i n g PFij a n d  A l t e r n a t i v e l y , a 1 5 4 - b y - l 54 A m a t r i x c a n be d i r e c t l y used to derive the i n d i c e s . I n s u c h a case, the d e r i v e d 5 ^ a n d PF^ are the same as the ones o b t a i n e d b y the above procedures, but Cij a n d IPFij are different. T h e r e is a n important reason f o r the use o f the 1 8 4 - b y - 1 8 6 , instead o f the 1 5 4 - b y - l 5 4 , m a t r i x . M o s t f i n a n c i a l institutions i n J a p a n h o l d a substantial a m o u n t o f shares i n c o m p a n i e s across groups. Therefore the large m a t r i x is not b l o c k d i a g o nal b y groups. B e c a u s e o f this, most c o m p a n i e s are, at least indirectly, inter-connected e v e n i f they are not i n the same group. I f the s m a l l m a t r i x is used, this important fact is o m i t t e d .  4.3.5  S u m m a r y Statistics for the Variables  Tables 4.4 a n d 4.5 p r o v i d e s u m m a r y statistics for the v a r i a b l e s u s e d i n the e s t i m a t i o n s .  68  The n u m b e r o f o b s e r v a t i o n is 2 3 5 6 2 ( = 154 x 153) for r e l a t i o n a l v a r i a b l e s (i.e. v a r i a b l e s w i t h Subscript ij) w h e n f i n a n c i a l institutions a n d the three c o m p a n i e s w h i c h are m e n t i o n e d before are e x c l u d e d , otherwise 3 4 4 1 0 ( = 186 x 185). S e v e r a l important characteristics o f o u r data are as f o l l o w s : SGRPDUMij  s h o w s that about 1 9 . 8 % o f the 23562 i-j b i l a t e r a l relations are b e t w e e n  f i r m s i n the same group. T h e m e a n o f SICDUM^  indicates that 3 . 1 3 % o f the relations  are b e t w e e n f i r m s i n the same industry. N o t i c e that, since the sample f i r m s are f r o m 4 3  6 8  T h e statistics i n table 4.3 are c a l c u l a t e d f r o m data u s e d i n the p o o l e d m o d e l s p e c i f i c a -  t i o n w h i c h w i l l be d i s c u s s e d later.  94  different industries, there i s a p r o b a b i l i t y o f 1 / 4 3 = 2 . 3 3 % o f any t w o f i r m s b e l o n g i n g to the same industry, a s s u m i n g a n equal distribution. T h e c o m p a n i e s u s e d i n o u r analysis are o l d , large c o m p a n i e s . T h e average corporate age w a s 55.39 years, w h i c h m e a n s that m a n y o f the f i r m s have their h i s t o r i c a l roots i n the p e r i o d before the S e c o n d W o r l d War. T h e youngest c o m p a n y is 20 years o l d a n d the oldest 107. T h e n u m b e r o f e m p l o y e e s varies f r o m 258 t o 7 7 9 8 1 , w i t h a n average o f 8 7 2 4 . 1 . I n table 4.5, the m e a n o f A ^ - ( o r Aji) indicates that the fraction o f a f i r m ' s shares h e l d d i r e c t l y b y another firm is, o n average, s m a l l . F o r e x a m p l e , it w a s o n l y 0 . 0 6 9 2 6 % i n 1980. I n other w o r d s , 1 0 . 6 0 % ( = 0 . 0 6 9 2 6 % x 153) o f e a c h c o m p a n y ' s shares are o w n e d b y the other 153 f i r m s o n average.  A l t h o u g h i t i s not s h o w n i n the table, b y a d d i n g the shares  h e l d b y financial institutions i n the same group, the amount rises to about 3 0 % f o r most companies. The mean o f  d e c l i n e s s l i g h t l y o v e r the s a m p l e p e r i o d . B e c a u s e  includes  indirect investments b y its construction, the m e a n o f B^ is h i g h e r than that o f Aij. T h e m e a n o f PFij s h o u l d indicate w h a t fraction, o n average, o f a f i r m ' s p o r t f o l i o i s a l l o c a t e d to another c o m p a n y ' s shares. T h i s w a s 0 . 0 7 0 4 7 % i n 1 9 8 0 , for e x a m p l e .  This  means that, i n 1 9 8 0 , 1 0 . 7 8 % ( = 0 . 0 7 0 4 7 % x 153) o f a f i r m ' s total asset v a l u e is h e l d i n the f o r m o f other firms's shares, w h i l e the rest, 8 9 . 2 2 % , i s i n other forms o f assets.  69  IPFij  accounts f o r indirect investments a n d their netting-out effects. A s s h o w n i n the e x a m p l e  6 9  T h i s i s fairly consistent w i t h m i c r o data p r o v i d e d b y H a y a s h i a n d Inoue (1990). A c -  c o r d i n g to the data, about 1 0 - 2 0 % o f total asset v a l u e i n a n average Japanese firm d u r i n g 1 9 7 7 - 1 9 8 6 consists o f affilliated c o m p a n i e s ' stocks. H o w e v e r , i f non-affiliated c o m p a n i e s ' stocks are added, the figure s h o u l d b e bigger.  95  c a l c u l a t i o n , PF^ c a n b e either greater o r s m a l l e r than IPFij.  Therefore, the average o f  PFij c a n be as w e l l . B y i n c l u d i n g indirect investment relations, the n u m b e r o f n o n - l i m i t observations i n b o t h control-rights a n d p o r t f o l i o indices drastically increases. O n l y about 4 % o f i-j c o m b i nations i n o u r data have direct investment relations. W i t h i n d i r e c t investments, about 7 0 % o f the c o m b i n a t i o n s have some investment relations. T h e i n c l u s i o n o f f i n a n c i a l institutions i n c o m p u t i n g indirect i n d i c e s largely contributed to this change.  4.4  M o d e l s a n d Tests  A s e x p l a i n e d , c o m m o n stocks have t w o d i s t i n c t i v e characteristics as control-rights and p r o f i t - c l a i m s , a n d each o f the hypotheses is related t o one o f them. H e n c e the m o d e l s used i n the estimations have b e e n d e s i g n e d i n order to c o r r e s p o n d to these t w o features: the c o n t r o l rights m o d e l s a n d p o r t f o l i o - c h o i c e m o d e l s , respectively. I n the control-rights m o d e l s , the fraction o f f i r m j ' s shares h e l d b y f i r m i i s e x p l a i n e d b y the characteristics o f the invested ( i n c l u d i n g zero-invested) a n d i n v e s t i n g f i r m s . T h e p o r t f o l i o - c h o i c e m o d e l s , focus o n the fraction o f f i r m z's stock investments i n f i r m j . W i t h the reasons g i v e n before, w e estimate the indirect investment m o d e l s , as w e l l as the direct investment models. T h e dependent v a r i a b l e i s A  iJ7  o r P>ij for the c o n t r o l rights  m o d e l , a n d PF j, o r IPFy for the p o r t f o l i o c h o i c e m o d e l . t  C a u t i o n must be taken, however, t o interpret the outcomes f r o m the i n d i r e c t investment m o d e l s because w e have a statistical d i f f i c u l t y t o measure the i n d i r e c t investment relations.  96  O u r indirect investment indices are constructed b y t a k i n g the inverse o f m a t r i x (I — A). A s a result, the disturbances are, to some extent, correlated w i t h o n e another.  T h i s is a n  70  inevitable p r o b l e m because n o one c a n observe Bij o r IPFij, o n l y A j - I r o n i c a l l y , this is w h y P>ij a n d IPF^ are c a l l e d " i n d i r e c t " indices. M a n y o f the dependent variables are zeros, e s p e c i a l l y w h e n indirect investments are not a c c o u n t e d for. I n o r d e r t o deal w i t h this l i m i t e d dependent v a r i a b l e issue, a Tobit m o d e l is e m p l o y e d . W i t h the use o f a latent v a r i a b l e , the Tobit m o d e l is d e f i n e d as f o l l o w s :  yt^ax  + etj  (4.2)  and  T h e dependent v a r i a b l e , y  ijy  jft,-=0  if  yij = ytj  if  is A j , B  iJ7  yt  5  <0  yti > o.  PF ,  o r IPFij.  tj  T h r e e categories o f indepen-  dent variables, X, are e m p l o y e d ; (1) relational variables (SGRPDUMij,  SICDUMij,  DCOVOPEij,  jt  a n d either one o f the counter stock investment measures, A ,  Bji a n d  Dji, d e p e n d i n g o n the dependent v a r i a b l e ) ; (2) characteristics o f the invested c o m p a n y (logAGEj, DSDOPEj) SGROWi,  7 0  XogKLj, XogEMPj, SGROWj,  ADj/SALEj,  RDj/SALEj,  DOPEj,  and; (3) characteristics o f i n v e s t i n g c o m p a n y (logAGEi, logKLi, ADi/SALEi,  RDi/SALE  u  DOPE , t  and  and  logEMPi,  DSDOPEJ  T h e estimates are c o n s i d e r e d to b e consistent b u t has n o statistical inference. S t r i c t l y s p e a k i n g , the direct investment measurement, A j , a n d therefore PFij, are also  correlated o n e another because is are the same for different j s . T h i s p r o b l e m i s , however, different f r o m the one d i s c u s s e d i n the above. 7 1  F l a t h (1996) presents a s i m i l a r Tobit estimation m o d e l , i n w h i c h the fraction o f f i r m  97  T h e sample p e r i o d o f the dependent variables is every t w o years f r o m 1980 to 1988, since data o n Aij are o n l y a v a i l a b l e for those years. B e c a u s e o f the use o f the l a g g e d v a r i ables, y e a r l y estimations are c o n d u c t e d for 1982, 84, 86 and 88. P o o l e d e s t i m a t i o n m o d e l s , w h i c h a l l o w o n l y the constant t e r m to be different b y year, are e x a m i n e d as w e l l . A H a u s m a n test, p r o p o s e d b y S m i t h and B l u n d e l l (1986), is c o n d u c t e d to c h e c k i f any o f the explanatory variables are endogenous, a n d it is f o u n d that SGROWij  and  DOPEij  are endogenous. A s a r e m e d y for this p r o b l e m , l a g g e d values for these variables are e m p l o y e d i n the analyses.  S u b s c r i p t -2 is u s e d to denote l a g g e d variables. B e s i d e s these,  l a g g e d variables are used for the counter stock investment measures i n order to a v o i d a s i multaneity problem. Tables 4.6.1 to 4.6.4 report the estimated coefficients i n the Tobit for b o t h control-rights a n d p o r t f o l i o c h o i c e m o d e l s w i t h a n d w i t h o u t indirect investments. A L R test is c o n d u c t e d to e x a m i n e the v a l i d i t y o f p o o l i n g the y e a r l y data sets into a single equation. T h e p o o l e d estimations, w h i c h are v i e w e d as restricted m o d e l s o f the separate y e a r l y estimations, are rejected for a l l the m o d e l s .  j ' s shares h e l d b y f i r m i, that is o u r A^, is e x p l a i n e d b y p r o x y variables for intermediate input transaction relationships b e t w e e n the t w o f i r m s a n d s o m e other c o n t r o l variables. B e s i d e s the difference i n the purpose o f studies, there are a f e w major differences to o u r studies. F i r s t , neither i n d i r e c t investment n o r p o r t f o l i o c h o i c e m o d e l is not c o n s i d e r e d i n h i s m o d e l . S e c o n d l y , his data set consists o f a single year o b s e r v a t i o n w h i c h does not i n c l u d e investment i n f o r m a t i o n across groups.  98  4.5 Empirical Results T h e f o l l o w i n g reports details o f the e s t i m a t i o n outcomes for e a c h argument. N o t e that, because o f the c o r r e l a t i o n p r o b l e m i n the indirect investment m o d e l s , s i g n i f i c a n c e l e v e l s are noted o n l y i n the direct investment m o d e l s .  The Competitive-effect Argument T h e coefficient o n SICDUM  is s i g n i f i c a n t l y p o s i t i v e at 1 or 5 % l e v e l i n m o s t o f  the direct investment m o d e l s (tables 4.6.1 a n d 4.6.3). T h i s indicates that c o m p a n i e s have a tendency to invest m o r e , i n terms o f b o t h control-rights a n d p o r t f o l i o - c h o i c e i n d i c e s , i n other c o m p a n i e s i n the s a m e industry. T h e i n d i r e c t investment m o d e l s p r o v i d e a s i m i l a r o u t c o m e for SICDUM  i n b o t h p o r t f o l i o - c h o i c e a n d control-rights m o d e l s (tables 4.6.2 a n d 4.6.4).  T h e c o m p e t i t i v e argument t h r o u g h control-rights is c l e a r l y supported b y the data despite the fact that c o m p a n i e s i n o u r data set are subject to the one-set principle.  The Risk-Sharing Argument T h e coefficient o n DCOVOPEij  is statistically i n s i g n i f i c a n t (table 4.6.3). T h i s c o n -  tradicts one o f the predictions o f the r i s k - s h a r i n g m o d e l — t h a t the relationships b e t w e e n the a m o u n t o f investment a n d the c o v a r i a n c e o f operating profits s h o u l d be negative ( R S - H 1 ) .  7 2  A c c o r d i n g to the r i s k - s h a r i n g argument, f i r m s w i t h l o w e r standard deviations i n o p erating profits s h o u l d attract m o r e investment b y other f i r m s ( R S - H 2 ) . T h i s hypothesis is supported b y the data. T h e coefficient o n DSDOPEj  7 2  is negative a n d s i g n i f i c a n t at 1%  W h e n i n d i r e c t investments are considered, the coefficient i s m o s t l y negative, but w h i c h  m a y not be s i g n i f i c a n t (table 4.6.4).  99  l e v e l i n a l l o f the direct p o r t f o l i o - c h o i c e m o d e l (table 4.6.3). It is negative i n the indirect i n vestment m o d e l estimations (table 4.6.4). T h i s i m p l i e s that firms w i t h l o w e r standard d e v i ations i n operating profits d o attract m o r e investment b y other firms. T h i s is consistent w i t h the e m p i r i c a l f i n d i n g o f C a v e s a n d U e k u s a (1976) a n d N a k a t a n i (1984) that firms w h i c h attract m o r e investment b y other f i r m s tend to e x h i b i t l o w e r v o l a t i l i t i e s i n their profit rates. T h e coefficient o n DSDOPEi  is negative a n d s i g n i f i c a n t at 1% l e v e l i n a l l o f the  direct p o r t f o l i o - c h o i c e m o d e l (table 4.6.3). T h i s is consistent w i t h the t h i r d hypothesis o f the r i s k - s h a r i n g argument ( R S - H 3 ) . T h e estimated coefficients o f the counter investment, Aji is s i g n i f i c a n t l y p o s i t i v e (table 4.6.3). T h i s result contradicts one o f the predictions o f the r i s k - s h a r i n g m o d e l — t h a t f i r m s invest less i n other f i r m s w h i c h o w n large portions o f the i n v e s t i n g f i r m s ( R S - H 4 ) . T h e o u t c o m e s for the r i s k - s h a r i n g argument are m i x e d . T w o out o f four p o s s i b l e h y potheses are not supported. I n s u m , w e cannot c o n c l u d e that the data p r o v i d e e n o u g h e v i dence to support the r i s k - s h a r i n g a r g u m e n t .  73  The Control-Rights Argument T h e coefficient o n A^  i n the estimations indicates that a f i r m has a tendency to invest  m o r e i n f i r m s w h i c h directly o w n m o r e o f the i n v e s t i n g f i r m ' s shares (table 4.6.1).  This  supports the hypothesis regarding m u t u a l i t y o f investment relationships r e q u i r e d i n c o n t r o l rights argument ( C R - H 1 ) .  7 3  T h i s is consistent w i t h B e a s o n (1998).  100  T h e coefficient o n SGRPDUMij  i n the estimations c l e a r l y s h o w s that a f i r m has a  tendency to invest m o r e i n the firms w h i c h b e l o n g to the same g r o u p as the i n v e s t i n g f i r m (table 4 . 6 . 1 ) .  74  T h i s i s not a s u r p r i s i n g result, w h i c h j u s t r e c o n f i r m s that m e m b e r s o f a  presidents' m e e t i n g are the participants o f a c r o s s - s h a r e h o l d i n g arrangement. T h e s i g n coefficients o n the v a r i a b l e o f g r o w t h rate i n sales values, SGROWj,  varies  f r o m y e a r to year. T h e coefficients are m o s t l y i n s i g n i f i c a n t . T h i s tells us that corporate stock investment i s not responsive to the sales performance o f target c o m p a n i e s , w h i c h i s consistent w i t h the "stable shareholders" hypothesis ( C R - H 3 ) . T h e coefficient o n operating profit rates, DOPEj,  is s i g n i f i c a n t l y negative except i n year 1982 (table 4.6.1). T h i s is the  o n l y o u t c o m e w h i c h i s against the t h i r d hypothesis o f the c o n t r o l - r i g h t s argument. G i v e n a l l these outcomes, w e c a n c o n c l u d e that the data p r o v i d e e v i d e n c e to support the control-rights argument.  Some O t h e r Results G e n e r a l results r e g a r d i n g the characteristics o f invested firms are as f o l l o w s ,  hunger  f i r m s are l i k e l y to attract m o r e investment. O n e p o s s i b i l i t y f o r this o u t c o m e i s that the age factor m a y capture the future prospect o f company. T h e result m a y also reflect the fact that  7 4  I n general, this i m p l i e s that, against its " o f f i c i a l " view, the presidents' meetings are  not j u s t i n f o r m a l s o c i a l i z i n g functions. O n the contrary, they must have s o m e s i g n i f i c a n t e c o n o m i c m e a n i n g w i t h respect to stock investment d e c i s i o n s . A l t h o u g h the f o r m a t i o n o f cross s h a r a e h o l d i n g arrangements seems to be the m o s t important cause o f this o u t c o m e , there are s o m e other p o s s i b l e causes. F o r e x a m p l e , i n a w i d e l y accepted v i e w , the participants o f the presidents' meetings exchange s o m e m a n a g e r i a l i n f o r m a t i o n a n d s o m e t i m e s reach m a n a g e r i a l d e c i s i o n s together. T h i s leads to the hypothesis that firms tend to invest i n other m e m b e r f i r m s o f the same presidents' c l u b because i n v e s t i n g f i r m s have private access to the m a n a g e r i a l i n f o r m a t i o n o f the i n v e s t e d firms t h r o u g h personal connections.  101  some o f the f i r m s i n the s a m p l e are subsidiaries o f another company. C o m p a n i e s w i t h l o w e r advertisement and/or R & D expenditures are also invested i n more. R e g a r d i n g the characteristics o f i n v e s t i n g f i r m s , o u r data f i n d that c a p i t a l i n t e n s i v e f i r m s w i t h large n u m b e r o f w o r k e r s tend to h o l d a larger f r a c t i o n o f shares i n other c o m p a nies. T h e large n u m b e r o f e m p l o y e e s indicates that the i n v e s t i n g f i r m s are large. T h e s i z e o f i n v e s t i n g c o m p a n i e s s h o u l d affect their investment amounts, e s p e c i a l l y w h e n the amounts are m e a s u r e d b y the fraction o f an i n v e s t e d f i r m ' s shares h e l d b y the i n v e s t i n g f i r m (i.e. Aij).  C o m p a n i e s w i t h l o w e r advertisement and/or R & D expenditures a l s o invest m o r e .  T h e operating profit rate, as w e l l as its standard d e v i a t i o n , tend to be s m a l l e r i n h e a v i l y investing firms. T h e negative coefficients o n advertisement expenditures for b o t h i n v e s t i n g a n d i n vested f i r m s are consistent w i t h the f i n d i n g o f F l a t h (1996). I n l i g h t o f his argument that t r a d i n g partners s h o u l d invest m o r e i n each other, c o m p a n i e s w i t h s m a l l advertisement expenditures are c o n s i d e r e d to be manufacturers o f intermediate products rather than f i n a l c o n s u m e r products. T h e i r products are traded b e t w e e n firms.  102  4.6  Concluding Remarks  T h e r e are several features o f this study that d i s t i n g u i s h it from p r e v i o u s e m p i r i c a l research. F i r s t o f a l l , m a n y p r e v i o u s e m p i r i c a l studies o f Japanese corporate groups u s e d a " c r o s s s h a r e h o l d i n g " i n d e x , w h i c h is the fraction o f a c o m p a n y ' s shares that are o w n e d b y other m e m b e r s o f the same corporate group, i n order to e x a m i n e h o w the corporate shareholdi n g structure c a n be related w i t h the profit rate o f a c o m p a n y (see for e x a m p l e , C a v e a n d U e k u s a , 1976; N a k a t a n i , 1986 and; Itoh and H o s h i , 1992). I n other w o r d s , the share h o l d i n g structure w a s treated as exogenous.  I n contrast, this chapter l o o k e d at e n d o g e n i z e d  s h a r e h o l d i n g relations a n d e x a m i n e d the determinants o f corporate shareholding. Secondly, i n d e a l i n g w i t h corporate stock investment, this paper c o n s i d e r e d t w o s i g nificant factors o f corporate s h a r e h o l d i n g ; inter-group investment a n d i n d i r e c t investment. F i r s t , i n this a n a l y s i s , the s h a r e h o l d i n g matrices for each g r o u p were e x p a n d e d to a large m a t r i x to a c c o m m o d a t e s h a r e h o l d i n g across c o m p a n i e s i n different groups. S e c o n d , w i t h s o m e m a t r i x operations, w e presented a w a y to take i n d i r e c t investment relations into c o n sideration. A l t h o u g h analyses o n indirect investment were l i m i t e d b y a data availability, these t w o features enable us to f i n d interesting results. F o r e x a m p l e , the competitive-effect argument m a y not be supported i f intra-group investments are o n l y c o n s i d e r e d , because f e w c o m p a n i e s i n a g r o u p b e l o n g to the same industry. I n a d d i t i o n , any covert r e l a t i o n s h i p t h r o u g h i n d i r e c t investment between f i r m s c a n be, theoretically, captured i n analyses.  103  O u r study suggests that competitive-effect arguments need to be researched more. P e r haps i n f l u e n c e d b y a strong b e l i e f i n the one-set principle,  a n d i n the effectiveness o f anti-  m o n o p o l y l a w s , the competitive-effect m o t i v e o f corporate s h a r e h o l d i n g has not d r a w n m u c h attention f r o m researchers o f the Japanese economy. Consequently, the p o s s i b i l i t y o f distortions i n market c o m p e t i t i o n t h r o u g h corporate s h a r e h o l d i n g has not been studied. T h e data h a v e s h o w n that there exists stock investment relations between c o m p a n i e s w i t h i n the same i n d u s t r y .  75  It w i l l be interesting to study the degree o f d i s t o r t i o n w h i c h m i g h t be pos-  s i b l y c a u s e d b y s u c h stock investments. R e m e m b e r that c o n v e n t i o n a l m a r k e t concentration ratios such as H e r f i n d a h l i n d e x do not p r o p e r l y reflect the true state o f market c o m p e t i t i o n under a cross s h a r e h o l d i n g situation. See chapter 2 for m o r e detail. W i t h respect to the r i s k - s h a r i n g argument, the coefficient o n the c o v a r i a n c e i n operating profits is i n s i g n i f i c a n t l y p o s i t i v e except i n one year. T h e r e are t w o p o s s i b l e reasons for this result. F i r s t , as m e n t i o n e d above, the data cannot d i s t i n g u i s h v e r t i c a l investment relations f r o m others. Suppose there i s a f i n a l d e m a n d shock. It is v e r y u n l i k e l y that either upstream o r d o w n s t r e a m f i r m s absorb a l l the shock. F o r e x a m p l e , i f n e w entries are not a l l o w e d , the  7 5  E x a m p l e s o f such investment c a n be f o u n d i n a u t o m o b i l e , synthetic fiber, paper a n d  p u l p , and electronics industries (Kigyo Keiretsu Soran, 1983). T o y o t a o w n e d 1 2 . 7 5 % o f D a i h a t s u i n 1982. T o y o t a g r a d u a l l y increased its o w n e r s h i p i n D a i h a t s u a n d f i n a l l y m a d e D a i h a t s u as its subsidiary.  I n synthetic f i b e r industry, N i s s i n b o o w n e d 3 3 . 9 2 % o f Toho  R a y o n , a n d Teijin o w n e d 3 . 4 2 % o f N i s s i n b o i n 1982. I n paper a n d p u l p industry, S h i n O j i S e i s h i o w n e d 1.05% a n d 0 . 9 6 % o f H o n s h u S e i s h i a n d N i h o n S e i s h i , respectively. S h i n O j i S e i s h i eventually merged H o n s h u S e i s h i i n O c t o b e r 1996. In electronics industry, " M i t s u b i s h i E l e c t r o n i c s - O k i " , " H i t a c h i - N i h o n C o l u m b i a " , " F u j i t s u - H i t a c h i " h a d investment relations i n 1982. N o t e that m a n y o f these investment relations are b e t w e e n the f i r m s i n different f i n a n c i a l keiretsu groups.  104  f i n a l d e m a n d s h o c k affects b o t h upstream and d o w n s t r e a m f i r m s . I n this case, operating profits are h i g h l y correlated. I f w e c o u l d c o n t r o l this factor, the e s t i m a t i o n result m a y change i n favor o f the r i s k - s h a r i n g argument. Secondly, i f t w o c o m p a n i e s arrange to exchange e a c h other's shares w i t h o u t actual m o n e y transactions ( s w a p transaction), s u c h " s t o c k investments" reduce the v o l a t i l i t y o f f i n a l profit unless operating profits o f the f i r m s are perfectly correlated—that is e v e n i f they are p o s i t i v e l y correlated. A l t h o u g h s w a p transactions d o not s e e m to be so c o m m o n , the data, again, cannot d i s t i n g u i s h whether the shares are obtained b y a s w a p or not. T h e i n c l u s i o n o f s u c h investment relations m a y have shifted o u r estimated coefficient o n the c o v a r i a n c e to the p o s i t i v e side. T h e l a c k o f e v i d e n c e for the r i s k - s h a r i n g argument m a y also s i m p l y m e a n that m o s t f i r m s d o not, o r cannot, efficiently use the i n f o r m a t i o n o n target f i r m s i n order to d i v e r s i f y themselves.  W h i l e it is c o m m o n that investors o n l y have l i m i t e d i n f o r m a t i o n o n f i r m s ,  corporate s h a r e h o l d i n g m a k e s it m o r e d i f f i c u l t to c o r r e c t l y estimate the r i s k i n v o l v e d i n e a c h share. U n d e r this circumstance, it is n a i v e to t h i n k that stock prices carry correct r i s k i n f o r m a t i o n because it requires e v e r y b o d y i n the market to c o r r e c t l y estimate the r i s k s .  7 6  H a v i n g partial i n f o r m a t i o n is sometimes equivalent to h a v i n g n o i n f o r m a t i o n at a l l a n d s o m e managers m a y s i m p l y invest i n a market i n d e x .  7 7  I f there are m a n y managers w h o d i v e r s i f y  their c o m p a n i e s ' assets i n s u c h a way, our estimate m a y f a i l to produce clear e v i d e n c e for  7 6  See F e d e n i a , H o d d e r , a n d Triantis (1994).  7 7  I n fact, j u d g i n g f r o m the Japanese c o m p a n i e s ' t y p i c a l p o r t f o l i o s — a s m a l l fraction o f  shares i n a n u m b e r o f c o m p a n i e s — m a n y managers appear to be a c t i n g as i f they h a v e n o i n f o r m a t i o n a n d are s i m p l y i n v e s t i n g i n a market index.  105  the  risk-sharing  argument. R e m e m b e r that this is not a d e n i a l o f the  risk-sharing  argument,  because managers are still c o n s i d e r e d to be t r y i n g to reduce their risk, j u s t i n a less efficient way. T h e strongest e m p i r i c a l support is g i v e n to the control-rights argument i n this analysis. H o w e v e r , m a n y e m p i r i c a l studies o f Japanese corporate groups s u c h as C a v e s a n d U e k u s a (1976) a n d N a k a t a n i (1986) have f o u n d a c o n t r a d i c t i o n to the p r e d i c t i o n o f the c o n t r o l rights argument—that firms w h i c h are invested m o r e b y other g r o u p m e m b e r s tend to have l o w e r profit rates. I n the f r a m e w o r k o f this paper, this discrepancy c o u l d not be addressed. T h i s issue needs to be investigated i n the future. F i n a n c i a l institutions are not i n c l u d e d i n our analysis because financial institutions and n o n - f i n a n c i a l institutions p r o v i d e the data i n totally different w a y s .  7 8  W h a t i f comparable  data are a v a i l a b l e for f i n a n c i a l institutions? F i n a n c i a l institutions must have m a n y different m o t i v e s for stock investment as discussed i n the m a i n bank argument. T h o s e factors m u s t b e c o n t r o l l e d i n order to i n c l u d e  financial  institutions i n the analysis. F o r e x a m p l e , the  s u p p l y o f loans from a b a n k to each c o m p a n y s h o u l d be a d d e d as a n explanatory v a r i a b l e . Suppose that s u c h adjustments were made. W o u l d our results be affected b y the i n c l u s i o n o f f i n a n c i a l institutions? T h e competitive-effect argument m a y be supported m o r e strongly because m a n y banks h o l d shares i n trust banks. E v i d e n c e to support the r i s k - s h a r i n g argument m a y be s t i l l w e a k because the extent o f f i n a n c i a l institutions' investment d i v e r s i f i c a t i o n is great. T h e effect o f the i n c l u s i o n o f f i n a n c i a l institutions o n the control-rights argument is a m b i g u o u s . W i t h i n a group, apparently financial institutions are the centre o f stock 7 8  I f i n c l u d e d , it is l i k e l y to introduce a large d i s t o r t i o n i n o u r estimates.  106  investment relations. M a n y m u t u a l investment relations are added into the sample. O n the other h a n d , f i n a n c i a l institutions invest i n c o m p a n i e s i n other groups too. T h o s e i n v e s t e d c o m p a n i e s s e l d o m invest b a c k i n the f i n a n c i a l institutions. A d i r e c t i o n o f future research is to e x p a n d the data set a n d to test the robustness o f the results i n this study. It w o u l d be interesting i f independent c o m p a n i e s w h i c h d o not b e l o n g to any o f the s i x corporate groups are added to o u r data set. International c o m p a r i s o n m a y also p r o v i d e further insight.  107  Table 4.1: Comparative Statics on C o r p o r a t e Investment (a*,) Unilateral a  * . = _£4f  (equation 3.10) C o v a r i a n c e i n operating profit rates  (a^)  St. D e v i a t i o n i n j ' s operating p r o f i t rates  Bilateral  (equation 3.18)  < 0  (aj)  da*.  .  -g£ |ffy<0  St. D e v i t a t i o n i n i ' s operating profit rates (cr,)  C o u n t e r Investment (cx^)  | ^ < 0  * These are predictions d r a w n f r o m the r i s k - s h a r i n g m o d e l s i n chapter 3. ** i and j stand for i n v e s t i n g a n d invested f i r m s , respectively. ***ctij is the fraction o f f i r m j ' s shares h e l d b y f i r m i (i.e. ai i n chapter 3).  108  < 0  Table 4.2: Data Items  Period  \foriables  1980, 82, 84,  ASSET  total asset v a l u e ( m i l l i o n y e n i n 1990 v a l u e )  EMP  number o f employees  86, 88 1980-1988  SALE  sales ( m i l l i o n y e n i n 1990 v a l u e )  1980-1988  SGROW  sales g r o w t h f r o m p r i v i o u s y e a r (1 = 100 % )  1980-1988  AD  a d v e r t i s i n g expenditure ( m i l l i o n y e n i n 1990 v a l u e )  1980-1988  RD  R & D expenditure ( m i l l i o n y e n i n 1990 v a l u e )  1980-1988  KL  capital-labor ratio (thousand y e n i n 1990 value/per person)  1980-1988 1980-1988  OPE  operating p r o f i t rate (%)  EYEAR-f  y e a r o f establishment o f each f i r m  constant  FDUMf  f i n a n c i a l institution d u m m y (one for a f i n a n c i a l institution)  constant  G1-G6  g r o u p d u m m y for each o f s i x major corporate groups  constant  SIC  industry c o d e (3 d i g i t )  constant  /  1980, 82, 84,  a fraction o f f i r m j ' s shares h e l d b y f i r m i  86, 88  (in matrix)  * Superscript / indicates that the data o f the f i n a n c i a l institutions are available. * T h e o b s e r v a t i o n p e r i o d is annual at the end o f a c c o u n t i n g year.  Table 4.3: Constructed Variables in Estimations  SGRPDUMfj SICDUMt AGEj DOPEj DSDOPEj DCOVOPE Bij PFij i:i  same group d u m m y (one i f f i r m s i and j are i n the same group) same industry d u m m y (one i f f i r m s i and j are i n the same industry) age o f f i r m j adjusted operating profit ( d e v i a t i o n from the y e a r w e i g h t e d average) standard d e v i a t i o n i n DOPEi c o v a r i a n c e of DOPEi  for e a c h f i r m i n the past  a n d DOPEj  i n the past  c o n t r o l - rights i n d e x constructed f r o m Aij, i n c l u d e s indirect investments p o r t f o l i o - c h o i c e i n d e x constructed  from  p o r t f o l i o - c h o i c e i n d e x constructed from D j, t  Dij  includes indirect investments  a fraction o f f i r m j ' s operating profits contributed to the f i r m i's f i n a l profit  * Superscript / indicates that the data o f the f i n a n c i a l institutions for the i t e m are available.  109  Table 4.4: S u m m a r y Statistics f o r E x p l a n a t o r y Variables  Mean  St. D e v  EMPj  8724  13034  258  77981  SGROWj  0.0479  0.2191  -0.7794  4.028  ADj/SALEj  0.0060  0.0115  0.0000  0.0886  Variables  Min  Max  RDj/SALEj  0.0133  0.0536  0.0000  0.7438  KLj DOPEj  21758 5.3185  39800 5.2044  1194  436270  -18.919  33.536  FDUMj  0.1560  0.3946  0.0000  1.0000  SGRPDUMij  0.1983  0.3987  0.0000  1.0000  SGRPDUMfj  0.1929  0.3946  0.0000  1.0000  SICDUMij  0.0313  0.1742  0.0000  1.0000  SICDUMl  0.0285  0.1742  0.0000  1.0000  AGEj  55.39  18.64  20  107  DSDOPEj  1.5945  1.2976  0.0292  10.668  DCOVOPEij  0.4070  2.6674  -32.455  54.502  * Superscript / indicates that the reported values w e r e d e r i v e d f r o m the data i n c l u d i n g the f i n a n c i a l institutions.  110  Table 4.5: S u m m a r y Statistics o f the Dependent Variables  Variables  Mean  St. D e v  Min  Max  Frac. o f Non-limit O b .  (1980)  0 0006926  0.01044  0 0000  0 5899  0 0438  Aij (1982) Aj (1984) A^ (1986)  0 0006402  0.009891  0 0000  0 5877  0 0339  0 0006395 0 0005970  0.009728 0.009451  0 0000 0 oooo  0 5569 0 5597  0 0448  A^ (1988)  0 0005438  0.009139  0  0 5569  0 0420  Bij ( 1 9 8 0 )  0 0009661  0.01069  0  0 5930  0 6819  0 5897  0 6885  0 5596  0 6949  0 5624  0 7079  0 5593  0 7079  oooo oooo oooo oooo oooo oooo  0 0482  A,(1982) 5^(1984)  0 0008744  0.01011  0  0 0008893  0.009975  0  ^(1986)  0 0008592  0.01068  0  5^(1988)  0 0008224  0.009352  0  PFij (1980)  0 0007047  0.008693  0 0000  0.4231  0.0438  PFij ( 1 9 8 2 ) PFij (1984)  0 0006258 0 0006387  0.008176 0.007953  0 0000 0 0000  0.3879 0.4118  0.0339 0.0448  PF^ ( 1 9 8 6 )  0 0005963  0.007424  0  0.4327  0.0482  PF^ ( 1 9 8 8 )  0 0005676  0.007433  0  0.4071  0.0420  0 0007027  0.006381  0  0.3273  0.6819  7/^(1982)  0 0006297  0.006102  0.2968  0.6885  /PF^(1984)  0 0006671  0.006022  0.3201  0.6949  JPi^(1986)  0 0006383  0.005477  0.3280  0.7079  /Pi^-(1988)  0 0006253  0.005167  0.3063  0.7079  IPF^  (1980)  oooo oooo  oooo 0 oooo 0 oooo 0 oooo 0 oooo  * T h e variables are i n the f o r m o f fraction. * * F i n a n c i a l institutions are i n c l u d e d to c o m p u t e the adjusted v a l u e f o r i n c l u s i o n o f indirect s h a r e h o l d i n g , a l t h o u g h the reported v a l u e s are o f 154 n o n - f i n a c i a l companies. * * * T h e total n u m b e r o f observation i s 2 3 5 6 2 .  Ill  T A B L E 4.6.1: Tobit Estimation Results: Control Rights M o d e l (Direct Investments: A y ) 1982  YEAR  1984  1986  1988  POOL (rejected)  S I G N EXPECTED ESTIMATED  Relational (ij)  SGRPDUMjj  SICDUM  U  DCOVOPEy  AlL-2  1.590  1.745  1.765  1.747  1.689  36.96  38.10  37.98  35.76  76.09  0.249  0.242  0.255  0.299  0.237  2.495  2.368  2.465  2.924  4.685  0.011  0.011  -0.006  0.007  0.009  1.531  1.090  -0.582  1.076  2.320  5.306  5.431  5.446  5.082  5.500  7.585  7.351  7.258  6.491  14.94  -0.153  -0.129  -0.132  -0.145  -0.157  -2.896  -2.320  -2.276  -2.347  -5.665  0.041  0.120  0.129  0.118  0.096  1.621  4.859  5.025  4.399  7.802  -0.035  0.009  -0.013  0.005  -0.016  -1.842  0.472  -0.647  0.256  -1.700  0.183  -0.231  1.017  -0.140  0.078  2.310  -1.206  3.937  -1.160  1.513  -11.772  -7.327  -8.166  -5.078  -8.412  -4.444  -3.482  -3.720  -2.625  -7.809  -7.749  -2.246  -1.671  -0.798  -1.854  -4.691  -3.584  -3.816  -2.693  -7.264  -0.003  -0.014  -0.017  -0.008  -0.011  -0.641  -3.129  -3.529  -1.782  -5.526  •0.011  -0.034  -0.009  -0.043  -0.024  -0.541  -2.967  -3.129  + (CR)  +  + (CE)  +  + (CR)  +  Invested F i r m (j)  logAGEj  logKLj  logEMPj  SGROWjj  ADj/SALEj  RDj/SALEj  DOPEjj  DSDOPEj  -0.628  -1.795  (continues to the next page)  112  0(CR)  0(CR)  -  T A B L E 4.6.1: T o b i t Estimation Results: C o n t r o l Rights M o d e l (continued) (Direct Investments: A y ) Investing Firm (i)  logAGE;  -0.125  -0.117  -0.044  -0.065  -0.101  -2.376  -2.114  -0.770  -1.062  -3.664  logKLi  0.122  0.193 7.435  0.165 6.173  logEMPj  4.615 0.193  0.200  0.168  0.142 4.969 0.174  0.170 13.21 0.196  10.62 -0.103  8.664  8.784  20.98  SGROWi.2  10.41 0.166  1.254  -0.454  0.078  1.841  -0.566  4.878  -3.241  1.203  ADj/SALEj  -14.22 -5.393  -19.64 -6.911  -22.56 -7.011  -16.55 -12.70  RDj/SALEj  -9.822 -4.907  -1.102 -2.089  -0.961  -14.40 -5.625 -0.497  -2.438  -1.882  -0.015  -0.012  -0.020  -0.014  -1.192 -5.261 -0.020  -3.002 -0.107  -2.484 -0.206  -3.943 -0.110  -2.748 -0.130  -8.898 -0.124  -5.493  -9.616  -5.901  -7.985  -14.34  -4.013  -5.821  -5.751  -5.498  -10.03  -9.207  DOPE  i 2  DSDOPEj  Others  CONSTANT  -7.587  -10.84  Y82  -5.152 -19.31  Y84  -5.181 -19.23 -5.150  Y86  -18.94 -5.182  Y88  -18.74 Standard Error Logjikelihood Sq'd Corr.*** Frac. of non-limit obs.  0.0580 -162.70 0.0233 0.0396  0.0540 52.732 0.0224 0.0432  0.0523 98.851 0.0227 0.0429  0.0538 -13.702 0.0173 0.0389  0.0554 -123.01 0.0219 0.0411  *CR and CE stands for control-rights and competitive-effect argument, respectively. ** For each variable, the above is the coefficients normalized by the standard deviation of Sjj. The below is the asymptotic T-ratio. *** is the squared correlation between observe and expected value.  113  T A B L E 4.6.2: Tobit Estimation Results: Control Rights M o d e l (Direct and Indirect Investments: B y )  YEAR  1982  1984  1986  1988  POOL  (rejected)  S  Relational (ij) SGRPDUMy  0.255 14.11  SICDUMjj  0.171  0.162  4.287  4.031  0.003 0.986  -0.005 -1.376  -2.202  -2.358  5.005 7.778  5.373 7.916  5.239 7.614  4.482 6.294  -0.067  -0.063  -0.058  -0.059  -0.063  -3.355  -2.998 -0.015  -2.681  -2.618  -6.030  -0.015  -0.019  -0.017  -1.608 -0.036 -4.836  -1.920 -0.034  -3.603 -0.034  0.138  -4.568 -0.005  -9.435 0.005  DCOVOPEjj  Bji,.  2  0.260 14.40  0.217 12.04  0.241 26.83  + (CR)  0.174  0.180  0.170  + (CE)  4.346 -0.008  4.490 -0.005  8.511 -0.004 -2.520 5.091  + (CR)  0.242 13.43  15.00  Invested Firm (j) logAGEj  logKLj  -0.020 -2.051  SGROWj.2  0.004  -1.687 -0.033 -4.613 -0.082  0.163  -1.125  1.446  -0.123  0.263  ADj/SALEj  -0.630 -0.823  -0.619 -0.938  -0.756 -1.122  -0.909  -0.323  -0.230  -0.667 -1.088 -0.167  -0.746 -2.249 -0.217  -2.021  -1.652  -1.917  -1.832  -3.241  -0.001  -0.002  -0.001  -0.000  -0.001  -0.732  -0.941  -0.461  -0.118  -1.081  0.003  0.000  0.000  -0.002  -0.001  0.390  0.070  0.034  -0.487  -0.408  logEMPj  RDj/SALEj  DOPE  j j 2  DSDOPEj  -0.034 -4.702  (continues to the next page)  114  I  G  N  EXPECTED ESTIMATED  0(CR)  0(CR)  T A B L E 4.6.2: T o b i t Estimation Results: C o n t r o l Rights M o d e l (continued) (Direct and Indirect Investments: By) Investing F i r m (i) logAGEj  logKLj  lOgEMPj  0.031  -0.004  0.069  0.050  0.032  1.584  -0.190  3.242  2.264  3.067  0.174 18.18 0.198  0.191  0.169 17.53  0.176 17.74  0.172 36.84  0.164  0.163  0.177  25.89 -0.009  22.44  22.72  50.22  0.656  -0.078  -0.127  6.817  0.020 0.840  -14.55  -20.49  -21.43  -1.884 -17.65  -18.81  -16.23  -22.19  -21.59  -20.91  -42.17  -4.303  -0.052  -0.421  ^.518  -6.182  -0.021  -0.277 -0.010  -0.331 -2.676  -0.420  -8.453  -0.023  -0.021  -0.018  -12.00  -5.810  -12.49  -0.016 -2.387  -0.110  -0.052  -13.12 -0.064  -22.32 -0.060  -15.29  -8.300  -12.47  -20.39  27.75 SGROW^  A D j /SALEj  RDj/SALEj  DOPE^i  DSDOPEj  -0.063 -1.644  20.61 0.182  Others  CONSTANT  -2.682  -2.557  -2.547  -2.501  -13.71  -13.11  -12.28  -11.97 -2.496  Y82  -25.48 -2.499  Y84  -25.21 -2.495  Y86  -24.94 -2.529 -24.85  Y88  Standard Error Loglikelihood Sq'd Corr. Frac. of non-limit obs.  0.0121 44778 0.0189 0.6885  0.0119 45558 0.0200 0.6949  0.0114 47231 0.0184 0.7079  0.0111 47742 0.0145 0.7079  0.0116 185084 0.0177 0.6998  *CR and CE stands for control-rights and competitive-effect argument, respectively. ** For each variable, the above is the coefficients normalized by the standard deviation of sy. The below is the asymptotic T-ratio. *** is the squared correlation between observe and expected value.  115  T A B L E 4.6.3: Tobit Estimation Results: Portfolio Choice M o d e l (Direct Investments: P F ) y  YEAR  1982  1984  1986  1988  POOL  S I G N  (rejected)  EXPECTED ESTIMATED  Relational (ij) SGRPDUMjj SICDUM  U  DCOVOPEy Aji,_  2  1.587  1.753  1.779  1.752  1.695  37.27  38.54  0.181  0.168  38.50  36.25  76.96  0.209  0.172  0.157  1.765  1.604  1.990  1.608  3.012  0.011  0.007  -0.010  0.007  0.008  1.501  0.677  -0.968  0.966  2.151  6.870  7.334  7.764  7.211  7.489  10.01  10.15  10.58  9.472  20.77  -0.126  -0.100  -0.100  -0.103  -0.133  -2.403  -1.801  -1.733  -1.680  -4.842  0.066  0.160  0.169  0.150  0.128  2.579  6.419  6.524  5.567  10.38  0.015  0.069  0.046  0.057  0.041  0.802  3.695  2.384  2.881  4.410  0.243  -0.104  1.308  -0.254  0.113  -2.043  2.226  + (CE)  9  -(RS)  ?  -(RS)  +  -(RS)  -  Invested Firm (j) logAGEj logKLj logEMPj SGROWj,_  2  ADj/SALEj  RDj/SALEj DOPEjj DSDOPEj  3.064  -0.560  5.090  -14.18  -8.819  -9.319  -5.664  -10.02  -5.212  -4.119  -4.190  -2.896  -9.096  -7.841  -2.305  -1.662  -0.810  -1.852  -4.604  -3.699  -3.772  -2.720  -7.198  -0.005  -0.020  -0.023  -0.013  -0.017  -1.177  -4.757  -2.800  -8.007  -0.045  -4.311 -0.081  -0.042  -0.076  -0.057  -2.519  -4.215  -2.457  -5.183  -7.144  (continues to the next page)  116  T A B L E 4.6.3: Tobit Estimation Results: Portfolio C h o i c e M o d e l (continued) (Direct Investments: PFy )  Investing Firm (i) LogAGEj  -0.052  -0.021  0.043  0.012  -0.016  -0.988 0.112  logEMPi  4.314 0.115  -0.377 0.175 6.879 0.113  0.749 0.155 5.893 0.084  0.202 0.138 4.938 0.084  -0.583  logKLj  6.218  6.025  4.392  0.170 1.966  -0.102  1.161  4.233 -0.379  12.08 0.087  -0.554  4.509  -2.843  1.399  -14.00  -18.57 -6.754  -21.29 -6.869  -14.56  -15.83  -5.835  -12.50 -1.122 -5.059 -0.021  SGROWi,  2  ADj/SALEj  -5.363  0.159 12.63 0.112  RDj/SALEi  -8.166 -4.405  -0.839  -0.899  -0.454  -1.629  DOPE  -0.016 -3.222 -0.090  -0.014 -2.943 -0.179  -2.334 -0.023  -1.746 -0.016  ^.499 -0.095  -3.349 -0.117  -9.581  ^.727  -8.548  -5.191  -7.397  -13.31  -4.225  -6.201  -6.220  -5.833  -8.020  -11.55  -10.85  -9.781  i i 2  DSDOPEj  -0.113  Others CONSTANT  -5.460  Y82  -20.49 -5.497  Y84  -20.43 -5.473  Y86  -20.16 -5.514  Y88  -19.97 Standard Error Loglikelihood Sq'd Corr.*" Frac. of non-limit obs.  0.0493 -34.40 0.0254 0.0396  0.0449 216.02 0.0295 0.0432  0.0416 307.05 0.0385 0.0429  0.0448 126.84 0.0278 0.0389  0.0461 519.75 0.0297 0.0411  * CE and RS stands for, respectively, competitive-effect, and risk-sharing argument. ** For each variable, the above is the coefficients normalized by the standard deviation of £;J. The below is the asymptotic T-ratio. *** is the squared correlation between observe and expected value.  117  -(RS)  -  T A B L E 4.6.4: Tobit Estimation Results: Portfolio C h o i c e M o d e l (Direct and Indirect Investments: rPF y ) YEAR  1982  1984  1986  1988  P O O L  S I G N  (rejected)  EXPECTED ESTIMATED  Relational (ij)  SGRPDUMy  SICDUMij  DCOVOPE  u  Cjj,_2  0.244  0.254  0.245  0.238  0.243  13.48  13.99  13.55  13.22  26.91  0.070  0.049  0.087  0.012  0.057  1.751  1.223  2.161  0.291  2.854  0.002  -0.007  -0.009  -0.004  -0.004  0.682  -2.089  -2.599  -1.927  -2.862  47.59  66.82  66.09  55.94  58.36  32.55  39.04  40.40  34.51  72.02  -0.067  -0.056  -0.056  -0.051  -0.063  -3.340  -2.688  -2.578  -2.255  -6.026  + (CE)  -(RS)  -(RS)  Invested Firm (j) logAGEj  logKLj  logEMPj  SGROWj.2  ADJ/SALEJ  RDj/SALEj  DOPEJ,2  DSDOPEj  -0.001  0.006  0.009  0.004  0.005  -0.098  0.667  0.951  0.429  1.145  0.018  0.021  0.023  0.027  0.023  2.460  2.909  3.052  3.719  6.420  0.033  0.055  0.358  -0.096  0.017  1.313  0.759  3.753  -2.474  0.944  -1.998  -1.669  -1.449  -1.102  -1.633  -2.609  -2.530  -2.152  -1.797  -4.918  -0.844  -0.468  -0.245  -0.181  -0.230  -1.878  -2.395  -2.044  -1.979  -3.439  -0.003  -0.006  -0.005  -0.004  -0.005  -1.911  -3.465  -3.037  -2.729  -5.844  -0.024  -0.032  -0.023  -0.031  -0.028  -3.604  -4.655  -3.841  -6.132  -9.550  (continues to the next page)  118  -(RS)  T A B L E 4.6.4: Tobit Estimation Results: Portfolio C h o i c e M o d e l (continued) (Direct and Indirect Investments: I P F ) y  Investing Firm (i)  0.108  0.085  0.156  0.130  5.473  4.061  7.282  5.838  11.22  0.177 19.22 0.111  0.158  logEMPj  0.162 16.99 0.128  0.171 17.25 0.086  0.161 34.53 0.104  18.04  15.80  12.56  12.11  29.61  SGROW^  -0.042  -0.026  -0.035  0.028  -1.154  -0.371  0.534 5.554  -0.847  1.199  -14.42  -20.11 -21.99  -21.08 -21.54  -18.09 -21.65  -18.62 -42.14  logAGEj  logKLj  ADj /SALEj  -16.15  16.37 0.091  0.117  0.283 1.516  -0.237  -0.347  -0.300  -1.921  DOPEj-2  -3.625 -7.189 -0.020  -0.010  -0.023  -3.755 -0.022  -4.433 -0.018  DSDOPEj  -11.76 -0.008  -5.74 -0.095  -12.61 -0.044  -13.61 -0.058  -22.38 -0.051  -1.177  -13.18  -6.975  -11.38  -17.31  -2.859  -2.811  -2.855  -2.813  -14.63  -14.41  -13.76  -13.47  RDi/SALEi  Others  CONSTANT  -2.741  Y82  -27.98 -2.740  Y84  -27.65 -2.743  Y86  -27.44 -2.780  Y88  -27.31 Standard Error Loglikelihood Sq'd Corr.*" Frac. of non-limit obs.  0.0071 53118 0.0227 0.6885  0.0069 54224 0.0248 0.6949  0.0062 57167 0.0343 0.7079  0.0059 57917 0.0275 0.7079  0.0066 221879 0.0265 0.6998  * CE and RS stands for, respectively, competitive-effect, and risk-sharing argument. ** For each variable, the above is the coefficients normalized by the standard deviation of 6y. The below is the asymptotic T-ratio. *** is the squared correlation between observe and expected value.  119  -(RS)  Chapter 5 Conclusion  T h i s thesis focuses o n corporate s h a r e h o l d i n g issues s u r r o u n d i n g Japanese c o m p a n i e s . A f t e r the s o - c a l l e d b u b b l e economy, Japan's e c o n o m y has been u n d e r g o i n g  tremendous  changes. A s m e n t i o n e d i n the Introduction, banks started to sell some o f other c o m p a n i e s ' shares they o w n e d . I n order to finance business losses, m a n y c o m p a n i e s i n other industries also h a d to liquidate the shares they o w n e d . These are the factors w h i c h reduce the amount o f corporate s h a r e h o l d i n g i n Japan. O n the other h a n d , s o m e c o m p a n i e s have i s s u e d n e w stocks i n order to increase their equity p o s i t i o n , a n d most o f the stocks are a l l o c a t e d to aff i l i a t e d or non-affiliated f i n a n c i a l institutions. A s a part o f a restructuring process, s o m e c o m p a n i e s started creating j o i n t c o m p a n i e s . W i t h a r e v i s i o n o f the A n t i - M o n o p o l y A c t i n 1997, the b a n o n s h a r e h o l d i n g c o m p a n i e s w a s lifted. T h e s e factors contribute to a n increase o f corporate shareholding. T h e net effect o f these e c o n o m i c changes o n the corporate shareh o l d i n g structure is yet to be studied. A l o n g w i t h these changes, corporate s h a r e h o l d i n g across groups appears to be increasi n g i n Japan.  F u r t h e r m o r e , corporate s h a r e h o l d i n g is b e c o m i n g m o r e a n d m o r e interna-  t i o n a l . F o r e x a m p l e , G o o d y e a r Tire a n d R u b b e r a n d S u m i t o m o R u b b e r Industry ( k n o w n as D u n l o p ) agreed to have G o o d y e a r h o l d 1 0 % o f S u m i t o m o ' s shares, w h i l e S u m i t o m o also invests the same amount v a l u e i n G o o d y e a r ( A s a h i S h i n b u n , F e b r u a r y 3, 1 9 9 9 ) .  7 9  79  Nissan  T h e i r c o m b i n e d share i n the w o r l d m a r k e t w i l l be the largest at 2 0 % . B r i d g e s t o n e a n d  M i c h e l i n b e c o m e the s e c o n d a n d the t h i r d , respectively, i n terms o f the w o r l d share.  120  M o t o r s a n n o u n c e d the issue o f n e w shares w h i c h are a l l o c a t e d to R e n a u l t . A s a result, R e nault w i l l have 3 6 . 7 5 % o w n e r s h i p interests i n N i s s a n ( A s a h i S h i n b u n , M a r c h 16, 1999). T h e s e k i n d s o f events i m p l y that any analysis o n corporate s h a r e h o l d i n g s h o u l d not be restricted to c o m p a n i e s w i t h i n the s a m e group. I n this sense, o u r use o f a large s h a r e h o l d i n g m a t r i x w h i c h includes investment relations across groups is a m o v e i n the right direction. T h e e m p i r i c a l analysis i n chapter 4 presented supporting e v i d e n c e for the c o m p e t i t i v e effect argument. gument.  T h e e x a m p l e s g i v e n above are also clear cases w h i c h support this ar-  G o v e r n m e n t a l anti-trust agencies c a n m o n i t o r corporate s h a r e h o l d i n g b e t w e e n  d o m e s t i c c o m p a n i e s i n the same industry. T h e i r authorities are, however, l i m i t e d against international corporate shareholding. I n the N i s s a n a n d R e n a u l t case, the  announcement  w a s o n l y a d d i t i o n a l to the already c o m p l e x o w n e r s h i p structure i n the a u t o m o b i l e industry. S o m e c o m p a n i e s are p a r t i a l l y integrated b y means o f corporate shareholding: N i s s a n o w n s 4 . 2 % o f F u j i H e a v y Industry ( k n o w n as Subaru); F o r d o w n s 3 3 . 4 % o f M a z d a ; T o y o t a o w n s 51.2%  o f Daihatsu; and General M o t o r s owns 3 7 . 5 % o f I s u z u .  8 0  S o m e others are d i r e c t l y  integrated: C h r y s l e r a n d D a i m l e r - B e n z merged i n 1998; a n d F o r d p u r c h a s e d V o l v o ' s passenger v e h i c l e d i v i s i o n i n 1999. It w i l l be interesting to study h o w m a r k e t c o m p e t i t i o n is altered w i t h this structural c h a n g e .  81  8 0  N i k k e i K a i s h a J o h o ( S p r i n g 1999).  8 1  It is not necessarily straightforward to f i n d out a p r e d i c t i o n because there are u s u -  a l l y m a n y factors i n v o l v e d i n this k i n d of, partial and/or direct, integrations. C l o s u r e s o f s o m e factories and shares o f d i s t r i b u t i o n channels are c o m m o n factors, w h i c h change the cost functions o f the integrating f i r m s . F u r t h e r m o r e , products are, generally, not perfect substitutes.  121  A s F e d e n i a , H o d d e r , a n d Triantis (1994) p o i n t out, corporate shareholding introduces v a r i o u s potential estimation difficulties. F o r e x a m p l e , it distorts standard market return a n d r i s k measurement w h e n u s i n g o b s e r v e d returns a n d market c a p i t a l i z a t i o n i n an economy. Japan is not the o n l y country w h i c h encounters this p r o b l e m . C o m p a n i e s i n m a n y c o u n tries, e s p e c i a l l y i n E u r o p e , h o l d a substantial fraction o f shares i n other c o m p a n i e s ( N y b e r g , 1994; F e d e n i a , et a l . , 1994). P u r c h a s i n g a R e n a u l t share means p u r c h a s i n g some o w n e r s h i p interests i n N i s s a n , F u j i H e a v y Industry's a n d m a n y other c o m p a n i e s . Therefore, investors m u s t k n o w s h a r e h o l d i n g structures o f a l l these c o m p a n i e s i n order to c o r r e c t l y estimate the r i s k i n v o l v e d i n the R e n a u l t ' s share. S u c h i n f o r m a t i o n is, however, not currently a v a i l a b l e , at least i n a n accessible manner. A s p e o p l e start r e c o g n i z i n g these p o s s i b l e p r o b l e m s , the d e m a n d for disclosure o f s h a r e h o l d i n g structure i n f o r m a t i o n w i l l be stronger. A l t h o u g h our e m p i r i c a l study does not f i n d e n o u g h e v i d e n c e to support the r i s k - s h a r i n g argument, there are a f e w reasons to b e l i e v e that the r i s k sharing argument is yet to bec o m e important.  A s d i s c u s s e d i n chapter 4's c o n c l u s i o n , the l a c k o f e v i d e n c e m a y be a  consequence o f the fact that, w i t h o u t f u l l i n f o r m a t i o n o n corporate shareholding structure, m a n a g e r s ' investment d e c i s i o n s are also distorted. O n c e f u l l s h a r e h o l d i n g i n f o r m a t i o n bec o m e s a v a i l a b l e , managers s h o u l d be able to c o r r e c t l y estimate the risks i n v o l v e d i n each share and, as a result, m o r e evidences to support the r i s k - s h a r i n g argument m a y arise. S t o c k o p t i o n s , as a part o f m a n a g e r i a l rewards, were i l l e g a l until 1997 i n Japan. A f t e r the l e g a l i z a t i o n o f stock o p t i o n i n 1997, m a n y c o m p a n i e s are g r a d u a l l y i n t r o d u c i n g the system i n J a p a n ( A s a h i S h i n b u n , June 2 2 , 1998). T h i s is the second reason to b e l i e v e the  122  i m p o r t a n c e o f the r i s k - s h a r i n g argument. A l t h o u g h K a p l a n (1994) already suggested the existence o f performance-based p a y m e n t schemes i n Japan d u r i n g 1980s, the i n t r o d u c t i o n o f stock o p t i o n s h o u l d reinforce the c o n n e c t i o n between m a n a g e r i a l rewards a n d a c o m p a n y ' s performance, a n d hence the basis for the  risk-sharing  argument.  T h e control-rights argument is c l e a r l y supported b y o u r data. H o w e v e r , i n the course o f current e c o n o m i c changes, the future o f this argument is uncertain. D i s i n t e g r a t i o n o f groups seems to be a n i n e v i t a b l e trend for m a n y Japanese corporate groups. T h e trend is stronger e s p e c i a l l y i n D a i - i c h i K a n g i n , F u j i (Yasuda o r F u y o ) , a n d S a n w a groups (e.g. Kigyo Keiretsu Soran, Toyo K e i z a i S h i p o S h a , 1994, p 2 8 ) .  82  A s m e n t i o n e d above, some c o m -  panies are s e l l i n g the shares they o w n e d . Intergroup, as w e l l as international, investments are b e c o m i n g c o m m o n . A c c o r d i n g t o a p r e d i c t i o n o f the arguments, as groups started to disintegrate, m o r e take-overs s h o u l d occur. W e n e e d t o c o n t i n u o u s l y w a t c h i f this happens.  8 2  O n A u g u s t 2 0 , 1999, D a i - I c h i K a n g i n , F u j i , a n d the Industrial B a n k o f Japan h a d an-  n o u n c e d their future integration ( A s a h i S h i n b u n , A u g u s t 2 1 , 1 9 9 9 ) . 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