Japanese firms in financial distress and main banks: Analyses of interest-rate premia

ELSEVIER ECONOMY

Japan and the World Economy 8 (1996) 175-194

Japanese firms in financial distress and main banks: Analyses of interest-rate premia’

Masahiro Kawai,*v2 Juro Hashimoto,2 Shigemi Izumida2

Institute of Social Science, Uniuersity of Tokyo. 7-3-l Hongo, Bunkyo-ku. Tokyo 113, Jupan

Received 24 March 1994; accepted 11 January 1996

Abstract

The main bank system can play an important financial role for Japanese firms in distress by alleviating the firm’s financial cost. First, firms pay positive premia on interest rates at the time of financial distress. Second, firms with positive bank borrowing tend to pay significantly lower though still statistically significantly positive interest-rate premia, in periods of financial distress than do firms with zero bank borrowing. Third, if we focus on firms with positive bank borrowing, firms with main banks pay

significantly lower interest-rate premia than do firms without main banks. Fourth, the discounting notes receivable, due to intra-firm trade credit, plays an important role for

liquidity-constrained firms without main banks.

Keywords: Main banks; Financial distress; Interest-rate premia

JEL &ss$cation: G21

*Corresponding author.

‘This paper is a substantially revised version of the manuscript presented at the Ninth Annual

Technical Symposium, “Soft Budget Constraints and Trade and Industrial Organization”, spon-

sored by the Center for Japan-US Business and Economic Studies, Leonard N. Stern School of

Business, New York University, held on 24 and 25 March 1994 in New York. The authors thank Paul Wachtel and an anonymous referee for useful comments and David Leheny for editorial

assistance.

‘Masahiro Kawai and Juro Hashimoto are Professors of Economtcs and Shigemi lzumida is a

Research Associate at the Institute of Social Science, University of Tokyo.

SO922-1425/96/$15.00 Copyright :c 1996 Elsevier Science B.V. All rights reserved

PII SO922-1425(96)00009-6

176 M. Kawai et al. / Japan and the World Economy 8 (1996) 175 194

1. Introduction

One of the distinctive features of the Japanese capital market is the presence of the main bank system. It is often claimed that Japanese firms have relied heavily on direct bank finance and have maintained a close long-term relationship with a particular commercial bank, called the "main bank". The "main bank" is typically defined as a bank both with the largest share among private commercial banks of loans provided to a firm and with large stakes of share- holding in the firm. Its alleged roles are to monitor firm management, to extend various types of financial assistance at a time of distress, to replace firm management if necessary, to restructure firm organizations in bad situations, and to allow the firm to go bankrupt or to be liquidated in the worst situations.

There are several shortcomings in the existing literature on the financial role of the main bank system. The first is that the literature has typically assumed that a main bank exists for every Japanese firm. However, the bank with the largest amount of loans outstanding and with large stakes in shareholdings at one moment in time does not always play the main bank role for a firm, and it is quite possible for a firm not to have any main bank; whether a bank is "the main bank" must be judged by the actual relationships between the firm and the largest commercial-bank lender. The second shortcoming is that the past studies on the financial role of main banks have been based on a collection of case studies, anecdotal evidence and financial press reports, without being subjected to rigorous statistical investigations based on a large sample of observations. Case studies and anecdotal examples convey some useful information as to what a main bank might do when the borrowing firm goes through severe distress. Such an approach, however, does not provide general information concerning what a typical main bank generally does when the borrowing firm is in financial distress.

This paper employs a large sample of Japanese firms that have experienced financial distress, including those which went bankrupt, and examines some aspects of the financial role of main banks for firms in distress. Specifically, we investigate the financial data of 1412 Japanese firms which have been listed in the First Section of the Tokyo, Osaka and Nagoya Stock Exchanges and attempt to find if a firm benefits from the main bank relationship by receiving favorable financial treatment at bad times. We are not in the position to analyze all aspects of the main bank system, but instead focus on one important issue, i.e., differential interest-rate premia firms face in financial distress. 3

The organization of the paper is as follows. Section 2 provides a survey of what the main bank system is considered to be and what it is supposed to do

3Quantitative studies on the role of the main bank system, using a large sample of Japanese firms, include Hoshi et al. (1990, 1991) and Horiuchi et al. (1988). Horiuchi and Okazaki (1994) use a sample of 38 Japanese firms in the electric equipment industry.

M. Kawai et al. / Japan and the World Economy 8 (1996) 175 - 194 177

when the borrowing firm's perfomance deteriorates. Section 3 explains data and identifies firms in "financial distress", using a large sample of the listed firms in Japan during 1964 through 1993. It also classifies firms into two categories; those which have a stable, long-term relationship with the largest commercial-bank lender, called the "main bank", and those which do not. Section 4 tests if firms which have their main banks receive favorable financial treatments in the form of low interest-rate premia in the period of financial distress. Section 5 gives concluding remarks and suggests directions for future research.

2. A survey on the financial role of the main bank

2.1. Wha t is the main bank?

It is hard to offer a precise definition of the main bank; it is usually defined as a bank which has the largest outstanding stock of loans provided to a particular firm among private commercial banks and with large shareholdings in the firm. It encompasses a wide variety of commercial banks such as city banks, long-term credit banks, trust banks, regional banks, regional banks II, Shinkin banks, and many other smaller banks; it thus excludes semi-public banks (such as the Japan Development Bank and the Export - Import Bank) and institutional investors (such as life and non-life insurance companies).

The main bank is also typically a principal shareholder in the firm; it has the largest loan share and, at the same time, holds a large stake in the firm as a shareholder. The main bank, therefore, has a distinctive feature of pursuing its interests both as a lender and as an owner. As a lender it attempts to ensure that the firm repays the loans and interest, and as a shareholder it attempts to force the firm managers to pursue profit-maximizing policies.

The main bank also offers various types of banking services to the borrowing firm, such as provision of corporate bank deposits, operation of settlement accounts, functioning in bond issues as trustee administrator (domestically) and co-underwriter (internationally), and handling of foreign exchange trading. The main bank is thus involved in a substantial part of the borrowing firm's business activities. 4

It is often said that each firm typically has at most one main bank, though there are firms which have a second main bank. Each bank may have business relationships with many firms as their main bank. The relationship between the main bank and the borrowing firm tends to be intimate (face to face), stable and long term. In reality, however, as we will see below, there are firms which do not maintain stable, long-term relationships with the largest

4See Aoki et al. (1994) and Sheard (1994) for recent surveys of the main bank system.

178 M. Kawai et al. / Japan and the Worm Economy 8 (1996) 175-194

commercial-bank lender. If commercial banks with the largest loan share change often, particularly at times of the firm's financial distress and difficulties, such commercial banks may not be functioning effectively as the main bank.

2.2. Information sharing and monitoring

The most important aspect of the main bank system is the close information-sharing relationship between the bank and the borrowing firm. The main bank can gather information directly about the borrowing firm by monitoring financial transcations through the working balances and settlement accounts the firm holds with the bank. For the bank, firm activities recorded as changes in the working balances and settlement accounts are the most important sources of information of the firm's business perfomance. The bank can keep track of the firm's daily cash flows, its important business partners, the types of transcations being made, and the firm's financial position, i.e., assets and liabil- ities. This amounts to de facto, though only partial, "opening of the book" (Aoki, 1994).

In addition, information sharing often takes the form of frequent commun- ication between bankers and firm managers. Sometimes the main bank sends in its own executives as members of the firm's board of directors to obtain more detailed information, because it allows easy access to valuable inside information through a directorship link with the firm. Since standards of corporate auditing and disclosure are typically poor in Japan, such valuable information cannot be obtained easily from the firm's published accounts and tends to be shared only by top management, i.e., among the top few of the corporate hierarchy. The main bank system may provide a way of economizing on the costs of monitoring corporate perfomance. In this sense it can be thought of as a cooperative mechanism of information sharing, disclosure and monitoring.

The bank can monitor the firm with ease and at a low cost due to its close relationship with the borrowing firm and effective information sharing. In addition, the monitoring role tends to be delegated to the firm's main bank by other private financial institutions and non-main banks. 5 Close, delegated monitoring enables the bank to punish firm managers who do not pursue policies consistent with the bank lenders' interest. To the extent that such a punishment threat is credible, it can impose a "hard budget constraint" on the borrowing firm. 6 The fact that the main bank often owns large shares in the

SSee Sheard (1989). Aoki (1994) provides an excellent survey on how the Japanese main bank system copes with the problems arising from imperfect and incomplete information. He examines the roles of ex ante, interim, and ex post monitoring and argues that exclusive delegation of integrated monitoring is a special feature of the main bank system. 6The concept of softness or hardness of budget constraints is important in the theoretical works

of Dewatripont and Maskin (1990, 1993) and Gertner et al. (1993).

M. Kawai et al. / Japan and the World Economy 8 (1996) 175 194 179

f i rm can r educe the p o t e n t i a l s cope for conf l ic ts o f in te res t b e t w e e n the b a n k

a n d sha reho lde r s . 7

2.3. Correct ing the bad behavior

T h e i n f o r m a t i o n - s h a r i n g a n d m o n i t o r i n g ro le of the m a i n b a n k sys tem sug-

gests t ha t the m a i n b a n k m a y be in a pos i t i on to co r r ec t the b a d b e h a v i o r of

m a n a g e m e n t w h e n the f i rm's p e r f o r m a n c e de t e r i o r a t e s b a d l y o r w h e n the

i n c u m b e n t m a n a g e r s ' ob jec t ives dev i a t e f r o m those of prof i t m a x i m i z a t i o n .

I t is c l a i m e d tha t the m a i n b a n k of ten i n t e rvenes in the m a n a g e m e n t of the

f i rm w h e n it does n o t p e r f o r m well o r is in need of r e s t ruc tu r ing . A va r i e ty o f

case s tudies h a v e been d o c u m e n t e d to d e m o n s t r a t e t ha t m a i n b a n k s p r o v i d e

f inanc ia l ass i s tance to f i rms in dis tress , dev i se a r e c o v e r y plan, a d d m o r e

execu t ives of the i r o w n to supe rv i se the r e s t r u c t u r i n g a n d r e o r g a n i z a t i o n p l an

f r o m wi th in the f irm, a n d t ake o v e r the m a n a g e m e n t of the f i rm if necessary ,

s o m e t i m e s r ep l ac ing i n c o m p e t e n t i n c u m b e n t m a n a g e r s , s

7In the United States, the Glass Steagall Act prohibits this practice and mandates that banks which are actively involved in the management of the firms to which they have extended loans may lose their seniority status as creditors in the event of bankruptcy.

8There are various case studies about what a main bank might do when the borrowing firm performs badly. See Sheard (1989, 1994) and Hashimoto (1991 ) for many anecdotal examples.

The first step the main bank might take is to provide financial assistance to the firm, in the form of extending emergency finance and reducing or writing off interest payments, The bank in this situation typically requires a recovery plan from the firm, including personnel reallocation, in- tracompany temporary layoff, employment adjustment, wage cuts, and asset sales. It is said that such a plan is devised with close consultation with the bank.

The second step the bank might take, when the firm is in a more serious condition it is to add or newly send in its own executives to restructure and reorganize the entire firm, and to take over the management of the firm if necessary, firing incompetent incumbent managers. The bank might oust the top executives who have led the firm to managerial trouble and thus punish those key managers.

Finally, the bank might arrange a merger with a healthy firm or allow the insolvent firm to go bankrupt.

Komiya (1989, p. 138) suggests that such a bank firm relationship is analogous to a family physician-client relationship. If the client firm is only slightly ill, the main bank may simply provide managerial advice (prescribing drugs). But if the firm is in serious trouble, the main bank intensifies monitoring (sending the patient to a hospital for closer medical examination) and corrects the bad perfomance, if necessary, by replacing the ineffective management and reorganiz- ing the firm (conducting surgery). Once the firm's perfomance recovers, the monitoring intensity returns to a normal level (allowing the patient to leave the hospital) and a normal bank-firm relationship resumes (seeing the client for regular check-ups). On the other hand, if the firm's perfomance does not recover and continues to be bad, the main bank may arrange its merger with a healthy firm or allow liquidation (allowing the patient to die). Komiya's analogy with the family physician-client relationship corresponds to what Aoki calls the "contingent governance structure". However, such an analogy requires detailed and in-depth quantitative analyses of bank--firm relationships. This paper is our first attempt in this direction.

180 M. Kawai et al. / Japan and the World Economy 8 (1996) 175-194

In the presence of an effective external capital market, takeover agents would serve the useful function of raising the efficiency of asset utilization, by seeking out assets that are not being managed properly, taking over these assets, or threatening to do so. An effective, arm's-length external capital market can discipline managers to pursue objectives consistent with shareholders' interests, because of the credible commitment to get tough with managers who perform poorly. In the absence of an active external capital market, like in Japan, the main bank may perform the role of providing a substitute mechanism for a "missing" external capital market to ensure that incumbent managers behave well, thus imposing a "hard budget constraint" on the firm to avoid lax management. 9 The efficient monitoring technology enables Japanese main banks to provide a disciplinary mechanism. I° Such a main bank role is strengthened by the fact that the main bank is often the largest shareholder in the borrowing firm among commercial-bank lenders.

3. Data investigations

3.1. Firms in financial distress

We use financial data for a large sample of 1412 firms which have at some time been listed in the First Section of the Stock Exchanges in Tokyo, Nagoya, and Osaka for the period April 1964 through March 1993. Our sample includes firms listed continuously during the sample period as well as firms which were once listed but ceased listing in the Stock Exchanges due to bankruptcy, mergers and acquisitions by other firms, and for other reasons. The financial data of the firms listed continuously in the Stock Exchanges until March 1993 are obtained from the Nikkei-Needs financial data sources. Since the financial data of firms which are no longer listed as of March 1993 cannot be easily obtained from Nikkei-Needs, they are collected from the individual Yukashoken Hokokusho (Annual Financial Statement).

Though our sample does not cover firms in the financial industry (banks, securities firms, insurance firms, etc.) or in finance-related services (lease firms,

9Even an external capital market may not function as a discipliner because shareholders do not always exercise effective control due to a separation of ownership and control. It is possible, therefore, that banks exert the biggest influence, through their threat not to renew loan contracts, and serve as the most effective monitors of management (Stiglitz, 1985).

l°Gertner et al. (1993) present an analytical framework to analyze pros and cons of internal versus external capital market financing. They focus on the importance of asset redeployability, hardness of budget constraints, and monitoring incentives and claim that the modes of a firm's financing is determined by a combination of these factors. The Japanese main bank system regards monitoring as the most important factor in hardening the budget constraint, which would other- wise be soft. Horiuchi (1993), however, presents empirical evidence that the financial discipline of firms with strong ties with banks was lost in the latter half of the 1980s.

M. Kawai et al. / Japan and the World Economy 8 (1996) 175-194 181

credit sales companies, etc.), it represents major Japanese firms in manufacturing, wholesale and retail trade, transportation, construction, mining, and other industries. It is essential to examine the financial data of all these major firms including those no longer listed in the Stock Exchanges in order to avoid sample selection biases.

A firm is defined to be in "financial distress" if its current profits (ordinary income) are negative for two consecutive years or longer. This benchmark judgement is adopted here as a result of our interviews with business people, which suggest that two consecutive years of negative profits tend to arouse concerns on the part of commercial-bank lenders with regard to the borrowing firm's management, and invite some form of bank intervention. This is because the banks tend to view the consecutive losses as a reflection of something fundamentally wrong with the firm's management and operation rather than as temporary adverse shocks to the firm. In our sample of 1412 firms, we find 334 firms that have experienced more than two consecutive years of negative profits at some time in our sample period. Since some of these firms have had such experiences more than twice, we find 549 occasions where firm profits are negative over consecutive years.

A closer investigation of the profit data reveals that firms do not always return to consecutive years of positive profits following consecutive years of negative profits; they often sink into consecutive negative profits for a year or even several years after having briefly returned to positive profits. It is reason- able to interpret all these years as part of a long period of financial distress. Our interviews with the business people also suggest that it takes about three years for a firm to finally get out of financial distress. Based on these observations, we assume that once a firm is in financial distress and experiences more than two consecutive years of negative profits, it must record positive profits for at least three consecutive years to recover from financial distress. We then define the "period of financial distress" as beginning with the first year of consecutive negative profits and ending with the third year of consecutive positive profits. I~ The period of financial distress, therefore, is at least five years long. According to this definition, we obtain a sample of 448 periods of financial distress altogether, whose average duration is 6.9 years.

Table 1 summarizes the distribution of 448 periods of financial distress over time and across industries. The distribution over time is based on the first year of a period of financial distress and the industry distribution is based on

~lThe period of financial distress for those firms which ceased listing in the Stock Exchanges before experiencing three consecutive years of positive profits is assumed to end in the final year of listing. Similarly, the period of financial distress for firms which did not experience three consecutive years of positive profits by March 1993 is assumed to end in March 1993. There are 36 firms (and as many periods of financial distress) in the former category and 47 firms (and as many periods of financial distress) in the latter category. In either case, the duration of financial distress can be less than five years.


Table 1 Dis t r ibut ion of firms in f inancia ldis t ress across industries, 1965 1993

year

Indus t ry 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

Agriculture, forestry and fishing 1 1 Min ing 2 3 1 2 Manufac tu r i ng 27 13 4 4 5 3 21 27 4 8 62 25 11

F o o d 4 3 2 1 2 1 Textile p roduc t s 5 1 1 I 1 1 1 4 12 1 Pulp a n d paper 1 1 2 1 1 6 Chemicals 4 3 4 9 6 4 I Pet ro leum 1 1 4 Rubbe r p roduc t s Stone, clay a n d 1

glass p roduc t s 2 1 2 2 1 4 I I ron and steel 5 1 2 3 7 5 2 Non-fe r rous

metals 5 1 6 1 Metal p roduc t s 1 1 2 2 Genera l mach ine ry 3 2 1 2 5 3 5 4 4 Electric and

electronic equ ipment 3 1 1 4 1 7 2 T r a n s p o r t a t i o n

equ ipment 2 1 2 1 1 1 Precision ins t ruments 1 2 O t h e r manufac tu r ing 1 1 2 2 1

Cons t ruc t ion 1 3 3 Wholesale and

retail t rade 1 1 1 7 1 Real es tate 1 1 2 Ra i l road

t r anspor t a t ion 1 2 Wate r and air

t r anspor t a t ion 1 1 1 3 1 W a r e h o u s i n g C o m m u n i c a t i o n Electricity and

gas supply 1 1 Services 1 5 1 1 2

Tota l 31 22 5 7 5 3 23 28 6 12 75 36 15

Note: The year ly d is t r ibut ion is based on the first year of each per iod of financial distress.

classification reported in firms' Yukashoken Hokokusho. The table reveals that a large number of firms suffered from financial distress in 1965-1966, 1971-1972, 1975-1976, 1982-1983, and 1986-1987 in various sectors of the economy, particularly in manufacturing. Textile products, iron and steel, chemicals, general machinery, and electric and electronic equipment are hardest hit in times of macroeconomic downturn. Fig. 1 shows that the occur- rence of financial distress is associated with Japan's macroeconomic cyclical fluctuations represented by the growth rate of real GDP. It is no surprise that the severest recession in 1974 was accompanied by a large number of firms facing financial distress in 1975-1976.


1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 Total

14 6 4 11 16 21 9 6 17 15 1 1 1 1

2 2 3 1 2 1 1 2 1

2 1 3 5 1 3 1 1 1 1 1 1

1 1

1 2 1 6 8

1 0 3 8 14 359 17

I 39 1 1 19 1 2 52

9 3

1 5 1 2 0 1 3 2 1 1 4 1 1 39

3 2 2 1 21 6

3 2 l 1 1 2 4 7 1 51

2 1 1 3 1 2 2 1 1 8 41

3 3 3 1 5 2 25 2 1 1 7

1 1 1 10 2 1 2 1 13

1 1 2 1 1 2 2 21 1 5

3 1 2 2 3 1 19 0 0

2 1 1 12

17 6 4 12 20 24 12 10 20 18 1 1 6 11 18 448

Table 2 summarizes the size of the firms which experienced financial distress. Firm size is measured by the number of employees. The table shows that our sample does indeed focus on the largest private firms in Japan, most of which employ more than 1000 people.

3,2. Stability of the largest bank lender

To prepare for the analysis of the financial role of the main bank system at a time of a firm's financial distress, we first determine whether a firm maintains a


Number

8O

70

~, 6o

.~ 50

.~ 40

N N 30

~ 20

10

1965 1970

Number of Firms in Financial Distress (left-hand scale)

/

1975 1980 1985 1990 'fear

%

14

12

10~.

0

8-~ e

2 ~

Fig. 1. The number of firms in financial distress and growth rates of Japan's real gross domestic product.

stable, long-term relationship with a particular bank with the largest loan share among the private commercial banks.

We classify firms in financial distress into two categories, depending on whether they maintain stable, long-term relationships with the largest commercial-bank lenders. For the first category of firms, the largest commercial-bank lender is unchanged at least for five years prior to the beginning of financial distress as well as during the period of financial distress. Each firm in this category is considered as having a main bank because it relies on the bank for at least ten years as a source of bank financing. For the second category of firms, the largest bank lenders change at least once over the same period. Firms in this category do not maintain stable relationships with a particular commercial bank as the largest source of bank financing and, hence, are regarded as having no main bank. 12

It turns out that out of 448 periods of financial distress, nine periods represent cases where nine firms have zero bank borrowing, meaning that the above

~2Firms' financial data reveal the fact that, when profits become negative for consecutive years, the amounts of borrowing tend to rise and the sources of bank lenders tend to diversify. If the amounts of borrowing from several commercial banks prior to financial distress are about the same, it is often the case that the largest bank lenders change, particularly during the period of financial distress. On the other hand, if the amount of borrowing from a particular commercial bank is dominantly large, then this bank tends to continue to be the largest bank lender both before and during the period of financial distress.

M. Kawai et al. / Japan and the World Economy 8 (1996) 175-194

Table 2 Distribution of firms in financial distress by size, measured by the number of employees

185

Number of Period employees

1965-1969 1970 1974 1975 1979 1980 1984 1985-1989 1990 1992 Total

1 300 0 0 2 5 3 2 12 301 500 I 2 5 2 4 1 15 501 1000 16 6 25 13 1:~ 5 78

1001 3000 29 44 73 36 2~ 19 224 3001 5000 9 9 19 10 3 1 51 5001 10000 8 6 17 4 2 3 40

10001 30000 7 4 8 2 2 4 27 30001 0 1 0 0 0 0 1

Total 70 72 149 72 5(I 35 448

Note: The distribution over time is based on the first year of the period of financial distress.

classification cannot be made. Focusing on the remaining 439 periods of financial distress, firms maintain stable, long-term relationships with their largest bank lenders in 220 cases (50.1%) and firms do not maintain such stable, long-term relationships in 219 cases (49.9%). This suggests that about one half of the firms which experienced a period of financial distress during 1965-1993 had main banks and the remaining one half of the firms did not have main banks.13 This finding clearly provides some evidence on the presence of stable, long-term relationships between a large number of major Japanese firms and their largest commercial-bank lenders, and it rejects the idea that all major firms in Japan maintain such stable relationships with the largest bank lenders. Thus the presence of a main bank system cannot be denied, but this system can hardly be observed for every major firm. 14

Table 3 summarizes which banks are the largest lenders to major Japanese firms five years prior to financial distress in our sample of 439 cases. It shows the number of firms for which the largest bank-lender positions did or did not change for at least ten tears, before and during the period of financial distress. It is interesting to note that major city banks, such as Dai-Ichi Kangyo Bank, Sakura Bank, Sanwa Bank, and Mitsubishi Bank, in addition to the Industrial

131t is of some interest to see if there exists any cor re la t ion between the presence of stable, long- te rm re la t ionships wi th the larges t bank lender and the con t inua t ion of l is t ing in the Stock

Exchanges . Ou t of 439 per iods of f inancial distress, 403 cases result in the con t inua t i on of l is t ing

and 36 cases in the cessa t ion of l ist ing. 51% of the former (403) cases involve firms which m a i n t a i n stable, long- te rm re la t ionsh ips wi th the largest b a n k lender, while only 4 2 % of the la t ter (36) cases involve firms tha t do not. This difference, t hough s ta t is t ica l ly insignificant , is large enough to

suggest the exis tence of a weak cor re la t ion between the two. 14Miwa (1990) also casts d o u b t on the p ropos i t ion tha t every firm in J apan has a ma in bank by

c o m p a r i n g bank- f i rm re la t ionsh ips in two periods, 1973 and 1983.


Table 3 The largest lender banks five years prior to the beginning of financial distress

The largest lender position

Unchanged Changed Total

Dai-lchi Kangyo Bank 34 12 46 Hokkaido Takushoku Bank 0 0 0 Bank of Tokyo 4 2 6 Sakura Bank 19 8 27 Mitsubishi Bank 13 10 23 Fuji Bank 10 15 25 Sumitomo Bank 12 14 26 Daiwa Bank 13 7 20 Sanwa Bank 18 11 29 Tokai Bank 5 3 8 Asahi Bank 8 5 13

Industrial Bank of Japan 42 29 71 Long-term Credit Bank of Japan 4 i I 15 Nippon Credit Bank 1 6 7

Mitui Trust Bank 3 9 12 Mitsubishi Trust Bank 7 14 21 Sumitomo Trust Bank 8 16 24 Yasuda Trust Bank 2 9 11 Toyo Trust Bank 0 3 3

Norin Chukin Bank 4 17 21 Yokohama Bank 2 2 4 Other local banks 7 8 15 More than one bank 4 8 12

Total 220 219 439

Note." The figures represent numbers of firms in financial distress.

Bank of Japan (Kogin) are major ma in banks in Japan. Smaller banks are not impor t an t ma in banks for major listed firms, though they play main bank roles for small-scale firms.

3.3. Interest rates on intrest-bearin9 debts

It is postulated that a firm which has a ma in bank, as a stable source of bank financing, is likely to receive financial assistance from it in a period of financial distress. There are various types of such financial assistance, one of which is a reduct ion of interest payments and /or a write-off of debts.

Unfor tunate ly , Yukashoken Hokokusho (Annual F inanc ia l Statement) does no t publish interest payments to banks separately; they are reported under the

M. Kawai et al. / Japan and the World Economy 8 (1996) 175 194 187

heading of "interest expenses". The item "interest expenses" is the sum of (a) interest paid by the firm to short- and long-term lenders, holders of corporate and convertible bonds, and employees holding deposits with the firm, and (b) interest expenses due to the discounting of notes receivable.t 5 This is the only item that includes the interest cost of financing for the firm. Though data on "interest payments" are thus broadly defined, we use the item in our analysis for want of a more complete indicator.

To calculate the "interest rate" the firm faces, we simply divide "interest expenses" by the corresponding interest-bearing debts or their equivalents (period average outstanding), that is, outstanding stocks of short- and long- term borrowing, corporate and convertible bonds, employees' deposits, and notes receivable discounted. These stock data are readily available from Nik- kei-Needs and individual Y u k a s h o k e n H o k o k u s h o .

To remove cyclical and seasonal components from the interest rates, we obtain the difference between the interest rate each firm in financial distress must face during the period of distress and the interest rate a typical listed firm faces in the same period. This difference is nothing but the "interest-rate premium" a firm in financial distress must pay to compensate for the risk of bankruptcy.

There are three observations in our sample where one firm recorded zero "interest expenses". We have decided to delete such observations from our data set. x6 Since the interest-rate premium is calculated for each year during the period of financial distress, we obtain 3097 observations.

4. Financial assistance to firms in distress

In this section we investigate whether the interest-rate premia paid by firms in financial distress are affected by the presence of commercial bank borrowing and of stable, long-term relationships with the largest commercial-bank lender. At the same time we examine the composition of interest-bearing debts and their equivalents.

15One of the distinctive features of the Japanese financial system is the large size of intra-firm trade credit, where a creditor firm receives "notes receivable" from a debtor firm (see Cargill and Royama, 1988, Ch. 3). On the due date, the creditor firm can earn the full amount of claims plus interest by presenting the notes. However, if the creditor firm discounts the notes before the due date, it typically receives the amount less than the face value and thus forgoes interest, a difference between the face value and the discount price. Yukashoken Hokokusho (Annual Financial State- ment) reports such forgone interests under the heading "interest expenses".

16To calculate the interest rate a typical listed firm faces, we also delete observations with zero "interest expenses".

188 M. Kawai et al. / Japan and the Worm Economy 8 (1996) 175 194

4.1. Effects of borrowing from commercial banks

It turns out that there are 61 observations in which nine firms reported zero borrowing from any commercial bank five years prior to the period of financial distress. According to our definition, these firms do not have a main bank. Hence, it is of some interest to test whether any significant difference exists between the interest-rate premia paid by these firms and the interest-rate premia paid by firms which recorded positive amounts of commercial bank borrowing five years prior to the beginning of financial distress.

Table 4 shows that the mean interest-rate premium paid by firms with positive amounts of bank borrowing prior to the beginning of financial distress is 0.15%, which turns out to be statistically significantly greater than zero. On the other hand, the mean interest-rate premium paid by firms without any bank borrowing is much higher, and statistically significantly so, at 4.34%. Firms in financial distress must pay positive risk premia regardless of whether they have zero or positive bank borrowing. But firms with zero commercial bank borrowing from the outset must pay a significantly higher interest-rate premium in the period of financial distress.

This result suggests that a firm can reduce the financial cost at a time of financial distress by having established a relationship with commercial banks in the form of borrowing before it falls into financial distress. One interpretation for this is that such a relationship mitigates the cost of monitoring, and gathering information concerning, the borrowing firm for the commercial bank as an external lender, thereby allowing the bank to lower the cost of finance at the time of the firm's financial difficulty. The bank can gather relatively precise information and make a fairly accurate risk assessment of the firm by closely monitoring daily changes in the working balances and settlement accounts the firm would typically maintain with the bank lender. An- other interpretation is that the commercial bank has an incentive to lower the

Table 4 The size of interest-rate premia

Number of observations

Mean interest-rate premia

Mean Standard t-statistics (%) error(%)

All sample 3097 Firms with zero bank borrowing 61 Firms with positive bank borrowing 3036

Firms with a main bank 1356 Firms without a main bank 1680

0.236 0.041 5.78** 4.336 1.050 4.13"* 0.154 0.034 4.46** 0.076 0.048 1.58 0.216 0.049 4.45**

Note: Double asterisks (**) indicate that the t-statistics are statistically significant at the 1% level.

M. K awai et al. / Japan and the World Economy 8 (1996) 175- 194 189

interest-rate premia charged to the firm, as long as it makes profits in other areas of banking services with the firm. 1~ However, there is no way of verifying the latter interpretation due to the lack of data.

4.2. Effects o f stable, long-term relationships with the largest bank lender

Let us now test whether any significant difference exists between the interest-rate premia paid by the firms in financial distress whose largest commercial-bank lender did not change over the course of five years prior to and during the period of financial distress and the premia paid by firms whose largest bank lenders changed at least once over similar periods. In other words, we test if there is any statistical difference in the interest-rate premia paid, at times of financial distress, by firms with main banks and the premia paid by firms without them.

Table 4 again reveals that the mean interest-rate premium paid by firms which maintained stable relationships with their largest commercial-bank lenders, i.e., their main banks, is 0.08%, which turns out statistically insignific- antly different from zero. The hypothesis that firms that have main banks do not pay extra interest-rate premia in a period of financial distress cannot be rejected. On the other hand, the mean interest-rate premium paid by firms which changed their largest bank lenders at least once is 0.22%, which is both statistically significantly positive and significantly higher than the mean premium paid by firms that did not change the largest bank lender. Hence, the hypotheses that firms without main banks do not pay extra interest-rate premia and that their premia are the same as those paid by firms with main banks are both rejected.18

As explained earlier, our sample of 3097 observations includes those firms whose periods of financial distress did not continue for the full five years either due to the cessation of listing in the middle of distress (228 observations) or due to the end of available data in March 1993 (196 observations). We now examine if any bias exists in our results by mixing together all these observations. Specifically, we calculate interest-rate premia by narrowing our sample

7Other areas of financial services include involvement in bond issues, foreign exchange trading, and access to banking business for subsidiary or related firms.

XSThough the difference between interest-rate premia paid by firms with and without main banks is only 0.14% and small, it can have a non-negligible impact on the firms' current profits. For example, the average outstanding interest-bearing debt of all the listed firms in 1994 was 87.3 billion yen (49.2 billion yen for manufacturing firms and 162.8 billion yen for non-manufacturing firms), 0.14% of which is 0.12 billion yen (0.07 billion yen for manufacturing firms and 0.23 billion yen for non-manufacturing firms), a non-negligible amount for firms experiencing negative profits. See Toyokeizai Shinposha, Kaisha Zaimu Karute (Corporate Financial Papers, 1996), for data on interest-bearing debts.


Table 5 Size of interest-rate premia, sub-sample observations

Number of observations

Mean interest-rate premia

Mean Standard t-statistics (%) error (%)

( a ) Sub-sample observations with full periods of financial distress

All sub-sample 2673 0.208 0.045 4.67** Firms with zero bank borrowing 34 7,024 1.735 4.05** Firms with positive bank borrowing 2639 0,120 0.036 3.31"*

Firms with a main bank 1167 0.016 0.050 0.32 Firms without a main bank 1472 0.203 0,052 3.94**

( b ) Sub-sample observations with less-than-full periods of financial distress due to the cessation of listing in the middle of financial distress

All sub-sample 228 0,019 0,149 0.13 Firms with zero bank borrowing 0 - - - - - - Firms with positive bank borrowing 228 0.019 0.149 0.13

Firms with a main bank 76 0.306 0.306 1.00 Firms without a main bank 152 -0.124 0.162 -0.77

( c ) Sub-sample observations with less-than-full periods of financial distress due to the end of available data in March 1993

All sub-sample 196 0.869 0.126 6.91"* Firms with zero bank borrowing 27 0.951 0.377 2.52** Firms with positive bank borrowing 169 0,856 0,133 6.42**

Firms with a main bank 113 0.547 0,152 3.59** Firms without a main bank 56 1.481 0,241 6.41"*

Note. Double asterisks (**) indicate that the t-statistics are statistically significant at the 1% level.

to those covering the full five-year period of financial distress, that is, by excluding observations with less-than-full periods of financial distress. We also calculate interest-rate premia using sub-sample observations with less-than-full periods of financial distress.

The results are reported in Table 5. The qualitative results in Table 5(a) (sub-sample observations with full periods of financial distress) are essentially the same as those reported in Table 4. That is, firms with zero bank borrowing pay larger interest-rate permia than do firms with positive borrowing. Focus- ing on firms with positive bank borrowing, firms without main banks pay significantly higher interest-rate premia than do firms with main banks.

Looking at other sub-sample observations with less-than-full periods of financial distress in Table 5(b) and (c), some differences are observed. Table 5(b), which uses sub-sample observations with less-than-full periods of financial distress due to the cessation of listing in the middle of distress, shows that the interest-rate premia paid by firms with main banks are positive and the premia paid by firms without main banks are negative, though they are all


s ta t is t ical ly insignificant. 19 Resul ts r epo r t ed in Tab le 5(c), where sub-sample obse rva t ions wi th less- than-ful l pe r iods due to the end of ava i lab le da t a in M a r c h 1993, are less str iking; the difference between in teres t - ra te p remia pa id by firms with zero and posi t ive bank b o r r o w i n g are no t s ta t is t ical ly significant.

These results largely indicate tha t a firm with stable, long- te rm re la t ionships with the largest c o m m e r c i a l - b a n k lender receives favorable f inancial t rea t - ments from the bank in a pe r iod of f inancial distress. It also indicates tha t a firm wi thou t such re la t ionships with a commerc ia l bank pays a high interest- ra te p r e m i u m in a pe r iod of f inancial distress. The ma in bank appea r s to extend f inancial ass is tance to firms is distress by way of sacrificing risk premia . In general , however , the size of f inancial ass is tance is not so big as to dr ive the in teres t - ra te p remia negative; the Japanese ma in bank system does not lower the f inancial cost of f irms in distress be low the levels an average l isted firm would face.

4.3. Compositions o f interest-bearing debts

As men t ioned earlier, in te res t -bear ing debts and their equivalents consist of ou t s t and ing s tocks of shor t - and long- te rm bor rowing , c o r p o r a t e and conver t - ible bonds , employees ' deposi ts , and notes receivable d iscounted.

Table 6 Composition of interest-bearing debts of firms in financial distress (%)

Number Short-term Long-term Corporate Employees' Notes ofobserva- borrowing borrowing and con- deposits receivable tions vertable discounted

All sample 3097 35.8% 41.1% 3.4% 1.9% 17.8% Firms with zero

bank borrowing 61 25.1 41.2 18.6 2.4 12.7 Firms with positive

bank borrowing 3036 36.1 41.1 3.1 1.9 17.9 Firms with a

main bank 1356 38.4 41.0 3.8 1.9 14.9 Firms without a

main bank 1680 34.2 41.1 2.5 2.0 20.3

19A closer examination of the types of firms in this sample set reveals the fact that some of them received special financing from the government (Chisso) or government-related financial institutions (Hokkaido Colliery and Steamship, Nippon Coal Mining, Yubetsu Tanko, Kaijima Coal Min- ing, and Akimoku Kogyo). Essentially, they were allowed to go bankrupt gradually while receiving financial support from the government. If we limit our focus only to these firms (39 observations), then the interest-rate premia paid by firms without main banks are negative and statistically significantly so. If we exclude these firms from our sample and use the remainder (189 observations), the interest-rate premia paid by firms without main banks are positive though statistically insignificant.

192 M. Kawai et al. / Japan and the Worm Economy 8 (1996) 175-194

Table 6 summarizes the composition of these outstanding debts of firms in financial distress. The share of short-term borrowing is low, at 25%, for firms that had zero borrowing from commercial banks prior to the period of financial distress and high, at 38%, for firms which have main banks. The share of long-term borrowing is remarkably invariant, at about 41%o, across firms regardless or whether they had zero or positive bank borrowing initially and whether they maintain stable, long-term relationships with the largest commercial-bank lender, i.e., the main bank. The share of corporate and convertible bonds is high, at 19%, for firms which had zero bank borrowing initially and low, at only 3%, for firms which had positive bank borrowing initially; firms that can depend on commercial banks for financing do not have to issue bonds to secure external financial resources. The share of employees' deposits is low and invariant, at about 2%, across firms. Finally, the share of notes receivable discounted is low, at 15% for firms which have main banks and substantially higher, at 20%, for firms which do not have main banks.

This last result suggests that firms without main banks or stable sources of bank financing tend to discount the notes receivable before due dates and to obtain liquidity at a time of financial distress. Discounting the notes is thus an important source of securing liquidity for firms without main banks. Firms with main banks which can secure a stable source of liquidity, on the other hand, do not have to rely heavily on discounting the notes in periods of financial distress.

5. Concluding remarks

This paper has demonstrated that the main bank system can play an important financial role for Japanese firms in distress by alleviating the firm's financial cost. It has done so by statistically investigating a large sample of Japanese major firms in financial distress, rather than by just collecting case studies and anecdotal examples.

Our major findings are summarized as follows: First, firms pay positive premia on interest rates at the time of financial distress. Second, firms with positive bank borrowing tend to pay significantly lower interest-rate premia, though still statistically significantly positive, in periods of financial distress than do firms with zero bank borrowing. Third, if we focus on firms with positive bank borrowing, firms with main banks pay significantly lower interest-rate premia than do firms without main banks. Fourth, the discounting of notes receivable, due to intra-firm trade credit, plays an important role for liquidity-constrained firms without main banks.

However, this paper is only a first step toward a statistical analysis of the Japanese main bank system and there remain many unresolved questions.


More detailed quantitative evidence must be accumulated to understand fur- ther the financial role of the main bank system. First, when the borrowing firm's performance continues to deteriorate despite financial assistance, what does the main bank do, on average, when intervening in the firm's management? How should we measure statistically the degree of main bank intervention during the course of firms' financial distress? Second, how does the main bank system provide a substitute mechanism for the external capital market and keep managers from engaging in objectives inconsistent with the interests of shareholders, thereby imposing a "hard budget constraint" on the firm? These questions are the next subjects we wish to investigate.

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Japanese firms in financial distress and main banks: Analyses of interest-rate premia

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