Conflicts of Interest in Japanese Insolvencies: The Problem of Bank Rescues

Economists and legal scholars routinely posit an implicit contract between Japanese firms and their principal lender (called their "main bank"). Under this arrangement, the bank implicitly agrees to rescue the firm (through financial and managerial help) when times turn bad. Out of court, it rescues the firm from insolvency. Not only does it save the investments specific to the troubled firm, it lowers the use of costly bankruptcy proceedings and cuts the costs of those bankruptcy procedures it does occasionally invoke. Given the creditor-shareholder conflicts of interest that arise as firms approach insolvency, such arrangements would seem unstable. Yet according to a long sociological tradition, conflicts of interest are inherently less problematic in Japan than in the West. According to the emerging economic and legal tradition, Japanese economic actors do face those conflicts, but keep them in check through reputational concerns, close-knit ties, and government supervision. Using two datasets of troubled firms from the 1970s and 1980s, we ask whether Japanese main banks in fact rescue distressed borrowers. We find no evidence that they do: large Japanese firms fail; when large firms approach insolvency main banks do not increase the share of the firm's debt they bear; stronger ties between distressed firms and their main bank do not facilitate loans; and troubled firms do not try to preserve their main bank relationship. Instead, the claim that Japanese banks implicitly agree to rescue firms is sheer myth. Conflicts of interest do indeed matter in Japan -- and they matter enough to prevent precisely the incentive-incompatible rescue deals that scholars in the field so routinely posit.