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A Tale of Two Relationship-based Financial Systems: Main bank vs. Venture Capital System

Kangkook Lee

Abstract

We study the relationship-based financial system in this paper, focusing on the Japanese main bank system and American venture capital system. We emphasize the relationship-based system is good at solving agency problems with a close financier-firm relationship and information sharing. Both of the main bank and venture capital system have in common with this character. However, there is also difference that the main bank system has advantage of encouraging long-term investment and economic stability, while the venture capital system tends to destabilize the economy, depending too much on the stock market. Examining two countries’ experience, we will argue the Japanese trouble is due to a demise of the main bank system, not inherent problems of the system, and the U.S. venture capital indeed played an important role in the new economy boom but the coming recession would be more serious due to a character of the venture capital investment. This study calls on us to making efforts to establish a well functioning relationship-based system to promote long-term economic growth, stability and innovation as well.

2001. 5. 22. [email protected] 1. Introduction

Recently, interest in financial systems has gained a great momentum with new studies of the role of the financial system in the economy. Lots of economists have shed light on the importance of the financial system to encourage economic growth. Now, it is a common belief that well-functioning financial system to channel capital to the productive investment and allocate financial resources is crucial for economic success (Levine, 1997). The role of the financial system already got attention in explaining different economic performance of countries like U.S. and Japan from the perspective of comparative financial system study. They divide financial systems into a market-based one with a strong role of the stock market and a bank-based one with relative importance of banks. In the 80s, it was widely believed that the bank-based system of Japan or Germany was much better to encourage long-term investment and growth, while the U.S. system is suffering short-termism and thus bad for long-term growth. However, in the 90s everything seems to have changed. As Japan fell in long recession and the U.S. economy enjoyed a long new economy boom with the fast-growing IT sector, pendulum swayed to opposite direction big time. Nowadays, most of people believe that Japanese failure was due to inherent problems of the financial system and the market-based system with venture capitals brought out American success. But so-called venture capital system itself indeed has a strong character of relationship-based system, and Japanese experience shows how the relationship-based system works well in what conditions. This reality calls on us to study the relationship-based system more carefully. In this paper, we will show what is advantage and disadvantage of the relationship-based system, focusing on the Japanese financial system and American venture capital system. First section will discuss pros and cons of the relationship-based system and examine the important bank-business relationship and macroeconomic effect. Next, we will turn to the Japanese system and study the rise and fall of the system. We will argue that a balanced and cooperative bank-business relationship was essential for success of the main bank system in which long-term investment was encouraged with good monitoring. But the demise of the system along with the government deregulation and change of corporate financing brought about the financial crisis. The section 3 deals with the venture capital system and argues it is basically relationship-based one but mostly backed by the stock market boom. We will present how venture capitals were helpful to the new economy boom but it is likely that

2 venture capital investment may be very volatile and aggravate the economic cycle, causing the serious problem. In so doing, we can get important lessons about a successful relationship-based financial system for both of innovation and stable long-term growth that we will turn to in concluding remarks.

3 2. Relationship-based financial system : better than market?

2.1. Advantages of the relationship-based system

A ‘financial system’ is defined as broad arrangements of financial markets and institutions, and the way that capital is allocated. It serves an important role in an economy by channeling savings to productive uses and providing corporate governances. Broadly speaking, the system is divided into the bank-based and the market-based one according to the relative role of financial intermediaries and the market like stocks or bonds. The debate about which is better is constantly being fuelled by the differing economic development experiences of different financial system (UK, US vs. Germany, Japan), Japan).1 In fact, up to the early 1990s, most economists argued the bad performance of the U.S. economy compared to Japan was due to inefficiency of the market-based system especially for long- term economic growth, while the bank-based system is good at long-term investment (Grabel, 1997). But the pendulum swung in the opposite direction according as the Japanese economy faltered and the U.S. economy was in a good shape in the late 90s. However, distinction between the bank-based and market-based system is a bit too broad to study reality with various types of financing relationship. In this paper, following a recent study, we define a “relationship-based financial system” as a system in which the financial intermediaries provide capital that invest in obtaining customer-specific information and evaluate the firms’ performance through multiple interactions over time (Boot, 2000). The essential character of the system is a close financier-firm relationship to address serious information problem, and banks or nonbanks plays a crucial role in the corporate governance or monitoring.2 It includes several cases such as the Japanese main bank system, venture capital system and small firms bank borrowing in the U.S. Also, the state-led bank-based system of the East Asian countries has the character of the relationship-based system so much.3 In the main bank system, the main bank monitors the

1 For a general comparative approach, see Allen and Gale (1995). More recent theoretical surveys include Stulz (2000) and Takagi (2000). For empirical studies, see Levine (2000), Levine and Demirguc-Kunt (2000). For a slightly different approach with a more progressive view, see Pollin (1995). 2 This concept is similar to what Aoki and Dinc call “relational financing” that financier is expected to make additional financing in a class of uncontractible states in the expectation of future rents over time (Aoki and Dinc, 2000). The opposite concept would be the arm’s-length financial system including the market-based system like stocks and bonds, and the arm’s-length banking. In the arm’s-length banking, the bank-business relationship is not close, the role of banks in corporate governance is not active and they are prohibited from owning equities and the role (Aoki et al., 1994, p. 42). 3 For example, in Korea the government established the close government-business relationship with strong

4 client firms very intensively, based on cross-shareholding of stocks, and it gives financing to a firm contingent on the economic prospect (Aoki, et al., 1994). In the case of venture capital investment studied by burgeoning recent literatures, we can see strong monitoring by venture capitalists who pursue capital gains at the IPO, and additional financing is step- financing contingent on the project developed (Gompers and Lerner, 1999). In addition, it is argued that the small firm-bank relationship in U.S. shows similarity to the relationship- based system (Peterson and Rajan, 1995). Already, most of corporate finance theories recognize the benefits of the relationship- based system, mainly related to addressing agency and information problems.4 The financial market is never complete, always suffering from inherent problems of hidden information and action and financial systems solve these in their own way. First of all, it is well known that the market-based system has serious flaw in monitoring. Even if the market for corporate control, shareholder meetings, and performance pay can be a monitoring mechanism, they have serious limits mainly due to information and free-rider problems. In principle, bank debts are better than equities in disciplining managers since it can economize on resources with more flexibility, reducing the serious cost of verification and collective action of the equity or public debts (Takagi, 2000). Moreover, in the relationship-based system, a close relationship between a financier and firm can further lead to much better monitoring function (Boot, 2000). For example, when banks and businesses make an intimate relationship like in Japan, banks can have more information and incentives to monitor the firms. In most cases, the monitoring function is integrated into and done by one agent, a main bank or venture capitalist, who has informational advantage or special knowledge. The relational financier is subject to intervene into the management of firms or does rescue operation when its performance is bad, and thus providing a ‘contingent governance structure’. Second, it is important that long-term investment could be encouraged more in the relationship-based system, whereas investment in the market-based system is sensitive to the stock market price with short-termism. In the market-based system, managers should care about the stock price, faced with a threat of hostile takeovers. It is affected a lot by

control of banks and played role of monitor of the corporate sector. For details, see Lee (2001). 4 First, investors or lenders do not see all actions management takes and management has information those investors or lenders do not have. Accordingly, there must be market failures in the financial market leading to so-called ‘agency problem’ and monitoring over management is crucial (Stultz, 2000). In debt market in general, it may result in the credit rationing between lenders and borrowers, and in the stock market it leads to conflict between investors and managers. More macroeconomic perspective and progressive view, see Pollin (1995).

5 investors, who are mostly concerned about short-term financial gain, not long-term growth potential of the firm. Also, managers tend to have more information about investment projects that the market can’t finance due to deficiency of information.5 The long-termism of the relationship-based system is obvious especially when firms are in financial distress. Rescue operation of the main system can avoid myopic liquidation that does harm to workers’ investment in firm-specific human assets investment, thus helpful to long-term growth.6 Another benefit related to this is that this system reduces macroeconomic volatility by stabilizing investment activity, unlike the market-based system. However, all relationship-based systems are not up to this. The venture capital system may not meet it because it is too much dependent on the stock market though even if it is a kind of the relationship-based system. Also, the relationship-based system is better at so-called ‘staged financing’ for a new firm.7 When information symmetry is prevalent in the financial market, the capital market is no good to support startups. Staged financing requires investors to provide new funds under some conditions but it is not possible to specify all the possible conditions and the character of the limited liability of the capital market makes it harder. Rather, the relationship-based system is much better because of sharing information with their specialized skills of evaluation, clearly seen in the case of venture capital investment and small firms’ borrowings in U.S. In the staged financing, financiers have incentives to undertake financing on less favorable terms, for which he is compensated in the long term after a success of the project invested, getting a kind of monopoly based rent. 8 In reality,

5 There are lots of evidences to show the short-termism of the stock market. Pollin (1995) presents several studies showing the managers in the relationship-based system have longer-term horizon with less cost of capital (Pollin, 1995). Shaberg argues the system can lower borrowers’ and lenders’ risk and thus encourage more investment from Minsky’s perspective (Shaberg, 1998). Recently it is reported that when a firm announces an equity issues the stock price falls in U.S. due to information discrepancy, while it doesn’t in Japan. Hence, managers sometimes have hard time starting new positive net present value projects (Kang and Stulz, 1996). For international comparison, see Grabel (1997). Dewatripoint and Maskin (1995) present an interesting theoretical model with multiple equilibria in which the relationship- based system in Germany and Japan tends to reach a long-term investment equilibrium. 6 In principle, banks may be more concerned about repayment, taking less risk than entrepreneurs, raising some conflict about expansion of firms, but it can be addressed by cross-shareholding to arrange incentives of both of them. Hoshi et al.’s (1991) famous study shows that the investment of Japanese firms belonging to keiretsu with a stronger tie to the bank was less sensitive to liquidity than independent firms in recession. For a conflicting argument, see Weinstein and Yafeh (1998) and Hall and Weinstein (2000). 7 Staged financing means a method of financing that involves financing in stages, where future financing depends on how the project is evolving. Entrepreneurs who want to start a new business mostly turn to this to initiate the project (Stultz, 2000). 8 When the financier has monopolistic position in the relationship, it may allow him to smooth financing costs over time. For more details, see Aoki and Dinc (2000) and Peterson and Rajan (1995).

6 most of small firms that can’t get capital in the market facing with liquidity constraint turn to the relationship-based financing. Lastly, the relationship-based system provides more possibility for the government to intervene into the economy managing economic problems. Thus, several policies like industrial policy and expansionary economic policy could be implemented in the system much better, while the market-based one blocks it or just encourage speculation. Thus, it enables people to control the economy democratically pursuing egalitarianism, as well as the government to promote development with active policies (Pollin, 1995).

2.2. For successful relationship-based the system

Of course, the relationship-based system may go into malfunction and the market-based system could be better in some respects. Most economists point out drawbacks of the relationship-based system, including so-called ‘soft-budget constraint problem’ and ‘hold- up problem’. First, soft budgeting might happen in the system, i.e. bank rescues of inefficient firms that should be liquidated. If banks are not tough enough and it is so easy for borrowers to renegotiate their contracts ex post then borrowers may exert insufficient effort in preventing a bad outcome (Boot, 2000). This argument recently got so popular with the economic trouble of the Japanese economy compared to the U.S. success. Most researchers contend that the main bank system continues give capital to firms in trouble, even ignoring the price signal of the market and decreasing the efficiency of investment (Rajan and Zingales, 1998). To them, the most important problem is that the system is without a good process of disclosure and price signals are so bad that widespread and costly misallocation of resources may happen (Morck and Nakamura, 1999; Weinstein and Yafeh, 1998). Interestingly, they interpret the fact that main bank’s rescue operation we mentioned above, as an evidence of soft budget constraint. There might be this problem in reality, especially in somewhat centralized financial system (Dewatripoint and Maskin, 1995). However, the extent of the problem also depends on information available, and ex ante and interim monitoring function of banks.9 Rather,

9 Dewatripoint and Maskin (1995)’s famous model itself assumes that “banks cannot initially distinguish between good and poor projects” (p. 544) but if better ex ante monitoring addresses this the result would be different by increasing the number of good projects. Moreover, better interim monitoring can lead to social benefit even with somewhat soft-budgeting, that is, better information flow can maximize the benefit of the relationship-based system, while the underinvestment problem of the arm’s length system is more serious.

7 the main bank system itself is a good device of monitoring with more information to justify their decision to help firms in trouble. It should be noted that Japanese success itself was based on the relationship and the recent trouble is mostly due to weakening the main bank system, as we will see. In terms of the problem, the venture capital system may face less soft budget constraint problem since they invest capital in several steps based on performance. Meanwhile, mainstreams assert that the market-based system is generally better in aggregating and generating information, not customer-specific. In spite of worse monitoring, still the capital market is argued to be better with information feedback from equilibrium market prices to guide investment decision (Rajan Zingales, 1999). It might be justified when information about the industry is really not known, so that the market is better suited to generate it like totally new industries with new technology.10 This could be a reason why new industries emerged mostly in the market-based system countries (Allen and Gale, 2000). The debt finance requires the availability of collateral mostly as a form of fixed capital, so that it may repress the innovative activity like R&D, not involved in fixed capital. In this respect, the venture capital system shows a possibility of the relationship- based system to overcome it, based on the stock market. However, even if it is true to some extent, still the Japanese manufacturing sector is strong enough and there is no reason that the stock market is always helpful to innovation (Singh et al., 2000). Another dark side of the relationship-based system is that there could be a situation that some agents are held up by others. If power of banks is too strong compared to that of business without any competition in the banking sector or other capital markets, then banks may capture rents from the industrial sector. A puzzling study about the main bank system reports that firms with stronger tie with the main bank in keiretsu generally had lower economic growth and higher interest payment (Weinstein and Yaffeh, 1998). They interpret it as evidence that too strong banks extracted rents from the corporate sector.11 Indeed, big firms tried to turn to alternative financing like bonds after the 70s, but much more interesting is that along with a decrease of firms’ dependence on banks and weakening of the bank-business relationship, the monitoring function of the main bank decreased

Interestingly enough, we can see the same kind of debate about limits of ‘market socialism’ (Pollin, 1995. pp. 53-57). 10 So-called ‘diversity of opinion’ in the stock market is helpful to pick up the best investment projects when uncertainty is so predominant with fast-changing technology and governance function by financiers is less important (Allen and Gale, 2000. pp. 403-437). 11 However, it is also reported that the longer duration of the relationship, the better contract terms firms face with better availability of credit, which reputes the hold-up problem (Boot, 2000).

8 significantly, only to raise a problem.12 All of this underscores that balanced bank-business relationship as such is so crucial to make the relationship-based work well. Having said that, the relationship-based system but the system is better than the market- based system in many ways. In general, the relationship-based system has advantages in minimizing agency problems with its better monitoring function, and long-term investment and stability as well as new firms can be encouraged in the system. In fact, the relative attractiveness of each financial system depends on broader institutional settings, the stage of economic development and regulation policies. Then, the blind mainstream support for the market-based system has no firm ground. Recently, it is argued that there could be some complementarity between both of the financial systems for better monitoring and less hold- up problems.13 Meanwhile, to understand the relationship-based system better, it should be noted that the relationship itself is quintessential for success but the financial system itself cannot help evolving, which may brought about a demise of the relationship and former system. In this respect, the government should make efforts to build and reform well functioning relationship and financial system continuously. In reality, we see several cases of the relationship-based financial system. In the following sections, we will examine the main bank system in Japan and venture capital system in the U.S. The main bank system has been studied a lot as an essential institutional base to promote economic growth of Japan, but now the long recession of Japan poses a question about what was wrong with the system or what has changed. Meanwhile, the U.S. venture capital system is attracting such attention with the new economy boom since the late 90s. Both of the systems have much in common with the microeconomic features of relational financing like the close financier-firm relationship and good monitoring to address information problems. However, there is significant difference in terms of long/short-termism and in particular, macroeconomic stability, and each of them has its own problems. For example, in terms of stability and long-term investment the main banks system is way better than the venture

12 A similar case happened in Korea where chaebols grew too strong, only to have financial autonomy from the government after the late 80s. In the development period, it was the government that monitored the private sector with strong financial control but the change of corporate financing made it harder, which led to the crisis coupled with more financial liberalization and opening (Lee, 2001). 13 Some argue that the firms that borrow capital from banks see their stock price going up so that the bank relation complements the information problems in the market. Also some competition from the capital market can address the possibility that banks can extract too much rent from firms (Stultz, 2000). Similarly, with a different perspective, Pollin (1995) also argues a proper mix of the voice and exit-led system is helpful to monitoring.

9 capital system. In fact, the recent surge of venture capital investment is so much dependent on the stock market bubble, which may lead to more instability, aggravating economic cycle, and doesn’t seem good for long-term stable investment. Thus, the venture capital system has a serious limit for economic growth in spite of the popular applause nowadays. Concerning soft budgeting and staged financing, the venture capital system might be better than the main bank relationship. Also, very interesting is the change of relationship of the main bank and business in Japan. Since the late 70s, there was a big change in corporate financing, which weakened the main bank relationship, making banks so weak, and finally it resulted in the financial crisis of the 90s in Japan. Recently, further change of the main bank system is expected with the so-called big-bang financial deregulation policy. We will analyze both of the system in terms of the advantage/disadvantage of the relationship-based system in following chapters. In so doing we can understand the working and change of the relationship-based system much better. The two cases of the relationship-based financial system will show that the role of the financial system is crucial in the economy and the well-managed, not just dependent on the market, relationship-based system is desirable.

10 3. Japanese Main bank system : Rise and fall of Japanese system

3.1. Main features of main bank system

3.1. What is the Japanese main bank system?

Already, the Japanese main bank system drew huge attraction from most of people. It is a specific kind of a relationship-based system, in which banks and businesses establish a cooperative and long-term relationship, sharing information. In Japan, the main bank is a major partner bank of firms that obtain the largest share of borrowings from the bank in most cases.14 Almost all of firms have their main banks including small firms as well as big business groups called keiretsu with their own bank in the group. Besides the borrowing relationship, main banks and client firms own their stocks reciprocally, so called cross- shareholding. Historically, the main bank system started when the military government established the one bank-one business relationship to mobilize resources stably. But, the cross- shareholding relationship was a development of policies and history. Although big corporate groups were dismissed after world war II, several changes in the 60s generated the main bank system. Since the mid-60s, with implementation of capital market liberalization and bear market, top managements and government officials worried about foreign takeovers and tried to shore up the stock market.15 Though the zaibatshu style holding company was still not allowed, the government created 2 quasi-governmental organization to buy up stocks using special loans from the BOJ. Soon after that, about 80% of the share were resold to stable shareholders, mostly banks and other companies in corporate groups. Also, other measures were adopted to stabilize the ownership like allowing directors to sale equities without formal approval, and restricting individual share ownership. Thus, since the mid 60s, stable share ownership of financial institutions and

14 Frequently, Japanese firms get long-term credit from long-term credit banks but in short-term credit, it is always main banks that account for the most shares. The main banks’ share of the short-term credit in 77- 91 is around 20% and almost 40% in the total short-term loan by city banks. 15 Before the war, there were many holding companies with concentrated ownership, from big corporate groups called zaibastu, to small-family based corporate networks. After the World War II, the zaibatsu system was dissolved with strong antimonopoly polices to prohibit manufacturing companies form owning other companies’ stock by the GHQ (general headquarters) of the Allied powers. With a collapse of the stock market and harsh hostile takeover efforts, the government allowed firms to own other stocks and raised a limit of banks’ ownership of firms. However, still in the 1950s, more than 50% of stocks were owned by individuals, well dispersed (Miyajima, 1998).

11 corporations in all listed nonfinancial companies increased from less than 30% in 1963 to about 70% in 1987.16 The role of the main bank covers everything from giving credits to managing payment settlement accounts. In particular, it plays the most important role of monitoring of firms to a great extent, and the system is understood as a specific system of corporate financing and governance with a special relationship between banks and businesses, and regulatory authorities (Aoki et al., 1994). The main bank protects the firms in the stock market with big holding shares which gives no possibility M&A hostile takeovers, to provide managers with stability. Different from the market-based system, it is the banks that monitor the economic performance of firms closely. The main bank often has its managers sit as directors or auditors on the board of client firms and sends its employees as permanent managers of client firms.17 This monitoring by the main bank is further facilitated by the fact that the main bank knows more information about client firms by running payment settlement accounts and it’s a major shareholder. In the process, the main bank has a responsibility of monitoring delegated by other financial institutions that give loans to the firm. When firms borrow there established a kind of de facto loan syndicate with hierarchy led by the main bank. 3 monitoring functions are integrated into the hands of the main bank, such as ex ante monitoring--screening investment projects and checking the capacity of the borrowing firms to implement them, interim monitoring—gathering information on the ongoing business, and ex post monitoring—verifying the outcome of investment projects and, if necessary, disciplining failing incumbent managers of the firms by management. Especially, when firms’ performance is bad, they directly intervene in the management and do the rescue function. In most cases, they give more loans to firms in financial distress, so-called “patient capital”. That is, the main bank acts as a kind of subordinated lender and provider of management assistance, restructuring or, even receivership service. The main bank takes disproportionate share of the losses, which in turn present strong incentive for the main bank to monitor client firm very intensively. Hence, corporate governance under the main bank system is characterized by a kind of closed insiders’ system.

16 In fact, cross-shareholding is seen between the main bank and firms, firms in the same group, and suppliers and customers in business relation. For the extensive study of the share ownership, see Sher (2001), pp. 1-5. 17 In 92, 1/4 of directors of all listed firms are from outside directors, of which 1/5 are from main banks. The share of borrowings from banks that dispatch them is 21% in total borrowings, with their loan rank 1.95 on average and the banks’ share ownership of firms is around 4.1% (Aoki et al., 1994).

12 The system generates some rents for the main bank mainly from large loan share of the good borrower, non-lending business with fees and commission, and some opportunity to extend its business to clients’ business partners. Also, the firm can get assistance in adversity by submitting itself to the bank’s monitoring with share ownership. Thus what we see is a very close and mutual bank-business relationship in the main bank system. Of course, it was maintained by the strong government regulation including entry and branch regulation of banks called “convoy system” in which all incumbent city banks grew at about the same pace with sufficient rents. In addition, close supervision and prudential control of the regulatory authorities could avoid serious moral hazard problem of main banks (Ueda, 1994). Moreover, the incentive for good monitoring was provided by the practice of ‘amakudari’ in which many retired government officials obtain executive positions at city banks. The bureaucrats are collectively interested in the continual growth and security of a system.18 In sum, the Japanese main bank system was involved in a nexus of relationship, including the most important financial, informational and shareholding relationship between a firm and main bank, a reciprocal relationship among major banks, and relationships between the government and banks.

3.2.2. Pros and cons of the main bank system

Already lots of economists underscored benefits of the main bank system as an essential base for the surprising long-term economic growth of Japan. As we pointed out already, the system has rather advantage in monitoring to address agency problems, while the monitoring in the stock market through corporate control is not good, full of short-termism. In theory and reality, it is obvious that the debt-based system is better in monitoring, and the main bank system is even better with close bank-business relationship and more information.19 Among others, the system is better at encouraging long-term and stable investment. Since, the firms are free from the M&A in the stock market that suffers from short-termism,

18 As of 1992, there were 78 former MOF (Ministry of Finance) officials and 64 former BOJ (Bank of Japan) officials on the board of directors of the 115 listed banks, 69% of banks had an official from one or the other. The post-retirement job is arranged not by the individual concerned but by the Personnel Division of MOF or BOJ publicly, which addressed potential moral hazard problem. 19 For a theory of the main bank monitoring, see Aoki (1994). Kang and Shivdasani (1997) show that banks are so active in the corporate governance with bad economic performance of firms empirically.

13 they can have longer time horizon and more investment. High and stable investment with long-termism is said to give Japan the most important edge before the 90s (Grabel, 1997). In Japan, the social cost of myopic liquidation of temporarily depressed, but potentially productive firms, may be avoided by the main bank rescue operation. The coordination problem that might lead to entrapment in low equilibrium was effectively solved by the main bank relationship (Sheard, 1994; Dewatripoint and Maskin, 1995). This character of the main bank system also can generate more macroeconomic stability because there is less investment volatility along with stability of external finance. A recent study shows generally the voice-dominated financial system is characterized with less volatility of investment and less relationship between internal funds and external financing in those countries like Japan (Shaberg, 1998). Moreover, in the firm level, it is quite well known that investment of Japanese firms in the keiretsu is less sensitive to cash flow of firms as we mentioned (Hoshi et al., 1991).20 Thus, in Japan, the main bank’s intensive support for firms in financial distress brought out less hardship to firms in recession can ease financial constraint and stabilize the economy better. It means the social and economic cost of instability is significantly lower in Japan and in reality harsh restructuring with huge layoff or mass unemployment has been so rare. This feature of the main bank system can help workers develop firm-specific assets, coupled with life time employment system, which was another source of surprising economic growth (Aoki et al., 1994). Of course, the system also has some drawbacks as we already examined. It may face a possibility of a soft budget constraint problem of the relationship-based system, and lead to continuous misallocation of financial resources (Rajan and Zingales, 1999).21 In that sense, the system could be a double-edged knife, although the cooperative relationship and rescue function could increase social welfare. The extent of the problem would depend on how well the monitoring function of the main bank and supervision function of the government can be performed.22 Considering Japanese success, the problem seems not that serious with 20 Morck and Nakamura (1999) support this result, but Kang and Shivdasani (1997)’s study shows somewhat different result that the asset downsizing and layoffs in Japanese firms increases with the ownership by the firm’s main bank and other blockholders. It might be because their study is for latter period than others. It is intriguing that Hall and Weinstein (2000) report, in financial distress the borrowing to firms in corporate groups from their main banks didn’t increase relative to independent firms. However, their studies cover latter period when the role of the main bank decreased, and it is obvious that restructuring in Japan is in general much milder with less asset sales and layoffs than that of U.S even in their study. 21 Even Aoki et al., raise this question, “whether such mechanism led to excessively soft rescues of failed firms that should have been liquidated, or whether they obliged main banks to take the responsibility for rescue is a controversial issue.” (Aoki et al., 1994. p. 32). 22 Morck and Nakamura (1999) present the same concern that the main bank might just prop up troubled bank group firms, but their variable like entertainment expense as a sign of bad corporate governance is not

14 better information flows. Then, at least the main bank system is a way to address the problem that may exist in the monopolized bank debt in general. Rather, it should be noted that financial deregulation and weakening the main bank relationship made the problems more serious, as we will see below.23 The real source of serious soft budget problem was not in the main bank but in the market after financial deregulation. However, as Japan gets into the state where more complex and creative technological innovation is more and more needed with high uncertainty in the fast-changing economic environments, the relevance of the main bank system could be less and less (Sheard, 1997). In this regard, more efforts should be made to improve the system, although the Japanese manufacturing sector is still internationally so competitive. Besides, recently it has been argued that the strong banks may extract rents from firms too much. We already saw the argument that the growth rate of firms in keiretsu group was lower and financial cost was higher due to rent extraction (Weinstein and Yafeh, 1998). However, still the character of the bank-business relationship in the system is quite cooperative relative to the market-based system and they pursue both of growth together. With regard to the main bank system, we must point out that the success of the main bank system is based on the balanced bank-business relationship along with bank debt and cross- shareholding. In fact, the change of the bank-business relationship might bring about a crack to the system. As firms depend less and less dependent on the main bank, with a change of corporate financing structure, the monitoring function could go into malfunction. In reality, the Japanese big firms started to have enough internal funds and diversify their external financing with financial deregulation since the late 70s. This change caused a fundamental change or even demise of the main bank system and that’s what we turn to the next section.

3.2. Demise of the Japanese financial system?

3.2.1. From change of the financial system to the crisis

clear and indeed share price appears to increase in corporate group firms than independent firms after bank intervention. Interestingly, their result that corporate firms suffer less decrease of asset growth and employement supports Hoshi and Kashyap’s argument of the main banks’ bailout operation . 23 For example, the discretion of the government to give incentives to the banking sector and the power to monitor them got weakened due to financial deregulation, which made it hard to manage financial problems in cooperative way. The conflict among banks and the government in the process of insolvent financial institutions in the 90s shows it clearly (Sheard, 1997).

15 In spite of great success of the main bank system in encouraging long-term development, the system itself has changed so much since the 70s and Japan is in a history-long recession in the 90s with serious problems in the banking sector. The change happened due to so many factors but most of all, the change in the corporate financing pattern and big business- bank relationship are crucial. Traditionally, banks dominated the financial system of Japan in the high-growth period up to the late 70s but since then several changes took place to raise a demise of the relationship-based system dominated by main banks. First of all, the government deregulation in the financial sector was very important in this change. It adopted several measures to develop bonds market since the late 70s. Because of the government deficit for social security system and economic expansion, it increased its bond issuance, which reduced profitability of the banks that had been forced to absorb the government bonds with low-yield. Thus, the Ministry of Finance was compelled to open a secondary market for government bonds and paved a way for interest rate liberalization including interbank rates in the late 1970s and deposit rates through the 1980s gradually.24 The most important change was the development of domestic and international bonds markets. Before the 1970s, bonds issuance was strongly regulated by the Bond Issuance Committee with strong conditions, but the government deregulated the domestic bond market from 1975.25 Besides, other measures to encourage the capital market like creation of commercial paper market and easing listing requirement in the stock market. In the 80s, there were also serious deregulation measures in issuing bonds in the foreign market, such as the reform of Foreign Exchange and Trade Control Act in 1980 to permit foreign exchange transaction free, lifting the real demand principle in 1984 and the Euro-market deregulation in 1986. Because it was easy for the Japanese firms to issue bonds in the foreign market without any collateral, Japanese big firms could bypass banks in getting capital. However, deregulation for banks was very gradual that may new types of business were not allowed including fee-generating activities, and there were significant barriers between investment and commercial banking up to the late 1990s. In addition to the serious government deficit problem, there were strong demands of

24 Since the government bonds were now traded at market prices, investors and savers could stay away from the other financial assets like deposits, whose interest rates were set at artificially low levels. Thus, the expansion of the secondary market for government bonds undermined the interest rate controls (Hoshi and Kashyap, 1999. p.6) 25 In 1975, the Bond Issuance Committee introduced a policy of honoring the requested amount of bond issues and the collateral requirement decreased, in 1979 unsecured straight and convertible bonds were allowed.

16 financial deregulation from capitalists both of domestic and international, and also from politicians.26 Most of all, the demand came from strong corporate sector that wanted more freedom in investment decision and financing, as they grew with huge cash, no logner reliant on the bank or government. And many major Japanese banks wanted it too in order to get new business opportunity when big firms borrowing decreased.27 Ideologically, the LDP(Liberal Democratic Party) government of Japan turned to more conservatism in the 1980 with Nakasone as a prime minister, who followed the Thatcher and Reagan’s neoliberal economic policies. Also the U.S. government pressed the Japanese government to open the financial market and adopt more deregulation in an attempt to correct the huge trade imbalance since the 80s. Hence, the change of the financial system itself is much related to the politics and power-relationship. What was brought out by these changes was a significant change of corporate financing, especially big business, and demise of big business-banks relationship. As big manufacturing firms could finance less and less with borrowings from banks, the power of banks decreased and they got into trouble since they lost their best borrowers. It is clear that the share of bonds in the corporate financing increased so much in the 80s, while that of bank borrowings decreased. In particular, big manufacturing firms’ bank debt ratio to total asset decreased from about 37% in 1978 down to as low as 16% in 1998, though small firms bank debt ratio didn’t change with more than 34% on average.

Table. Change of the gross sources of finance of nonfinancial firms in Japan.(%) 70-74 75-79 80-84 85-89 90-94 Internal finance 32.4 36.6 46.5 41.6 62.4 Bank Finance 37.1 34.7 36.0 29.8 24.3

26 Deregulation policies were introduced more aggressively after the early 80s with establishment of commission on administrative reform called ‘rincho’ of which the basic orient of the reports was mostly reducing the government. The coalition of rincho covered big business community led by Keidanren, conservative LDP politicians and some bureaucratic agencies like MOF. For details, see Carlie(1997), pp. 3-7. A researcher reports financial deregulation is also related to the arbitrage of financial assets (Teranish, 1994) 27 For the government, deregulation of the financial system proved to be relatively easier than other deregulation like introducing competition and opening market to more imports against resistance from the large manufacturers (Hoshi et al, 1996)

17 Bonds 3.9 8.0 5.8 7.2 8.3 Equity 2.9 3.2 3.6 4.5 1.8 Trade Credit 20.3 16.2 10.3 10.2 0.7 Others 3.2 1.1 -2.4 6.3 2.2 Source : recited from Shaberg(1998)

Based on the former system, the Japanese firms grew so much, only to have huge internal surplus to finance their investment. Moreover, investment lowered since the 70s after the oil shock with Japan getting into a lower growth period, which made big businesses less dependent on banks. They might have tried to get more freedom from banks diversifying their financing, to avoid potential hold-up problem for banks to extract rents. Thus, the balanced and close bank-business titled toward decreasing power of banks.

Table. Change of external corporate financing of big firms (%) 57-59 60-64 65-69 70-74 75-79 80-84 85-88 Loans 68.3 65.2 79.9 83.3 55.1 45.0 10.0 Equity 20.5 21.2 8.0 6.4 19.6 30.0 38.6 Bonds 11.1 13.6 12.1 10.3 25.3 25.1 51.4 * for firms with more than 1 billion yen in equity Source : Ueda(1994), p. 105

In response to losing big borrowers and with ongoing regulation for banks,28 banks had no choice to find out another source of profit and reorganize the lending pattern. With the decrease of big firms borrowing, the banks increased the lending to small firms like wholesale and retail industry and construction industry. It resulted in higher debt ratio for them and also their share in total borrowing of banks also went up from 60% in 1973 to 80% in 1997. Besides, banks increased foreign lending, especially to the United States. Among others, there was a big increase in bank loans to the real estate industry and especially small housing loan companies called “Jusen”, in order to reap a profit from increasing land prices. By the early 1990s, the proportion of loans to real estate industry by banks had doubled from the early 1980s’ level.

28 For example, city banks were not permitted to engage in underwriting business, thus there was asymmetric financial deregulation for businesses and banks in Japan, which gave more hardship to banks.

18 Table. Increase of the share of bank lending to the real estate sector and nonbank institutions (%) 84 85 86 87 88 89 Real estate 7.5 8.9 11.1 11.3 11.7 12.1 Nonbanks 10.2 11.9 13.5 15.2 15.8 16.7 Source : BOJ, recited from Cargill et al.(1997).

Nevertherless, the profitability of banks continuously declined through the 1980s, and especially banks went into trouble in the 90s when the bubble burst and the stock market collapsed. Thus, the banking sector was left with huge nonperforming loan mainly due to collapse of land price, which went more serious as their asset value declined with the declining stock market. This problem of the banking sector, with bad loans 12% of total loans, was one of the important causes that led the Japanese economy into the long recession in the 90s. It should be noted that the serious nonperforming loan problem is not in the manufacturing sector composed of big firms that already reduced bank borrowings. Thus, bad loan problems of Japan in the 90s was not due to the soft budge problem of the main bank system as many argue, but because of a demise of the stable business-bank relationship that pushed banks to lend to other sectors related to bubbles. Of course, overinvestment by the manufacturing sector was very serious in the 80s’ bubble economy but it’s mostly related to easy equity financing, not through banks but market itself like stocks and bonds. The government policy mistake also played a role. In the late 80s, the Japanese government took quite expansive macropolicies, based on the Plaza Accord in which developed countries agree that Japan should prop up consumption and investment, and appreciate exchange rate to correct the serious international imbalance, mainly the U.S. huge trade deficit. In response to appreciation of the yen after the Accord, the government cut interest rates so much and bought dollars, to cause more monetary expansion.29 The policy led to the bubble boom after 1988 with skyrocketing stock and land price, which

29 The value of yen was appreciated so much from 242 per dollar in September of 1985 to 180 in February of 1986 and 155 in February of 1987. Japanese government cut the interest rates from 5% in January of 1986 down to 2.5% in February of 1987 to stimulate the corporate sector. And the growth of the M2+CD to GDP ratio increased after to more than 10% after 1987 from around 7-8% before.

19 helped firms with equity finance related to issuing new shares, reducing the cost of financing. Thanks to financial deregulation, the big firms aggressively turned to equity finance such as issuing convertible bonds and warrant bonds in the foreign market after the late 1980s. Firms spent this excess capital in high investment in mass production industry like autos and electronics, and construction or real estate. The most important problem in this period is the monitoring function of the main bank system was not working well because of the autonomy of big firms from the main bank. The result was kind of governance vaccum that caused overinvestment and economic problems.30

Growth of GDP and investment in Japan

20 15 10 5

% 0 -5 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 -10 -15 -20 year

GDPgrowth real nonresidential investment growth

However, when bubble burst as the government made a mistake to raise interest rate so high and regulated the loans to the real estate sector, the economy went into a crumble. The Nikkei stock index fell to 14000 in fall of 1992 from the peak of 38900 in December of 1989 and land prices declined since summer of 1990. Thus, a lot of financial institutions went bankrupt and nonperforming loans of big banks got serious, which led to more asset

30 Hoshi et al., argue financial deregulation and decrease of firms’ debt weakened the main bank-based corporate governance, which was main reason for economic crisis. According to them, high debt, main bank, stock concentration and product market competition together can play a role of monitoring but after the mid 80s in Japan former monitoring mechanism like the main bank disappeared, while new ones like competition didn’t appear (Hoshi et al., 1997).

20 deflation and credit crunch around the whole economy.31 In addition, high investment done in the manufacturing sector in the bubble period made the recession more serious. Therefore, the reason of the recent trouble of the Japanese economy is not due to the problem of the old main bank system but its dismantlement that delinked the former bank- business relationship, causing worse monitoring and problems of the banking sector.

3.2.2. Decline of the main bank system

Then, can we say the main bank system itself has been totally disappearing? In the future, it would be possible that the main bank relationship and the specific Japanese corporate governance system would break up, though it seems a bit too early to argue it. As we have already seen, it is indeed true that big firms bank debt declined a lot after the 80s and the financial power of banks decreased. In the process, naturally the monitoring function of main banks would get weakened with decreasing bargaining power. Some big businesses started to get multiple main banks, and more competition among banks can also weaken ex ante monitoring to choose investment. It may explain why excessive investment in the late 80s was not prevented and checked. Actually, in the late 80s’ bubble, most of new stocks issued by firms were taken over by main banks and insider’s share ownership rather increased. Since there was no monitoring of the capital market due to cross- shareholding, if main banks’ discipline didn’t work well it could be a serious problem. That is, main banks could not play a good monitoring role of the corporate sector that raised too much capital, bypassing banks, for overinvestment in the bubble period.32 The so-called ‘soft budget constraint’ was mainly due to a weakening of the main bank monitoring. Furthermore, already there has been a change in the organization of main banks themselves that the monitoring section was downsized and less important since the 80s, along with the diversification of the bank business and change of bank-business relationship from the earlier loan-centered one to more diversified.33 However, when it comes to the stock ownership structure, still the cross shareholding

31 For details of Japanese crisis, see Hoshi and Kashyap (1999), Lazonick (1998). Pigeon interprets the experience of the crisis from Minsky’s perspective (Pigeoon, 2000). 32 From the mid-80s, already internal funds of Japanese firms exceeded their equipment investment but they keep raising external funds by equity finance. With a decrease of investment opportunity it led to a decline of profitability with less monitoring by main banks. Meanwhile, negative correlation between financial performance and indicators of main bank intervention also is not applied in this period (Miyajima, 1998. pp. 53-58). 33 For more details, see Miyajima (1998), p. 54.

21 structure doesn’t seem to break up and still main banks continue to dispatch their employee to firms. Although it is true that keiretsu firms try to sell stocks of main banks for their settlement, but still big banks continue to hold the stocks very stably up to recently. Moreover, even when firms issued bonds since the 80s and do the equity finance in the 90s, it was the main banks that played a great role to guarantee the process, which means just the change of corporate financing may not necessarily mean the role of main banks.34 Some report when firms restart borrowings they just turn to their main banks in most cases and stability of the main bank relationship still continues through the 90s (Aoki et al, 1994). Thus, we can’t say the main bank system has been really broken up (Miyajima, 1998), although the decline of the bank-based financial system in Japan was very clear for big firms since the late 80s.35 In spite of it, it could be possible that ownership of other shareholders including institutional investors and foreigners will grow more and it can cause for different kind of shareholders, not stable main banks to emerge. Especially, the Big Bang financial reform announced in 1996 can pave the way for the change. So far, institutional investors like investment trusts, insurance companies and pension funds were restricted by strong regulation and subordinated by keiretsu, but incoming radical financial reform may give them autonomy, bringing about the change of the corporate governance system to more open, Anglo-saxon one. The financial Big Bang deregulation include removing barriers to business among banks, allowing financial holding companies, insurance companies and security companies, liberalization of trade fee of stock transaction, deregulation of asset management of insurance companies and pension funds, further deregulation of foreign exchange transactions. If these measures are realized, more competition would be introduced and the stable main bank relationship might be in more danger.36 This trend looks clear very recently. In actuality, a recent study emphasizes that the cross-shareholding between banks and business declined clearly very recently and the trend will continue, only to weaken the base of the main bank system (Sher, 2001). The NLI

34 For example, it is reported that 77% of all warrant bonds issued between 1984 and 1987 were guaranteed by banks, mainly by their main banks (Campbell and Hamao, 1994). 35 Even without big firms dependence on borrowing from banks, main banks could monitor based on share ownership of firms. For example, Toyota have not borrowed any from banks for 20 years but still 3 main banks own its share by around 5% each and Toyota owns the banks’ shares. 36 If the relationship-based system is sustainable with more competition is a very serious issue taken by several economists. Generally, most of them see the relationship-based system is based on restricted competition, some argue that competition itself can raise a need of more relationship (Boot, 2000). In the similar vein, Aoki and Dinc argue the main bank system itself may continue but the environments must be different (Aoki and Dinc, 2000).

22 research data of 1998 shows the share of stable shareholders in total stock declined from 41.3% in 92 to 35.7% in 98, especially after 1996, while the foreigner’s share increased from 6.3% to 13.4% during the same period. Cross-shareholding, the essence of main bank system, also fell after 1996. It was mainly because firms sold their main bank stocks and even banks seem to start to dispose of firms’ stock after 98.

Table. The share of stable cross-shareholding in Japanese firms Stable Cross- Firm Firm Bank Bank Other Shareholder Shareholding holds holds holds holds entities ratio ratio Firm’s bank’s firm’s bank’s 1987 41.53 21.5 4.1 6.7 6.2 0.4 4.0 1988 41.64 21.0 4.4 6.0 6.7 0.4 3.6 1989 40.27 20.3 4.7 5.5 6.8 0.3 3.0 1990 41.07 21.4 4.8 5.9 7.2 0.4 3.1 1991 41.08 21.3 4.9 5.7 7.3 0.4 3.1 1992 41.30 21.2 4.7 6.0 7.2 0.4 2.9 1993 40.58 20.8 4.7 5.8 7.0 0.4 2.9 1994 40.51 20.7 4.8 5.7 7.1 0.4 2.9 1995 39.03 20.3 4.9 5.4 7.0 0.3 2.8 1996 37.67 19.5 5.0 4.2 7.7 0.2 2.5 1997 35.69 18.2 4.7 3.5 7.5 0.1 2.3 1998 -- 16.0 4.3 3.2 6.5 0.0 2.0

Source : NLI Research Institute, recited from Sher (2001).

In addition, recent surveys show that more and more firms don’t think main bank relationship is helpful to them any more, and monitoring of main bank is not effective at all (Scher, 2001). Surprisingly enough, most of bankers answered the rescue function of main banks as ex post monitoring was nowhere since the late 80s. Plus, it is reported that already the power of shareholder has been increasing.37 Thus, in the future we may well see more change of the Japanese main bank system

37 Miyajima (1998) shows dividend rate is affected a lot by return on equity after the 90s.

23 toward more open and market-oriented one. But even if the Japanese main bank system or so-called J-type firm goes through some kind of metamorphosis, it will not be a convergence to the totally Anglo-Saxon system. It would be impossible to adopt the Anglo- Saxon system very fast, because it would generate too much social cost of transformation like huge unemployment. As long as other subsystems like life-time employment system and cooperative subcontracting system continue, the change of main bank system would be quite gradual.38 Perhaps, the system can be more diversified and we would probably see different bank-business relationship and corporate governance, according to the size of firms and industries.39 In sum, what we see in the Japanese experience is a demise of the former bank-based system due to the change of the corporate financing structure and bank-business relationship, which is especially clear in big firms. And it is a main cause of the serious recession in the 1990s after a bubble boom. The main bank system still appears to be in place, not totally gone, but it may get through a future change to some extent too. In the future, establishment of new system to promote good monitoring and long-term development again would be essential to the Japanese economy.

38 In fact, the Japanese system consists of several sub systems including the main bank system, lifetime employment, close intercompany system et al. When we consider every institutions has path-dependency and still other systems are not changing a lot, it is not likely that the Japanese system will be repealed (Aoki and Dinc). For the current situation and some future prospects to encourage flexibility, see Lazonick (1998). 39 In this respect, interesting issue is the effect of competition on the main bank system with the big bang policy. Some argue that the relationship-based system would weaken with increasing competition but others also see the system would be still important even faced with competition. Probably, proper extent of competition is necessary to make the system work well (Boot, 2000).

24 4. Venture capital : brave new relationship-based system?

4.1. Emergence of VC system

4.1.1. VC and the new economy boom

In contrast to stagnant Japan, the U.S. economy was proud of a long boom in the 90s, especially since 1995. High growth, low inflation and increasing productivity led people to applaud the so-called ‘new economy’ based on the IT technology and the specific financial system. And it is widely acknowledged that the specific financial system called ‘venture capital to support innovation is at the center of this success.40

Table. Major economic indicators of the U.S. economy 74-80 81-90 91-95 96 97 98 99 00 Real GDP growth 2.9 3.6 2.6 3.6 4.4 4.4 4.2 5.0 Unemployment 6.6 7.1 6.6 5.4 4.9 4.5 4.2 4.0 Inflation 9.4 4.5 2.8 3.3 1.7 1.6 2.7 3.4

Labor productivity 1.0 1.5 1.5 2.5 2.0 2.7 2.6 4.3 growth* * Nonfarm business sector Source : BEA

Although it is not up to the performance of Golden Age, the late 90’s U.S. new economy boom was indeed clear and it is mainly based on high investment, in particular information processing equipment and software. It would have resulted in high growth, and productivity

40 Of course, there is still a debate going on about the new economy. Supporters believe the IT technology changed the economic structure with higher productivity and growth since it can allow firms new production and flexible inventory management system, online commerce with less transaction costs and others (Blinder, 2000; Council of Economic Advisers, 2001; Litan and Rivlin, 2000). Meanwhile, critics argue that the recent boom is mostly thanks to the bubble and serious macroeconomic imbalance like minus net saving of the private sector is unsustainable (Brenner, 2000; Monthly Review, 2000; Palley, 2001). Some argue that traditional Marxists have hard time explaining the nature of the new economy boom, arguing the IT technology can increase the profit rate with long-cycle theory (Hossein-Zadeh and Gabb, 2000). But the recent investment surge is hardly explained by the profit rate.

25 increase to some extent.41

Table. Growth of real nonresidential fixed investment (%) 88-90 91-95 96 97 98 99 00 Real nonresidential 3.9 5.1 10.0 12.2 12.9 10.1 12.6 fixed investment growth(A) A/GDP 9.6 9.8 11.5 12.4 13.4 14.1 15.1 Information processing equipment 20.4 26.7 31.9 34.6 37.8 43.2 47.9 and software / A Source : BEA, National Income and Products Accounts

The investment boom was clearly led by the IT sector, and IT related investment accounts for much of the economic growth after the 1995. According to the BEA, the most share of investment boom was thanks to the IT spending and contribution of the IT sector to economic growth is almost 2/3 in the late 90’s.

Table. Equipment investment and IT equipment (%) 93 94 95 96 97 98 99 Real growth of capital equipment investment 11.4 11.8 11.9 11.0 11.5 15.8 12.1 The share of IT equipment investment 5.4 5.3 7.4 7.5 7.5 9.8 9.4 IT equipment contribution to investment (%) 47 45 62 69 66 62 78

Source : BEA, recited from the U.S. Department of Commerce (2000), p. 27.

Accordingly, IT producing industries have grown so fast that its contribution to economic growth is over 30% after 95 (U.S. Department of Commerce, 2000). Though its share of the economy is still less than 10%, it is also increasing from less than 6% in 92 up to 8.3% in 2000. Behind the process, venture capital disbursement skyrocketed along with amazing the stock market boom and it encouraged startups in high tech sector, which might

41 Regarding the increase of productivity growth, there is a serious debate on how it can be explained and sustained. Many researchers argue that the productivity gain after 1995 is very significant and structural one based on the IT technology though still it’s not diffused to the every sector (Jorgenson and Stiroh, 2000; Robert, 2001; President Council of Economic Advisers, 2001), while skeptics like Gordon (1999) argue it’s mainly thanks to cyclical effect and about 95% of productivity increase is concentrated on IT related sector. In reality, productivity growth turned minus 0.1% in the first quarter of 2001 and it is fueling the debate again (Economist. 2001. 5. 12).

26 bring about more competition and investment.42

venture capital investment ($ billion)

120 100 80 n o i l

l venture capital i 60 b

investment ($ billion) $ 40 20 0

0 2 4 6 8 0 2 4 6 8 0 8 8 8 8 8 9 9 9 9 9 0 9 9 9 9 9 9 9 9 9 9 0 1 1 1 1 1 1 1 1 1 1 2 year

Source : NVCA(National Venture Capital Association)

In fact, the recent investment boom may be explained in terms of the typical capitalist economic cycle, coupled with the financial market, with several old economists’ theories. First, Keynes argued firms invest based on future expectation of profitability, and excessive expectation about the new brave future in boom can encourage high investment recently. In particular, in the IT sector, firms have a strong tendency to do the creative innovation process with new technology, pursuing big gains or super profit, which stimulate further investment, already pointed out by Schumpeter and Marx. Furthermore, stock market bubble paved a way for more investment by venture capitalists, as Minsky argued the financial market with boom euphoria can increase more investment, in the end raising financial vulnerability. If we consider venture capital very sensitive to the stock market, then the stock market boom can lead to more venture investment and more innovative startups. And, emergence of new startups and more competition can lead to further investment as firms try to compete against others and existing firms adopt new technology

42 In 1999, companies in internet, communications and computer software and services received a combined 72% of total venture investment. The investment has been concentrated on fast-growing IT sector recently (Gradeck, 2000, Council of Economic Advisers, 2001. p. 107). For data before 1996, see Gompers and Lerner (1999), p. 12-13.

27 faster.43 This investment drive tends to be strengthened since the most of IT sectors have strong network externality and increasing return to scale, which made firms make efforts to dominate market and standards first with huge investment. Hence, so-called competition- coerced investment (Crotty, 1993) can be more serious in the new economy because of the nature of the IT industry and, in particular, venture investment. In turn, high investment and growth of firms may lead to cost reduction and high productivity. Probably, this intense competition and high investment were helpful to increase high tech innovation and growth rate with repressing inflation and productivity increase to some extent, making a virtuous cycle.44 That is, the new economy cycle is something that could be called a Marx-Keynes- Schumpeter-Minsky cycle. In sum, the recent new economy boom based on high investment basically stems from drive of capitalist accumulation and in the process, future expectation, the stock market boom, and more competition played an important role. It should be noted that the new economy boom got bigger thanks to incorporation of technology and financial markets through venture capital and the character of IT sector. In this respect, one may well think venture capital system was at the center of the new economy boom, of which operation we will turn to below.

4.1.2. Venture capital as a relationship-based financial system

Venture capital specializes in financing high-risk, and potentially high-return projects, mostly of startups in the high technology sector.45 There are various organizations for this

43 This is clear in some cases including the internet browser market between Netscape and Microsoft. Mandel (1999) suggests some interesting examples of competition-coerced investment in the IT sectors due to venture capital investment. Several studies show there is a kind of technology race among firms and intense competition may result in more innovation and investment. Lerner shows the greatest innovative activity is shown by the firms that follow the leader (Lerner, 1997). Also, Council of Economic Advisers (2001) emphasizes the role of competition for innovation in the IT sector (pp. 34-36). 44 In this respect, the traditional Marxian arguments mostly concerning profit rates have a limit to analyze the new economy boom. In fact, profit rate recovered very gradually since the mid 80s and it can’t explain huge and sudden investment surge in the late 90s and most of dotcoms generate even minus profit but do high investment. Thus, Moseley raises a question why investment increased so much without the big increase of profit rate in the period and suggests huge foreign capital inflow as a possible answer (Moseley, 1998). It was partly important but we need to shed light on the stock market bubble and venture capital investment incorporating Kyenes and Minsky’s theories. 45 Many see almost 3/4 of investment go failure but a few of investment can bring about 10-100 times returns of the initial investment, thus compensating capitalists.

28 kind of investment. Of course, financial institutions and industrial corporations play a role too, but as much as 80% of investment has been from independent private venture capital firms since the early 1980s (Kenney, 2000). They are a kind of partnership funds that raises funds from various sources, including pension funds, university contribution wealthy individuals etc. Among them, the share of pension funds is the biggest by around 40%, followed by corporations’ 30% and endowments in 1996. (Gompers and Lerner, 1999). The duration of a particular fund is mostly between 7 and 10 years and for the first 3 years, they invest aggressively and at the end of the period they try to cash out. More than half of venture investment went to the very early stage firms including seed fund, start-ups and others, relatively high to other countries. In the United States, the history of venture capitals started with wealthy family venture funds and the establishment of American Research and Development, famous for investing in Digital Equipment Corporation. The government policies were also helpful, like creating Small Business Investment Corporation in 1958 and lowering capital gains tax rates in 78 and most of all deregulation of the pension funds’ venture investment in 79.46 Venture capital is mostly invested in technology firms by more than 70% and recently the internet- related or computer firms and biotechnology sector get the most of venture investment. The most important role of venture capital is to support innovation, and several studies show that venture capital investment reduces the time taken to bring products to market and increase rate of patents compared to other investment.47 It is argued that venture capital has been extremely successful recently in the new economy boom, making prominent corporate successes like Yahoo, eBay and Cisco, generating huge returns, and lots of technology firms like Intel, Microsoft and Apple got venture investment in the past. Then, how does the venture capital system work? With the huge success and development of venture capital, lots of economists recently shed light on the venture capital system and most of them understand it as a good mechanism of the efficient financial contract, screening and monitoring (Kaplan and Stromberg, 2001). It is very interesting that the venture capital system has a strong character of a relationship-based financial system that we already mentioned. There is a very close relationship between venture capitalists and startup companies to address agency problems due to information asymmetries, which

46 For a detailed history of the venture capitals, see Kenney (2000) and Gompers (1995a). Berlin (1998) shows how the venture capital investment is done very concretely. 47 Kortum and Lerner (1998) argue venture capital investment was helpful to encourage patents and Hellman and Puri (1999) show venture-backed firms tend to take innovative strategy with shorter time to market products.

29 helps startups to get financing. In most cases, startups or small young firms can’t get an access to external financing to finance their projects since the don’t have enough reputation with investors that have no enough information. Issuing stocks is almost impossible and even banks are reluctant to give credits to them with no tangible collaterals and very uncertain future. Thus, uncertainty and information problem led them to have hard time and face serious financial constraints. In this case, venture capital can tackle the problems, providing high-risk and high-return investment. To overcome adverse selection and moral hazard problems, venture capitals have unique control and monitoring mechanism to encourage information flows between them (Sahlman, 1990). First of all, the financial contracts are established that voting rights, board rights and liquidation rights are allocated contingent on corporate performance. When the company performs really poorly, sometimes venture capitalists obtain full control, while as company performance improves the entrepreneur retains more control rights. It is common for venture capitalists to include non-compete and vesting provisions that make it more expensive for the entrepreneur to leave the firm, mitigating the hold-up problems between the investor and firms. Also, venture capitalists are experienced experts to bring up start- ups in most cases, and they are more informed investors to make efforts to gather more information when they first examine the project by start-ups. Besides, they frequently provide management assistance to firms like recruiting necessary management and technology personnel and counsel business, as well as monitor them. Thus, in financial contracting and screening venture capital is argued to have advantage (Kaplan and Stromberg, 2000).48 Among others, since venture capitalists hold equity of firms that they finance like the main bank, they have strong incentives to monitor them. The monitoring mechanism covers various measures. It is so common venture capitalists participate in boards of directors with effective control rights. The most important monitoring mechanism is so-called ‘staged financing’ that funds are always provided in several stages, not in one go, after reassessing the prospect and performance of the firms’ projects. Many argue that this staged infusion of capital enables venture capitalists to threat firms credibly and discipline them better, which addresses the soft-budget-constraint problems (Gompers, 1995b; Zilder, 1998). This mechanism is also supported by diversification of venture capitalists investment and establishment of syndication to enable cross-checks by several venture capitalists and

48 Kaplan and Stromberg (2001) shows empirically that venture capitalists expend a lot of time and effort in evaluating and screening transactions, examining how venture capital actually works.

30 diversify risk. In addition, they usually use convertible preferred stock as a contract. Preferred stock is similar to debt because it requires firms to make fixed payments to the stock’s holder before any common stock’s holder and fixed liquidation value per share. Thus, convertible securities can help discipline firms better. In sum, the venture capital system is argued to be advantageous to mitigate principal- agency problems, with sophisticated contracting, pre-investment screening and post- investment monitoring and advising. It is indeed a relationship-based financial system with a close relationship of venture capitalists and firms and better monitoring system. It can help to finance start-ups and young firms faced with agency problem, improving resource allocation and supporting innovation. In this regard, it’s quite similar to the Japanese main bank system in monitoring, while especially staged financing gives more control power to venture capitalists. But the exit mechanism and the length of relationship are quite different, and of course the macroeconomic effects. In the main bank system, bank-business relationship mostly goes so long, while in the venture capital system, the relationship continues till the venture capitalists cash in investment in the stock market. When we consider there might be a problem of soft budget constraint and hold up problems when monitoring gets weakened and the relationship changes in the main bank system, the venture capital system is said to be more flexible to some extent. However, the system has a serious flaw in encouraging the long-term stable investment. Apparently, the venture capital investment appears to be with long-termism. Their investment is for innovative start-ups with high-risk by nature, even if market prospect is very uncertain and firms make no profit soon, they still do invest in those firms with expectation of future growth. But, it should be noted that the venture capital investment has so much to do with stock market situation, as the most important exit mechanism or the way to cash out is selling stocks through the IPO. That is what we turn to in the next section in which we argue venture capital investment could be very volatile and even magnifies the economic instability.

4.2. Venture Capital and Instability

31 4.2.1. Venture capital, short-termism and stock market

To venture capitalists exit mechanism is the most important concern since it is a way to cash in their investment. There are 3 common exit strategies including acquisition by another firm, share repurchase by the portfolio company and issuing stocks via an initial public offering (IPO), otherwise bankruptcies. But the most important exit mechanism is indeed the IPO and in this regard, live venture capital investment needs the deep and wide stock market (Black and Gilson, 1998).49 That may explain why venture capital industry emerged in the U.S. and other countries with the bank-based system have hard time developing it (Nuechterlein, 2000).50 In the United States, successful IPOs in the NASDAQ give venture capitalists a great chance of the exit. Besides, in U.S. pension funds were allowed to invest in venture capital in U.S. from 1979 and now accounts for most of funding, another factor of venture capital development in the states. It may mean that active venture capital is a relationship-based system based on the well-developed market-based system, or the stock market. Thus, some see the venture capital system is ‘a happy marriage’ of both of the systems drawing only benefits from them and shows strong complementarity of the financial systems. However, when investors just try to gain financial gains from the stock market, it is hard to say the venture capital investment is stable and based on long-termism, and the complementarity seems to work only in the stock market boom.51 Already some raised problems of institutionalization of the venture investment along with the increasing importance of pension funds who just seek for short-term financial gains.52 First, as more

49 Black and Gilson argue IPO is desirable because the successful IPO returns control rights to the entrepreneurs back, giving more incentives, and the stock market is good at evaluating venture capitalists performance. Also, they argue implicit contracts are more preferable due to uncertainty, which is well functioning in the states with a good reputation market based on capital market (Black and Gilson, 1998, pp. 13-16). But the latter argument is not clear and implicit contracts could be working well in the bank- based system. 50 Most people find the most of the Japanese venture capital funds are coming from corporations (46%) and banks (30%) and invested in non-technology firms in most cases. Their workers don’t have expertise for high-technology industries. Also, in Germany, most of venture funds are from banks to existing, non- technology firms, not start-ups, and exit strategy is a repurchase by portfolio companies and sales of them since active IPO markets are not there (Milhaupt, 1997; Black and Gilson, 1998). 51 Zilder clearly recognizes after studying how venture capital works, saying “Venture money is not long- term money… in essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker.” (Zilder, 1998, p. 132). 52 Now it is well-known that a pension fund manager is rewarded and penalized according to how well he does compared with other fund managers. Moreover, economic performance of pension funds itself was not good at all in the 80s, compared to S&P 500 index. Lakonishock et al (1992) explains it is due to serious agency problems of pension funds.

32 and more pension funds participated after deregulation, the share of venture investment for see and startups declined a lot in the 80s.53 And this change has sometimes caused venture capitalists to take firms public too early, called “grandstanding” (Gompers, 1995a). Even when venture capitalists and investors own stocks after the IPO, they may only focus on trading the stocks to reap short-term financial gains. Thus, although some contend continuous stock ownership of venture capitalists after the IPO and setup of venture funds can address the shor-termism (Berlin, 1998), venture capitalists are always under the strong pressure of pension funds that are not concerned about long-term investment. Furthermore, considering that venture investment depends so much on the stock market, it must be unstable. There are many studies showing a strong tie between the health of pubic equity market and venture capital growth. A study shows when IPOs are hot new funds flow into the venture capital industry is big (Gompers, 1995a). Although venture capital fundraising is also driven by several institutional factors in demand and supply side like an increase of R&D spending decrease of capital gains tax and allowance of pension funds investment, it is clear that the high return with the booming stock market is so important (Gompers and Lerner, 1998). Other studies confirm the close relationship between venture capital fundraising and the strong IPO market or stock market (Black and Gilson, 1998).54 Especially, recent surge of venture capital investment, in particular after 1998, seems so much associated with the boom of the NASDAQ market till the collapse of 2000. But it should be noted that the boom was indeed generated by boom-euphoria and excessive expectation like Minsky argued. Most of studies show that the recent stock market boom is mainly thanks to speculative bubbles, not explained by fundamentals rationally at all (Shiller, 2000; Evans, 2001).

Figure. Recent increase of venture capital investment and stock market index

53 According to Gompers (1995a), venture investment for seed and startups declined from 25% in 80 to 12.5% in 88. In the 90s, venture investment for the early stage financing is not that big, accounting for around 20%, though higher than other countries (Black and Gilson, 1998; www.v1.com) 54 For more details of related studies, see Gompers and Lerner (1999), pp. 21-24, and chapter 11.

33 Venture capital investment (86=100)

2500

2000

1500

1000

500

0

0 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 2

Venture capital investment (86=100)

Montly stock market index

1800 1600 1400 )

0 1200 0 1 1000 =

1 0

800 : 6

8 600 ( 400 200 0 6 7 9 0 3 5 6 8 0 8 1 4 7 8 8 8 8 9 9 9 9 9 9 9 9 0 0 2

Venture backed stock index NASDAQ monthly index

Therefore, recent skyrocketing venture capital investment itself is based on irrational exuberance in the financial market coupled with excessive expectation about future

34 profitability, hence venture investment is hardly to be thought of as long–term and stable one.

4.2.2. Venture capital and coming the new economy recession?

Then, this venture capital cycle, highly related to the stock market, must have a serious effect on macroeconomy. The new economy is never free from the economic cycle and recession, even worse, the venture capital cycle can aggravate the economic cycle. The stock market adjustment will bring about a reduction of venture capital investment. Even the best specialists admit “the recent surge of venture capital begs the question of sustainability and the industry is inherently cyclical”, arguing the side effects associated with periods of rapid growth generate sufficient difficulties that periods of retrenchment are sure to follow (Gompers and Lerner, 1999, p. 325). In reality, since 2000 stock market bubble started to burst as people see low return of the IT sector firms like dotcoms. Already, lots of firms are suffering from problems of overcapacity and overinvestment done in the boom period with intense competition, and their profitability is in decline. The investment boom now turns into the investment bust. What’s happening was a typical capitalist economic cycle already analyzed by Marx. Firms try to increase the amount of profit faced with a fall of profit rate and fierce competition, but in the end some of them should go bankrupt in the process of overaccumulation, and the whole economy would be jittering. As overaccumulation with strong competition was excessive with the help of the nature of the IT industry and stock market bubble coupled with excessive expectation, incoming adjustment could be more serious. As of the early 2000, a sign of hard landing of the U.S. economy is very obvious. Lots of economists predict the growth rate would be less than 1.5% this year and every indicator like industrial production and manufacturing purchase index shows a sharp decline since the late 2000, and even R&D growth rate in the corporate sector decreased. Most of all, fixed investment growth fell significantly and, particularly investment of equipment software that led the boom started to drop a lot after the late 2000.55 The most of the decrease in the first quarter of 2001 was because of a big decrease of investment of information processing equipment and software with about –7.2% of growth at annual

55 According to the BEA announcement, in the first quarter of 2001, real gross private domestic investment growth was surprising negative 13.3% mainly due to a big decrease of inventories. But fixed investment growth also shows very stagnant.

35 rates.56

Table. Growth of real fixed investment and investment of equipment and software

98 99 I 00 II 00 III 00 IV 00 I 01 Real nonresidential fixed investment 10.1 12.6 21.0 14.6 7.7 -0.1 2.1 Equipment and software 15.0 14.1 20.6 17.9 5.6 -3.3 -2.6 * quarters seasonally adjusted at annual rates Source : BEA

When the U.S economy is hit hard by recession vulnerability of the U.S. economy will reveal itself more serious. In fact, the new economy boom was partly supported by huge foreign capital inflow and excessive household consumption with wealth effect, leading to even net minus saving. But with the stock market collapse, inverse wealth effect might bring further recession and even massive foreign capital outflow could happen.57 The most important is the virtuous cycle of venture capital-innovation-competition- investment-low price-high growth and productivity, in the boom period, can turn into a vicious cycle, which may make recession more serious and deeper. In boom period, high venture capital investment with the stock market boom can encourage more innovation and start-ups, resulting in more competition and investment, bringing about higher growth and lower inflation. But when recession comes as bubble bursts, venture capital investment decreases significantly and so does innovation and competition, then existing firms faces less competition and don’t have incentives to adopt new technology fast and repress their product prices. In other words, the downturn of Marx-Shumpeter-Keynes-Minsky cycle of the new economy would be awful with stagnant productivity growth and even high inflation.58 The amount venture capital disbursement really fell sharply since the early 2000 with the

56 The Fed announced the capacity utilization ratio of the manufacturing sector is only 78.1%, lowest in 9 years, with semiconductor about 80% and auto industry some 70% (BusinessWeek, 2001. 4. 30). 57 For a macroeconomic imbalance of the new economy boo, see Palley (2001). For a study on the wealth effect in the U.S., see Poterba (2000). International imbalance is also very serious. With huge foreign capital inflows that finance the big trade deficit, it is not easy for the Fed to cut interest rates so much because it might cause foreign capitals to outflow. 58 Mandel (2000) calls the cycle a “tech-cycle”. He points out new nature of the new economy cycle and warns a possibility of the incoming “internet depression”.

36 NASDAQ collapse. It fell continuously three quarters in a row, from $ 27.8 billion at peak of the third quarter, the first time since the 87 stock market crash.59 And, their condition of investment is getting more harsh and the more withdrawal of investment is happening (Economist, 2001. 5. 5.).

venutre capital investment ($ billion)

35 30 25

20 venutre capital 15 investment ($ billion) 10 5 0 1999. 1999. 1999. 1999. 2000. 2000. 2000. 2000. 2001. 1 2 3 4 1 2 3 4 1

Source : NVA and Venturewire(for 2000)

Though the amount of venture capital investment and the size of the IT sector may not big, considering the growth of the IT sector and IT investment were that important in the new economy boom, it may hit the economy a lot. Therefore, venture capitals could be helpful to magnify boom but it can also make recession more serious, and the capitalist new economy is exposed to further instability due to the venture capital cycle. In summary, though venture capital investment was important in financing innovative start-ups and encouraging more investment in the high-technology sector, it is quite volatile related to the stock market. When the stock market is full of speculative bubbles, the collapse of bubbles can lead to a significant decrease of venture capital, changing the former virtuous cycle to vicious cycle. Thus, the venture capital could have a serious

59 Along with the change, a deep recession in the new economy sector is very clear, already, shipment of the IT sector decreased by 2.8% in January and 3.1% in February compared to previous month (BusinessWeek, 2001. 4. 16.). Especially, with stagnant productivity and increasing wage cost, the 900 top firms profit decreased by 25% in the first quarter of 2000 and the new economy firms like telecommunication and computer software were hit severely (BusinesWeek, 2001. 5. 21.)

37 impact on the macroeconomic cycle, totally opposite to the main bank system. While main bank system can stabilize the economy, helping firms in financial distress in recession with long-term relationship and long-termism, the venture capital system may destabilize it. In this respect, policy recommendation that all countries including developing ones must develop the stock market has no strong grounds. Rather, we should think of another alternative institutional framework to support innovation and economic development, not based on the U.S. style system. For developing countries, it is still worth establishing a relationship-based financial system with long-term relationship mediated by the government, and the government could play an important role in the process, even supporting innovation.60

60 Singh et al. (2000) emphasizes there is no strong relationship between the stock market development and IT sector development. He argues stock market development is not necessary to support innovation and high technology and in reality it was the government itself that did the job so well in developing countries.

38 5. Concluding Remarks

The recent new economy boom of the U.S. economy and long recession of the Japanese economy made a myth that the market-based financial system is better in economic efficiency and growth. One of important purposes of the paper is to challenge this common myth. As we examined even the U.S. venture capital system is a kind of the relationship- based system and Japan’s trouble was originated from the demise of the main bank system. In this paper, we argued that in general the relationship-based system has advantage in addressing serious agency problems with better monitoring. And some relationship-based system is good at encouraging long-term and stable investment, while others play an important role in supporting new firms and innovation. Though it is not free from problems, the well-functioning relationship-based system with a close financier-firm relationship is more helpful than the market-based system. From the viewpoint of the relationship-based system, we analyzed the main bank system of Japan and the U.S. venture capital system. The main bank system with cross- shareholding between banks and business was good at stabilizing the economy and promoting the long-term investment and thus a base of the Japanese high growth period. But the change of the main bank relationship and the corporate financing structure along with financial deregulation led to weakening the monitoring function and giving a serious trouble to banks that turned to the bubble-related lending. The demise of the main bank sysem caused a trouble of the Japanese economy. The Japanese main bank system is going through more change with recent financial deregulation, if not a convergence to the Anglo- Saxon system. Similar to the main bank system, the U.S. venture capital system has also a strong character of the relationship-based financial system such as intensive monitoring based on a close and cooperative relationship. It was a good way to overcome the market- based system that can’t finance startups due to information problems. However, different from the main bank system, it is so much related to the stock market, and tends to destabilize the economy further, hardly good at encouraging long-term investment. The recent new economy boom of the U.S. economy was thanks to a surge of investment, especially IT-related one. In the process, the stock market bubble and skyrocketing venture investment played a crucial role making the boom bigger. But with the coming recession, the decrease of venture capital investment could aggravate the recession, turning the former virtuous high investment-growth-productivity-low inflation cycle into a vicious one.

39 The Study on the two relationship-based system gives us important lesson about the well-functioning financial system. First of all, in establishing a good relationship-based system, it is quintessential we should make efforts to establish and manage the close and cooperative bank-business. Especially, we should be careful about deregulation policies that might bring out the change of the relationship. With better information flow, the system can encourage stable economic growth. Second, it is also important to establish a good system to support innovation and new firms in order to bring out more productivity and a new technology. However, we should not depend on the stock market but devise an alternative system, maybe with a more positive role of the government. In this paper, we didn’t study the role of the state or government policies extensively. But in building a financial system, the government plays a significant role, especially in developing countries as the East Asian countries shows, and some policies like deregulation have a big consequence. Thus, we should shed more light on it in understanding the financial system and thinking of alternatives.

40

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- Japanese main bank system and its change

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- U.S new economy and venture capital

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