Corporate governance and investment incentives of Japanese firms

This thesis studies the vertical governance structure employed by large Japanese manufacturing firms that creates transaction relations that are different from arms-length relations. Chapter 2 describes the regulatory environments of post-war Japan that fostered the bank-centred financial system and then analyses the manufacturer-supplier relationships today. The findings suggest that equity participation by a large manufacturer may have been motivated by its need for expanded suppliers and by their suppliers' borrowing constraints. Chapter 3 formalizes this proposition and examines the effects of the manufacturer's equity holding on the supplier's investment incentives when a large manufacturer has access to a lower cost of capital than the supplier. I assume that the supplier can make either general or specific investment. Specific investment is more profitable than general investment but requires the supplier's effort for its successful implementation. With this set-up, I obtain a unique equilibrium in which the manufacturer holds minority equity interest, and the supplier invests more in physical assets and exerts more effort than the case when the manufacturer holds no equity. Chapter 4 evaluates the theory developed in Chapter 3 empirically, using unique data on Japanese trading relationship in which the actual good traded between the parties is used to infer the nature of investment (general or specific) involved in the relationship. The empirical results indicate that the supplier's investment decision and the manufacturer's equity holding decision are influenced by the supplier's borrowing constraints and their trading relationships. Hence, they provide empirical support for the incentive effects of the manufacturer's equity holding. Chapter 5 considers a strategic value of having a director on the supplier's board when a downstream firm faces Cournot competition in a final good market. Under the assumption that an outside director collects private information about the supplier, I show that the expected profit of the downstream firm increases with the amount of information it has. The largest gain from having a director on the supplier's board is obtained when both downstream firms have their directors on a common supplier's board because of the improved coordination of the production decisions by the downstream firms.