Banks and Labor as Stakeholders: Impact on Economic Performance

Stijn Claessens is Head of Financial Stability Policy at the Bank for International Settlements (BIS) and Professor of International Finance Policy at the University of Amsterdam; Kenichi Ueda is associate professor of economics at the University of Tokyo. This post is based on their recent paper. The views expressed are those of the authors and do not necessarily represent those of the Bank for International Settlements.

Corporate governance is in essence about how various stakeholders exert their influences over firms. In the U.S., corporate governance is currently often characterized as a combination of strong managers, relatively strong creditors, weak owners, and relatively weak workers; in continental Europe, in contrast, it is described as a combination of weak managers, relatively strong creditors and owners, and strong workers (Roe, 1994, Gelter, 2009). Historically, however, the relative powers of stakeholders in the U.S. differed, especially those of creditors and workers. Before the 1970s, banks were stronger while workers were weaker. Between the early-1970s and the mid-1990s, as the US banking sector was deregulated, banks lost some of their monopolistic powers. Over the same period, US workers gained more statuary protections (albeit still basic compared to many European countries).

The effects of these financial and labor reforms on economic activity have largely been studied separately in the finance and labor economics literatures. This is understandable since in classical economic theories of production, the two reforms have separable impacts on outputs and can thus be studied independently. Separation is not warranted, however, in the presence of product- or financial-market frictions. Then interactions between workers, creditors, and shareholders, and the bargaining among them, determine the full corporate governance regime under which a firm operates, which in turn affects the firm’s productivity and growth. Conversely, shifts in the relative bargaining power of stakeholders—due to legal, regulatory, factor market, and other changes—can have real outcomes. Since frictions are a reality, this stakeholder corporate governance model, defined in a broad sense, is thus the one that prevails in practice.

While, also with a greater recognition of frictions, theories have increasingly recognized this stakeholders model, empirical research has largely yet to acknowledge these interactions. In our working paper, we study the combined effects of time- and state-variation in the level of financial and employment protections using value added data at the state-industry level from the early-1970s to the mid-1990s, i.e., a quasi-natural experiment. We conduct panel data regression analyses utilizing measures of state- and year-specific bank branch deregulation and introductions of basic employment protection over these 20 years. Since reforms happen at the state-level, we focus on their overall consequences, i.e., their impact on aggregate state-industry-level growth.

We find positive effects of financial reforms (bank branch deregulation) for industries with greater external financing dependence and of labor reforms (introduction of basic employment protection) for industries with greater knowledge-intensity. The first effect is well established in the literature and confirms the beneficial role of financial liberalization for economic growth. The finding that basic employment protection is beneficial to economic growth for knowledge-intensive industries differs, however, from the existing empirical literature. From a labor-side viewpoint, the literature has found generally negative effects of employment protection on jobs creation in the U.S. and perverse effects of generous labor protection, in particular for continental Europe and Japan. Importantly, we find evidence of positive interaction effects between financial and labor reforms, with the interaction of the two reforms further reinforced for knowledge-intensive industries.

Our regression results are robust in several ways. By focusing on aggregate effects, we can be less concerned about reverse causality, which can be a problem for studies at the individual firm level where performance can drive firm level changes in worker protection (i.e., better performing firms providing greater protection to their employees). We nevertheless conduct robustness tests that allow for reverse causality and find similar results. Studying financial and employment protection reforms using US state-industry-level data also overcomes some of the problems prevalent in cross-country studies where results can be driven by country characteristics and other factors hard to control for. Our findings are also robust to using additional institutional measures as well as using various output measures, sample periods, and econometric specifications.

While we do not develop in the paper a theory that could reconcile our findings with those in the literature, we expect that such reconciliation could emerge in a setting with firm-specific human capital. With firm-specific investment, basic protection of employment is likely beneficial for knowledge-intensive industries. This is because workers have more incentives to invest in firm-specific skills when their jobs are safer due to the reforms proving more job security. Yet, very high job security, including rigid firing constraints, is likely detrimental as that hurts the efficiency of aggregate resource allocation when bad shocks arise. Provided firm-specific investment is correlated with the general human capital variables we used, which seems very plausible, the empirical results found in our analyses could emerge.

The effect which can explain the finding regarding the interaction of the two reforms is likely more subtle. Jobs should also become safer indirectly due to financial deregulation, as better external financing provision increases the survival probability of firms and as more bank competition lessens banks’ power to determine workers’ compensations and employment in distressed firms. This latter mechanism can explain the positive interaction effect between financial and labor reforms especially for knowledge-intensive industries: in the presence of more secure jobs due to better financial conditions, workers in knowledge-intensive firms invest more in firms-specific skills, boosting overall productivity.

Our empirical finding that the growth enhancing effect of basic labor standards is stronger when bank branch deregulation also takes place, and vice versa, is thus consistent with the importance of balancing the roles of various stakeholders in a firm. Different from many existing theories on monopolistic banks, which mostly focus on the ex ante lending decisions and have little implications what happens when firms face ex post shocks, we suspect that such indirect, interaction effects can arise in a model with ex post bargaining between creditors and workers on layoffs and loan repayments.

Our findings still may not answer the question why state-level formal laws are necessary. In particular, if indeed some level of employment protection is beneficial to a firm, why doesn’t a firm just offer a contract promising long-term employment? Here, we surmise that the ex post bargaining on worker layoffs and loan repayments is again an important ingredient of an underlying theory. Because a firm is unlikely to be able to honor its promise ex post when in a bad financial condition, workers will not rely on firm promises. Rather, state-level formal protection are needed to mitigate layoff demands from managers, creditors, and shareholders in such circumstances. Although it means some ex post inefficiencies—as fewer workers are laid off than is efficient, ex ante state such rules increase overall productivity by inducing more firm-specific human capital investment by workers.

Overall, our work highlights that financial and labor institutional reforms can interact with each other, with the balance between the two to affect corporate decisions in terms of worker layoffs and loan repayments. This finding contrasts to much past research, which has usually studied the effects of labor protection and financial liberalization separately from each other. Our findings therefore naturally requires us to recognize that corporate governance in the real world is broader than just creditor or shareholder rights and is much about balancing interests of multiple stakeholders. A better perspective of corporate governance may thus be seeing it as the complex set of constraints that determine the quasi-rents (profits) generated by the firm and that shape the ex post bargaining over these rents in the course of relationships with many stakeholders.

The complete paper is available for download here.

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