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E-MailAsli M. Colpan is Professor at Kyoto University Graduate School of Management, and Randall Morck is Jarislowsky Distinguished Chair and Distinguished University Professor at the University of Alberta. This post is based on their recent paper.
Unlike in the US, large firms in many foreign stock markets come in business groups: sets of seemingly distinct firms—each with its own stock price, annual reports, public shareholders, board of directors and CEO—but all effectively controlled by on apex firm, often itself controlled by a tycoon of wealthy family. Business groups were commonplace in the economic histories of most of today’s developed economies and in today’s emerging market economies. Adolf Berle and Gardiner Means, members of Franklin Delano Roosevelt’s “brain trust” deemed large business groups undue concentrations of power and successive New Deal reforms largely expunged this mode of corporate governance from the US. Institutional reforms later marginalized business groups in in Australia, Britain and Canada.
Investors and boards of directors contemplating investments elsewhere must factor in the non-independence of firms in each business group. This is especially important where banks, near-banks and other financial firms such as pension fund portfolio managers, belong to business groups. How this plays out depends on where agency lies within the business group. This is because the apex controlling party often has a larger real investment in some group firms and a minor real stake in others, yet controls them all via super-voting shares, board appointment rights, or (most commonly) control pyramids.
If the group cement firm, automaker, and mining company all matter more than the group bank to the apex controlling party’s wealth, they can be governed knowing the group bank is always there to provide bailouts. A group bank whose governance is subordinated to other firms in the business group is called an organ bank. Organ banks are shakier, prone to running up nonperforming loans, and associated with inefficient capital investment projects. Economies in which organ banks are more important are prone to more frequent banking crises.
If the group bank matters more to the group’s ultimate controlling party than do other firms in the group, bank governance tends to extend to other group firms. Other group firms can be directed to borrow from the group bank, pay higher interest rates, and submit to more intrusive bank monitoring. The result is a business group of high-debt firms governed to avoid risk that might compromise interest payments. Firms governed in this way are called zombie firms
Actual business groups can fall between these polar cases. Subordinated group banks magnify risk-taking; subordinating banks suppress risk-taking; yet both distortions protect business group firms from competitive pressure and promote their survival. However, this protection has limits.
A systemic shock deep or long enough to adversely affect all the firms in the group can create a group-level governance crisis that drains organ banks dry. Governments usually bail out distressed banks because not doing so can cause collateral damage throughout the economy. Not bailing out an organ bank can also trigger cascades of defaults through its business group, each of those inflicting more collateral damage. Even if the bailout wrests control of the bank from the group’s ultimate controlling party, the rest of the group is saved, group firms’ losses having been transferred to the organ bank and thence to taxpayers. The business group can also always found a new financial-sector firm. Organ banks thus lead to moral hazard problems (offloading the consequences of failure) and adverse selection problems (survival of the less fit firms).
A systemic shock deep or long enough to adversely affect all the firms in the group can also exacerbate zombie firm problems. Such a shock threatens the group bank by threatening all its creditors, intensifying the bank’s pressures on other group firms to avoid risk and focus on meeting interest obligations. Intensified risk aversion brings another adverse selection problem here: the zombie firms stagger on. An economy populated by zombie firms can lack creativity, innovation, and productivity growth.
This paper, written for economic historians, discusses archetypical examples drawn from Japanese business history and other settings. Policy options to deal with business groups are considered. These include limiting intragroup income and risk shifting via anti-tunneling provisions, formal Business Group Law to pierce corporate veils in business groups, mandating banks be severed from business groups, and dismantling business groups (as the US did in the 1930s). These may mitigate both distortions of organ banks and zombie firms; but also limits business groups’ internal markets, thought important where external markets work poorly.
The complete paper is available for download here.
