A Tale of Two Relationship-based Financial Systems: Main bank ...
A Tale of Two Relationship-based Financial Systems: Main bank vs.
Venture Capital System
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.
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
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.
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
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).
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).
For example, in Korea the government established the close government-business relationship with strong
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
control of banks and played role of monitor of the corporate sector. For details, see Lee (2001).
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
care about the stock price, faced with a threat of hostile takeovers. It is affected a lot by
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
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
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.
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).
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).
after a success of the project invested, getting a kind of monopoly based rent. 8 In reality,
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-
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,
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).
Dewatripoint and Maskin (1995)’s famous model itself assumes that “banks cannot initially distinguish
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
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
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.
Interestingly enough, we can see the same kind of debate about limits of ‘market socialism’ (Pollin, 1995.
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).
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).
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
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.
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).
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.
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
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.
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-
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
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.
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).
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.
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.
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).
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
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,
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.
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.
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
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.
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).
Morck and Nakamura (1999) present the same concern that the main bank might just prop up troubled
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
3.2. Demise of the Japanese financial system?
bank group firms, but their variable like entertainment expense as a sign of bad corporate governance is not
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 .
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).
3.2.1. From change of the financial system to the crisis
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
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)
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
between investment and commercial banking up to the late 1990s.
In addition to the serious government deficit problem, there were strong demands of
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
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,
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)
Bank Finance 37.1 34.7 36.0 29.8 24.3
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.
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.
Table. Increase of the share of bank lending to the real estate sector and nonbank
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
helped firms with equity finance related to issuing new shares, reducing the cost of
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.
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
-5 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99
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
deflation and credit crunch around the whole economy.31 In addition, high investment done
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).
For details of Japanese crisis, see Hoshi and Kashyap (1999), Lazonick (1998). Pigeon interprets the
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
structure doesn’t seem to break up and still main banks continue to dispatch their employee
experience of the crisis from Minsky’s perspective (Pigeoon, 2000).
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.
For more details, see Miyajima (1998), p. 54.
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
research data of 1998 shows the share of stable shareholders in total stock declined from
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).
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.
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).
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
holds holds holds holds
Shareholder Shareholding bank’s firm’s bank’s entities
ratio ratio Firm’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
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
Miyajima (1998) shows dividend rate is affected a lot by return on equity after the 90s.
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.
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
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).
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
* 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
increase to some extent.41
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.
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
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
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).
bring about more competition and investment.42
venture capital investment ($ billion)
investment ($ billion)
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
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.
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-
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
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).
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.
Many see almost 3/4 of investment go failure but a few of investment can bring about 10-100 times returns
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
of the initial investment, thus compensating capitalists.
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.
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
and startup companies to address agency problems due to information asymmetries, which
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
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
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.
establishment of syndication to enable cross-checks by several venture capitalists and
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
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
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-
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).
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).
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
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
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.
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)
For more details of related studies, see Gompers and Lerner (1999), pp. 21-24, and chapter 11.
Venture capital investment (86=100)
Venture capital investment (86=100)
Montly stock market index
(86: 01 = 100)
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
profitability, hence venture investment is hardly to be thought of as long–term and stable
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
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.
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
The amount venture capital disbursement really fell sharply since the early 2000 with the
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).
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.
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”.