Jonathan R. Macey*
Editor's note: This article is based on a speech that Macey delivered
at the Nobel Symposium on Law and Finance in Stockholm on August
19, 1995. An expanded version, coauthored with Prof. Geoffrey P.
Miller of the New York University School of Law, will appear in
the Stanford Law Review (© 1996 by Jonathan R. Macey).
In recent years legal scholars have frequently criticized America's
system of corporate governance.(1) They have argued that America's
mechanisms for monitoring and controlling corporate managers are
grossly inferior to those of Japan and Germany, where commercial
banks are able to monitor and influence the business affairs of
borrowing corporations in ways that American banks cannot. American
law has traditionally limited the size of banks and the scope and
geographical range of their activities. At present, American banks
lack both the power and the incentive to monitor their corporate
borrowers. Critics have argued that without major changes in American
banking law that would allow American banks to play a role similar
to German universal banks and Japanese main banks, "the United
States is likely . . . to lag behind its European and Japanese competitors."(2)
The desirability of commercial bank involvement in corporate governance
has been greatly overstated. Proponents of bank involvement not
only fail to address the significant costs of the Japanese and German
systems of bank-dominated corporate governance but ignore important
benefits of the American system of equity-dominated corporate governance
as well. Advocates of bank influence also ignore critical differences
between the incentives of risk-averse, fixed claimants, such as
bankers who make loans, and residual claimants, such as shareholders
who invest risk capital. For those reasons, America would be better
off repairing the flaws in its own corporate governance system than
adopting an entirely new system, with all its attendant problems.
The Conflict between "Pure"
Equity Claimants and Banks
Modern corporate finance scholars have formalized the conflict
of interest that exists within the publicly held corporation between
the interests of fixed claimants (such as banks) and the interests
of shareholders who hold residual claims to the firm's earnings.(3)
When choosing how to allocate assets, firms that increase risk will
transfer wealth from the fixed claimants to the residual claimants.
Because fixed claimants, unlike residual claimants, do not capture
the upside potential gain from risky projects, they prefer asset
allocations that result in more certain cash flows and minimize
the risk of nonpayment of fixed claims. While that is a rational
preference, it results in suboptimal asset allocation from a societal
perspective, because the fixed claimants will discourage the asset
uses that have the greatest present value to the firm as a whole.
Two important insights emerge from the conflict of interest between
fixed and residual claimants. First, banks are not ideal institutions
to monitor corporate performance on behalf of shareholders. Second,
in a properly functioning capital market, an equilibrium emerges
among the disparate interests of all claimants such that claimants
who want less risk pay for it with lower returns. However, legal
and structural problemssuch as corporate managers' risk-averse
behavior when their compensation is fixed and the high cost of contractingraise
transaction costs, thereby impeding the operation of capital markets
and making it more difficult to resolve the inherent conflicts between
fixed and residual claimants.
Romanticizing the Role of German and
The critical distinction between the American model of corporate
governance and the German and Japanese models is that in Germany
and Japan large-block shareholders take an active management role
to mitigate managerial shirking and misconduct. German and Japanese
commercial banks are at the center of their respective corporate
governance models. In contrast, the American structure of corporate
governance focuses power in management, particularly in the chief
executive officer. For that reason, American shareholders are relatively
powerless to affect management decisions, as they are too disaggregated
to monitor management's activities, much less to galvanize into
effective political coalitions to oppose those activities.
The Japanese system of corporate governance is characterized by
a complex network of intercorporate equity holdings, known as keiretsu,
with Japanese banks at the center of the network.(4) The banks either
have or can obtain seats on the boards of directors of keiretsu
firms, particularly when cash flows become unstable. Management
gains from the Japanese pattern of bank domination and cross-ownership
because the system allows incumbent management to insulate itself
from takeovers and thus avoid the strict discipline imposed by the
takeover market. Banks gain because they are able to influence the
degree of internal risk taking by firms and thereby control risk
that would otherwise benefit shareholders at the banks' expense.
While Japanese banks do have substantial equity holdings in keiretsu
firms, the available evidence indicates that banks intervene in
keiretsu firms to increase the certainty of cash flows and profitability.(5)
That suggests that Japanese banks intervene to promote their interests
as fixed claimants rather than as residual claimants.
German universal banks play an even greater role in corporate governance
than their Japanese counterparts. Commentators argue that in sharp
contrast with American banks but similar to Japanese banks, the
German banks have "the position, information, and power to
effectively monitor the activity of management and, when necessary,
to discipline management."(6) Like Japanese banks, German banks
own only modest shares of the firms to which they lend money. Though
German banks own only about 6 percent of large share stakes in Germany,
they tend to exert effective control over a majority of the shares
voted in annual meetings.(7) For example, as of 1988, Deutsche Bank
and Dresdner Bank directly owned 28.2 percent and 1.6 percent, respectively,
of Daimler-Benz's outstanding shares. In comparison, in 1986 those
banks held voting rights in Daimler-Benz of 41.8 percent and 18.78
The disparity between small equity holdings and the large voting
power of German banks is attributable to two factors. First, German
banks vote bearer shares that they hold as custodians for shareholder-clients
of the banks' brokerage operations. Second, German banks augment
their voting rights by voting the shares owned by mutual funds they
operate. Like Japanese banks, German banks have a substantial economic
stake in corporations as a result of lending; German and Japanese
firms borrow about $4.20 from banks for every dollar they obtain
in capital markets, whereas American firms borrow $0.85 for every
dollar they raise in capital markets. Clearly, the prominent role
of German banks in corporate governance, like that of the Japanese
banks, creates significant conflicts between the banks as fixed
claimants and the residual claimants.
Commercial Banks as Fixed Claimants:
The Moral Hazard
Although German and Japanese banks are better able to monitor and
control the "adverse selection" problem (the danger that
bad borrowers will seek loans from banks in disproportionate numbers)
and the "moral hazard" problem (the tendency of debtors
to divert borrowed money to riskier investments) than American banks,
excessive risk avoidance in effect prevents the development of robust
primary and secondary capital markets in Germany and Japan. While
the evaluation processes that a firm must undergo before it obtains
funds either in the capital markets or from a bank are essentially
the same, banks are superior monitors of the firm. That is, commercial
banks like those in Germany and Japan can both monitor and control
the use of borrowed funds by a firm.
Arguably, equity claimants and fixed claimants should negotiate
to pursue the higher valued but riskier investment and split the
proceeds. That is not the case in Germany and Japan. To reach that
efficient bargaining solution, commercial banks would have to threaten
not to maximize shareholder value unless granted concessions. Because
German and Japanese bank representatives sit on the boards of many
borrower firms, and because German banks owe a fiduciary duty to
the owners of the shares the bank holds in trust and votes, that
sort of bargaining would unmask serious problems in the keiretsu
system and in the German universal bank system, if not expose the
banks to legitimate charges of extortion. In addition, a more fundamental
obstacle to efficient bargaining is that banks, with their highly
leveraged capital structures, are risk-averse; even considering
potential side payments, banks' expected utility loss on the downside
exceeds their expected utility gain on the upside.
Given their capacity to control adverse selection and moral hazard
problems, German and Japanese banks are more successful than American
banks and therefore play a larger role in their respective economies.
Moreover, their superior ability to control moral hazard suggests
that, at the margin, German and Japanese firms should find bank
financing more attractive than capital market financing. As banks
exert greater control over firms, the cost of raising equity capital
increases, because potential equity investors demand compensation
for the risk-averse firm behavior that results from bank domination.
Implications for American Corporate
This analysis does not establish that the American system of corporate
governance is necessarily superior to its German and Japanese counterparts.
It does show, however, that the advantages of the German and Japanese
systems have been exaggerated, while the costs have been underemphasized.
Those costs come not only in the form of excessive risk aversion,
which stifies innovation, but also in the form of illiquid, undeveloped,
and poorly functioning capital markets.
While the level of control in the Japanese and German bank-dominated
systems is probably too high, the level of control in the American
system is probably too low. Three sets of problems contribute to
that conclusion. First, the American system may cause firms to undertake
excessively risky projects, because weak banks in the United States
are unable to monitor and control excessive risk effectively.
Second, seemingly minor rules in the United States impede the ability
of fixed claimants to monitor and control borrowers. For instance,
several American legal doctrines have limited the enforcement of
contracts written to protect lenders from borrowers' moral hazard,
have changed substantive contractual provisions, and have even placed
massive liability on banks for environmental harm caused by the
Third, market forces in the United States have a declining capacity
to discipline managers and improve corporate performance. In particular,
politics has reduced the efficacy of the market for corporate control.
Thus America's corporate governance problem may stem not from a
lack of concentrated share blocks and powerful financial intermediaries
but from American courts' unwillingness to enforce contractual provisions
on which financial intermediaries and borrowers agree, and from
American legislatures' willingness to emplace legal obstacles to
a free and efficient market for corporate control.
Economies with the best corporate governance structures will outperform
rival economies at the margin.
The "continuous and textured" monitoring that characterizes
relational investing in Japan and Germany is not a panacea, however.
In those systems the interests of equity investors are insufficiently
represented in corporate governance. On the other hand, the American
system of corporate governance is also imperfect. In the U.S. system
fixed claimants are unable to protect themselves from the moral
hazard posed by the equity-dominated corporate borrowers. Rather
than investing resources in copying each others' systems, each system
would be better off focusing on, and repairing, its own problems.
* Professor Jonathan Macey is a professor at Cornell Law School
and Chairman of the Financial Institutions Practice Group.
- See, e.g., Ronald T. Gilson & Reinier
Kraakman, "Investment Companies as Guardian Shareholders:
The Place of the MSIC in the Corporate Governance Debate,"
45 Stan. L. Rev. 985, 989 (1993).
- Anthony Saunders & Ingo Walter, Universal
Banking in the United States: What Could We Gain? What Could We
Lose? 236 (1994).
- See, e.g., William A. Klein & John C.
Coffee Jr., Business Organization and Finance: Legal and Economic
Principles 225_26 (5th ed. 1993). For further discussion, see
Jonathan R. Macey & Geoffrey P. Miller, "Bank Failures,
Risk Monitoring, and the Market for Bank Control," 88 Colum.
L. Rev. 1153 (1988).
- Randall Morck & Masoa Nakamura, "Banks
and Corporate Control in Japan" 4_5 (Institute for Financial
Research, Faculty of Business, University of Alberta, Working
Paper No. 6-92, rev. July 26, 1993). In keiretsu, each member
firm generally owns less than 2 percent of the stock in other
member firms. However, between 30 and 90 percent of the stock
in each firm is owned by other keiretsu members.
- Id. at 36_37.
- Gilson & Kraakman, supra note 1, at 988.
- "Those German Banks and Their Industrial
Treasures," Economist, Jan. 21, 1995, at 71.
- Arno Gottschalk, "Der Stimmrechtseinfiuss
der Banken in den Aktionärsversammlungen der Grossunternehmen,"
5 WSI Mitteilungen 294, 298 (1988)