https://www.wsj.com/articles/SB900534120766240500　

By Nicholas Benes　　July 16, 1998 12:01 am ET

TOKYO — Japan’s outgoing Prime Minister Ryutaro Hashimoto and the ruling Liberal Democratic Party have been trying to convince the voters and the markets that they can lead the country out of recession with their “total plan,” which includes a scheme to set up a “bridge bank” to solve the bad loan crisis. As the elections for the upper house of parliament on Sunday showed, the voters don’t buy it; neither do the markets.

And they’re right. While these plans do set up a framework within which the disposition of insolvent banks could hypothetically proceed, they do almost nothing to ensure that the necessary hard decisions will in fact be made. That’s because Japan’s deeper problem of corporate governance hasn’t even been addressed.

The government’s plans are ambiguous on most of the tough but essential questions. Japan is being asked to trust the existing corporate management at both borrowers and banks to make most of the crucial decisions. So those decisions are likely to be delayed as long as possible, until problems become worse and there is an irresistible crisis requiring action.

Understaffed regulators in Japan do not know anything about borrowers’ true financial condition. So they will have to rely entirely on the information and opinions that are privately disclosed to them by internal bank managers. But, these are the same people who are already not disclosing their true condition. The same deception is practiced by managers of the borrowers themselves. There is no reason to expect this to change, since no one wants to lose his job or be branded traitor to his colleagues by releasing such information.

If this kind of insular thinking within management isn’t corrected, no bank will be declared insolvent until there is a run on its deposits or its stock price collapses. And at that point it will be too late to stop the contagion effect from imperiling the whole financial system. This is the very outcome that the “bridge bank” plan was supposed to avoid.

The solution is to break the power of the managers by requiring the boards of all listed corporations to have a majority of outside directors–i.e. directors not drawn from the management of the company or other cross-shareholding companies. This would do far more than any other measure to restore health to the banking and financial sector, and to promote the restructurings and the mergers and acquisitions that are needed to revitalize the economy and reallocate resources efficiently.

Japanese boards function as meetings of tribal elders, rather than shareholder fiduciaries providing an independent check and review of management. Because the boards are composed almost entirely of internal managers, there is no concept of fiduciary responsibility. The student is grading himself, with a perpetual make-up test.

These directors attained their positions after 35 or more years of keeping their heads low and working the internal politics to become popular with the other employees of their “tribe.” Few of them have significant stock in the company. So it is not surprising that they care little about shareholders and their economic returns, and focus instead on the continuation of the tribe and its internal politics. After all, that was how they climbed the ladder, and where they owe their favors.

Most large companies have spent the past 40 years constructing a web of cross-shareholdings in which the managers sit on each other’s boards of directors, so that “if you support me in shareholders meetings, I will do likewise, and then we can both do what we want.” With no checks and balances at work, and blessed with a fast-growth economy until recently, executives did the most convenient thing to ensure their own continued internal popularity: They proclaimed that the paramount corporate goals would be employment stability and the pursuit of corporate size and status. Thus was born the myth of “lifetime employment” and the preference for size over profitability, both of which served well in the rapid- growth era but are now value-destroying.

Ironically, the seeds of the present system were inadvertently sown by the occupying U.S. authorities after World War II. The U.S. authorities broke up the zaibatsu and prohibited holding companies, but relaxed their grip in mid-course. The zaibatsu then attempted to re-assemble themselves through cross- shareholdings. The result is that instead of corporate groups where there had once been clear owners in charge, now most large Japanese companies have become the virtually headless members of headless keiretsu groups. This structure was reinforced when, during market crashes, the Japanese government promoted the formation of joint share-buying schemes.

Most of Japan’s corporations lack the ability or incentive to make the painful decisions that major restructuring requires. As a result, Japan was unable to start a meaningful cleanup process five years ago, when the magnitude of its banking crisis and market crashes was far smaller than it is now. So the size of these problems bloated, as banks attempted to avoid disclosure of losses by rolling over loans and lending more to troubled companies so that they could pay interest.

The same structural defect prevents corporations from making detailed and timely disclosures about their financial problems, prevents boards from deciding upon merger and acquisition proposals until it is far too late, and has slowed bank write-offs and balance sheet shrinkage. Exactly as described in corporate finance theory, it is an “agency problem” on a nationwide scale, wherein the interests of management are not aligned with those of shareholders, thus creating inefficiencies and transaction costs.

If Japan is to recover it will have to embrace a power shift away from the employees and back in favor of shareholders and creditors. Independent boards with a majority of outside directors are the most important key to restoring market confidence in Japan, because without them, disclosure will never be reliable, and creditors cannot be sure that someone responsible will actually pull the plug before debts bloat excessively.

With independence, the board of each bank will be more likely to measure its own solvency. Only then can a “bridge bank” decide which managers should remain in some limited capacity. Boards of both financial and nonfinancial companies will be more willing to contemplate restructuring, merger or divestment strategies and proposals before it is too late to be of any help.

The “bridge bank” scheme as it is now conceived is not primarily intended to be a rapid cleanup measure at all. Rather it is designed to alleviate a credit-crunch and appease the markets. In fact it looks to be just a clever way of continuing the old practice of keeping a rising mountain of deadbeat borrowers on life support. Nobody should believe the Japanese government is serious about reform until it takes power away from managers and puts it back in the hands of shareholders, where it belongs.

Mr. Benes is president of Japan Transaction Partners, an investment bank specializing in merger and acquisition advisory services in the Japanese market.

–From The Asian Wall Street Journal