Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan

TLDR: In this paper, the authors examine the misallocation of credit in Japan associated with the perverse incentives faced by banks to provide additional credit to the weakest firms, and find that firms are more likely to receive additional bank credit if they are in poor financial condition, because troubled Japanese banks have an incentive to allocate credit to severely impaired borrowers to avoid the realization of losses on their own balance sheets.

Abstract: We examine the misallocation of credit in Japan associated with the perverse incentives faced by banks to provide additional credit to the weakest firms. Firms are more likely to receive additional bank credit if they arein poor financial condition, because troubled Japanese banks have an incentive to allocate credit to severely impaired borrowers in order to avoid the realization of losses on their own balance sheets. This "evergreening" behavior is more prevalent among banks that have reported capital ratios close to the required minimum, and is compounded by the incentives arising from extensive corporate affiliations.

Figures

Table 5 Corporate Affiliations and the Probability of Additional Bank Loans Logit Specification

Table 4 The Effects of Evergreening and Balance Sheet Cosmetics on Bank Lending Logit Specification

Table 3 Descriptive Statistics for Regressors, Market-Traded Bank Sample, 1993-99

Table 1 Bonds and Loans as a Percent of Assets, Mean Values

Table 2 Loan Increases and the Subsequent Change in Stock Prices Ordinary Least Squares Estimation

Full text

NBER WORKING PAPER SERIES
UNNATURAL SELECTION: PERVERSE INCENTIVES
AND THE MISALLOCATION OF CREDIT IN JAPAN
Joe Peek
Eric S. Rosengren
Working Paper 9643
http://www.nber.org/papers/w9643
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
April 2003
We would like to thank Jeremy Stein, David Weinstein, and participants at the NBER Strategic
Alliances Conference, the Japan Project meeting in Tokyo, and the American Economic Association
meetings for comments on an earlier version of this paper, and Steven Fay for invaluable research
assistance. This study is based upon work supported by the National Science Foundation under
Grant No. SES-0213967. Any opinions, findings, and conclusions or recommendations expressed
in this study are those of the authors and do not necessarily reflect the views of the National Science
Foundation, the Federal Reserve Bank of Boston, or the Federal Reserve System.The views
expressed herein are those of the authors and not necessarily those of the National Bureau of
Economic Research.
©2003 by Joe Peek and Eric S. Rosengren All rights reserved. Short sections of text not to exceed two
paragraphs, may be quoted without explicit permission provided that full credit including ©notice, is given
to the source.

Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan
Joe Peek and Eric S. Rosengren
NBER Working Paper No. 9643
April 2003
JEL No.E51, G21
ABSTRACT
This study examines the misallocation of credit in Japan associated with the perverse incentives of
banks to provide additional credit to the weakest firms. Firms are far more likely to receive
additional credit if they are in poor financial condition, and these firms continue to perform poorly
after receiving additional bank financing. Troubled Japanese banks allocate credit to severely
impaired borrowers primarily to avoid the realization of losses on their own balance sheets. This
problem is compounded by extensive corporate affiliations, which provide a further incentive for
banks to allocate scarce credit based on considerations other than prudent credit risk analysis.
Joe Peek Eric S. Rosengren
437C Gatton Business and Economics Building Supervision and Regulation Department, T-10
University of Kentucky Federal Reserve Bank of Boston
Lexington, KY 40506-0034 600 Atlantic Avenue
jpeek0@uky.edu Boston, MA 02106-2076
Eric.Rosengren@bos.frb.org

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Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan
The severe economic crisis in Japan, associated with the collapse of the Japanese stock
and real estate markets and the dramatic deterioration in the health of the Japanese banking
sector, represents one of the major economic events of the late twentieth century. It is even more
striking because the second largest economy in the world remained stagnant for more than a
decade, and even today shows no evidence of returning to the robust health that characterized
most of its postwar history. This study investigates an important contributing factor to this
economic malaise: the misallocation of credit by banks. Japanese banks have incentives to
continue making credit available to the weakest firms, many of which are already insolvent,
insulating those firms from market forces that otherwise would force the restructuring or
bankruptcy of those firms.
Bank regulation and supervision policies in Japan provide banks that have significant
nonperforming loans and impaired capital little incentive to be strict with troubled borrowers. In
fact, it is in the self-interest of banks to follow a policy of forbearance with their problem
borrowers in order to avoid pressure on the banks to increase their own loan loss reserves, further
impairing their capital. This leads to a policy of banks “evergreening” loans, whereby a bank
extends additional credit to a troubled firm to enable the firm to make interest payments on
outstanding loans and avoid or delay bankruptcy. By keeping the loan current, the bank’s
balance sheet looks better, since the bank is not required to report such problem loans among its
nonperforming loans. Although banks have the incentive to evergreen loans, their ability to
aggressively pursue such policies requires government complicity. Our evidence is consistent
with the government being unwilling to force recognition of asset quality problems in bank
portfolios in an attempt to limit costly bailouts of the banking sector and additional firm closures.

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Using detailed data on loans from individual lenders to individual firms, we show that the
misallocation of bank credit reflects a general problem with the incentives of banks to continue
lending to their most troubled borrowers. Additional credit is far more likely for deeply troubled
firms, which perform poorly after receiving additional credit. Furthermore, banks with reported
capital ratios close to their required ratios are even more likely to make loans to the weakest
firms. This misallocation of credit is far less prevalent for lenders without strong corporate
affiliations with borrowers, as well as for nonbank lenders relative to banks. While resolving
this misallocation of credit requires realization of losses at banks and sales in already depressed
markets, it does not require a complete realignment of the industrial organization of Japan that
would be needed if the problem were due primarily to corporate affiliations rather than
misaligned incentives for banks.
The rest of the study is as follows. The next section provides some background on the
role of banks in allocating credit in the Japanese economy. The second section discusses the
perverse incentives affecting bank lending behavior. The third section describes the data and
empirical results. The final section provides our conclusions.
I. The role of banks in allocating credit in Japan
Banking relationships in Japan are far more important than in the United States. While
the U.S. is characterized as a market-centered economy, Japan is considered to be a bank-
centered economy. Japanese firms rely more on bank debt than firms in the United States,
although bond financing in Japan has become increasingly important over the past decade (Hoshi
and Kashyap 1999). But the differences go deeper than simply the relative importance of
relationship versus arm’s length financing in the two countries. The relationships between banks

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and firms in Japan are much stronger, being characterized by main bank relationships, as well as,
in many instances, additional ties arising from the lending bank being in the same keiretsu group
as the firm. Furthermore, Japanese capitalism differs from the style prevalent in the United
States, especially when it comes to the allocation of credit. For example, many bank lending
decisions are guided by the perceived national duty of banks to support troubled firms, rather
than being a result of the careful credit risk analysis that would dominate the decision were a
profit maximization motive the primary consideration.
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The firm-main bank relationship in Japan is solidified in a number of ways. The main
bank takes primary responsibility for monitoring the firm and can serve as a form of corporate
governance (Kaplan and Minton 1994). The main bank is particularly important during times of
distress, when it can require changes in the affiliated firm’s management and alter its board of
directors (Kang and Shivdasani 1995; Morck and Nakamura 1999). This oversight provided by
the bank can reduce typical information asymmetries, resulting in firms having greater access to
external credit, which, in turn, affects firms’ investment decisions (Hoshi, Kashyap and
Scharfstein 1991). However, there is a dark side to this close lending relationship: If the bank
rather than the borrower becomes troubled, the ability of the firm to finance investment may be
impeded (Gibson 1995; Kang and Stultz 2000; Klein, Peek and Rosengren 2002).
During the 1980s and early 1990s, most studies of Japanese bank-firm affiliations have
found significant benefits. These studies emphasized the unique features of Japanese bank
affiliations that reduced agency costs (Hoshi, Kashyap, and Scharfstein 1993; Hoshi, Kashyap,
and Scharfstein 1990). Banks with intertwined business relationships, shareholding
relationships, board of directors relationships, and financing relationships with their loan
customers should have substantially more information about those firms than do external

Frequently asked questions

Q1. What allowed banks to understate their problem loans and overstate their capital?

The lack of transparency and the use of accounting gimmicks allowed bank supervisors to implement forbearance policies that allowed banks to understate their problem loans and overstate their capital so that they appeared to be sufficiently capitalized. 

Q2. What is the hypothesis that a bank made additional loans to weak firms to avoid declaring existing?

The “evergreening” hypothesis is that Japanese banks acted in their own self interest by making additional loans to weak firms to avoid having to declare existingloans as nonperforming. 

Q3. What was the effect of the decline in the loans-to-assets ratios?

during the 1993 to 1997 period, the general declines in the firms’ loans-to-assets ratios were less pronounced, and, from 1997 to 1999, the loans-to-assets ratios actually rose markedly, reaching levels exceeding their 1993 values, even as firm reliance on bond finance continued its decline. 

Q4. What are the main reasons why nonbanks are more likely to increase loans to troubled firms?

Other incentives were external to the banks, emanating from government pressure on banks to continue lending to financially weak firms in order to avoid an even larger surge in unemployment and firm bankruptcies, as well as limiting the financial costs associated with massive bank bailouts or failures. 

Q5. What are the variables that are used to control for differences between industries?

The specifications also include a set of annual time dummy variables to control for average changes in stock prices and the general macroeconomy from year to year, as well as a set of industry dummy variables to control for differences across industries. 

Q6. What is the evidence consistent with the balance sheet cosmetics hypothesis?

The evidence is also consistent with the balance sheet cosmetics hypothesis, insofar as those banks with reported capital ratios close to their required minimums are more likely to increase credit to firms, with somewhat weaker evidence that they are more likely than other banks to increase credit to firms the weaker is firm health. 

Q7. What is the effect of corporate affiliations on the availability of loans to affiliated firms?

In particular, the authors test three specific hypotheses: (1) that banks acted in their own selfinterest by evergreening loans to the weakest firms; (2) that balance sheet cosmetics were important, insofar as the incentive for banks to evergreen loans increased as their reported capital ratio approached their required capital ratio; and (3) that corporate affiliations had the effect of increasing the availability of loans to affiliated firms, insulating those firms from market discipline, rather than directing credit to firms with the best prospects as affiliated lenders exploited the superior information obtained from that affiliation. 

Q8. What is the value of a dummy variable when a firm exits the bond?

the dummy variable that has a value of one when a firm exits the bond market always has a significant positive estimated coefficient, as would be expected. 

Q9. What is the reason why the Japanese economy was unable to cope with the declining demand for credit?

Given the stagnation of the Japanese economy during the 1990s, one might easily attribute this decline to a weakening of the demand for credit by firms. 

Q10. Why are nonaffiliated banks more likely to increase loans to troubled firms?

This is true even for nonaffiliated secondary banks, perhaps due to pressure from main banks on other lenders to participate proportionately in any bailout of a troubled firm, pressure from the government for banks to support troubled firms, or some combination of such pressures. 

Q11. How do the authors obtain the differential effects of keiretsu ties?

The differential effects of keiretsu ties are obtained by using SAMEK, the (0,1) dummy variable that has a value of one if the lender is in the same keiretsu as the firm.