The choice of financing with public debt versus private debt: New evidence from Japan after critical binding regulations were removed

Japan and the World Economy 19 (2007) 393–424 www.elsevier.com/locate/econbase

The choice of financing with public debt versus private debt: New evidence from Japan after critical binding regulations were removed Yoko Shirasu a, Peng Xu b,* a

Financial Research and Training Center, Financial Services Agency the Japanese Government, Kasumigaseki 3-1-1, Chiyoda-ku, Tokyo 100-8967, Japan b Department of Economics, Hosei University, Aihara-Machi 4342, Machida-shi, Tokyo 194-0298, Japan Received 3 April 2005; received in revised form 1 June 2006; accepted 12 June 2006

Abstract The complete removal of binding regulatory constraints on bond issuance till 1993 provides an opportunity ripe enough to test hypotheses on the choice of financing with public debt and bank debt, comparing with the partial deregulation of Japanese financial markets in the late 1980s. Regardless of further deregulation, there is a U-turning to bank debt in Japan’s corporate financing as the 1990s’ recession prolonging. In particular, we find high quality Japanese firms leave banks to the bond market, while low quality firms U-turn to bank debt. We also provide new evidence that Japanese banks tend to lend loans to wealthy firms. Because of a shift from equity-linked bond to straight bond during 1993–1997, our study provides a complement to evidence on financing choices of equity-linked public debt versus bank debt with the late 1980s’ bull stock market. # 2006 Elsevier B.V. All rights reserved. JEL classification: G21; G32 Keywords: Deregulation; Public debt; Bank debt; Equity-linked bonds

1. Introduction One of the most important corporate financing decisions is the choice between bank debt and public debt. The earlier theoretical studies emphasized the role of information production and control functions of banks (Diamond, 1984, 1991; Fama, 1985). Because banks monitor

* Corresponding author. Tel.: +81 427 83 2533/2517; fax: +81 427 83 2611. E-mail address: [email protected] (P. Xu). 0922-1425/$ – see front matter # 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.japwor.2006.06.002

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borrowing firms and thus mitigate adverse selection and moral hazard problems, bank financing can be less expensive than public debt if the agency costs of debt are high. However, bank debt imposes other costs. First, monitoring costs and regulatory costs incurred by banks directly offsets the benefits of bank (Fama, 1985; Diamond, 1991). Moreover, Sharpe (1990) and Rajan (1992) discuss that while informed banks make flexible financial decisions which prevent a firm’s manager form continuing unprofitable projects, a monopolistic bank may obtain bargaining power over the firm’s profits due to the developed private information, once projects begun. Also, Diamond (1993) argues that short-term bank debt leads lenders to liquidate a firm too often to adversely influence investment decisions. In sum, bank loans, in particular, short-term bank loans can be troublesome or burdensome for high growth firms. Historically, Japanese firms had to heavily rely on bank borrowing due to strict restrictions on both equity finance and public bond finance. However, the Japanese financial system changed substantially during the 1980s (Hoshi and Kashyap, 1999). First, in the domestic bond market, Japanese firms were allowed to issue unsecured bonds. Next, the criteria for unsecured bonds were gradually relaxed. The deregulation in the Japanese financial system during the 1980s was viewed as a natural experiment to test hypotheses on the mix of bank debt and public debt. A few extant studies have examined the corporate finance in the late 1980s (Hoshi et al., 1993; Fukuda et al., 1998; Anderson and Mahkija, 1999; Hosono, 2003; Miyajima and Arikawa, 1999). Looking into the complicated regulations over the domestic and overseas markets, we find that it is not the time ripe enough to test the hypotheses, for the regulatory constraints were so stringent for us to identify a sample of firms having exactly identical options, even large enough for analysis. In this paper, we investigate the choice of corporate financing with public debt versus private debt for Japanese firms over 1993–1997. We choose this period because all binding regulations were removed after 1993. Most interestingly, the financing pattern during 1993–1997 shows a Uturn from public debt to bank debt during this long depression. Meanwhile, there was also a shift from equity-linked bond issuance to straight bond issuance, comparing with the big shift away from bank debt towards equity-linked bond issuance of Japanese firms in the late 1980s after the regulatory constraints had been gradually relaxed. Our finding suggests that business cycles may affect not only the choice between bank debt and public debt but also the choice of straight debt versus equity-linked debt. More importantly, our study also complements evidence of the choice of public equity-linked debt versus bank debt for Japanese firms in the late 1980s’ bull stock market. Our findings show that large, low leveraged, less wealthy Japanese firms tend to proportionately use more public debt over 1993–1997. We also find that small, high-leveraged, wealthy firms are more likely to borrow from private lenders. Most importantly, we find that high quality or high growth Japanese firms tend to access public bond market, while low quality or low-growth firms use more bank debt. Our findings suggest that Japanese banks monitor borrowers but may impose excessive costs, as argued in Rajan (1992) and Diamond (1991, 1993). In particular, Diamond (1991) suggests that in economy-wide times of distress, the proportion of loans will increase relative to public debt. This finding is also consistent with the hypothesis of Rajan (1992) that a private lender, usually, a commercial bank may develop monopolistic information and hold-up high quality firms ex post. Consistently with this argument, Houston and James (1996) have found that U.S. firms facing more serious banks’ hold-up problems use proportionately fewer bank loans. Our evidence suggests that Japanese banks monitor borrowers but may also impose excess hold-up costs. Moreover this is consistent with the stylized fact that in Japan monitoring is delegated to the main bank (Aoki and Patrick, 1994) and thus the main bank has monopolistic information power.

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Finally, the firm–bank relationship in Japan seems to be unaffected by the further development of bond financing in the early 1990s. Our inferences are based on a matter of fact that today more and more Japanese firms are going to restructure their businesses that they expanded in the late 1980s. The most important role of bank debt is to constrain management of declining firms and liquidate inefficient firms in financial distresses. Consistently, we found that more low quality Japanese firms have increased their reliance on private lenders as Japanese economy going from a boom to a recession. In short, such firms need to be monitored more intensively and thus banks are expected to play more important roles than they did before. At the same time, it is much more important for Japanese banks to pay attentions not only to the effects of changes in future profitability on the corporate financing choices of large firms, but also the effect on previously made loans, when Japanese large firms are completely free from regulation to issue corporate bonds, equity-linked bonds and equities. Our finding will shed new light into the debate on the roles of Japanese banks in post deregulation and corporate governance. The remainder of the paper is organized as follows. In Section 2, we provide a brief review of theoretical and empirical work on public versus bank debt and provide examples of other regulatory constraints that were not discussed in extant studies. In Section 3, we describe our data and methodology. Sections 3.1–3.5 presents regression results for public debt issued in the years 1993–1997. And we discuss the reasons that may cause the difference between our results and that in extant studies. Section 3.6 tests the robustness of our findings. Section 4 concludes the paper. 2. Bank versus bond financing In this section, we first briefly review the theoretical work on the choice of bank debt versus public debt. Then we discuss the implications for understanding Japanese corporate finance by associating the theoretical work on private debt with the Japanese main bank system and survey empirical studies on the benefits and costs of bank debt for both U.S. firms and Japanese firms. Because many earlier empirical studies on Japanese firms’ corporate financing choices use the data from the late 1980s, we provide a comprehensive review on the regulatory constraints on bond issuance at home and abroad till 1992. This comprehensive review also helps to understand why we choose the data from 1993. As we carefully confirm the differences between the criteria for issuing domestic bonds and overseas bonds, we find that a methodology used in some earlier studies can be problematic. This methodology has been used in a few empirical studies to identify a sample of firms, which corporate financing decisions were more likely to be unconstrained by the regulatory restrictions on bond issuance in the late 1980s Japanese financial markets. Finally, we discuss the issue that most bonds issued in the late 1980s are not straight bonds but equitylinked bonds. 2.1. Factors affecting corporate financing choice with bank debt versus public debt If a firm has to borrow from a large number of lenders, the diffused ownership of debt reduces the incentives of individual bondholders to engage in information production and monitoring activities. Moreover, duplicate monitoring by a large number of lenders is also inefficient. The delegation of monitoring, a large number of lenders delegate information production and monitoring activities to an intermediate, typically to a commercial bank, resolves the above problems (Smith and Warner, 1979; Blackwell and Kidwell, 1988; Diamond, 1984, 1991; Berlin and Loeys, 1988). The concentrated ownership of private debt, in particular, the bank debt

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mitigates free rider problems. This is the most important difference between private debt, or monitored debt and public debt, or unmonitored debt. A monitoring creditor, usually a commercial bank is able to produce private information and to negotiate more efficiently when a borrowing firm is in financial distress. From this point of view, the agency costs of bank debt are generally less expensive than public debt. Consequentially, a firm of high agency costs of debt and thereby needs to be monitored intensively, tends to use more bank debt than public debt. The delegation of monitoring is also a key word for understanding the Japanese main bank system. For example, Aoki and Patrick (1994) argues that all other private lenders of a Japanese firm delegate monitoring to the main bank, as well as depositors. Empirical evidence on U.S. firms suggests that the using of bank debt reduces agency costs of debt. For example, James (1987) and Lummer and McConnell (1989) find that stock prices rise following announcement of bank financing. Petersen and Rajan (1994) provide direct evidence on the benefits of relationship lending, or bank debt for small U.S. firms. In Japan, usually banks are allowed to intervene the management of borrowing firms more deeply than U.S. banks (Ramseyer, 1994; Roe, 1994). Similarly, a large number of empirical studies on Japanese corporate finance primarily focus on the benefits of lending relationships in Japan. For example, empirical evidence suggests that close bank ties help Japanese firms to restructure successfully during financial distresses (Suzuki and Wright, 1985; Hoshi et al., 1990b). In addition, Hoshi et al. (1990a, 1991) find that the investment of Japanese firms with strong bank ties is less liquidity constrained.1 Finally, the active roles of Japanese banks in Japanese corporate governance, such as executive turnover and appointment, have been examined in Kang and Shivdasani (1995), Kaplan (1994) and Kaplan and Minton (1994). However, bank debt imposes other costs. First, monitoring costs and regulatory costs incurred by banks directly offsets the benefits of bank (Fama, 1985; Diamond, 1991). For example, Diamond (1991) argues that while firms with established reputations that reduce agency costs tend to use more public debt, a firm without established reputations borrows from a bank, which is able to monitor the borrowing firm and therefore mitigate adverse selection and moral hazard problems. One of empirical implications of Diamond (1991) is that firms with lower future profitability use more bank debt proportionately, because the future becomes less important and thus the firms are more likely to take a chance to ruin their less valuable reputation. Furthermore, Sharpe (1990) and Rajan (1992) discuss another cost of bank debt. For example, Rajan (1992) argues that while informed banks make flexible financial decisions which prevent a firm’s manager form continuing unprofitable projects, a monopolistic bank may obtain bargaining power over the firm’s profits due to the developed private information, once projects begun. Using information monopoly power, a bank can hold-up a successful firm during the process of over-rolling bank short-term loans. Alternatively, Diamond (1993) argues that short-term bank debt leads lenders to liquidate a firm too often to adversely influence investment decisions. In sum, theoretical studies suggest that firms with more future profitability or more growth opportunities issue more corporate bonds. After the above theoretical models are developed, the main purpose of empirical research is to test the relationship between debt structure and firms’ growth opportunities. Houston and James (1996) find that high growth firms with a single bank use less bank debt. This empirical evidence suggests that U.S. banks hold-up firms. For Japanese firms, Hoshi et al. (1993), Fukuda et al. (1998), Anderson and Mahkija (1999), Hosono (2003) and Miyajima and Arikawa (1999) study

1

However, Hayashi (1996) recently does not support this viewpoint.

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Fig. 1. The volume of straight bonds, warrant bonds and convertible bonds issued over 1985–1997. This figure reports the volume of straight bonds, warrant bonds, convertible bonds issued and equity financing over 1985–1997. Bond domestic means the volume of each kind of bonds issued in Japan, and bond abroad means the volume of each kind of bonds issued outside Japan. CBs are convertible bonds. Abroad/domestic means the ratio of the volume of bonds issued in Japan to the volume of bonds issued outside Japan. Electric utility industrial firms are excluded. Equity means the volume of equity financing by quoted companies, by offering to shareholders, public offerings, prior stocks and private placements. Source: Japan Securities Dealers Association, 1985–1998; Tokyo Stock Exchange, 2001.

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the corporate financing choices of corporate bonds versus bank loans in the late 1980s. Most studies find that large firms, firms with high profits or high growth opportunities, low leveraged firms use more corporate bonds. The only exception is Anderson and Mahkija (1999) finding that the bond debt use is inversely related to growth opportunities. Even though Japanese financial markets were gradually deregulated throughout the late 1980s, many regulations were still in effect till 1992. Anderson and Mahkija (1999) note ‘‘an empiricist could inappropriately attribute relations between firms characteristics and debt compositions to unconstrained decisions’’, if the regulations ‘‘artificially bind the decisions of some firms’’. So it has been a main issue how to classify a sample of firms, in which all firms were likely to be unconstrained under the regulatory environment of bond markets at home and abroad during the late 1980s in order to investigate unconstrained decisions. However, earlier empiricists restrict their attentions to the criteria for issuing domestic bonds but ignore to the criteria for issuing bonds abroad. In next section, we provide a comprehensive review of criteria for issuing bonds in the late 1980s, in particular, we focus on the criteria for issuing foreign currency dominated bonds abroad. 2.2. The complicated regulatory constraints in the late 1980s Fig. 1 reports straight bonds, warrant bonds and convertible bonds issued at home or abroad and equity issuance during 1985–1997. Throughout the 1980s, the corporate financing choices Japanese firms were restricted by the regulations not only at home but also over foreign bond markets. Till 1992, many Japanese corporations issued bonds in foreign markets, instead in the domestic market. As Fig. 1 indicates, the ratio of overseas bond issuance volume to domestic bond issuance volume is 1.455 in 1985, then down to 0.940 in 1986, 0.944 in 1987, and 0.917 in 1988. After that, it went up to 1.255 in 1989, then up 3.502 in 1990, again down to 3.272 in 1991 and to 2.444 in 1992. Why did Japanese firms prefer to issue bonds in foreign markets? How about the regulatory constraints for issuing overseas bonds? Here we provide a comprehensive review. In 1980, the reform of Foreign Exchange and Trade Control Act first enabled the developments in foreign bond market (Sato and Kanovsky, 1990; Hoshi and Kashyap, 1999). Thereafter, U.S. and international pressure led to furthermore deregulation of the Euro-market (Sato and Kanovsky, 1990; Hoshi and Kashyap, 1999). Hoshi and Kashyap (1999) note ‘‘The foreign bond markets were attractive because they made it possible for Japanese firms to by-pass the Bond Issuance Committee. Perhaps, most importantly, no collateral was required in foreign markets’’. But it is only a part of story. More importantly, the issuing cost was cheaper in foreign bond markets. The real story is more complicated. In fact, the Ministry of Finance only allowed firms to issue foreign currency dominated unsecured convertible bonds if the criteria for domestic secured convertible bond issuance were cleared. In contrast, the criteria for issuing unsecured straight bonds at home, the most stringent criteria, were used for the criteria for issuing unsecured straight bonds and unsecured warrant bonds at foreign bond markets, regardless of foreign currency domination or yen domination. Thus it is not enough for Japanese firms to by pass the collateral requirement for issuing in domestic bonds, even limited to convertible bonds. Notably, convertible bonds, as Fig. 1 shows, were not popular in foreign bond markets in the late 1980s, perhaps because the option of conversion to equity makes the amount to be hedged uncertain ex ante, unlike straight bonds, warrant bonds. Instead, Japanese firms mainly issued warrant bonds abroad in the late 1980s. This is partially due to the regulation: bank guarantee was

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required in foreign bond markets instead of collateral requirement if firms only qualified to issue domestic secured bonds. Campbell and Hamao (1994) provide a comprehensive illustration for uses of domestic bonds and overseas bonds, bank guaranteed bonds and bonds without bank guarantee. Not surprisingly, it is reported that 20% of straight bonds and 40% of warrant bonds were issued with bank guarantee overseas, while no domestic bonds were with bank guarantee, and overseas convertible bonds were rarely bank-guaranteed. They also find that small firms tended to use bank-guaranteed bonds. This is consistent with the regulatory constraints, which qualified large and highly profitable firms: firms with net assets greater than 55 billion yen and at least dividends per share ¥6 for past 5 years, to issue unsecured and non-guaranteed warrant bonds, as well as unsecured and non-guaranteed straight bonds, regardless of domestic or abroad issuances (see Appendix A for the criteria in detail). Therefore, there is no way for Japanese firms to by-pass the domestic collateral requirement when it comes to straight bonds. Moreover, bank guaranteed bonds are more likely to be monitored debt rather than public debt. Another Japanese banks’ bond issuance related business in the late 1980s was collecting toll charge for managing collateral of secured bonds in the domestic bond market. Till March 1993, a commissioned or trustee bank managing collateral of secured bonds was required in the domestic market. By law, only banks could manage collateral. Traditionally, a commissioned bank had an implicit obligation to buy back defaulted bonds at the price of par for the defaulted issuing firm and then to negotiate with the defaulted issuing firm. Campbell and Hamao (1994) and Matsuo (1998) provide detailed evidence that commissioned banks bought back redeem defaulted bonds at prices of par till the early 1990s. In fact, commissioned banks guaranteed secured bonds issued in the domestic market. Thus it is reasonably conjectured that a commissioned bank had strong motivations to monitor the issuing firm since it had to buy back the defaulted bond at the price of par when the issuing firm went to financial distress. Moreover, the commissioned bank of an issuing company was usually the main bank, which did have information advantage. Following the context of delegated monitoring of the main bank system in Aoki and Sheard (1992), the holders of straight bonds also delegate the monitoring to a commissioned bank under the commissioned bank requirement. Consequentially, till 1992 secured straight bonds may be ‘‘monitored debt’’ rather than ‘‘public debt’’, as well as bank-guaranteed bonds. 2.3. Issues regarding the data from the late 1980s As discussed above, the regulations and practice were so complicated. They may raise several empirical problems. As argued in Hoshi et al. (1993) it is problematic to use the measure including bank guaranteed bonds because they may be similar to long-term bank loans. It is the same for secured bonds. Even bank guaranteed bonds can be viewed as public debt; we would face a problem to identify a sample of firms because we do not know the criteria for banks to grant guarantees. Basically, firms may have different options if we identify a sample of firms using less stringent criteria, for example, the criteria for issuing secured convertible bonds. Every firm would exactly have identical options if and only if one uses the most restrictive criteria, the criteria for issuing unsecured straight bonds to screen a sample of unconstrained firms. However, this would fail to balance a sample of firms, which is large enough for analysis. Actually, many issues have been addressed in Hoshi et al. (1993). In our understanding, Hoshi et al. (1993) did identify the underlying regulatory constraints and deal with the econometric problems, as carefully as possible. It is the first for them to develop a methodology to screen a sample of Japanese manufacturing firms that were eligible to issue domestic secured convertible bonds in every year from 1982 to 1989. They did carefully confirm that the same criteria were

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forced for issue unsecured convertible bonds in foreign bond markets. The main reason for them to focus on convertible bonds is that convertible bonds were a principal source in the domestic bond market during the late 1980s. Another reason for them to focus on convertible bond, rather than warrant bonds, which were an important source in the late 1980s’ foreign bond markets, is that many warrant bonds were issued with bank guarantee and thus similar to bank loans. To answer a criticism that their measure of debt composition includes bonds with bank guarantees, they show qualitatively similar results for a smaller sample excluding those firms with bank guaranteed bonds. For robustness, finally they analyze a subset of firms, which were allowed to issue unsecured convertible bonds and thus less susceptible to the screening criteria. We believe that the criteria for issuing unsecured straight bonds are too stringent for them to screen a sample of unconstrained firms, even large enough for analysis. As we identified, however, choosing convertible bonds can be mere the artifact of the regulations, rather than free choices of Japanese firms. This is because the criteria for issuing unsecured convertible bonds were less stringent than the criteria for issuing unsecured straight bonds, or unsecured warrant bonds. For instance, firms with net worth less than 55 billion yen, at least dividends per share ¥6 for past 5 years, were allowed to issue unsecured convertible bonds, but neither unsecured straight bonds nor unsecured warrant bonds. Moreover, the eligibility to issue unsecured warrant bonds outside Japan enabled firms to bargain the issuing cost with security houses at home. This essentially reduced the high issuing cost in the domestic market caused by the regulations. Indeed, the total costs were as high as ¥2.24 to issue unsecured straight bonds of ¥100 in the domestic bond market in 1987, while the total issuance fees only cost ¥0.56 in foreign bond markets (Matsuo, 1999; Karp and Koike, 1990). More critically, the high issuing costs in the domestic bond market of the late 1980s may substantially offset the benefits of public debt, in particular, for high-growth firms. This essentially reduced the high issuing cost in the domestic market caused by regulation. To deal with this problem, at least one must control for the effect of eligibility of issuing unsecured straight bonds on bond issuance in the regression, even if the criteria for issuing unsecured straight bonds is not so stringent to screen a sample of unconstrained firms, large enough for analysis. Anderson and Mahkija (1999) identify two samples using the criteria for issuing domestic secured convertible bonds, domestic secured straight bonds, respectively. They find that the use public bond is inversely related to growth opportunities. However, they did not control for the bank guarantee requirement or the collateral requirement while the measure of debt composition includes bank guaranteed bonds and secured bonds. Probably, it is easier for us to control for the effect of collateral. But it is not the case to figure out the criteria for Japanese banks to provide guarantee or to control for it because it is determined endogenously. As a result, their results may be susceptible to their measure or to their screening method. Recently, Miyajima and Arikawa (1999) analyze the use of bonds of Japanese firms in the late 1980s by excluding secured bonds and bank guaranteed bonds because secured bonds and bank guaranteed bonds issued under the regulatory environment of the late 1980s might be different from public bonds. Their findings suggest a positive relation between growth opportunities and the use of unsecured bond. They identify a sample of firms, which qualified to issue unsecured convertible bonds through the late 1980s, while the dummy for eligibility for issuing unsecured straight bonds is not controlled for. In summary, it may be problematic to use the data from the late 1980s even secured bonds, bank guaranteed bonds, and unsecured bonds are carefully identified. The reason is that the criteria were too stringent for empiricists to identify a sample of firms, in which all firms were exactly free to issue any kinds of bonds. Even if it is possible to identify a sample of firms large

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enough for analysis, selection biases can still be problematic, because the sampling excludes many firms, for instance, small and low profitable firms, which would have completely relied on bank debt if it had not been for the regulatory constraints. Because of the data problems addressed above, the deregulation of the late 1980s just provided an opportunity not ripe enough to test the hypotheses on the difference between public debt and bank debt even though it had been viewed as a natural experiment. 2.4. Complete deregulation of Japanese financial markets in the early 1990s The second step of deregulation came in the early 1990s. The accounting criteria were abandoned in 1990. The commissioned bank requirement was removed in 1993. It is substituted with a managing company for bond issuance is required. Unlike a commissioned bank, a managing company for bond issuance explicitly has no obligation to purchase defaulted bonds at price equal to the principal. This critical deregulation renders straight corporate bonds in Japan really different from bank loans since potentially no one can expect a managing company to monitor the issuing company. Therefore, this deregulation ensures us to analyze choice of financing with public debt that is no longer monitored by commissioned banks, or really unmonitored debt versus bank debt. Moreover, the issuing costs in the domestic bond market have substantially declined because the underwriting service market appeared to be more competitive after 1993 since Japanese banks were permitted to enter the underwriting service market through security sub-companies in 1993.2 In detail, the issuing costs of 100 billion of straight bond at home declined to 0.92 billion yen in 1993. Finally, we address the issue concerning with the rating criteria. After 1990, a minimum rating requirement qualifies Japanese firms to issue corporate bonds (Hoshi and Kashyap, 1999). As argued in Anderson and Mahkija (1999), we face the following problems because we use the data from the period over 1993–1997, in the first 3 years the rating criteria were still in effect. However, we do not have the data on ratings. Also, ratings are only observable for firms seeking to issue bonds. Thus we cannot distinguish firms that have chosen not to issue bonds but nevertheless could do so. Fortunately, the practice of bond financing after 1993 suggests that the rating criteria are less likely to be binding. If the rating criteria bound the corporate finance decisions of Japanese firms, we could expect a rush of corporate bond issuance with ratings below BBB or without ratings after 1996, the year when the rating criteria were removed. The aggregated data on the credit rating of straight bonds issued after 1993 shows that there was no such a rush of straight bond issuance with ratings below BBB or without ratings. Indeed, we cannot find even one issuance of bond with a rating below BB or without a rating. This fact suggests that the credit rating criteria were less likely to be binding. Consequently, we believe that it is less problematic without identifying ratings. As discussed above, all binding regulatory constraints on bond issuance were removed after 1993. In other words, Japanese firms were genuinely allowed to enjoy the freedom of corporate financing decisions with public debt versus private debt in the domestic market after 1993, but not in the late 1980s. We believe that the corporate financing data after 1993 ensures us to measure the proportionate use of public debt more accurately and perform Tobit regressions without any selection biases. We expect that Japanese firms with relatively high costs of private debt,

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The four biggest security companies were also permitted to enter the trust banking industry by establishing trust bank departments as sub-companies.

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Fig. 2. The ratio of straight bonds, warrant bonds and convertible bonds issued over 1985–1997. This figure reports the ratio of straight bonds, warrant bonds and convertible bonds issued over 1985–1997. STB/(STB + CBs + WB) means the proportion of straight bonds issued in the sum of straight bonds and convertible bonds and warrant bonds issued. WB/ (STB + CBs + WB) means the proportion of warrant bonds issued in the sum of straight bonds and convertible bonds and warrant bonds issued. CBs/(STB + CBs + WB) means the proportion of convertible bonds issued in the sum of straight bonds and convertible bonds and warrant bonds issued. Electric utility industrial firms are excluded. Source: Japan Securities Dealers Association, 1985–1998.

especially, high growth firms, leave banks to public bond market after substantial declines of transaction costs of public bond issuance in 1993, while firms with high agency costs of debt continue to rely heavily on bank finance. 2.5. Equity-linked bonds versus straight bonds Strictly speaking, the earlier studies on corporate financing choices of Japanese firms in the late 1980s investigated the relation between the proportionate use of equity-linked bonds and firm characteristics, rather than the proportionate use of straight bonds. Fig. 2 also shows that equitylinked bonds were the principle sources of Japanese corporate bonds at home and abroad. Over 1985–1989, 32% of bonds issued were warrant bonds, and 53% were convertible bonds. In sum, the proportion of equity-linked bonds was even as high as 85%. This fact suggests that corporate finance decisions for Japanese firms throughout the late 1980s were also decisions of equity-linked bonds versus bank debt. Consequently, the Japanese corporate finance data from the late 1980s is well suited to the purpose to examine the choice between bank loans and a hybrid of equity and bonds. Following a big decline of the Japanese stock market in 1990, Fig. 2 also shows, as the proportion of straight bond issuance in total bond finance sharply soared from an average 14% during the late 1980s to more than 36%. Meanwhile, the proportion of equity-linked bond issuance in total bond finance during 1993–1997 declined to 39%, from 85% in the late 1980s. Comparing with the composition of bond finance over the late 1980s, the bond finance data over 1993–1997 provides an experiment to examine the choice of corporate financing with straight corporate bonds versus bank loans. Therefore, our empirical finding provides a complement to evidence on corporate financing patterns for Japanese firms with a bull stock market in the late 1980s economic boom. Similarly, as Fig. 1 indicates, the volume of equity issuance (the sum of

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offering to shareholders, public offering, prior stock and private placements) increased sharply from 1985 to 1990. Soon after, there was a big decline in equity issuance.3 Potentially, there are two factors that may affect the change of financing patterns for Japanese firms. First, it is merely the rational response of Japanese firms to the regulatory constraints. As illustrated above, the issuing criteria for convertible bonds were less stringent than the issuing criteria for straight bonds. Another reason is that probably Japanese firms taped the overvalued stock market in the late 1980s. Recently, Kang et al. (1999) find that in long-term the stock prices of Japanese firms that issued equities or equity-linked bonds dropped more than firms without equity finance during the late 1980s. This evidence suggests that Japanese firms with equity finance in the late 1980s can be overvalued. Also Hadlock and James (2002) find that firms who exhibit large preannouncement stock price run-ups are relatively more likely to announce common stock issue. Once, Hoshi et al. (1993) doubted this viewpoint, arguing why equitylinked bond issuance did not dry up soon after a big decline of stock price in 1990. But both convertible bond issuance and warrant bond issuance finally dried up in the late 1990s as the depression staring in the early 1990s persisting. Finally, this shift from equity-linked bonds to straight bonds may be caused by business cycles. Because few firms were allowed to issue unsecured straight bonds under the regulatory environment of the late 1980s, we have to wait for the time ripe for such analysis in the future. 3. Data and empirical results In this section, we develop measures of debt structure as proxies for public debt versus bank debt. Then we describe firm characteristics that influence debt structure of Japanese firms. Finally, we explain econometric method employed to estimate debt structure. The data sources are Nikkei Zaimu CD-ROM and Toyo Keizai Stock Price CD-ROM. Our sample firms are firms listed in the first section of Tokyo Stock Exchange at the end of March 1998. Regulated industries, electric utility, gas, public transportation and telecommunication are excluded. We also exclude firm-years that neither borrowed new bank loans nor issued bonds over 1993–1997. 3.1. Debt issued during 1993–1997 We measure debt structure using corporate financing over 1993–1997. We have discussed reasons why we choose the period 1993–1997, rather than any earlier periods. Furthermore, we use corporate financing over this period, rather than fiscal year 1997 balance sheets, because bonds outstanding contain a considerable volume of bonds issued before 1992. Till 1995, the maturity terms were straight bonds at 6, 7, 10, 12, and 15 years to maturity, and convertible bonds at 6–10, 12 and 15 years to maturity. Moreover, corporate bonds issued by Japanese firms in Japan can be redeemed at maturity or converted to equities but never can be called before maturity till now. If we simply use balance sheets, it will include bonds issued under the very complex regulatory environment before 1992, which were not well suited to our purpose. Indeed, a considerable proportion of firms only have bonds outstanding in 1997 balance sheets were issued before 1993. Out of 640 firms that have bonds outstanding at the end of fiscal year 1997, 140 firms never issued any bonds during the period 1993–1997. For straight bonds, out of 404

3

We thank the referee to point out the issue how equity issuance during the same period was related to the observed change in debt financing patterns.

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firms with straight bonds outstanding, 65 firms issued neither straight bonds nor warrant bonds during this period. Obviously, measures using fiscal year 1997 balance sheets may overestimate the use of public debt and thus underestimate the reliance on bank debt. No call provisions can still cause another following problem. Even though the proportionate use of public bonds cannot be adjusted immediately, a firm whose agency costs of debt have risen will turn to a bank and call some of bonds outstanding. Without call provisions, however, a Japanese firm fails to substitute some or all bonds outstanding with bank loans, unless the bonds are at maturity. At least, no call provisions slow-down such substitution. Meanwhile, a firm can easily adjust its debt structure by substituting bank loans, in particular, short-term bank loans with public bonds. For this irreversibility of debt structure in short run, the inference based on examining balance sheets can be problematic since public bonds outstanding do not reflect the current choice of financing with public debt and bank debt. Perhaps, it sometimes reflects the financing decisions at a maximum 15 years ago. As argued in Hadlock and James (2002), cross sectional differences in the use of bank debt at a fixed point in time are more likely to reflect past information problems as well as agency costs. Also, Hori and Osano (2002) investigate the choice of bonds newly issued versus long-term bank loans newly borrowed for Japanese firms in fiscal year 1998, rather than debt composition at a fixed point in time. Recently, Denis and Mihov (2003) examine the choice among bank debt, nonbank debt and public debt, using new debt financing data. In contrast, the choice of corporate financing with public debt versus bank debt over a period is relatively flexible. Suppose that a firm needs outside funds. It can borrow loans, particularly, short-term loans from banks. And it can also issue public bonds. The choice depends on firm characters. For example, according to Rajan (1992) and Diamond (1991) a firm will prefer public bonds to bank loans as long as the quality is high whereas a low quality firm will continue to

Fig. 3. Debt composition outstanding of Japanese firms from 1992 to 1997. This figure reports the means and medians of debt structure over 1992–1997. Debt composition is measured using the fiscal years 1992–1997 balance sheets. Bonds mean straight bonds and convertible bonds and warrant bonds outstanding. Bonds/(bonds + loans) means the proportion of bonds outstanding in the volume of bonds outstanding and loans outstanding. Loans/debt means the proportion of loans outstanding in the volume of debt outstanding. Straight bonds/(bonds + loans) means the proportion of straight bonds outstanding in the volume of bonds outstanding and loans outstanding. The sample consists of observations of 1026 Japanese firms listed in the first section of Tokyo Stock Exchange at the end of fiscal year 1997. Regulated industrial firms are excluded. Source: Authors’ calculations using Nikkei-Zaimu CD-ROM.

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

405

borrow short-term loans from its bank. Therefore, using the data on Japanese firms’ corporate financing over 1993–1997 enable us to focus on the choice of corporate financing with public bonds versus bank loans when outside funds are at need over this period. Indeed, there are substantial differences between the compositions of new debt raised at each year and debt outstanding. Fig. 3 and Table 1, respectively, show statistics on the composition of debt outstanding over 1993–1997 and the newly raised debt’s composition averaged during 1993–1997. Surprisingly, many Japanese firms U-turned to bank debt during 1993–1997. At the end of fiscal year 1992 the median of bonds outstanding to the sum of bonds and loans outstanding is as high as 41.9%. But the median of the ratio of bonds issued to total debt issued is only 5.53%. Due to a rapid decline of warrant bond issuance in foreign markets, the median of straight bonds issued/(straight bonds issued + new loans) ratio, in which the underlying bonds of warrant bonds are accounted as straight bonds, is as low as 0. This means that more than 50% of Japanese firms issued neither straight bonds nor warrant bonds throughout these 5 years. As a result, the median proportion of bonds outstanding in bonds outstanding plus loans outstanding dropped to 21.9% in fiscal year 1997, from 41.19% in fiscal year 1992. The U-turn to bank debt also suggests the relationship between business cycles and the choices of straight bonds versus Table 1 Descriptive statistics of debt structure and firm characteristics Mean Debt structure (average over 1993–1997) Bonds/(bonds + loans) 0.20750 Bonds/(bonds + long-term 0.40548 loans) Bonds/(bonds + short-term 0.23657 loans) Straight bonds/(straight 0.13023 bonds + loans) Straight bonds/(straight 0.28566 bonds + long-term loans) Straight bonds/(straight 0.15342 bonds + short-term loans) Loans/debt 0.2942 Other variables (average over 1992–1996) Firm quality 1.4054 (market to book ratio) Firm size (log(assets)) 11.7262 Tangible asset ratio 0.4875 (tangible assets/liabilities) Leverage ratio (total 0.6127 debt/total assets) Coverage ratio < 2 0.1908

Standard Minimum Q1 deviation

Median

Q3

Maximum Sample size

0.29835 0.40173

0 0

0 0

0.0553 0.3411

0.8134 0.3680

1 1

938 875

0.32336

0

0

0.0714

0.1443

1

922

0.24490

0

0

0

0.5812

1

916

0.36771

0

0

0

0.1802

1

829

0.27447

0

0

0

0.4391

1

896

0.2099

0

0.1186

0.2729

0.3039

0.8947

938

0.3260

0.8269

1.1893

1.3369

1.5374

4.1161

938

1.1712 0.3650

8.9269 0.0027

10.8880 11.5422 12.4330 15.6857 0.2699 0.4421 0.6231 4.8213

938 938

0.1760

0.1162

0.4882

0.6197

0.7432

0.9742

938

0.3932

0

0

0

0

1

938

This table reports the means and medians of debt structure over the fiscal years 1993–1997 and firm characteristics over the fiscal years 1992–1996. Firms that neither issued bonds nor borrowed new loans are excluded. Debt structure is measured using bonds issued and loans newly borrowed during 1993–1997. All variables are averaged over 1993–1997. Other variables averaged over the fiscal years 1992–1996. Firm Quality is the average ratio of sum of market stock price and book debt, divided by total book assets. Firm Size is the logarithm of average book value assets. Tangible asset ratio is the average ratio of tangible fixed assets to total liability. Leverage ratio is the average ratio of total debt to total assets. Coverage ratio < 2 is a dummy variable equals 1 if the 1992–1996 average ratio of operation income before depreciation to total interest expense is less than 2.

406

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equity-linked debt is emerging an important future agenda. Moreover, Table 1 shows that the mean bonds/(bonds + loans) is 0.207 and the mean bonds/(bonds + short-term loans) is 0.236. This means that that most banks loans are short-term loans. It is consistent with the characterizations of bank loans in Rajan (1992) and Diamond (1993). In Diamond (1991), however, bank loans, directly placed public debt last only one period as well as all projects.4 Which firms U-turn to banks regardless of complete deregulation for bond issuance? Which firms continue to use more public debt during these 5 years? In next section, we present our empirical results to answer the above questions. We also show that our results are very robust to choices of period. First, we split the period 1993–1997 to two sub-periods, 1993–1995 and 1996– 1997. This is because during 1993–1995 the rating criteria were still in effect while in the second period all regulations are removed, as discussed above. Also, our main results are similar when we use an alternative measurement for debt composition. 3.2. High quality Japanese firms are leaving Japanese private lenders to public bond markets Table 2 reports Tobit regressions for each measures of debt structure. We use two-sided Tobit regressions that have been generally employed in empirical studies on the choice of the mix between public debt and bank debt because each debt structure measure has the upper threshold value of 1 and a lower threshold value of 0. However, all results are unaffected when we use ordinary lease squares regressions. Since short-term bank loans may be high costly due the holdup problem for high growth firms, we include measures for bonds to bonds and short-term loans, straight bonds to straight bonds and short-term loans as well as long-term loans. In this paper, we focus on the influences of firm quality and collateral on debt structure while controlling for other firm characteristics such as firm size, leverage, the product of market to book ratio and ratio of bonds issued before 1993. In theoretical studies, the costs of private debt are especially high for high quality, or high growth firms (Sharpe, 1990; Diamond, 1991; Rajan, 1992). So far, the high issuance costs of public debt due to the regulatory systems in Japan have prevented Japanese firms from enjoying the benefits of public debt. However, such costs decreased much after critical binding regulations were removed in the early 1990s. In contrast, the offsetting costs of private debt does not change so much after 1993. Given the agency costs of debt, we reasonably conjecture that the benefits of public debt for high quality firms are relatively higher during 1993–1997 than that in the late 1980s. Our measure for firm quality is the average market to book ratio over 1993–1997. As panel A in Table 2 shows, market to book ratio has significant positive coefficients at the 1% level for each measure of the mix between public debt versus bank debt. We also find that high quality firms use less bank debt. Notably, our paper is the first to examine that high quality Japanese firms use more public debt. We achieved substantially different results from that of extant studies that examine the corporate financing of public debt versus bank debt in Japanese firms over the late 1980s or the early 1990s. As shown in panel A of Tables 3 and 4, the results are qualitatively similar. This strongly suggests that the finding is very robust; high quality firms proportionately use more public debt. Our findings support the hypothesis that high quality

4 In this paper we analyze the choice between short-term bank debt and long-term corporate bonds. It is possible that the choice of short-term bank debt is at least in part driven by a maturity preference in addition to a preference for debt source. However, we do not have detailed data for debt maturities and thus we leave this question for future research.

Table 2 Two sided Tobit regressions of public debt ratio and bank loan ratio using flow data, 1993–1997 Dependent variables

Firm quality Firm size Leverage ratio Coverage ratio < 2 Tangible assets ratio Disturbance standard deviation Sigma Log-likelihood-function

916 1.698 *** 7.400 0.167 *** 2.974 0.155 *** 10.031 0.579 *** 4.286 0.249 *** 4.732 0.131 ** 1.993 0.437 23.996 532.05

0.664 22.501 663.473 2.422 *** 6.658 0.269 *** 2.950 0.248 *** 10.206 1.008 4.624 0.490 *** 6.111 0.330 *** 3.021

896 1.880 *** 7.025 0.176 *** 2.668 0.174 *** 9.703 0.680 *** 4.293 0.267 *** 4.426 0.099 1.309 0.505 23.354 586.063 1.880 *** 7.028 0.177 *** 2.679 0.174 *** 9.710 0.687 *** 4.326 0.267 *** 4.421 0.103 1.357

938 0.921*** 4.342 0.194*** 3.737 0.119*** 8.151 0.868 *** 6.802 0.314*** 6.282 0.219*** 3.564 0.448 27.672 628.696 0.921*** 4.341 0.194*** 3.733 0.119*** 8.148 0.866*** 6.779 0.314*** 6.283 0.218*** 3.545

875 0.012*** 3.182 0.242*** 3.031 0.170*** 7.914 1.231*** 6.377 0.585*** 8.130 0.430*** 4.515 0.640 25.470 770.573 1.012*** 3.183 2.414*** 3.026 0.170*** 7.912 1.229*** 6.350 0.585*** 8.131 0.429*** 4.495

922 0.938*** 3.930 0.193*** 3.277 0.127*** 7.813 0.978*** 6.773 0.338*** 6.093 0.184*** 2.683 0.499 26.959 679.843 0.938*** 3.929 0.193*** 3.271 0.127*** 7.809 0.975*** 6.739 0.338*** 6.094 0.182*** 2.648

938 0.132*** 1.835 0.062*** 3.531 0.025*** 5.161 0.676*** 16.021 0.180*** 11.825 0.194*** 10.337 0.168 41.809 277.805 0.134*** 1.880 0.061*** 3.505 0.025*** 5.162 0.667*** 15.864 0.179*** 11.806 0.188*** 10.006

407

Panel B: including the affiliation with a defaulted bank dummy Intercept 0.170 7.405 Firm quality 0.168 2.988 Firm size 0.155 10.040 Leverage ratio 0.586 4.327 Coverage ratio < 2 0.248 4.723 Tangible assets ratio 0.135 2.043

829 2.422 *** 6.659 0.267 *** 2.932 0.247 *** 10.198 0.995 *** 4.583 0.491 *** 6.130 0.324 *** 2.978

(5) Bonds (6) Bonds (7) Bank to bonds and to bonds and loans to long-term loans short-term loans debt

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Panel A: basic Sample size Intercept

(1) Straight bonds (2) Straight bonds (3) Straight bonds (4) Bonds to straight bonds to straight bonds to straight bond and to bonds and loans and long-term loans short-term loans and loans

408

Table 2 (Continued ) Dependent variables

Affiliation with a defaulted bank dummy

Log-likelihood-function

0.059 0.716

0.094 0.729

0.057 0.597

0.013 0.156

0.017 0.141

0.029 0.316

0.437 23.994 531.8

0.664 22.500 663.208

0.505 23.353 585.885

0.447 27.670 628.684

0.640 25.470 770.563

0.499 26.958 679.793

PANEL C: including the financial affiliation dummy Intercept 1.713*** 7.437 Firm quality 0.170*** 3.016 Firm size 0.156*** 10.049 Leverage ratio 0.564*** 4.126 Coverage ratio < 2 0.250*** 4.752 Tangible assets ratio 0.130** 1.977 Financial affiliation dummy 0.026 0.735 Disturbance standard deviation Sigma Log-likelihood-function

(5) Bonds (6) Bonds (7) Bank to bonds and to bonds and loans to long-term loans short-term loans debt

0.437 23.992 531.780

Panel D: including the industrial affiliation dummy Intercept 1.694*** 7.374 Firm quality 0.167*** 2.967 Firm size 0.155 ***

2.438*** 6.653 0.270*** 2.954 0.248*** 10.149 0.984*** 4.490 0.492*** 6.138 0.324*** 2.972 0.020 0.365 0.664 22.501 663.406 2.423*** 6.657 0.267*** 2.933 0.247***

1.905*** 7.101 0.180*** 2.736 0.176*** 9.769 0.653*** 4.085 0.268*** 4.458 0.098 1.293 0.046 1.142 0.504 23.349 585.412 1.877*** 7.005 0.175*** 2.664 0.173***

0.933 *** 4.375 0.196 *** 3.767 0.120 *** 8.159 0.856 *** 6.622 0.314 *** 6.294 0.218 *** 3.546 0.018 0.542 0.447 27.668 628.549 0.939 *** 4.424 0.197 *** 3.788 0.119 ***

1.014 *** 3.164 0.242 *** 3.023 0.170 *** 7.852 1.230 *** 6.300 0.585 *** 8.130 0.430 *** 4.513 0.002 0.044 0.640 25.469 770.572 1.037 *** 3.260 0.245 *** 3.078 0.171 ***

0.962 *** 4.013 0.197 *** 3.340 0.129 *** 7.879 0.954 *** 6.530 0.339 *** 6.118 0.182 *** 2.658 0.038 1.016 0.498 26.955 679.328 0.960 *** 4.014 0.196 *** 3.326 0.128 ***

0.088 *** 3.184 0.167 41.809 282.842 0.144 *** 1.991 0.064 *** 3.631 0.026 *** 5.294 0.665 *** 15.539 0.181 *** 11.877 0.193 *** 10.249 0.016 1.444 0.168 41.813 278.847 0.143 ** 1.985 0.638 *** 3.634 0.257 ***

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Disturbance standard deviation Sigma

(3) Straight bonds (4) Bonds (1) Straight bonds (2) Straight bonds to straight bonds to straight bonds to straight bond and to bonds and loans and long-term loans short-term loans and loans

Leverage ratio Coverage ratio < 2 Tangible assets ratio Industrial affiliation dummy

Log-likelihood-function ***

0.437 23.994 532.007

10.197 0.995 *** 4.583 0.491 *** 6.127 0.324 *** 2.978 0.006 0.066 0.664 22.500 663.470

9.690 0.680*** 4.290 0.267*** 4.429 0.099 1.309 0.014 0.197 0.505 23.353 586.043

8.186 0.863*** 6.783 0.311*** 6.228 0.218*** 3.547 0.076 1.396 0.447 27.672 627.726

7.943 1.225*** 6.358 0.581*** 8.091 0.430*** 4.521 0.125 1.540 0.639 25.473 769.391

7.854 0.975 *** 6.764 0.335 *** 6.037 0.183 *** 2.673 0.087 1.421 0.498 26.960 678.8385

5.234 0.676*** 16.080 0.178*** 11.746 0.194*** 10.364 0.050*** 2.660 0.167 41.817 281.3363

Significant at the 0.01 level, ** significant at the 0.05 level, significant at the 0.1 level. This table presents results of regressions of public debt ratio and bank loan ratio is measured sum of the 1993–1997 fiscal year issuing data. Explanatory variables averaged over the fiscal years 1992–1996. Firm quality is the average ratio of sum of market stock price and book debt, divided by total book assets. Firm size is the logarithm of average book value assets. Leverage ratio is the average ratio of total debt to total assets. Coverage ratio < 2 is a dummy variable equals 1 if the 1992–1996 average ratio of operation income to total interest expense is less than 2.0. Tangible asset ratio is the average ratio of tangible fixed assets to total liability. Affiliation with a defaulted bank dummy is a dummy variable equals 1 if the firms have close ties with three Japanese banks that defaulted or be were nationalized, Hokkaido Takusyoku Bank, The Nippon Credit Bank and Long-Term Credit Bank of Japan. Financial affiliation dummy is a dummy variable equals 1 if the firms are affiliated with Japanese financial groups according to the Dodwell definition. Industrial affiliation dummy is a dummy variable equals 1 if the firms are affiliated with Japanese industrial groups according to the Kigyo Keiretsu Soran definition. Firm-years that neither borrowed new loans nor issued bonds during 1993–1997 are excluded. Coefficient t-statistics are in lower rows.

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Disturbance standard deviation Sigma

10.018 0.579 *** 4.284 0.249 *** 4.738 0.131 ** 1.994 0.018 0.293

409

410

Table 3 Two sided Tobit regressions of public debt ratio and bank loan ratio using flow data, 1993–1995 Dependent variable

Firm quality Firm size Leverage ratio Coverage ratio < 2 Tangible assets ratio Disturbance standard deviation Sigma Log-likelihood-function

903 2.159*** 6.357 0.212*** 2.621 0.178*** 7.978 0.570*** 2.931 0.241*** 3.853 0.197** 2.037 0.586 20.006 562.381

(2) Straight bonds to straight bonds and long-term loans 785 2.992 *** 5.438 0.352 *** 2.586 0.284 *** 7.890 1.174 *** 3.655 0.461 *** 4.663 0.470 *** 2.878 0.904 18.398 644.091

Panel B: including the affiliation with a defaulted bank dummy 2.990 *** Intercept 2.161*** 6.363 5.438 0.354 *** Firm quality 0.213*** 2.635 2.603 Firm size 0.179*** 0.284 *** 7.990 7.904 1.194 *** Leverage ratio 0.581*** 2.980 3.706 Coverage ratio < 2 0.242*** 0.461 *** 3.858 4.662 Tangible assets ratio 0.204** 0.481 *** 2.103 2.939

(3) Straight bonds to straight bond and short-term loans 880 2.43 *** 6.225 0.242*** 2.605 0.201*** 7.878 0.675*** 3.007 0.254*** 3.568 0.167 1.516 0.665 19.267 594.441 2.429*** 6.229 0.244*** 2.619 0.201*** 7.888 0.686*** 3.052 0.254*** 3.575 0.175 1.587

(4) Bonds to bonds and loans 920 1.282*** 4.272 0.244*** 3.406 0.137*** 6.790 0.798*** 4.482 0.385*** 6.496 0.375*** 4.123 0.580 23.163 664.302 1.283*** 4.272 0.245*** 3.412 0.137*** 6.793 0.802*** 4.498 0.385*** 6.501 3.776*** 4.142

(5) Bonds to bonds and long-term loans 825 1.389 *** 2.953 0.317 *** 2.728 0.200 *** 6.395 1.359 *** 4.790 0.686 *** 7.582 0.717 *** 4.924 0.859 20.783 752.663 1.387 *** 2.949 0.318 *** 2.738 0.200 *** 6.400 1.369 *** 4.811 0.686 *** 7.585 0.723 *** 4.947

(6) Bonds to bonds and short-term loans 899 1.371*** 4.072 0.261*** 3.242 0.149*** 6.626 0.906*** 4.501 0.406*** 6.184 0.346*** 3.380 0.642 22.419 696.076 1.371*** 4.073 0.262*** 3.247 0.149*** 6.628 0.910*** 4.513 0.407*** 6.187 0.349*** 3.397

(7) Bank loans to debt 920 0.132 * 1.772 0.065 *** 3.607 0.022 *** 4.445 0.610 *** 14.284 0.183 *** 13.566 0.173 *** 9.209 0.168 41.416 271.801 0.135 * 1.823 0.065 *** 3.597 0.022 *** 4.446 0.602 *** 14.130 0.182 *** 13.556 0.167 *** 8.862

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Panel A: basic Sample size Intercept

(1) Straight bonds to straight bonds and loans

Affiliation with a defaulted bank dummy Disturbance standard deviation Sigma Log-likelihood-function

0.102 0.881

0.153 0.845

0.105 0.803

0.048 0.438

0.083 0.499

0.043 0.357

0.587 20.005 561.997

0.903 18.399 643.737

0.666 19.265 594.122

0.580 23.161 664.207

0.859 20.784 752.539

0.642 22.416 696.013

0.080 *** 2.893 0.167 41.415 275.964

***

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Significant at the 0.01 level, **Significant at the 0.05 level, *Significant at the 0.1 level. This table presents results of regressions of public debt ratio and bank loan ratio over fiscal years 1993–1995. Explanatory variables are average from fiscal years 1992–1994. Firm Quality is the average ratio of sum of market stock price and book debt, divided by total book assets. Firm Size is the logarithm of average book value assets. Leverage ratio is the average ratio of total debt to total assets. Coverage ratio < 2 is a dummy variable equals 1 if the 1992–1996 average ratio of operation income to total interest expense is less than 2.0. Tangible asset ratio is the average ratio of tangible fixed assets to total liability. Affiliation with a defaulted bank dummy is a dummy variable equals 1 if the firms have close ties with three Japanese banks that defaulted or be were nationalized, Hokkaido Takusyoku Bank, The Nippon Credit Bank and Long-Term Credit Bank of Japan. Firm-years that neither borrowed new loans nor issued bonds during 1993–1997 are excluded. Coefficient t-statistics are in lower rows.

411

412

Table 4 Two sided Tobit regressions of public debt ratio and bank loan ratio using flow data, 1996–1997 Dependent variable

Firm quality Firm size Leverage ratio Coverage ratio < 2 Tangible assets ratio Disturbance standard deviation Sigma Log-likelihood-function

875 3.135*** 8.963 0.172** 2.334 0.221*** 9.277 0.157 0.783 0.362*** 4.140 0.092 0.982 0.561 17.733 447.853

Panel B: including the affiliation with a defaulted bank dummy Intercept 3.134*** 8.964 Firm quality 0.172** 2.337 Firm size 0.221 9.278 Leverage ratio 0.159 0.790 Coverage ratio < 2 0.361*** 4.137 Tangible assets ratio 0.091 0.972

716 4.510 *** 7.433 0.263 * 1.941 0.368 *** 8.942 0.817 ** 2.206 0.687 *** 4.682 0.045 0.249 0.928 16.012 521.680 4.513 ** 7.435 0.265 * 1.950 ***

8.943 0.820 ** 2.213 0.686 *** 4.674 0.046 0.257

855 3.645*** 8.887 0.198** 2.299 0.257*** 9.211 0.171 0.729 0.412*** 4.075 0.147 1.368 0.648 17.083 477.572 3.647*** 8.887 0.198** 2.299 0.368*** 9.221 0.172 0.731 0.412*** 4.074 0.147 1.361

891 2.247*** 7.031 0.148** 2.042 0.178*** 7.946 0.396** 2.096 0.406*** 4.910 0.065 0.743 0.606 20.787 595.796 2.247*** 7.031 0.147** 2.032 0.257*** 7.945 0.393** 2.073 0.406*** 4.911 0.067 0.762

757 2.826 *** 5.172 0.216 * 1.670 0.278 *** 7.426 1.132 *** 3.332 0.724 *** 5.356 0.115 0.706 0.972 18.167 674.204 2.824 *** 5.169 0.215 * 1.656 0.178 *** 7.425 1.128 *** 3.318 0.725 *** 5.359 -0.113 -0.695

875 2.521*** 6.971 0.158* 1.928 0.200*** 7.944 0.444** 2.071 0.452*** 4.872 0.104 1.059 0.677 20.034 624.921 2.521*** 6.971 0.157* 1.915 0.278*** 7.942 0.439** 2.042 0.452*** 4.873 0.107 1.085

891 0.207 *** 2.862 0.047 *** 2.802 0.031 *** 6.093 0.667 *** 15.379 0.175 *** 10.563 0.196 *** 9.710 0.173 41.176 252.359 0.208 *** 2.892 0.045 *** 2.743 0.200 *** 6.104 0.658 *** 15.257 0.173 *** 10.531 0.190 *** 9.437

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Panel A: basic Sample size Intercept

(1) Straight bonds (2) Straight bonds (3) Straight bonds (4) Bonds to (5) Bonds to (6) Bonds (7) Bank to straight bonds to straight bonds to straight bond bonds and bonds and to bonds and loans to and loans and long-term loans and short-term loans loans long-term loans short-term loans debt

Affiliation with a defaulted bank dummy 0.017 Disturbance standard deviation Sigma Log-likelihood-function

0.017 0.138

0.048 0.226

0.008 0.054

0.038 0.302

0.053 0.257

0.058 0.416

0.561 17.733 447.843

0.928 16.012 521.653

0.648 17.083 477.570

0.606 20.788 595.750

0.972 18.167 674.171

0.677 20.034 624.835

0.100 *** 3.494 0.172 41.178 258.424

***

Y. Shirasu, P. Xu / Japan and the World Economy 19 (2007) 393–424

Significant at the 0.01 level, **Significant at the 0.05 level, *Significant at the 0.1 level. This table presents results of regressions of public debt ratio and bank loan ratio over fiscal years 1996–1997. Explanatory variables are average from fiscal years 1995 to 1996.

413

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Japanese firms use less bank loans as argued in Rajan (1992) and Diamond (1991) when the critical binding regulatory constraints were removed after 1993. In particular, Diamond (1991) suggests that in economy-wide times of distress, the proportion of loans will increase relative to public debt. The late 1990s prolonging recession in Japan is an economy-wide time of distress described in Diamond (1991). This is one of the reasons why many firms U-turn to banks in regardless of complete deregulation for bond issuance in Japan.5 In contrast, Anderson and Mahkija (1999) find an inverse relation between growth opportunities and the proportion of private debt during the late 1980s when Japanese firms were still facing complicated regulatory constraints. Now we discuss the potential reasons why the influence of firm qualities or growth opportunities in our paper is substantially different from their findings. As discussed above, their results may be susceptible to their sampling methodology, which provides a sample firms that exactly had different options of corporate financing, due the regulatory constraints in the late 1980s in the last section. For instance, some firms which are qualified to issue both unsecured straight bonds and unsecured convertible bonds, some of them are only eligible to issue unsecured convertible bonds but not unsecured straight bonds and the rest of them are only allowed to issue secured convertible bonds. If we take their results at face value, moderate quality firms are more likely to use equitylinked public debt than high quality firms are, in the booming stock market of the late 1980s. Stein (1992) hypothesizes that high quality firms prefer straight debt to convertible bonds, equity finance, middle quality firms prefer convertible bond finance to straight debt, equity finance, and low quality firms tend to issue equities. Considering most bonds issued in the late 1980s are equity-linked bonds, the debt compositions for Japanese firms are not only choices between public debt and private debt, but choices between equity-linked bonds and straight bonds. The inverse relation between the proportionate use of public debt and growth opportunities in Anderson and Mahkija (1999) may reflect the fact that high quality firms choose straight bonds to private debt while moderate quality firms prefer equity-linked bonds to straight debt. This is because the regulations in the late 1980s only allow high and moderate quality firms to issue public bonds. Consequentially, the relation between growth opportunities and proportions of equity-linked public bonds to bank loans may have little to do with the hold-up hypothesis. Finally, we discuss the possibility for Japanese banks to hold-up borrowing firms. The key word for investigations of the hold-up hypothesis is information monopolies (Sharpe, 1990; Rajan, 1992). Houston and James (1996) find the same relation between bank debt ratio for U.S. firms borrowing from a single bank but not for U.S. firms borrowing from multiple banks. If a firm borrows from a single bank, the bank is more likely to have information monopoly power to hold-up the firms than a case where the firm borrows from multiple banks. Indeed, Houston and James (1996) find evidence that borrowing from multiple banks mitigate the hold-up problem. In Japan, borrowing form multiple banks is very common (Aoki and Patrick, 1994). So Anderson and Mahkija (1999) argue that the hold-up problem is less likely. However, borrowing from multi-banks does not straightly imply that there are no information monopolies. It depends how many banks monitor a borrowing firm and how difficult for new competing lenders to acquire information ex post. In the context of the main bank theory, all private lenders such as banks, life insurance companies delegate monitoring to the main bank. Therefore, the main bank does have information monopoly power. And Aoki and Sheard (1992) argue that Japanese banks receive the

5

We thank the anonymous referee recommending to link our results and Diamond (1991)’s empirical implications more prominently.

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residual when the profits of a borrowing firm drops to a lower region. Also, it is possible for Japanese banks to force Japanese firms to sell high risky but profitable assets in financial distresses, unless the bank owns all shares. In support of this view point, Nakatani (1984) and Weinstein and Yahe (1998) find that Japanese firms affiliated with banks are low risky and low profitable. Similarly Hori and Osano (2002) examine that Japanese firms with lower Tobin’s q are less likely to use straight bonds. Also, Hadlock and James (2002) find that U.S. firms with higher market to book ratios are more prone to use public debt. 3.3. Collateral and debt structure of Japanese firms Usually, bank debt in Japan is secured (Corbett, 1987; Sheard, 1994). Indeed, a huge volume of bad loans of Japanese banks is one of the results of the sharp drop of land price in Japan. This is because historically land holdings have been used as collateral for bank loans. We measure the ratio of tangible assets to the sum of bank loans and bonds as a proxy for collateral and then average the ratios over 1993–1997. Table 2 indicates that firms with high ratios of tangible assets to total liability use more private debt versus public debt. Similarly, wealthy firms have high proportions of private debt in total debt. We provide new evidence on Japanese banks’ lending behavior. Splitting the period to two sub-periods 1993–1995 and 1996–1997, we find that tangible asset ratios are significant during 1993–1995 but not significant for any measures of debt structure during 1996–1997. But the effect of tangible asset ratios on bank debt in total debt remains similar for the two sub-periods. This finding is quite different from the extant findings. Hoshi et al. (1993) find that wealthy Japanese firms use more public debt for a sample of firms, which cleared the accounting criteria for non-secured bond issuance in the late 1980s. Their findings reflect such artifacts of the regulations in the late 1980s, when Japanese firms were allowed to issue unsecured bonds but the approval criteria were still restrictive. This is the very reason why we achieved a different result from Hoshi et al. (1993). No proxies for collateral are included in explanatory variables in Anderson and Mahkija (1999)’s empirical analysis, however. Recently, the fixed asset ratio is positively related to the probability of issuing public bonds for U.S. firms, as examined in Denis and Mihov (2003). In the literature of corporate finance, both priority and maturity of debt play important roles in corporate governance (Diamond, 1993). Actually, most public debt in Japan is long-term, usually at maturity of 5 years or longer. Traditionally, Japanese banks, in particular commercial banks provide short-term loans and roll them over (Suzuki and Wright, 1985; Hoshi et al., 1990a,b; Sheard, 1994). The above evidence may suggest that maturity and seniority in Japanese firms is determined consistently with Diamond (1993)’s argument that short-term bank loans is senior to long-term public bonds. Also, our findings are also consistent with Diamond and Rajan (2000, 2001) that collateral is important in the relationship lending. Anderson and Mahkija (1999) argue that another characteristic of Japanese bank lending that works against hold-up is the ambiguous priority of Japanese bank loans. Certainly, Japanese banks accept disproportionate shares of write-offs to help a borrower in financial distress to restructure. Virtually, however, Japanese banks forgive only unsecured loans when a borrower is in financial distress (Xu, 2005). Thus write-offs of unsecured loans do not mean the ambiguity of bank loans’ priority, unless banks write off some secured loans. More importantly, it is critical whether priority violation for secured claims occurs in bankruptcy resolution. Recently, however, it is found that priority for secured claims is less likely to be violated in Japan as well as in U.S. (Xu, 2004; Weiss, 1990).

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Rather, the behavior of Japanese banks’ write-offs of unsecured loans till the late 1980s is nothing more than the exchange for future regulatory rents. It is in support of hold-up hypothesis rather than against it. Indeed, Rajan (1992) argues that a bank with information monopoly power extract rents from a borrowing firm in financial distress, threatening to liquidate. As analyzed in theoretical studies, however, there is a difference between having rights to liquidate a profitable firm and having incentives to do so. In other words, Japanese bank lenders’ decision to rescue financially distressed borrowers has nothing to do with the point of view that Japanese banks are less likely to hold-up borrowing firms. In short, high priority of bank loans may give Japanese banks strong renegotiation powers to liquidate, or to restructure a borrower in financial distress. Our new evidence on collateral and debt structure in Japanese firms sheds new light to the study on bank–firm relation in Japan. 3.4. Firms with high bankruptcy probabilities use more private debt In this paper, we also control for firm size, leverage and low coverage ratio as proxies for agency costs of debt. These variables have been widely used in empirical studies. First, firm size could be a good proxy to count firm reputations argued in Diamond (1991). Most giant Japanese firms have succeeded from 1960s and have good reputations. It is also observed that usually giant Japanese firms have higher ratings than middle or small firms giving other conditions. It can be also interpreted as greater fixed costs associated with public debt issues. Comparatively, it is cheaper for a large firm to issue a large amount of bonds each time. As a result, large firms are more prone to issue public debt. In addition, large firms have good portfolios of product and thus their debt is less risky than small firms. We use the natural log of book value of assets (firm size) as the proxy for firm size in our analysis. On the other hand, high leveraged firms have relatively high likelihood of financial distress. Thus using more public debt is more costly due to re-negotiation in financial distresses. And Jensen and Meckling (1976) also argued that high leveraged firms also have strong incentives to transfer wealth form creditors to insiders by investing in risky projects. Most importantly, the Japanese commercial law still states that the total outstanding public corporate bond volume of a corporation could not exceed the double of its net wealth (assets minus liability). Then, leverage ratio can also help to capture how this legal regulation reduces the proportionate use of public bonds of Japanese firms. Because this legal regulation is based on book value leverage ratio, we use book value based leverage, the ratio of debt to assets as an explanatory variable. We expect high leveraged firms use more bank loans than public bonds. Similarly, the lower the cash flow, the higher the likelihood of financial distress is. When the coverage ratio of a firm is below a critical point, creditors need to monitor the firm more intensively, and renegotiate with the manager to change management direction. Unlike U.S. banks, Japanese banks are allowed to involve deeply in financial distress. In fact, usually new directors from banks are appointed in proximity of financial distress. Consequentially, we expect that firms with lower coverage ratio use more private debt than public debt. We measure the ratio of operating income to total interest expense. Consistently with our prediction, we find that proxies for the agency costs of debt are significantly related to debt compositions. First, our results suggest that large firms are more likely to use more public debt, and less private debt as shown in Table 2. Anderson and Mahkija (1999) also indicate that large Japanese firms tend to use more public debt. Similarly, Houston and James (1996) find the same effect of firm size for U.S. firms. Hoshi et al. (1993), however, find that firm size is statistically insignificant when it is included in the variables. Recently

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Hadlock and James (2002), Denis and Mihov (2003) examine that firm size is positively related to issuing public bonds. Table 2 also indicates that leverage ratios reduce public debt use and increase private debt use significantly. Both Anderson and Mahkija (1999) and Hoshi et al. (1993) report that high leveraged Japanese firms use more private debt. Houston and James (1996) and Hadlock and James (2002) find similar relations for U.S. firms. We also find that firms with lower coverage ratios use more private debt. Houston and James (1996) and Anderson and Mahkija (1999) provide the same evidence for U.S. firms and Japanese firms respectively. Recently, Denis and Mihov (2003) find that firms facing a high likelihood of bankruptcy, measured by an Altman Zscore, are more likely to borrow privately. In short, the positive relation between private debt use and leverage ratio, low coverage ratio is consistent with literature on agency costs of debt. In other words, risk-premiums in the Japanese public bond market seem higher than the monitoring costs of banks. As we addressed above, we cannot find even one bond issuance with credit rating of BB or lower after rating criteria were removed. Consequentially, the only one choice for a high agency cost firm is to rely on private debt because Japanese firms of high leverage ratios, low coverage ratios are less likely to get credit ratings of BBB or higher. 3.5. Do Japanese bank failures affect Japanese firms’ debt structure? Another factor that increases the offsetting costs of private debt is the national wide shortages of bank capital in Japan. Recently, Diamond and Rajan (2000, 2001) argue that relationship lending through intermediates resolves the liquidity problem. But when a bank does not have a fragile capital structure, it fails to provide liquidity and thus depositors who are facing a shock of discount rate may directly liquidate a firm though the liquidation is inefficient. After 1990, Japanese banks have suffered from bad loans that were lent secured by real estates. In Hoshi and Kashyap (1999), it is noted that estimated bad loans are 7% of Japanese GDP at the end of 1998. Almost all commercial banks in Japan are suffering from bad loans after rapid drop of Japanese land prices and stock prices from 1990. Under such troubled banking system, Japanese firms, especially high quality Japanese firms may feel it troublesome and burdensome to borrow from Japanese banks as well as other Japanese private lenders. We examine the effect of bank capital shortages in Japan on debt structure of Japanese firms as follows. First, we include a dummy for firms that have close ties with three Japanese banks that defaulted or were nationalized after 1998 in our explanatory variables. The three banks had substantial bad loans comparing to other Japanese banks and finally the Japanese government had to let them default or to nationalize them. One commercial bank, Hokkaido Takushoku Bank was sold to a domestic bank. The other two long-term credit banks, the Long-Term Credit Bank of Japan and The Nippon Credit Bank were on sale now after they had been nationalized in 1999. All the three banks had suffered from shortages of capital due to huge amounts of bad loans. We believe credit crunches were more serious in the three banks than other banks. However, we find this dummy has no significant effects on the choice of the mix between public debt and private debt as shown in panel B of Table 2. Inversely, we find that firms that have strong ties to the three banks increased private debt rather than public debt reliance. Probably, the default of the two long-term banks can be considered as important consequences of the deregulation after the 1980s, especially the critical deregulation in the early 1990s, rather than a reason for high quality Japanese firms to leave banks. In addition, the product of affiliation with a defaulted bank dummy and firm quality does not has a statistically significant effect on the choices of debt. This means that neither affiliation with a defaulted bank has a significant effect on the sensitivity of

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proportionate use of public debt to firm quality. For brevity, regressions including the product of affiliation with a defaulted bank dummy and firm quality are omitted. Alternatively, we use financial affiliation dummy or industrial affiliation dummy to examine the effect of credit crunch. Historically, it is said that financial affiliated Japanese firms have heavily relied on banks. If shortages of capital are not only occurred in the three banks but national wide, firms that have heavy reliance on private debt would use more public debt given other conditions. In this paper, we use Dodwell classifications that are used in Weinstein and Yahe (1998). Again, panel C of Table 2 shows no evidence supporting financially affiliated firms use more public debt due to national wide shortages of bank capital in Japan. Similarly, Anderson and Mahkija (1999) also find no evidence on financial affiliation and debt structure in Japan in the late 1980s. Also, we identify firm membership in financial groups and industrial groups, using Keretsu Soran of Toyo Keizai (1993–1997). However, we only find that industrial group firms borrow less from banks in estimation 7 of panel D in Table 2. Hoshi and Kashyap (1999) argue that a credit crunch in Japan occurred from 1996. Thus, we split the period 1993–1997 into two sub-periods, 1993–1995 and 1996–1997. This would also help us to focus on the effect of credit crunch caused by bank capital shortages in Japan. As shown in Tables 3 and 4, we find no evidence supporting that the dummy of heavy reliance on the three defaulted Japanese banks influences firms’ debt structure. It is neither the case for the financial affiliation dummy nor industrial affiliation dummy. For brevity, the results for financial affiliation and industrial affiliation dummies are omitted. In summary, we obtain no evidence that suggests that shortages of bank capital in Japan affect the choices of financing with public debt versus private debt. Rather, we find that the firms affiliated with default Japanese banks increased their bank debt to total debt ratios during 1996–1997. 3.6. Robustness As shown above, the basic relations between proportionate use of public debt and firm characteristics, especially the relation between proportionate use of public debt and firm quality, are robust when we split the period into two sub-periods. Finally, we show that our results are also robust to measurement for debt structure. Instead of the average composition of new debt issued at each year, here we consider to use balance sheets, taking the issue of bonds issued before 1993 into account. There are a couple of reasons to recognize outstanding bonds issued before 1993 as the same as public bonds ex post. First, unlike convertible bonds, warrant bonds will not be converted to equity even the underlying stock options of warrant bonds can be exercised. So the underlying bonds of warrant bonds should be redeemed finally as the same as straight bonds. Next, straight bonds issued under the commissioned banks also can be recognized as public debt ex post. This is because it is less likely for the commissioned banks which all have huge amount of nonperforming loans to purchase defaulted straight bonds from bondholders since the middle 1990s even though they earned huge commissioned fees from domestic straight corporate bond issuance.6 As argued in Aoki and Patrick (1994), a commissioned bank used to rescue a troubled firm in exchange for future regulatory rents under the regulatory system till the late 1980, as an

6 Even for unsecured corporate straight bonds, the commissioned bank fee was even as high as 0.25% of the principle of a bond. Actually, the commissioned bank did nothing unless the issuing corporation was going to default. If a bank had not paid off a defaulted bond for which it received commissioned bank fees, it would lose its customers in the future.

Table 5 Two sided Tobit regressions of public debt ratio and bank loan ratio using stock data, 1997 Dependent variable

Firm quality History  quality Firm size Leverage ratio Coverage ratio < 2 Tangible assets ratio Affiliation with a defaulted bank dummy Disturbance standard deviation Sigma Log-likelihood-function ***

903 2.432 *** 7.835 0.116 1.514 0.531 *** 2.959 0.202 *** 9.717 0.310 * 1.688 0.303 *** 4.461 0.070 0.804 0.071 0.655 0.563 21.797 583.468

(2) Straight bonds to straight bonds and long-term loans 818 0.139*** 2.164 0.107*** 6.581 3.767*** 68.710 0.051*** 11.676 0.683*** 16.820 0.230*** 15.074 0.120 *** 6.245 0.036 1.552 0.122 76.372 11978.03

(3) Straight bonds to straight bond and short-term loans 896 2.911 *** 8.398 0.142 * 1.657 0.473 *** 2.802 0.234 *** 10.118 0.243 1.195 0.337 *** 4.489 0.014 0.142 0.088 0.731 0.624 21.509 615.729

(4) Bonds to bonds and loans 938 1.184 *** 4.594 0.123 * 1.907 0.000 0.388 0.161 *** 9.157 0.876 *** 5.600 0.431 *** 7.171 0.249 *** 3.301 0.036 0.365 0.535 26.725 699.179

(5) Bonds to bonds and long-term loans 888 0.959*** 2.965 0.136* 1.658 0.000 0.538 0.188*** 8.621 1.321*** 6.524 0.508*** 6.942 0.400*** 4.051 0.095 0.786 0.649 25.460 769.226

(6) Bonds to bonds and short-term loans 935 1.494 5.435 0.144 ** 2.069 0.000 0.446 0.183 *** 9.758 0.809 *** 4.868 0.461 *** 7.243 0.189 ** 2.380 0.021 0.197 0.568 26.605 726.440

Significant at the 0.01 level, ** Significant at the 0.05 level, *Significant at the 0.1 level. This table presents results of regressions of public debt ratio and bank loan ratio is measured using the 1997 fiscal year balance sheets. Explanatory variables averaged over the fiscal years 1992–1996. Firm quality is the average ratio of sum of market stock price and book debt, divided by total book assets. History  quality is an interaction term between the ratio of bonds issued before 1992 and firm quality. Firm size is the logarithm of average book value assets. Leverage ratio is the average ratio of total debt to total assets. Coverage ratio < 2 is a dummy variable equals 1 if the 1992–1996 average ratio of operation income to total interest expense is less than 2.0. Tangible asset ratio is the average ratio of tangible fixed assets to total liability. Affiliation with a defaulted bank dummy is a dummy variable equals 1 if the firms have close ties with three Japanese banks that defaulted or be were nationalized, Hokkaido Takusyoku Bank, The Nippon Credit Bank and Long-Term Credit Bank of Japan, we excluded firm-years that neither borrowed new bank loans nor issued bonds over 1993–1997. Coefficient t-statistics are in lower rows.

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Sample size Intercept

(1) Straight bonds to straight bonds and loans

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equilibrium supported by folk theorem. From the middle 1990s, however, this equilibrium of reputation can be supported no longer, because the regulatory rents disappeared after the substantial deregulation during the early 1980–1993. In other words, straight bonds issued under the monitoring of commissioned banks were monitored debt ex ante but after 1993 they can be viewed as real public bonds, because implicit obligations of commissioned banks cannot be enforced any longer. Taking the change of properties of monitored bonds issued before 1993 into account, we adjust our estimation method as follows. For simplicity, we first assume that bonds are ‘‘first issued and first redeemed’’. Additionally, it is less likely for convertible bonds to be converted to equities since stock priced drooped so much over this period. Also, we assume that all long-term bank loans borrowed before 1992 were redeemed till 1997. Giving bonds issued before 1993, B0, the bonds redeemed over this period, BR, the bonds issued over this period, BI and private debt outstanding, L, the ratio of bonds issued before 1992 to the sum of bonds and loans outstanding will be: ðB0  BRÞ=ðB0  BR þ BI þ LÞ in cases of B0  BR > 0. In cases of B0  BR < 0, we treat bonds issued before 1993 in balance sheets 0. Thus the ratio of bonds issued before 1993 to bonds and bank loans is calculated as max{(B0  BR)/(B0  BR + BI + L), 0}. Suppose a firm has a huge amount of bonds outstanding that are issued before 1993. It will use less public debt when its growth rate goes down while it will use more public debt as long as it continues to have high growth opportunities. We expect that the product of market to book and the ratio of bonds issued before 1993 will increase proportionate use of public debt over 1993– 1997. However, we find no significant and robust effects of the products of market to book ratio and max{(B0  BR)/(B0  BR + BI + L), 0} for any measures of debt in Table 3 when it is added to explanatory variables. It is the same when we include max{(B0  BR)/(B0  BR + BI + L), 0} as an explanatory variable. Most importantly, the estimated relations between proportionate use of public debt and firm characteristics, especially firm quality are not affected when this variable is added to explanatory variables. For brevity, we omit these results. Now, we measure debt structure using 1997 fiscal year balance sheets. Even Japanese firms do not issue any bonds during the years of 1993–1997, they can have bonds outstanding in 1997 fiscal year balance sheet. In other words, the ratio of public debt to public debt and private debt has a range of max{(B0  BR)/(B0  BR + BI + L, 0) to 1. Thus we presume the low threshold value as max {(B0  BR)/(B0  BR + BI + L), 0} and the upper threshold value as 1. Tobit regressions are reported in Table 5. For each measure using 1997 fiscal year balance sheets, we find proportions of public debt are positively related to firm qualities and products of firm quality and max{(B0  BR)/(B0  BR + BI + L), 0}. The findings suggest that high quality Japanese firms use more public debt during 1993–1997. The results also show that Japanese firms that issued more straight bonds before 1993 continue to use more straight public debt as long as their firm qualities are high. We find leverage, low coverage ratio, firm size have the same effects on proportionate use of public debt. Similarly, affiliation with a defaulted bank dummy has no significant effects as well as financial affiliation dummy. Therefore, our main results are robust to each measure using 1997 fiscal balance sheets, taking the bonds issued before 1993 into account. 4. Conclusion In this paper we investigate debt structure of Japanese firms using debt issued during 1993– 1997, after the binding regulatory constraints were completely removed. In particular, we find

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that high quality Japanese firms are leaving Japanese banks to public bond after 1993, whereas, low quality Japanese firms U-turn to bank debt. Our findings suggest that Japanese banks monitor borrowers but may impose excessive costs, as argued in Rajan (1992) and Diamond (1991). In particular, Diamond (1991) suggests that in economy-wide times of distress, the proportion of loans will increase relative to public debt. Consistently with the agency theories, we also find those high-leveraged firms, or firms with lower interest coverage ratio use more bank debt. Our new evidence on collateral and debt structure of Japanese firms is consistent with Diamond (1993). Our results are robust to selection of periods, different measures. Most importantly, our inference is free from selection biases and measure errors, which may be caused by the regulatory constraints of the late 1980s and thus not problematic. It is the first for us to investigate the choice of public debt versus bank debt of Japanese firms after the complete deregulation of Japanese financial markets. We focus on not only debt outstanding but also debt issued, while the earlier studies only focus on debt outstanding of the late 1980s. Our data descriptive statistics of debt issued during 1993–1997 show that many Japanese firms are U-turning to bank debt as the depression is long lasting, comparing with the rapid shift of Japanese firms from bank away from bank debt to equity-linked bonds in the late 1980s. Consequentially, our empirical finding provides a complement to evidence on the choice of equity-linked bonds versus bank loans for Japanese firms in the bull stock market of the late 1980s economic boom. Our findings also provide important hints that business cycles may affect not only the bank reliance of Japanese firms but also the choice of straight debt and equity-linked debt. The finding of the U-turn of Japan’s corporate financing to bank debt throws new light on the debate how deregulation affects the corporate governance in Japan, in particular the roles of banks. Here, it is worth linking corporate financing choices in the 1990’s Japan and Diamond (1991) more prominently. Diamond (1991) has empirical implications about the portfolios of banks. A moderate economy-wide decline in future profitability leads new bank loans to be less risky because firms with higher ratings (lower default risk) choose to borrow from banks. When future profitability decreased sufficiently large, however, it would cause credit crunch. This provides important hints to understand corporate financing and banking system in the 1990s’ Japan. Because loans last one period as well as all projects and directly placed debt, the model says nothing about the effect of changes in future profitability on previously made loans. As results of the late 1990s economy-wide distress, however, non-performing loans and banks’ forbearance lending are severe issues for the Japanese banking system. Recently, Hoshi and Kashyap (2004) explain how the current dysfunctional Japanese banking system misallocates funds by keeping many insolvent firms in business. Similarly, Peek and Rosengren (2003) examine the misallocation of credit in Japan associated with the perverse incentives of banks to provide additional credit to the weakest firms. Nonetheless, the firm–bank relationship in Japan seems to be unaffected by the development of bond financing. Our inferences are based on a matter of fact that more Japanese firms are going to restructure their businesses than the high growth era. The most important role of bank debt is to renegotiate with the management, and liquidate inefficient firms ex post. Consistently with the theoretical prediction, low quality, low leveraged Japanese firms have increased their reliance on private lenders. As corporate finance literature suggests, such firms need to be monitored more intensively and thus Japanese banks are expected to play more important roles in financial distresses, regardless of the complete deregulation. Most importantly, Japanese banks need to carefully take the effect of changes in future profitability on previously made loans into account, when Japanese large firms are completely free from regulation to issue corporate bonds, equitylinked bonds and equities.

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Acknowledgements Comments by Ji Cong, Naoyuki Yoshino, Sui Qing-Yuan, Motonari Kurasawa, Yasushi Hamao (editor) and anonymous referee are especially valuable. This study had been conducted during Xu’s visit at Kenan Flagler Business School, University of North Carolina at Chapel Hill as a Hosei visiting scholar. He would like to thank the hospitality and intellectual interaction from Anil Shivdasani (the host), Henri Servaes and faculty members of the Finance Department. Financial support for this research was provided through Grant-in-Aid for Scientific Research (No. 17330083) by Japan Society for the Promotion of Science. This paper presents the author’s personal views, and these views are neither the official views of the Financial Services Agency the Japanese Government nor those of the Financial Research and Training Center. Appendix A Examples of the overseas issuance accounting criteria for unsecured straight bonds/unsecured warrant bonds without bank guarantees. The same criteria, the strictest criteria were used for issuing domestic unsecured straight bonds. The overseas criteria were valid from July 1987 through July 1989 and the domestic criteria were valid from July 1987 through November 1988. Firms with net worth less than 55 billion yen were not allowed to issue unsecured and non-bankguaranteed straight bonds, or unsecured and non-bank-guaranteed warrant bonds Performance standards

Book equity/total asset Book equity/paid in capital Operational profit/total asset Interest coverage ratio Dividends per share (yen)

Potential issuer’s net worth 55–110 billion yen

111–300 billion yen

>300 billion yen

50 5.0 12 5.0 At least ¥6 share for past 5 years

40 4.0 10 4.0 At least ¥6 per share for past 5 years

30 3.0 8 3.0 At least ¥6 per share for past 5 years

Source: Annual report of the international finance (1997, 1998) and author’s hearing from Ministry of Finance (MOF).

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