Capital Market, Banking Structure, and the Role of Profit

There is evidence that the Japanese business enterprise puts profits much lower on its scale of values than any Western enterprise. By any of the conventional measurements, the profitability of the Japanese business enterprise appears low. Measured, for instance, as percentage of sales—the most widely used measurement of profitability and profitability objective—Japanese business enterprises, especially large businesses, perform at a much lower rate of profitability than enterprises in similar lines of business in the United States or in Europe.

And yet it is also clear that the Japanese economy operates at a higher rate of profit than any Western economy. Japan has, ever since the Meiji period, managed to run its economy at a phenomenally high rate of savings and investments measured as a percentage of total gross national

product. This would not be possible unless profits—a major, if not the major, component of capital formation—were consistently very high.

The explanation for this apparent paradox lies in the structure of the Japanese banking system and capital market. As the result primarily of a historical accident—the ascendancy of Iwasaki Yataro, the founder of Mitsubishi, during the formative years of Japan's modern economy—"profit" is not what the business enterprise shows as such. The profit that matters to the economy is what the banks return, especially the zaibatsu banks that finance the zaibatsu industries.

In the early Meiji years when Japan started to build her modern economy, banking was already seen as central to economic development. Fukuzawa Yukichi stressed the need to develop a banking system in his very early writings. And the most brilliant of the young economic leaders in early-Meiji government, Shibusawa Eiichi (1840–1931), resigned from one of the most powerful positions in the Ministry of Finance at the age of thirty-four to become a banker and thus to serve his nation more productively and forcefully than he could even as a powerful civil servant and government leader.^[1]

At that time, the model of banking that dominated the developed world was the English banking system. Fukuzawa Yukichi focused on it in his writing. The early banks, started around 1870 or so, were meant to be joint-stock banks on the English model. But this model of what Americans call the "commercial" bank was not suitable for Japan.

The English banking system had been developed before the Industrial Revolution. It was a child of the Commercial Revolution of the late-seventeenth and early-eighteenth century and focused on trade, not industry. When industry developed almost a century later, it developed essentially outside the banking structure and without the benefit of the banking structure. Banking remained focused on the commercial, the trading transaction. The English capital market, and following it, the American capital market grew up almost entirely outside the banking system and contributed venture capital directly to local industry.

This original pattern has persisted to this day in Great Britain. No major British industry has been built by the banks, whether the joint-stock or merchant banks. The most comprehensive history of a major British industry does not even mention banks and bankers as factors in the founding, growth, or even the merger of the multitude of companies out of which Imperial Chemical Industries was created in 1926.^[2] While the entrepreneurial banker had a major role in the United States between 1870—when J. P. Morgan returned from Europe and started his own

[1] On Shibusawa, see the essay by Johannes Hirschmeier S.V.D., "Shibusawa Eiichi: Industrial Pioneer" in The State and Economic Enterprise in Japan , ed. William W. Lockwood (Princeton: Princeton University Press, 1965), which also contains an extensive bibliography especially of Shibusawa's writings and of the literature on him in Japanese.

[2] W. J. Reader, Imperial Chemical Industries: An History , I, :Oxford, 1970.

banking house in New York—and World War I, the capital market in the United States started outside the banking system and during the Depression was moved away from the banking system into separate institutions.

This was not a pattern Japan could adopt in 1870. To this day most Japanese books on banking are couched in language such as that used by nineteenth-century English banking theorist Walter Bagehot in his historic book, Lombard Street . But the English banking system was incompatible with Japanese reality. Industry had to be developed before there could be trade, and the English banking system, either in its original or in its modified American version, could not do this.

At the time of early Meiji, a second banking model was being designed. The continental European model, which has become known as the "universal bank," was a "deposit" bank unlike the English merchant bank.^[3] Its purpose was entrepreneurship: to find and finance industry, and to provide venture capital. The aim was to nurse an infant enterprise to the point where its securities would become marketable. At that point the bank would sell off part of its holdings in the enterprise at a substantial capital gain and recoup its investment. The bank would, however, retain sufficient stake in the enterprise to assure for itself the firm's commercial banking business. And it would continue to have a controlling voice, since the private investors, with whom the bank had placed the shares of the enterprise, would continue to hold their shares in the custody of the bank and vote their shares through the bank.

This universal bank was the model Japan needed, and the founder of Japanese banking, Shibusawa Eiichi, clearly had this model in mind. Indeed, as a young man shortly before the Meiji Restoration, Shibusawa had spent a year mostly in France—where the idea of the universal bank had originated—and it is highly probable that it is this experience that impressed him with the importance of both banking and business.

The universal bank was indeed founded to deal with a situation exceedingly similar to the one that existed in early Meiji Japan. The universal bank had truly developed in Germany—a country of small workshops and no industry but where there was, however, a heavy emphasis on education as the main engine for development and where the government had made economic development a major priority, if only to obtain and maintain military strength. Georg Siemens, who developed the model and served as the first head of the Deutsche Bank—the dominant financial institution on the European continent within a few short years—had, like Shibusawa Eiichi, started out as a young government servant, risen extremely fast to high position and then, contrary to all

[3] For the "universal bank" and the various models of banking, see the chapter "Georg Siemens and the Deutsche Bank," in my book, Management: Tasks; Responsibilities; Practices (New York: Harper & Row, 1974).

social tradition, left at a very early age to go into banking as a better way to serve his nation.

The bank that Shibusawa Eiichi founded as Japan's universal bank, the Dai-Ichi Bank, did eventually, within the last few years, become Japan's largest bank. Yet Japanese banking did not follow Shibusawa Eiichi's logical line, and the reason is one man: Iwasaki Yataro. Unlike Shibusawa, Iwasaki believed in profit maximization. He also believed strongly that it was unsound to sell shares of enterprises to the general public; an enterprise had to be controlled completely by one man. He grudgingly accepted the need for incorporation, but he made sure that control would remain vested totally in the family head and that the shares owned by other members of the family would be held in what, in effect, was a family voting trust, with the head of the house exercising voting power. As for nonfamily "outsiders" holding shares, this appeared to him to make management impossible.^[4]

Iwasaki did not represent a "Japanese" point of view. His beliefs were shared by most of the major business builders of the late-nineteenth/early-twentieth century. Even in the United States, it was strongly held, for instance, by Henry Ford. In Germany, Siemens's idea of the universal bank, which mobilized individual savings for direct investment in the equity capital of business, faced tremendous resistance from industrialists as well as from a government that did not want to have public savings directed into share ownership. Indeed, Siemens had to go into politics and get himself elected to the German Parliament to fight the governmental resistance to the idea of public ownership of businesses and of a stock exchange. And he did not win out until the very end of his life, when a historical confrontation with his own cousins, the heirs of the great Werner von Siemens who had founded the electrical company that still bears his name, forced Werner's sons to accept direct public ownership of Siemens shares and interference from representatives of the public—that is, from the bankers—with company management.

Iwasaki Yataro also saw banking as central, as indeed, any intelligent observer of 1870 Japan must have done. But his idea of a bank was as an institution to attract capital for investment in the industries and businesses of the Mitsubishi zaibatsu in such a form that the public would in no way acquire title of ownership or control. The public would come in as depositors, and not as "investors." In other words, he looked upon a bank not as a means to create a capital market, as Georg Siemens and Shibusawa did. He looked upon a bank as a substitute for a capital market. And it was Iwasaki who prevailed.

As a result, Japanese industry is financed primarily by what legally are

[4] For a discussion of the basic approaches of Shibusawa and Iwasaki to the economic development of Japan, and of the clash between them, see my book, The Age of Discontinuity (New York: Harper & Row, 1969), pp. 123–126.

bank loans. Economically, most of this money is equity capital. But it is not invested in the equity form, but in the form of short-term indebtedness. As a result, Japanese business is legally financed to only about 20 percent of its total investment by equity, that is, by common shares; 80 percent of the investment is in the form of loans. In the United States, the proportion is almost the exact opposite: 30 percent indebtedness and 70 percent equity. On the Continent, the proportion of equity is slightly lower in a large company than it is in the United States, but it rarely falls below 50 percent or so of total capital employed. Where most of the nonequity portion of Japanese capital is in the form of short-term bank loans, the continental European business tends to rely heavily on long-term bonds held by outside investors. In other words, the proportion of money in the form of bank loans is probably no higher in Europe than in the United States and may well be smaller.

The form of financing makes very little difference regarding the total return on the invested capital with which a business has to operate. The "cost of capital" is remarkably similar, especially in the period since World War II with its international and highly mobile capital market. It can be said that for the period 1950–1970 all business enterprises of any size whether American, continental European, British, or Japanese have had to earn 12 percent or so pretax income on total capital invested to earn the cost of capital.

Because of the different structure of banking and capital markets, the strategy needed to earn the cost of capital is totally different in the three areas. A Japanese business must earn enough money to pay the interest on what is legally a bank loan but economically is equity investment in business and industry. The profit in the Japanese economy—the return on venture capital—is essentially the difference between what it costs a Japanese bank to attract and hold deposits, and the interest it charges for the loans to industry. Therefore, Japanese banks have traditionally kept interest rates on deposits exceedingly low—in effect nothing. The interest they charge their industrial customers, on the other hand, is rather high and runs at least one-third, if not one-half, above interest rates charged for truly commercial loans. This is, of course, completely legitimate considering that most are not truly commercial loans and therefore include a much larger risk premium. As long as the interest on these loans is secure, the bank is satisfied. Business earnings over and above what is needed to cover the interest charge with a fair safety margin are of no benefit to the bank. The bank's income is fixed, and therefore it exerts little pressure on its customers to increase earnings over and above the interest required.

There is also little reason for the Japanese business executive to try to increase earnings on that fairly small portion of his total capital that is in the form of common shares and legal equity. By old tradition—which is only now beginning to change—companies can only issue additional

shares at par value. They cannot, as in the centuries-old Anglo-American business tradition, issue shares at their market value, even if the market value is many times the original-issue value. A Japanese business does not acquire the capacity to obtain capital at more advantageous cost if its share price goes up. In effect, successful Japanese enterprises issue new shares as a form of stock dividend, a distribution of earnings, and not as a way to obtain new capital at advantageous cost.

The Japanese business manager, therefore, has little incentive to increase earnings above what is needed to cover the bank's interest charges and earn a modest return on the shares outstanding in the hands of the public—which itself is a post-World War II innovation for the zaibatsu companies. Although his minimum profitability is high for interest charges, this needs qualification. Since legally his profit is paid out as interest on debts, the tax collector does not consider it profit, but a deductible business expense. Insofar as the tax on corporation profits is indeed a tax on profits—rather than a tax on the consumer as most economists would contend—the Japanese business has a decided advantage over its Western competitors. Increasing profits also do not make it possible for him to decrease his dependence on the bank and increase the amount of equity capital he can raise outside in the growing capital market. The tradition that forces him to offer new shares at par shuts this escape hatch.^[5]

From the point of view of the Japanese business executive, however, faced as he is by the high cost of the capital on which he depends, minimizing the cost of capital is the most rational business objective. Maximizing profit makes no sense to him: there is no benefit to his company and incidentally, with stock options being practically unknown in Japanese management, no benefit to him personally. But minimizing the cost of capital—that is, trying to operate the business with the very minimum of borrowed money—is indeed a major rational business objective. His business strategy, therefore, focuses on profit only to the extent to which it represents a minimum requirement. That minimum is quite high by Western standards. It is nonsense to say that the Japanese executive is not profit conscious. But he is not "profit-minded" in the sense that profit is an objective. It is a necessity; "minimizing the cost of capital" is the objective.

That this is the result of structure and not of values is clearly shown by the way the different banking and capital market structures determine business strategy in other areas. In the United States, where the commercial banking system traditionally has been kept out of the capital market, and where the capital market has furnished funds primarily in the

[5] This, it should be said, is changing fairly fast. In another few years, it may have become commonplace in Japan to sell shares of successful companies at the stock exchange price, that is, at a price that reflects earnings rather than "par"—with, in all likelihood, tremendous impact on Japanese business behavior and business strategy.

form of equity capital, profit maximization is a rational objective. It is the way a business is enabled to obtain the capital it needs at the lowest possible cost—the strategy calculated to produce "minimization of the cost of capital." The American business that depends on a capital market will have to pay less for new money the higher its shares are priced in the market. The price-earnings ratio, therefore, determines to a large extent—though not entirely—the cost of capital for the larger, publicly held American business. Maximizing profit on equity is, therefore, the way in which the American manager minimizes the cost of capital. Maximizing earnings per share are rational objectives for him. At the very least, it is a rational means to the same objective of "minimizing the cost of capital" which leads the Japanese manager to a very different strategy.

On the continent of Europe, the rational strategy is neither to maximize earnings per share nor to minimize the cost of capital, but to maintain the dividend on the common share. With the bank as the determining shareholder—even though its direct holdings may be only a fairly small proportion of the share capital—maintenance of this dividend best suits the needs of the decisive shareholders. The bank depends on dividends from its business investment to pay its liabilities—the interest it owes to its depositors. It has a fixed obligation, which is met out of the distribution of business profits. Maintenance of the dividends is, therefore, far more important to the German or French or Italian universal bank than rapid growth of earnings. Fluctuations in the dividends are intolerable and dangerous. For the continental European business, this means a policy aimed at maintaining dividends at a reasonable but not necessarily very high level and building reserves during years of high profit to make dividend maintenance possible in poor years. Again, maximization of profits is a secondary goal. Stability of dividends comes first.

In fact, all three systems can be said to have the same objectives: minimizing the cost of capital and minimizing the risk of not being able to obtain capital. These two objectives are the only rational foundation for a valid "theory of the firm." They are also the only valid objectives for rational business behavior. But the structural, institutional conditions that result from accidents of history rather than from cultural traditions dictate different strategies for the attainment of these objectives in different economies.

The profitability level of the economy is dictated by objective forces, especially by the objective need of an economy for capital. For this reason, profitability of the Japanese economy—an economy developing from a low base, with poor natural resources, and with a conscious policy of not depending on capital from abroad—had to be very high. And it has been high except during periods of severe economic depression like the early 1920s or the 1930s. But because the true venture capital of the Japanese economy is not investments of the public in equity or even investments of banks in equity but bank loans, the individual Japanese business

enterprise does not base its strategy on profit maximization. To do so would be economically irrational. Instead, it bases its strategy on minimizing the cost of capital.