Purifying Japan's Banks: Issues and Implications^*

We use a simple real options framework and empirical data to establish that although Japanese banks hold borrowers' shares, their interest is more along the lines of a contractual claimant than a residual claimant of corporations. We then explain why the Japanese model of corporate governance was useful during the “catching-up” growth of that country's postwar reconstruction decades but became problematic subsequently. The interests of shareholders, creditors, workers, and managers are more readily aligned because such growth entails investment in knowntechnology physical-capital-intensive projects with highly predictable cash flows. Once firms are on the technological frontier, “keeping-up” growth requires risk taking and a tolerance for “creative destruction.” This is better accommodated by entrusting corporate governance to firms' true residual claimants, their shareholders.