Investment-Cash Flow Sensitivity and Endogenous Financial Policy: Evidence from Japan (DRAFT)

The literature on the Japanese Horizontal Keiretsu, or Main Bank System, is divided on the real effects of bank dependence on firm performance. This paper presents evidence on this issue for the 1980’s and 1990’s using a large sample of Japanese manufacturing firms. Using the eligibility criteria for domestic bond issues that were in place in the 1980’s as a firm sorting criteria, I find that investment-cash flow sensitivity is lowest for those firms known to have faced financing constraints in the bond market. To test whether these results are driven by the relatively higher degree of bank dependence of restricted firms, or are simply an artifact of the problems associated with investment-cash flow sensitivity analysis, I perform several robustness checks using alternative specifications and cash-flow measures. I also derive and estimate an alternative model which is based on the firm’s maximization problem when facing a loan supply curve, and which does not rely on cash flow. The results from this expanded model suggest that bank dependence does reduce financing costs, thus confirming the cash flow sensitivity results. In addition, the results suggest that the over-investment in the 1980’s led to a collapse in the demand for loans in the 1990’s, which is further evidence against a credit crunch. ∗email: [email protected]