Governance through Shame and Aspiration

58 Pages·2017·0.55 MB·English

Governance through Shame and Aspiration: Index
Creation and Corporate Behavior in Japan
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Chattopadhyay, Akash, Matthew D. Shaffer, and Charles CY Wang. "Governance through Shame
and Aspiration: Index Creation and Corporate Behavior in Japan." Harvard Business School
Working Paper, No. 18-010, July 2017
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Governance through Shame and
Aspiration: Index Creation and
Corporate Behavior in Japan

Akash Chattopadhyay

Matthew D. Shaffer
Charles C.Y. Wang

Working Paper 18-010
Governance through Shame and
Aspiration: Index Creation and
Corporate Behavior in Japan

Akash Chattopadhyay
University of Toronto
Matthew D. Shaffer
Harvard Business School
Charles C.Y. Wang
Harvard Business School

Working Paper 18-010

Copyright © 2017 by Akash Chattopadhyay, Matthew D. Shaffer, and Charles C.Y. Wang
Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may
not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.
Governance through Shame and Aspiration:
Index Creation and Corporate Behavior in Japan
Akash Chattopadhyay
University of Toronto
Matthew D. Shaffer
Harvard Business School
Charles C.Y. Wang∗
Harvard Business School
July 2017
Abstract
We study how a stock index can affect corporate behavior by serving as a source of
prestige. After decades of low corporate profitability in Japan, the JPX-Nikkei400 in-
dexwasintroducedin2014. Theindexselected400largeandliquidfirmsdeemedtobe
best-performing in terms of profitability annually; membership was considered highly
prestigious. We document that index-inclusion incentives led firms to increase return
on equity (ROE) proportionally by 35% on average, through higher margins, efficiency,
or shareholder payouts, depending on where firms had “slack,” but not through chang-
ing investments or accruals. These incentives are driven by the prestige associated
with the index rather than capital market benefits. Back-of-envelope estimates suggest
that the index accounted for 23% of the average increase in aggregate annual earnings
over our sample period and a 3% increase in aggregate market capitalization. These
findings highlight a novel mechanism through which long-standing corporate behaviors
can be transformed.
Keywords: JPX-Nikkei 400 index; Corporate governance; Japan; Return on equity;
Capital efficiency; Corporate norms
JEL: G34, G38, G41, L51, M14, M52
∗Chattopadhyay ([email protected]) is an Assistant Professor of Accounting
at the University of Toronto. Shaffer ([email protected]) is a doctoral candidate at Harvard Business
School. Wang ([email protected]) is the Glenn and Mary Jane Creamer Associate Professor of
Business Administration at Harvard Business School. We thank Alma Cohen, Ian Gow, Jody Grewal,
Paul Healy, and Krishna Palepu for helpful suggestions. We also thank Raaj Zutshi for excellent research
assistance, and Naoko Jinjo and Nobuo Sato for coordinating interviews in Japan. Comments are welcome.
Governance through Shame and Aspiration 1
1 Introduction
Thepursuitofprestigeandsocialstatusarecentraltohumanmotivation(e.g.,Kostritsky,
2013;PosnerandRasmusen,1999). Somescholarshavearguedthattheallocationofprestige
is vital to a properly functioning market economy (Zingales, 2015) and must be central to a
complete understanding of economic and corporate behavior (e.g., Williamson, 1963; Hayek,
1967).
Although these propositions imply that prestige could be actively employed as a tool to
influence managerial and corporate behavior (Miller and Prentice, 2016), since Jensen and
Meckling (1976) the corporate governance literature in economics, finance, and accounting
haslargelyfocusedontheroleofformalcontractsandfinancialincentives. Butpolicy-makers
and boards could become more constrained in using these tools in the future, in light of the
increasing scrutiny of executive compensation. They may need to become more attentive to
other, non-pecuniary, channels to motivate and govern managers, including social prestige.
In this paper, we study how membership in a stock index can serve as a source of prestige
that can thereby motivate managers and influence corporate behavior. Specifically, we study
theimpactoffirms’incentivestobeincludedintheJPX-Nikkei400(JPX400), anewprestige
index designed to select and showcase the 400 top-performing Japanese firms in terms of
profitability, capital efficiency, and corporate governance. The index premiered in 2014 as
a response to Japanese policymakers’ concerns that poor capital efficiency, and a culture
of de-prioritizing shareholders, had contributed to Japan’s decades of economic stagnation.
We find that this index had powerful effects in improving corporate profitability and capital
efficiency, as measured by ROE, and that this incentive was primarily due to a concern for
prestige.
The JPX400 selects its membership each year using a composite score based on operating
Governance through Shame and Aspiration 2
income, ROE, and market capitalization. We focus on measuring firms’ responses in ROE,
becausethismeasureisthemostheavilyweighteddeterminant, themostdirectlycontrollable
bymanagers, anddirectlyrelatedtopolicymakers’goalofincreasingcapitalefficiency. Firms
ranked around the margin of index inclusion are most likely to see their inclusion status
change as a function of their performance; thus, we hypothesize that these firms have the
strongest incentives from the index.1
To study how firms behave as a result of their index-inclusion incentives, we compare the
ROE responses of those firms we predict to be most affected versus those less affected by the
JPX400. Identifying firms’ incentives ideally requires firms’ relative ranks in the composite
score, which is not published by the Japan Exchange Group. However, since selection for the
JPX400 uses a transparent algorithm based on publicly available information, we are able
to synthetically replicate these ranks, and show that our synthetic ranks are able to predict
actual JPX400 membership with a high degree of accuracy as well as explain the variations
in index-inclusion likelihoods across firms.
We employ a difference-in-differences (DID) design using these synthetic ranks, where
treated firms are defined as those with synthetic ranks around the inclusion threshold (ranks
301–500 in our main specification) and controls are defined as firms with similar ranks but
much smaller probability of gaining inclusion in the index (firms ranked 501-800). Our DID
comparesthedifferenceinoutcomesforthesetwogroupsinthepost-period(years2015-2016)
relative to their differences in the pre-period (years 2011-2013).2 A unique feature here is
1More formally, assume there is some fixed benefit to being included in the index. Conditional on any
effort level, firms close to the margin of inclusion (e.g., firms ranked 401-500) have a higher probability of
gaining this benefit than firms ranked further from the margin of inclusion; symmetrically, conditional on
any effort level, firms closer to the margin of exclusion (e.g., firms ranked 301-400) have a higher probability
of losing this benefit than firms ranked further from the margin of exclusion. Therefore, these firms have a
higher expected benefit from exerting effort to be included in the index. For shorthand, we refer to these
higher expected benefits as higher “index-inclusion incentives.”
2We exclude the 2013 selection year, since firms did not have sufficient time to respond in the first year
Governance through Shame and Aspiration 3
that, unlike traditional DID designs, a firm’s treatment status varies over time: a firm’s
ranking for JPX400 selection, thus its distance from the index-inclusion threshold, varies
year by year. Therefore, our research design in effect combines multiple “experiments” in
the post-JPX400 period with multiple placebo “experiments” in the pre-period to infer the
effect of JPX400-inclusion incentives.
We document three main empirical findings. First, firms closest to the JPX400-inclusion
threshold achieve differential and economically significant increases in ROE. We estimate
that these firms improved ROE by 1.8%, a 35% proportional increase relative to the pre-
period mean among the treated firms. A battery of tests supports the hypothesis that this
effect is driven by index-inclusion incentives, i.e., the firms’ efforts to improve ROE in order
to be included in (or avoid exclusion from) the index. In particular, we document that the
ROE increases a) do not appear to be driven by differential trends, b) are not due to the
realized consequences of being included in the index, and c) are monotonically related to a
firm’s distance to the threshold of inclusion.
Second, we show that the prestige associated with the index, rather than benefits relating
to the cost or availability of capital, is the primary factor motivating treated firms to improve
ROE. We show this by comparing the ROE response of Nikkei225 firms—who have high
public visibility and thus especially strong “shame” from exclusion from the index, but
smaller marginal cost-of-capital benefits—to the ROE response of non-Nikkei225 firms—
who would have larger cost-of-capital benefits from index inclusion, but less “shame” from
exclusion.3 Using a modified DID design and a difference-in-difference-in-differences design,
of the index’s implementation. Nevertheless, including this year does not change our results qualitatively.
Details of the index and its implementation are described in Section 3 and Figure 1.
3TheNikkei225isJapan’sleadingstockmarketindexaswellastheoldeststockindexinAsia. Itconsists
ofJapan’smostwell-respectedandprestigiousfirmsacross36industries,asselectedbyJapan’stopfinancial
publication, Nihon Keizai Shimbun.
Governance through Shame and Aspiration 4
we show that the ROE response is substantially larger among Nikkei225 firms. This is
consistent with the hypothesis that the prestige of index inclusion, as opposed to capital
market benefits, is the primary factor motivating treated firms to improve their performance.
Third, we show that treated firms improve their ROE by improving margins, asset effi-
ciency, or shareholder payouts, rather than by earnings management or cutting investments.
Ourfindingssuggestthattreatedfirmsexploitthechannelswheretheyhavethemost“slack”
to improve their ROE. Treated firms with below-median profit margins differentially improve
their margins; those with below-median asset turnover improve efficiency; and companies
with above-median cash-to-equity ratios increase shareholder payouts. However, while the
effect sizes for profit margins and asset turnover are economically meaningful, the effect on
shareholder payouts is economically small. Additionally, we find that the treated firms’ ROE
improvements drove higher market valuations.
Overall, our findings suggest that the JPX400 “shame” index was quite successful in
leveraging prestige incentives to improve shareholder equity efficiency at Japanese firms.
Theseestimatesalsoimplythat,intheaggregate,theJPX400madeasignificantcontribution
to the overall economy. Our back-of-the-envelope estimates suggest the introduction of
JPX400 increased the aggregate net income by JPY977.28 billion per year, representing
a 6.5% increase relative to the pre-period average aggregate income of Japanese firms or
23.4% of the change in average annual aggregate net income from the pre-period to the
post-period. Moreover, we estimate that the incremental total earnings attributable to the
JPX400 represents a 3% increase in Japanese market capitalization.
Our findings contribute to the corporate governance literature in two ways. First, we
show that prestige incentives—whether the prospective shame from loss of prestige or the
aspiration to attain prestige—can powerfully shape how organizations and managers behave.
Governance through Shame and Aspiration 5
We add to a small body of literature showing the importance of prestige incentives to cor-
porate executives (e.g., Avery, Chevalier, and Schaefer, 1998; Raff and Siming, 2017; Focke,
Maug, and Niessen-Ruenzi, 2017), offering a fresh perspective to the governance literature
that has primarily focused on pecuniary incentives (e.g., Bebchuk and Fried, 2003). Second,
we show that, by creating a source of prestige, a stock index can shape these prestige incen-
tives and thereby influence corporate behavior. These insights could inform policy makers as
they seek to design non-pecuniary channels of corporate governance, which may be particu-
larly useful in the context of increasing pressures in the U.S. and abroad to limit executive
compensation or in developing markets that may face limits to contracting.
Our findings also contribute to the index-inclusion literature. Most prior literature on
indexes has examined how index constituents behave and perform in response to being
included in an index (e.g., Shleifer, 1986; Harris and Gurel, 1986; Dhillon and Johnson, 1991;
Lynch and Mendenhall, 1997; Chen, Noronha, and Singal, 2004; Doh, Howton, Howton, and
Siegel, 2009). In contrast, we study how firms behave and perform in order to achieve
inclusion in or in order to avoid exclusion from an index. We also develop a novel empirical
strategy for estimating the effects of index-inclusion incentives more generally. Our DID
researchdesigncouldbeadaptedtoestimatetheeffectsofotherindicesthathavetransparent
inclusion criteria using publicly-observable performance measures.
The remainder of the paper proceeds as follows. Section 2 provides background on the
literature on prestige and human behavior and on the JPX400 index. Section 3 details our
research design and identification strategy. Section 4 describes in detail our empirical anal-
ysis. Section 5 discusses the overall effect of the JPX400 and provides back-of-the-envelope
estimates on aggregate earnings and market capitalization impacts. Section 6 concludes.
Governance through Shame and Aspiration 6
2 Background
2.1 Governance and Reform in Japan
In Japan, in the post-war period, managers prioritized the interests of employees, sup-
pliers, customers, and strategic stakeholders over those of shareholders (e.g., Yoshimori,
1995; Ito, 2014). Although shareholders developed strong formal legal rights over the years,
Japanese corporate culture assigned low prestige to the pursuit of shareholder value, and
more status to the guardianship of other stakeholders’ interest, limiting shareholders’ de
facto power. Even through the early 21st century, shareholders’ interests carried less weight
and legitimacy with managers, and activists were often unsuccessful convincing even their
fellow shareholders to vote for initiatives to boost payouts and efficiency. These norms per-
sisted even despite the country’s efforts to improve its formal corporate governance regime
(e.g., Allen, Carletti, and Marquez, 2015; Kato, Li, and Skinner, 2017). Many policymak-
ers in Japan cited the country’s stakeholder-oriented culture as an important reason for its
lagging corporate capital efficiency—its low return-on-equity (ROE) and return on assets
(ROA)—and the country’s decades of economic stagnation.4
Many policymakers came to believe that improving Japanese corporations’ capital ef-
ficiency, by increasing dialog with and focus on investors, would be vital to reviving the
economy, an urgent concern in light of Japan’s looming problems. As the Ito (2014) report
notes:
“Japan faces a rapidly aging and declining population and a decreasing stock
of labor and household financial assets. Japan has no room to waste its limited
resources and capital. Japan must effectively leverage the resources... In other
4For example, Chart 3 of Ito (2014) reports an average ROE of 5.3% among Japanese firms in the
TOPIX500 in 2012, roughly a quarter of the average among the S&P500 firms in the U.S. and a third of the
average among the firms in the Bloomberg European 500.