Basu Et Al. (2007) STD DEV SOURCE PDF

Pacific-Basin Finance Journal 15 (2007) 56 – 79
www.elsevier.com/locate/pacfin
Corporate governance, top executive compensation

and firm performance in Japan
Sudipta Basu a , Lee-Seok Hwang b ,
Toshiaki Mitsudome c , Joseph Weintrop d,⁎
a
Goizueta School of Business, Emory University, 1300 Clifton Road, Atlanta, GA 30322-2710, United States
b
College of Business Administration, Seoul National University, San 56-1, Shinlim-dong, Seoul, 151-742, Korea
c
Department of Economics, CUNY-Hunter College,695 Park Avenue, New York, NY, 10021, United States
d
Stan Ross Department of Accountancy, CUNY-Baruch College, 17 Lexington Ave.
New York, NY 10010, United States
Received 13 May 2004; accepted 16 May 2006
Available online 3 October 2006
Abstract
For 174 large Japanese corporations during 1992–1996, we find that top executive pay is higher in firms
with weaker corporate governance mechanisms, controlling for standard economic determinants of pay. We
use management ownership and family control (“the ownership mechanisms”), and keiretsu affiliation, the
presence of outside directors, and board size (“the monitoring mechanisms”) to measure corporate
governance mechanisms. We also find that the excess pay related to ownership and monitoring variables is
negatively associated with subsequent accounting performance, consistent with the presence of an agency
problem. We do not, however, find an association between this excess pay and subsequent stock returns.
© 2006 Elsevier B.V. All rights reserved.
JEL classification: G32; G34; J33

Keywords: Main bank; Managerial opportunism; Family control
1. Introduction
Core et al. (1999) investigate the role that corporate governance mechanisms play in
controlling CEO pay. They find that U.S. firms with weaker governance mechanisms have greater
agency problems, as reflected in higher pay to CEOs than their firms' performance would justify.
⁎ Corresponding author. Tel.: +1 646 312 3092; fax: +1 646 312 3091.
E-mail address: Joseph_Weintrop@baruch.cuny.edu (J. Weintrop).
0927-538X/$ - see front matter © 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.pacfin.2006.05.002
S. Basu et al. / Pacific-Basin Finance Journal 15 (2007) 56–79 57
It remains to be examined if corporate governance mechanisms in other countries control

managerial opportunism through excess executive pay in a similar fashion. We study this question
using Japanese firms since Japan is sufficiently economically and culturally different from the U.S.
to make the analysis meaningful.1
Ang and Constand (1997) and Kang and Shivdasani (1995) delineate how Japanese corporate
ownership and control mechanisms differ from those in the U.S. Japanese executives tend to own
less equity, there are fewer individual investors, and large shareholders tend to be passive unless
the firm undergoes extreme financial distress (see, Kaplan and Minton, 1994). This diffusion of
control could generate greater agency problems between managers and owners in Japan than in
the U.S. However, several distinctive Japanese corporate governance mechanisms might mitigate
these agency problems. Most Japanese firms have close relations with “main banks” that own
substantial equity and debt in them and thus have incentives to monitor them (e.g. Hiraki et al.,
2003). Also, firms are often interlinked by implicit and explicit contracts into industrial groups
called keiretsu, and mutual monitoring of keiretsu managers could reduce managerial
opportunism and information asymmetry. We examine if these Japanese corporate governance
mechanisms help control excessive top executive pay.
In Japan, like most of the world's business communities, managerial compensation packages
are still a relatively well-kept secret. Although the U.S. has long required that individual
compensation data be disclosed for the five highest-paid officials, very few countries have
followed its lead.2 Japan's securities regulators have mandated the disclosure of the total
compensation given to boards of directors (see Ang and Constand, 1997; Kaplan and Minton,
1994), but do not require disclosure of individual executive compensation. However, the Japanese
Ministry of Finance is not as secretive. We hand-collect data on the personal income taxes paid by
the top executives of the 200 largest Japanese companies for the years 1992–1996 from the
Kogaku Nozeisha List, which publishes data on the income taxes paid by the highest wage
earners in Japan from the tax rolls of 520 Regional Tax Offices (Kogaku Nozeisha List, 1993–
1997). We gross up the personal income taxes paid to estimate the individual executive
compensation earned in each year, following Kato and Rockel (1992) and Kato (1997).
We examine whether these unique Japanese corporate governance mechanisms are associated
with reduced top executive pay, after controlling for other economic determinants of pay,
following Core et al. (1999). We use Japanese corporate governance mechanisms identified by
Hiraki et al. (2003), Chen et al. (2003), and Kang and Shivdasani (1995) to examine the
effectiveness of Japanese governance mechanisms in controlling managerial opportunism. We
use standard firm (size, performance and risk) and executive (age, education and tenure)
characteristics to model these economic determinants. As expected, we find that top executive
compensation is, on average, lower for keiretsu firms than for non-keiretsu firms, controlling for
the economic determinants of top executive pay. We also find that the presence of outside
directors is associated with significantly reduced top executive pay.
An alternative explanation for the associations between corporate governance variables and
excess pay is that these associations reflect mismeasurement or misspecification in our
benchmark model of executive pay. However, if our ownership and monitoring variables are good
proxies for reduced agency problems, then the excess pay related to poor governance should be
associated with poor future firm performance (Core et al., 1999). We find a negative relation
1
For a broad-based review of accounting and financial research on Japan, we direct the reader to the essays assembled
by Sunder and Yamaji (1999).
2
The notable exceptions to this have been the United Kingdom (see Conyon et al., 1995) and more recently China (see
Fund et al., 2001) and New Zealand (see Andjelkovic et al., 2000).
58 S. Basu et al. / Pacific-Basin Finance Journal 15 (2007) 56–79
between the pay explained by the ownership and monitoring variables and subsequent accounting
performance. This finding suggests that the monitoring and ownership variables reflect the
effectiveness of the firm's governance structure, rather than acting as proxies for any omitted
determinants of the CEO's equilibrium pay. Our results suggest that Japanese firms with weaker
corporate governance mechanisms have greater shareholder-manager agency problems; top
executives receive higher pay at Japanese firms with greater agency problems; and firms with
greater agency problems perform worse. Our results also suggest that Japanese corporate
governance mechanisms such as the keiretsu and outside director monitoring help solve agency
problems in the different Japanese business environment.
In Japan, similar to the U.S., founding family members often retain strong ownership and
control rights.3 We find that Japanese top executives earn more in family-controlled firms than
firms lacking such influence. Furthermore, Japanese top executives earn more in firms with
higher insider ownership. Both results hold after controlling for firm performance, consistent with
top executive equity ownership conveying benefits in excess of direct remuneration (Demsetz,
1983).
Section 2 describes corporate governance mechanism in Japanese firms, focusing on the main
bank, keiretsu, board and ownership structures. In Section 3, we describe how top executive pay
and its components are determined in Japanese firms. Section 4 explains how our governance
variables are measured, and predicts their effects on top executive compensation. Section 5
describes the sample selection and data. The model and empirical results are provided in Section
6. Section 7 summarizes and concludes.
2. Japanese corporate governance mechanisms
In contrast to the external market-oriented monitoring systems of U.S. public firms, many
Japanese firms rely on “relationship-oriented” systems. In these systems, group managers monitor
each other. In this section, we describe distinctive Japanese institutional features and relevant
related prior research.
2.1. The main bank
The lead monitoring role in Japanese firms is customarily designated to one bank, called the
“main bank,” which is usually the top lender to and often one of the largest shareholders of the
firm (e.g. Aoki, 1990a,b; Sheard, 1994a,b). Aoki (1994) argues that the main bank passively
monitors management during a “normal” time, but often takes a more active role and intervenes
with the management when the firm faces financial difficulty. This is how the main bank system
can effectively substitute for an external, market-based control mechanism (e.g., Aoki et al.,
1994). Hiraki et al. (2003) offer an alternative view of the monitoring role of the main bank. They
argue that the main bank constrains member firms from undertaking high-risk, and potentially
high return, investments.
Kang and Shivdasani (1995) study the role of alternative governance mechanisms during
Japanese top executive turnovers. Using data on 270 Japanese firms during 1985–1990, they
show that the sensitivity of non-routine top executive turnover to earnings performance measures
3
Demsetz (1983) documents that S&P 500 CEOs own substantial equity interests in their firms. Anderson and Reeb
(2003) document that about one-third of the S&P 500 can be classified as founding-family controlled firms. They find
that founding family-controlled firms perform better than non-family firms, at least on some measures. However, they do
not examine if their executives are rewarded commensurate with this added performance.
is significantly higher for firms with main bank ties than for firms without such ties. The authors
attribute this result to the main banks playing an important corporate governance function. They
also show that the likelihood of outsider succession is higher for firms with large block
shareholders and main bank ties, suggesting that these governance mechanisms are effective in
terminating poorly performing top executives.
2.2. Keiretsu
Many firms in Japan belong to corporate groups called keiretsu. A keiretsu is an industrial
group, whose member firms, bound together by stable cross-shareholdings, maintain long-term
business and financial ties with one another. According to Dodwell Marketing Consultants
(1990), there are seventeen major keiretsu in Japan. Eight of these are organized around a major
commercial (main) bank and are commonly referred to as the “financial” keiretsu. The eight
financial keiretsu are Mitsubishi, Mitsui, Sumitomo, Fuyo, Daiichi Kangyo Bank (DKB), Sanwa,
Tokai and Industrial Bank of Japan (IBJ). For the financial keiretsu, the main bank serves as “the
central organ in the group and plays the leading role in the financial activities in the group” (Kang
and Shivdasani, 1995). Also, financial keiretsu firms are generally more highly leveraged
(Nakatani, 1984), and they borrow more heavily from financial institutions within the group,
particularly the main bank (Berglof and Perotti, 1994).
As opposed to the financial (“horizontal”) keiretsu, a “vertical” keiretsu is one in which a
group of subcontractors is organized under one large manufacturing firm (Hoshi, 1994). We argue
that the main bank relation is stronger for the financial keiretsu firms than for vertical keiretsu
firms and non-keiretsu firms.4 Some previous studies focus on the characteristics of financial
keiretsu and distinguish them from other keiretsu firms and independent firms (Berglof and
Perotti, 1994; Nakatani, 1984), and we follow this classification. Hereafter, keiretsu refers to a
financial keiretsu unless otherwise noted.
Berglof and Perotti (1994) argue that the keiretsu system encourages cooperation and mutual
monitoring among managers of its member firms through a coalition-enforced threat of dismissal.
By pooling voting rights, the keiretsu coalition can exercise control over member managers to
ensure that no manager behaves opportunistically. Collusion among managers is discouraged
because poor profitability results in financial distress, which leads to intervention by the largest
lender, often the main bank. Berglof and Perotti (1994) term this keiretsu style of corporate
governance a “state contingent” mechanism, in which the source of control shifts from an implicit
threat of coalition power to a more explicit intervention by the main bank in a time of financial
difficulty.
2.3. Boards of directors
Japanese boards of directors (called “torishimari-yaku” or “yakuin”) are legally appointed by

shareholders to make strategic decisions and “supervise affairs of directors” on behalf of the
shareholders (Yasui, 1999). While a typical Japanese firm has 20 board members, large firms
often have more than 40 directors; Toyota Motors had 61 directors in 1998.5 Japanese boards are
4
Although virtually every firm in Japan has one bank serving the role of the main bank, the strength of the relationship
between a firm and its main bank depends upon several factors, such as the degree of the firm's reliance on bank loans
and the financial health of the firm.
5
As of July 1997, 49 publicly traded firms have over 40 directors (Weekly Toyo Keizai, 1997).
usually dominated by insiders, i.e., senior officials within the company. The president is usually
the most powerful member of the board, except in rare cases when the chairman (“kaicho”), who
often is a former president, has higher authority than the president (Kaplan, 1994).
The practice of promoting insiders creates a hierarchical structure on the board, in which each
director's promotion, as well as job security, depends largely on his relation with the top executive
(Yasui, 1999). Therefore, despite the legal rights of each director, Yasui (1999) suggests that it is
difficult for the board of directors to effectively monitor and control the top executive. However,
Japanese boards sometimes include “outside” directors. One function of these outside directors is
to strengthen the monitoring of the host firm's management (Aoki et al., 1994; Kaplan and
Minton, 1994; Sheard, 1994a). Kaplan and Minton (1994) distinguish between “bank” outside
directors, who were previously employed by banks, and “corporate” outside directors, who were
previously employed by non-financial institutions.
Kaplan and Minton (1994) investigate the determinants of outside director appointments in
Japanese firms. For 119 publicly traded Japanese firms during 1980–1988, they find that outside
director appointments are more likely following poor stock price performance. In addition, a bank
director is more likely to be appointed following reported accounting losses. They also show that
bank director appointments are more likely if a firm has larger bank borrowings, while corporate
director appointments are more likely if a firm has more concentrated shareholders or if it is
affiliated with a keiretsu. They compare the above results to those for large, non-financial U.S.
firms over the same period, and find that appointments of directors affiliated with large block
holders in the U.S. are about as sensitive to corporate performance as outsider appointments in
Japanese firms. These prior results suggest that the relationship-based governance mechanisms
play important monitoring and disciplinary roles in Japan.
To add more validity to the above conjecture, Kaplan and Minton (1994) show that incumbent
top executive turnover substantially increases in the year of an outside director appointment, while
the results for U.S. firms are somewhat weaker. They also report some improvement in the
performance of the Japanese firms after outsider directors were appointed. Kaplan and Minton
(1994) conclude that the evidence on outside director appointments suggests that Japanese
relationship-based governance effectively disciplines poorly performing managers. They also
argue that these relationships may substitute for the more market-oriented governance mechanisms
in the U.S.
3. Japanese top executive compensation
3.1. Japanese compensation practices
According to the Commercial Law, the board of directors is responsible for determining
individual executive compensation amounts. These amounts must be approved by shareholders,
typically at the annual general shareholders' meeting (Nihon Keizai Shinbun, 4/20/96).
In Japan, top executive compensation typically consists of cash salary and cash bonus. Stock-
based compensation, such as stock options and stock grants, was not used until recently due to
legal restrictions on share buybacks and unfavorable tax treatments for recipients (Yasui, 1999).6
6
Until the Commercial Law was revised in 1997, firms were not allowed to buy back their own shares, and, as a result,
it was difficult to grant stock options. Since the revision, which allows firms to buy back up to 10% of their own shares,
96 listed firms have adopted stock option programs (Yasui, 1999). Also, an unfavorable tax treatment of stock options,
which is currently under review, has impeded stock option grants (OECD, 1996).
The Commercial Law requires that the amounts of executive salary be either clearly stated in the
Articles of Corporation and/or approved at the general shareholders' meeting (Kobayashi, 1997).
In practice, most firms set the maximum amounts of total annual salary that they pay to all
directors, and have this total approved by the general shareholders (Dai-ichi Mutual Life
Insurance Company, 1999).7 Firms usually revise the maximum salary amounts every four to five
years to adjust for factors such as inflation, macroeconomic conditions, and the number of board
members (Dai-ichi Mutual Life Insurance Company, 1999). Once the maximum amount is
approved, the board of directors is legally responsible for deciding the individual amount paid to
each director. However, boards customarily assign this responsibility to their top executive,
usually the firm's president (Dai-ichi Mutual Life Insurance Company, 1999; Kobayashi, 1997).
An individual executive's salary is commonly determined as a multiple of a non-director
manager's salary (Employment System Research Center reported in Nihon Keizai Shinbun, 4/20/
96). On average, the chairman earns 420% of a non-director manager's annual salary, the
president 360%, a vice president 310%, a senior managing director 240%, a managing director
200%, a director 160%, and a statutory auditor 150%. Around 70% of the firms surveyed by
Employment System Research Center said that they review and adjust the amount of executive
salary every year, and the revision is based upon factors such as firm performance, industry
standards and a percentage increase for employees' salary.
In contrast to salary, executive bonus is an appropriation of the firm's retained earnings, and
therefore, the total amount of bonus must be approved at the annual general shareholders'
meeting. The total amount of director bonuses is based almost entirely on firm performance,
especially the amount of after-tax profit (Nihon Keizai Shinbun, 4/20/96). The Commercial Law
requires that the general shareholders approve the total bonus amount before individual bonuses
are determined. Individual bonuses are based on factors such as executive rank and individual
performance. As with executive salary, top executives normally decide individual bonus amounts
(Kobayashi, 1997).
Japanese shareholders rarely exercise their veto power over top executive compensation at the
general shareholders' meetings (Okushima, 1996). This is because it is extremely difficult for
individual shareholders to obtain a majority vote, since corporations and financial institutions
affiliated with the firm hold a majority of the shares. These large shareholders are generally
sympathetic to the incumbent management, and do not intervene unless the firm is financially
distressed (e.g., Sheard, 1994a,b). This is why some argue that shareholders do not exercise
enough oversight and control over executive compensation decisions (e.g., Nihon Keizai
Shinbun, 4/20/96). In short, most Japanese top executives significantly influence compensation
decisions and can overpay themselves, absent strong governance mechanisms.
3.2. Prior research on Japanese executive compensation
There is little prior empirical research on the determinants of Japanese executive compensation
and the role corporate governance plays in setting the level. This is mainly because there is no
publicly available data on top executive compensation packages. Kaplan (1994) collected data on
the total salary and bonus earned by all directors of 119 large Japanese firms from 1981–1984,
7
Revising the Articles of Corporation requires approval by two-thirds of all the attendees of the general shareholders'
meeting, while simply revising the total amount of executive salary only requires a majority. The Commercial Law
requires that the general shareholders' meeting only approve the total, not individual, amount of executive salaries
(Kobayashi, 1997).
and examines the association between the aggregate director compensation and firm performance.
He finds that the change in total compensation is significantly associated with four (accounting
earnings and stock returns) measures of firm performance considered individually. However, in a
multiple regression including all four measures, negative pretax income and the change in pretax
income deflated by assets have the greatest explanatory power.8
Ang and Constand (1997) collect data on the total salary and total bonus paid to all directors
for 364 Japanese firms during 1980–1992. They investigate the sensitivity of total directors'
compensation components to short- and long-run firm performance. Ang and Constand (1997)
find that (a) only total bonus is associated with short-term (i.e., one year) share returns, while both
salary and bonus are sensitive to changes in longer-term (13 years) share price and sales growth;
(b) the association between the bonus and short-term share returns is found only for positive
annual returns; (c) firms with lower pay-to-performance sensitivity achieve on average higher
returns; (d) the sensitivity of pay to performance is higher for keiretsu firms than for non-keiretsu
firms; (e) total salary changes are significantly associated with changes in lagged earnings and
current share price, while the total bonus changes are significantly associated with changes in
lagged share price, lagged income and the current sales growth.
Instead of examining aggregate board compensation, Kato and Rockel (1992) directly
investigate the determinants of Japanese top executive pay. They impute individual top executive
pay from the personal income tax paid in 1985 by each executive of the 599 largest firms in Japan.
The personal income tax amounts paid by the highest individual taxpayers are reported in Jinji
Kanri Soran Special Issue published by Toyo Keizai Inc. Kato and Rockel (1992) regress log of
individual executive pay on firm size and performance, as well as human capital variables such as
tenure and education. They conclude that the level of Japanese executive compensation is
positively associated with firm size and the tenure of the executives.
Kato (1997) examines the role corporate governance plays in setting pay levels. Using the
same data set as Kato and Rockel (1992), Kato (1997) investigates the effect of keiretsu affiliation
on the level of top executive pay. He finds that top executives of keiretsu firms earn 21% less than
top executives of independent firms, after controlling for firm performance and human capital
variables. He suggests that this result is consistent with the hypothesis that main bank monitoring
is effective in keiretsu firms, and as a result, managers are less likely to behave opportunistically
in keiretsu firms by paying themselves too generously.
In sum, prior research finds that Japanese top executive compensation is positively associated
with current and lagged firm performance, based on both accounting and stock price measures.
Prior research also documents evidence that compensation practices appear to differ between
keiretsu and other firms. However, the relation between other Japanese corporate governance
mechanisms and excessive top executive pay has not been examined.
4. Governance variables and their hypothesized effects on top executive compensation
Core et al. (1999) show that firms with greater agency problems pay their top executives more
than the equilibrium level. We expect that this argument also applies to Japanese firms, even though
they operate in a different institutional environment. Within the U.S., Ke et al. (1999) find a significant
8
Kaplan (1994) also examines the association between firm performance and top manager turnover for 119 Japanese
firms during 1980–1988 and finds that the likelihood of turnover is negatively related to stock returns and earnings,
controlling for managers' age and tenure. The Economist (A Survey of Corporate Leadership, Oct. 25, 2003, p. 12)
reports that performance-related CEO turnover was lower during the late 1990s in Japan than in North America, Europe
and the rest of Asia/Pacific.
positive association between the level of compensation and firm performance, measured by ROA, for
publicly-held insurers but no such relation for privately-held insurers. The authors argue that if there is
an alternative monitoring mechanism, as in the case of privately-held insurers, firms tend to rely less
on objective performance measures, such as ROA, in determining the executive compensation. They
argue that the incentive contract in a diffuse ownership setting substitutes for other types of monitoring
mechanisms that are possible in a more tightly controlled firm. We adapt this contracting argument to a
different institutional setting, i.e., public firms in the Japanese environment.
The following are the governance variables that we use in this study, and their hypothesized
effects on the top executive compensation, after controlling for firm- and executive-specific
economic determinants of pay.
4.1. The main bank
Aoki et al. (1994) and Sheard (1994a,b) argue the main bank can effectively monitor the
management of a borrower firm. If this is true, then top executive pay is expected to be lower as
the firm's relationship with the main bank becomes stronger. This association is expected because
strong main bank monitoring helps reduce the probability of managerial opportunism. An
alternative hypothesis offered by Hiraki et al. (2003) is that the main bank extracts surplus from
their client firms, consistent with their empirical results for 1985–1991.
4.2. Keiretsu membership
If, as argued by Berglof and Perotti (1994), the keiretsu system provides effective monitoring
and control of the member firms' managers, then top executive pay is expected to be lower for
keiretsu firms than for non-keiretsu firms. Further, the stronger main bank role in a keiretsu
reduces the need for the riskier (incentive) compensation contract that would necessitate increased
expected pay to risk-averse managers. Therefore, we expect a keiretsu firm to pay its top
executive less than independent firms, ceteris paribus (Kato, 1997).
4.3. Outside directors and board size
Weisbach (1988) provides evidence that the greater the number of outside directors on the
board, the stronger the corporate governance of the firm. Thus, top executive pay is expected to be
lower when a firm has outside directors. In theory, any board member who is not formally part of
the company would be considered an outside director. For purposes of our tests, we classify any
director who came from another firm as an outside director. We note that it is crucial here to control
for firm performance since, as argued by Kaplan and Minton (1994), outside directors
appointments are much more likely for poorly performing firms. The effect of the board size on
top executive pay is expected to be negative, because a large board is unlikely to facilitate effective
monitoring of top management of firm (Jensen, 1993). Consistent with this argument, Yermack
(1996) provides evidence that firm value and performance is a decreasing function of board size.
4.4. Family influence
A non-trivial number of Japanese firms are under the influence of the founding families.
Family members or associates frequently serve as top executives of family-controlled firms
(“dozoku”). Such family-appointed top executives likely have increased incentives and ability to
overpay themselves, a manifestation of the more severe agency problems between weak external
shareholders and powerful insiders.
We know of no direct empirical tests of the role of founding families in monitoring top
executive compensation. This type of study can only be carried out in the few countries in which
CEO compensation, firm governance and performance variables are publicly available. Anderson
and Reeb (2003) study the S and P500 firms for 1992–1999, and find that founding family-
controlled and operated firms perform better than non-family firms as measured by ROA and
Tobin's q. This result suggests that family ownership is an effective governance mechanism. On
the other hand, others argue that concentrated shareholders, such as founding family members,
can exercise significant control over the firm and extract private benefits from the firm (Fama and
Jensen, 1983; Demsetz, 1983; Shleifer and Vishny, 1997). We test to discriminate between these
competing hypotheses regarding family ownership using Japanese data.
5. Sample
5.1. Sample selection
Firms are included in the sample if they have data available on Compustat's Global Vantage
database on year-end share price, consolidated annual net income, sales and assets for two
consecutive years. This allows us to control for the effect of current, as well as lagged firm
performance on executive pay, using both accounting and stock-based performance measures.
This initial screen results in a sample of 200 firms, that are among the largest in Japan.
We identify the names and addresses of top executives for each firm in each year using the
1993–1997 issues of Yakuin Shikiho, published annually by Toyo Keizai Inc (Yakuin Shikiho,
1993–1997). This directory provides detailed personal data, such as name, home address, title,
birthday, date of assuming the position, and hobby, for all board members and statutory auditors of
all listed firms. We include executives who are equal to and above the rank of president (“shacho”).
We did this because, as mentioned earlier, despite the president usually being the highest decision-
maker, the chairman sometimes has greater authority than the president (Kaplan, 1994). As a
result, our sample includes a few vice chairmen (“fuku kaicho”) and honorary chairmen (“meiyo
kaicho”), although most of the executives identified are presidents and chairmen (“kaicho”).
Subsequently, we obtain data on income tax amounts paid by the executives for each year from
the 1992–1996 issues of Kogaku Nozeisha List (List of High Income Tax Payers) published by
Tokyo Shoko Research. This list provides the actual income tax paid by an individual, as long as
his/her tax payment exceeds ¥10 million, or approximately $100,000. It also provides each
individual's address and, sometimes, occupation. We match the names and addresses of the
executives obtained from Yakuin Shikiho with those in Kogaku Nozeisha List to obtain the actual
amounts of income tax that they paid each year. The entries are arranged by municipal taxation
office location, and within each location, they are ranked by tax amount. The 1993 edition has
data on more than 125,000 individuals.
We then estimate the total amount of compensation earned by each individual each year using
the following algorithm, which is essentially the same as in Kato and Rockel (1992). We first add
back the tax credit amounts applicable each year, i.e., ¥3.9 million for 1992–1994 and ¥6.6
million for 1995–1996, to the tax amount. We divide the amount obtained by the marginal tax rate
of 50%. For example, if an executive pays ¥27,000,000 in tax in 1993, then his estimated income
is ¥61,800,000 or (¥27,000,000 + 3,900,000) / 0.5. Although Japan has adopted a progressive
income tax system, we apply the highest tax rate of 50% to everyone in the sample. Anyone on the
list has paid a minimum of ¥10 million in tax, which translates into a minimum pretax income of
¥27.8 million, which is above the threshold of ¥20 million for the highest bracket.
This formula has a few limitations. First, the amount obtained is an estimate of total income,
i.e., it includes not only salaries and bonuses earned by the individual, but also other income, such
as dividends, capital gains, inheritances, and so on. Kato and Rockel (1992) defend their
methodology by quoting anecdotal evidence suggesting that Japanese top executives do not earn a
significant portion of their income from sources other than their firms. Second, this method
ignores all potential loopholes for income tax computations. If they are in fact available but
applicable differently to each individual, then the application of the same tax rate to back out the
amounts of incomes will lead to erroneous amounts. However, Kato and Rockel (1992) argue that
it is virtually impossible for salaried workers to find loopholes for income tax.
The data on outside directors and the percentage of shares owned by the board of directors are
obtained from Yakuin Shikiho, and the data on the percentage of shares owned by foreign
investors are obtained from Kaisha Shikiho, also published quarterly by Toyo Keizai Inc (Kaisha
and Shikiko, 1992–1997). To determine whether a firm is family controlled, we refer to the 1992
issue of Kigyo Keireysu Soran published by Toyo Keizai Inc. A firm is coded as family-owned if
there are terms such as “dozokushoku”, “ichizoku-shoku”, or “ichizoku-kei” in the firm description
column.
The data on keiretsu affiliation are obtained from the 1990 edition of Industrial Groupings in
Japan published by Dodwell Marketing Consultants. Dodwell classifies all listed firms in Japan
either as keiretsu or non-keiretsu using criteria such as the proportion of common stock owned by
the ten largest shareholders, the amount of total borrowing and the amount of borrowing from
main banks. Dodwell identifies members of the eight financial keiretsu listed in Section 2.2. We
obtain a total of 1083 executive year observations for 174 firms and 300 executives.
5.2. Descriptive statistics
The descriptive statistics are reported in Table 1. The sample average pay of Japanese top
executives is ¥86,007,000 year. This translates roughly into US $716,725 per annum, using an
exchange rate of ¥120 per US dollar. The top executive pay variable is highly right-skewed, so we
use the log of compensation, LNCOMP, in our regressions. Average firm performance is low in
the aftermath of the Japanese bubble, with mean return-on-assets, ROA, being 1.4%, while the
mean annual stock return, RET, is 2.7%. The median annual stock return for this sample is
0.001%, which indicates that approximately half the sample had negative returns.
Rosen (1982) and Smith and Watts (1992) among others argue that larger firms with greater
growth opportunities and more complex operations will demand more highly talented executives
and, therefore, pay higher equilibrium compensation. To control for size and growth opportunities,
we use the natural logarithm of sales, LNSALE, and market-to-book ratio, MB, measured at the
beginning of each year, respectively. We use the natural logarithm of sales because sales itself is
highly right-skewed. The means of LNSALE and MB are 13.314 and 2.214 respectively.
Prior studies argue that top executive pay is increasing in the executive's human capital (e.g.,
Agarwal, 1981; Leonard, 1990). An executive with greater human capital is expected to perform
better, and, therefore, be paid more. We use age, tenure and education level as proxies for
Japanese top executives' human capital. The mean age of the sample executives is 66.320 years,
and the mean tenure is 5.850 years, which is similar to that reported by Kaplan (1994). Due to the
lifetime employment system, employees generally stay with one firm until they retire, and the
same principle applies to top executives. An education indicator, DEDU, is set to one if an
Table 1
Descriptive statistics on Japanese executive compensation, economic determinants of pay, ownership and governance
variables
Variable # of obs. Mean Median Std. dev. Min. Max.
Compensation variables
COMP 1083 86,007 57,842 111,264 27,884 1,514,846
LNCOMP 1083 11.095 10.965 0.606 10.236 14.231
Firm performance variables

ROA 1083 0.014 0.012 0.024 − 0.230 0.168
RET 1083 0.027 0.001 0.273 − 0.647 1.447
Size variable
SALE 1083 1,901,049 525,289 3,870,006 9792 20,610,475
LNSALE 1083 13.314 13.172 1.488 9.189 16.843
Growth opportunity variable

MB 1057 2.214 1.933 1.334 0.414 18.100
Risk variables
STDRET 904 0.239 0.197 0.175 0.005 1.468
LEV 1083 0.648 0.650 0.199 0.104 0.977
Human capital variables

AGE 1076 66.320 66.000 6.589 45.000 89.000
TENURE 1075 5.850 3.700 6.724 0.000 46.880
DEDU 1083 0.835 1.000 0.371 0.000 1.000
Ownership variables
OWN 1083 2.289 0.100 5.349 0.000 32.600
DFAMILY 1083 0.199 0.000 0.399 0.000 1.000
Governance variables
KR 1083 0.433 0.000 0.496 0.000 1.000
OUT 1082 2.059 1.000 2.951 0.000 18.000
DOUT 1083 0.657 1.000 0.475 0.000 1.000
BSIZE 1083 29.991 28.000 10.808 10.000 60.000
DMBANK 1083 0.504 1.000 0.500 0.000 1.000
COMP is the cash compensation in thousands yen estimated from the actual income tax amount using the following formula (in
thousands yen): COMP= (Tax + 3900)/ 0.5 if the years are between 1992 and 1994, and COMP= (Tax + 6600) / 0.5 afterwards.
LNCOMP is the natural log of COMP. ROA is the return on assets calculated as (Net Incomet) / (Total Assetst−1). RET is the
annual stock return calculated as (Stock Pricet + Dividend Per Sharet) / (Stock Pricet−1) − 1, adjusted for stock splits and stock
dividends. SALE is annual total sales in millions yen. LNSALE is the natural log of sales. MB is the market-to-book ratio at the
beginning of each year. STDRET is the standard deviation of annual stock returns for 3 years adjusted for dividends paid. LEV
is leverage calculated as (Total Liabilityt) / (Total Assetst). AGE is the age of a top executive on December 31 of each year.
TENURE is years in the current position as of July 31 of each year. DEDU is an education indicator, 1 if he has a bachelor's
degree or higher, 0 otherwise. OWN is the percentage of shares owned by all directors. DFAMILY is a family (“Dozoku”)
indicator, 1 if a firm is described as a “dozoku” by Toyo Keizai (Kigyo Keiretsu Soran, 1992). “Dozoku” refers to a firm of
which its founding family members have strong influence on management. KR is a keiretsu indicator, 1 if a firm belongs to one
of the eight corporate groups, 0 otherwise. OUT is the number of outside directors. DOUT is an outside director indicator, 1 if
there is at least one outside director, 0 otherwise. BSIZE is the number of directors on the board. DMBANK is a main bank
indicator, 1 if a firm's largest lender is also the largest shareholders among banks.
executive has a bachelor's degree or higher, and zero otherwise. In our sample, more than 83% of
the executives have received higher education.
Management ownership, OWN, is the percentage of shares outstanding owned by all board
members.9 Increased managerial ownership can have the effect of entrenching managers (Stulz,
1988). We expect that entrenched managers are more likely to pay themselves higher levels of
compensation. We expect OWN and COMP to be positively correlated. The mean ownership is
2.289% with 32.6% being the highest. Lastly, the DFAMILY indicator is 1 if a firm is founding
family controlled and 0 otherwise. Nearly 20% of our sample firms are family controlled.10
We discuss next the governance variables that are the focus of our tests. KR is a keiretsu
indicator, which is set to one if a firm belongs to one of the eight financial keiretsu and zero
otherwise. About 43.3% of the firm-year observations are for keiretsu firms. The average number
of outside directors, OUT, is 2.059. As an alternative measure of external monitoring, we use
DOUT, which is an indicator variable set to 1 if there is at least one outside director on the board,
and zero otherwise.
BSIZE is the number of directors on the board, whose mean is 29.991 and whose maximum is
60. DMBANK is a main-bank indicator variable set to 1 if the largest lender is also the largest
shareholder among banks. Kang and Shivdasani (1995) used a similar indicator variable to
indicate whether a firm has ties to a main bank. However, since most companies have a main
bank, we think the relation of interest is whether the main bank is the leading lender and among
the largest shareholders. We use DMBANK to measure the strength rather than just the existence
of a relationship with a main bank. The mean of DMBANK is 0.504.
In Table 2, we report summary statistics for our regression sample, focusing on differences
between keiretsu and non-keiretsu firms. We eliminate observations with values greater than the
99 percentile level or smaller than 1 percentile for the following variables: LNCOMP, ROA,
LNSALE, MB and OWN. This process results in a final sample of 751 executive-year
observations for 117 firms and 147 executives for our regressions. Our regression sample contains
405 non-keiretsu firm years and 346 keiretsu firm years.
The non-keiretsu firms pay their executives significantly more (COMP of ¥ 85,778,000 vs.
¥64,591,000) than keiretsu firms. The non-keiretsu firms are more profitable, mean ROA is 0.016
vs. 0.011; and cumulate higher returns, 0.071 vs. 0.055. The non-keiretsu firms are also riskier,
0.259 vs. 0.213 using our measure risk, STDRET, which is the standard deviation of a firm's
monthly returns for the prior three years. Non-keiretsu executives are slightly younger than their
keiretsu counterparts. However, they have held the top position for an average of 6.910 years, as
opposed to 4.040 years for keiretsu executives.
The more interesting results are with the ownership and governance variables. Compared to
keiretsu firms, the OWN value is significantly higher for non-keiretsu with a mean of 3.532,
and non-keiretsu firms are more likely to be family controlled. The average DFAMILY value is
0.321 for non-keiretsu firms vs. 0.078 for keiretsu firms. This suggests that families are not able to
retain direct control in the interlinked keiretsu organizations. Keiretsu firms tend to have larger
boards of directors, but have similar numbers of outside directors as non-keiretsu firms. Of
specific interest in the governance variables is DMBANK, the case where the largest lender is also
the top shareholder among all banks that hold shares. Sixty-seven percent of keiretsu firms have a
9
We are unable to collect individual executive shareholdings, because these are not publicly disclosed in Japan.
10
Core et al. (1999) suggest four measures of ownership structure. The first three, CEO percentage of ownership, Non-
CEO insider owns 5%, and Outside Director percentage of ownership are not available for Japanese firms in our time
period. The variable, outside blockholder owns 5%, is observed for most of the firms in our sample.
Table 2
Comparison of executive compensation and firm characteristics between keiretsu and non-keiretsu firms
Variable Non-keiretsu firms (n = 405) Keiretsu firms (n = 346) Differences in means
Mean S.D. Mean S.D. t-statistics p-value
Compensation variables
COMP 85,778 67,266 64,591 53,633 4.72 0.0001
LNCOMP 11.172 0.522 10.890 0.452 6.26 0.0001
Firm characteristics
ROA 0.016 0.018 0.011 0.018 3.34 0.0009
RET 0.071 0.287 0.055 0.242 0.83 0.4071
LNSALE 13.128 1.482 13.483 1.308 −3.45 0.0006
MB 2.054 1.046 2.223 0.878 −2.37 0.0179
STDRET 0.259 0.155 0.213 0.147 4.16 0.0001
LEV 0.597 0.182 0.702 0.165 −8.20 0.0001

AGE 65.435 6.618 67.338 5.803 −4.16 0.0001
TENURE 6.910 6.592 4.040 3.760 7.17 0.0001
DEDU 0.803 0.399 0.867 0.340 −2.37 0.0182
Ownership variables
OWN 3.532 7.181 0.751 1.795 7.02 0.0001
DFAMILY 0.321 0.467 0.078 0.269 8.54 0.0001
OUT 1.689 2.335 2.038 2.463 −1.99 0.0471
DOUT 0.659 0.475 0.676 0.469 −0.49 0.6219
BSIZE 27.595 9.891 31.954 10.072 −5.97 0.0001
DMBANK 0.388 0.488 0.673 0.470 −8.14 0.0001
See Table 1 for variable definitions.
strong main bank relationship compared to 38.8% of non-keiretsu firms, and the difference is
statistically significant.
6. Empirical evidence
6.1. Determinants of Japanese top executive pay
We report the first set of our regression results in Table 3. In column (3), we show the results
regressing LNCOMP, the log of top executive compensation, on economic determinants and
selected control variables not related to corporate governance. An advantage of using log
compensation as the dependent variable is that the regression coefficients measure the
proportionate effects of a variable on compensation, rather than the dollar value effect.11 We
indicate the predicted sign on each variable in the regression in column (2). We include industry
and year indicator variables to capture potential mean differences in executive pay across
industries and years.
11
Core et al. (1999) also point out that the log specification does not require deflation of compensation to reduce scale
effects.
Table 3
Regressions of log of top executive compensation, LNCOMP, on the economic determinants of pay, ownership and
governance variables with industry- and year-indicators (N = 750)
(1) (2) (3) (4) (5)
Variable Expected Basic model- Full model- Full model-annual
sign pooled pooled averages
Intercept 9.479⁎⁎⁎ 8.702⁎⁎⁎ 8.812⁎⁎⁎
(34.61) (27.22) (16.96)
Firm performance variables

ROA + 1.965 3.539⁎⁎⁎ 3.487
(1.31) (2.40) (1.79)
RET + − 0.122 −0.109 − 0.044
(−1.21) (− 1.24) (− 0.22)
Size variable
LNSALE + 0.136⁎⁎⁎ 0.120⁎⁎⁎ 0.113⁎⁎
(8.27) (5.43) (3.59)
Growth opportunity variable

MB + 0.067⁎⁎⁎ 0.072⁎⁎⁎ 0.055⁎⁎
(2.40) (2.69) (2.67)
Risk variable
STDRET + 0.112 −0.012 0.044
(0.83) (− 0.09) (0.25)
LEV +/− − 1.072⁎⁎⁎ −0.709⁎⁎⁎ − 0.640⁎⁎⁎
(−5.83) (− 3.78) (− 7.27)

AGE + 0.001 0.009⁎⁎⁎ 0.008⁎⁎
(0.14) (3.15) (4.37)
TENURE + 0.031⁎⁎⁎ 0.027⁎⁎⁎ 0.026⁎⁎⁎
(7.80) (7.54) (5.64)
DEDU + − 0.101⁎ 0.025 − 0.004
(−1.79) (0.45) (− 0.06)
Ownership variables
OWN + 0.022⁎⁎⁎ 0.026⁎⁎⁎
(4.95) (7.14)
DFAMILY + 0.279⁎⁎⁎ 0.273⁎⁎⁎
(4.81) (8.06)
KR − −0.052 − 0.033
(− 1.50) (− 0.86)
DOUT − −0.062⁎ − 0.057⁎
(− 1.77) (− 1.75)
DMBANK − 0.050 0.013
(1.44) (0.31)
BSIZE + 0.004 0.006
(1.42) (1.37)
Industry indicators Yes Yes Yes
(continued on next page)
Table 3 (continued )
(1) (2) (3) (4) (5)
Variable Expected Basic model- Full model- Full model-annual
sign pooled pooled averages
Year indicators Yes Yes No
Adjusted R2 0.280 0.375 0.385
F-value 18.16⁎⁎⁎ 20.53⁎⁎⁎
F-value: ownership and governance 19.45⁎⁎⁎
variables = 0
⁎⁎⁎ (⁎⁎,⁎) Significant at the 1% (5%, 10%) level, two-tailed.
See Table 1 for variable definitions.
We find that the coefficients on firm size (LNSALE) 0.136, growth opportunities (MB) 0.067,
and executive tenure (TENURE) 0.031 are statistically significantly positive, as predicted.
However, the coefficients on ROA, an earnings based metric and RET, our annual stock return
measure are not significant, suggesting that current performance measures do not explain current
pay very well.
The coefficient on education (DEDU) is marginally significantly negative, inconsistent with
our hypothesis. Kato (1997) also found a negative coefficient on the education variable, but it was
statistically insignificant. The coefficient on financial leverage (LEV) is significantly negative,
suggesting that firms with higher debt levels pay their top executives less. We conjecture that
LEV captures monitoring by external debtholders (John and John, 1993).12 Our direct risk
measure, STDRET, is positive, but statistically insignificant. The overall regression statistics
(adjusted R2 = 28%, F = 18.16, p b 0.01) indicate that total CEO compensation is significantly
associated with the firm's demand for a high quality CEO, performance, risk and human capital.
Columns (4) and (5) show the results for the full model incorporating the monitoring and
ownership variables, using a pooled approach and annual regressions, respectively. Including the
monitoring and ownership variables increases the adjusted R2 of the regression from 28.0% to
37.5%. This evidence indicates that the corporate governance variables add significant
explanatory power to the model for top executive pay. The biggest coefficient changes between
column (3) and column (4) are for ROA that is now 3.539 (as opposed to 1.965) and is now
statistically significant in the expected direction. This suggests that top executive pay is strongly
positively related to accounting performance but unrelated to stock return performance. The
coefficient on the top executive education variable, DEDU, is now 0.025 (as opposed to − 0.101),
although statistically insignificant. The sign change of the education coefficient in the full model
(including governance variables) is similar to that in Kato (1997).
We now discuss the ownership variables, OWN and DFAMILY. The coefficient on the
ownership by all directors (OWN) is 0.022 and significant at the 1% level. This suggests that a top
executive whose board owns a higher percentage of his own firm's shares earned higher income.
Absent detailed individual share ownership data, we cannot infer whether this greater income
came mostly from his salary and bonus or from dividends on shares he owned. This finding is in
slight contrast to Hiraki et al. (2003) and Chen et al. (2003) that find a positive relation between
managerial ownership and firm value.
12
We do not include BETA as part of this model since it is not significant in explaining the overall relation.
The coefficient on DFAMILY is positive (0.279) and significant at the 1% level. This suggests
that a founding family-controlled firm tends to pay its top executive more, which is consistent
with lax governance. The interpretation of the coefficient on DFAMILY is that top executive pay
in firms whose founding family members exercise strong influence in management is 22% higher
than that in firms without such influence. These findings are consistent with the theoretical
arguments offered in Demsetz (1983), who suggests that when a family is a major owner in the
firm, family members have incentives to overpay themselves.
Lastly, we look at the governance variables. We find that for keiretsu firms, KR is negative
(− 0.052), consistent with Kato (1997). This result is marginally consistent with the keiretsu
governance mechanism being effective in reducing managerial opportunism. In economic terms,
we find that the top executive pay of keiretsu firms is approximately 5% smaller than that of non-
keiretsu firms, all else equal.
The coefficient on presence of outside directors, DOUT, is − 0.062 and marginally
significantly negative. This finding is similar to Kaplan and Minton (1994) who suggest that
these outside directors perform an important governance function. Economically, executive pay is
6.2% smaller for similar performance levels when there is at least one outside director on the
board.
In a (untabulated) follow up test, we examine if the keiretsu exerts its influence, in part,
through the board of directors. Although there is much evidence that outside board members do
more monitoring, Kaplan and Minton (1994) suggest that the bank board members are more
vigilant than corporate board members. We partition the outside directors by whether or not they
are affiliated with a bank.13 We then interact each group with a keiretsu indicator. We find that if a
keiretsu firm has a bank director, the level of compensation, LNCOMP, is significantly less than
that for a keiretsu firm without a bank director. This suggests that bank board members are
associated with lower top executive compensation. Kaplan and Minton (1994) show that the
presence of a bank-related outside board member is correlated with negative current income and
poor stock market performance, suggesting that this potential monitoring effect is endogenous.14
The indicator variable, DMBANK, represents the influence of a main bank. We find its
coefficient to be 0.050 and not statistically significant. This positive but insignificant coefficient
contrasts with Kang and Shivdasani (1995), who find that non-routine top executive turnover is
more likely for firms with main bank ties. The lack of significance is effectively similar to Hiraki
et al. (2003) for their test period 1992–1998.15 We do not find a main bank monitoring effect.
Finally, the coefficient on board size, BSIZE, which is 0.004 is positive, although not
statistically significant. The coefficient on BSIZE implies that a one-standard deviation increase in
the size of the board (i.e., about 10) is associated with a 4% increase in total CEO compensation.
Our finding is similar to other studies that fail to find a significant relation between board size and
corporate governance proxies in Japan. Our finding contrasts with Core et al. (1999) who find a
strong positive relation between top executive compensation and board size for U.S. firms.
6.1.1. Sensitivity tests

In untabulated tests, we examine the sensitivity of our results in two areas. First, we examine
the impact of negative earnings on top executive compensation. An indicator variable for losses
has a negative coefficient of − 0.134 that is statistically significant at the 10% level, indicating that
13
It is common for either a keiretsu or other large bank to send a senior member to sit on the Board of companies to
which they have loaned money.
14
We find results that are similar but not statistically significant for our sample.
15
However, Hiraki et al. (2003) find a negative influence of the main bank during a sub-period from 1985–1991.
CEOs of unprofitable firms are paid 13% less on average than CEOs of profitable firms. The
coefficient on ROA is 7.983, which is more than twice the coefficient of 3.539 in the pooled
regression in column (4), and it remains significant at the 1% level. The interaction between the
loss indicator variable and ROA has a coefficient of − 10.150, which is significant at the 1% level
and negative as expected. This coefficient indicates that the pay/performance sensitivity is
significantly lower for unprofitable firms than profitable firms. The net slope coefficient for loss
reporting firms (− 2.167 = 7.983–10.150) is not significantly different from zero, consistent with
pay cuts not being likely to follow poor performance. Overall, this specification check indicates
that the pay-performance sensitivity for Japanese top executives is considerably different for
profitable and unprofitable firms.
Second we examine the effect of lagged ROA, RET and LNSALE for our column (4)
regressions. The coefficient estimates for RET, − 0.086, and lagged RET, − 0.119, are not
statistically significant. This likely reflects the general decline in the Japanese stock market during
the time period we study. However, the lagged ROA coefficient of 4.889 is significant at the 1%
level and the lagged LNSALE coefficient of − 0.061 is not statistically significant. The strong
relation between top executive pay and both current and lagged ROA suggests that Japanese top
executive pay is primarily based on accounting profitability rather than sales or stock returns.
Column (5) reports the results for the average coefficients from the five annual cross-sectional
regressions. This approach controls for cross-sectional correlations in regressions (Fama and
MacBeth, 1973). The signs and statistical significance of the ownership and governance variables
are similar to those for the pooled regression in column (4). A notable change is that the ROA
coefficient reduces slightly to 3.487 and becomes statistically insignificant.
In summary, both ownership and monitoring variables have a substantive cross-sectional
association with the level of top executive pay, after controlling for its standard economic
determinants (firm size, growth opportunities, contemporaneous firm performance, firm risk, and
human capital variables). In particular, with respect to ownership variables, we find that CEO
compensation is an increasing function of the directors' total ownership and founding family
influence. With respect to the monitoring variables, CEO compensation is higher when the board
is larger, there is no outside director on the board, and the firm is not a keiretsu group member.
6.2. Predicted excess compensation and future performance
This section examines whether the cross-sectional variation in top executive pay explained by
the ownership and board-monitoring variables represents agency problems or omitted economic
determinants of the equilibrium compensation level. Our maintained assumption is that the
significant results on ownership and monitoring variables reflect the existence of unresolved
agency problems; that is, certain ownership and monitoring mechanisms are conducive to CEO
entrenchment. Under this hypothesis, ownership and monitoring variables proxy for the
effectiveness of the firm's governance structure in controlling agency problems.
Alternatively, the cross-sectional evidence that ownership and monitoring variables explain
variation in CEO pay may result from an ill-specified model for the equilibrium wage of the CEO,
exclusive of the monitoring and ownership mechanism variables. Under this scenario, the
monitoring and ownership variables proxy for some correlated omitted economic determinants,
such as CEO quality, the CEO's job complexity, or the firms' potential monitoring-incentive
provision tradeoff. To distinguish between these alternative explanations, we examine whether
the component of compensation explained by the corporate governance variables is correlated
with future period accounting and stock market performance (Core et al., 1999).
In Appendix I, we summarize how Core et al. (1999) empirically distinguish between the two
explanations. Equation A1 defines ‘predicted excess compensation’ as a single variable formed by
the weighted linear composite of the corporate governance variables, where the firm-specific values
of the corporate governance variables are multiplied by the coefficients estimated in our Table 3.
Japanese firms operate under a mandated disclosure regime that is considerably more lax than that in
the United States. To apply the Core et al. (1999) approach in our context, we select governance
variables that were at least marginally significant in Table 3. Two monitoring variables are used to
construct PREXMN: DOUT, the presence of an outside director on the board; and BSIZE, the
number of directors on the board. Similarly, two ownership variables are used to construct
PREXOW: OWN, the percentage of outstanding shares owned by all directors; and DFAMILY, the
indicator variable for a family-controlled business. PREDEX, the predicted excess compensation
due to corporate governance, is constructed using all four corporate governance variables.
If the association between compensation and governance mechanisms reflects the degree of
managerial entrenchment, we expect to observe a negative association between predicted excess
compensation and subsequent firm performance. If the association between compensation and
board structure and monitoring variables reflects omitted economic determinants of CEO pay, we
expect no association or perhaps a positive association.
Table 4 reports the results of the regressions of one-year-ahead accounting performance (ROAt+1)
and stock market performance (RETt+1) against predicted excess compensation attributable to the
board structure and ownership monitoring mechanisms and a set of variables representing the
economic determinants of firm performance. We also include industry-indicator variables to control
for idiosyncratic accounting and stock price performance within each industry group over the
relevant period, and time-indicator variables to measure performance relative to the average
performance in the sample over the same time period. We modify the Core et al. (1999) model to
include leverage (LEV), firm size (LNSALE) and a risk measure, the standard deviation of the prior
three years of monthly stock market returns (STDRET), as controls for determinants of accounting
performance. LEV captures the impact of capital structure (i.e., interest costs) on earnings
performance, and hence, we expect it to have a negative coefficient. LNSALE is used to capture
growth opportunities and profitability associated with large firms and we expect it to be positively
associated with future earnings performance (e.g. Gaver and Gaver, 1993) and STDRET is a measure
of firm risk.
Panel A reports the results when the dependent variable is one-year-ahead accounting
performance (ROAt+1). Column (3) shows that using a pooled regression, the coefficient on
predicted excess compensation (PREDEX) is − 0.007 and statistically significant at the 1% level.
Thus, this negative association suggests that the coefficients on the governance variables
estimated in the CEO compensation model (in Table 3) reflect the effectiveness of corporate
governance, instead of capturing omitted economic determinants of the equilibrium wage. The
economic significance of excess compensation on subsequent operating performance is material:
a one-standard deviation increase in excess compensation (= 0.234, untabulated) is associated
with a decrease in annual ROA of approximately 0.002% (=− 0.007 × 0.234) per year. Since the
average ROA in the sample is approximately 1.4%, this implies a loss of approximately 2.8%
(= 0.002%/1.4%) of the sample average ROA. The coefficient on leverage, LEV, − 0.078, is
significantly negative and the coefficient on firm size, LNSALE, is 0.003 significantly positive,
both consistent with predictions. The average of the annual cross-sectional regressions reported in
column (4) is almost identical to column (3).
In order to further assess the relative importance of the board structure and ownership
mechanisms, we compute two different measures of predicted excess compensation, attributable
Table 4
Regressions of subsequent operating performance (ROAt+1) and subsequent stock performance (RETt+1) on predicted
excess CEO compensation, control variables and industry- and year-dummies
(1) (2) (3) (4) (5) (6)
Variable Expected Total excess compensation Components of excess compensation
sign
Pooled Annual averages Pooled Annual averages
Panel A: Dependent variable is ROAt+1
Intercept 0.029⁎⁎⁎ 0.024⁎⁎⁎ 0.026⁎⁎⁎ 0.018⁎⁎
(4.60) (5.11) (4.12) (2.42)
PREDEX − − 0.007⁎⁎⁎ −0.011⁎⁎⁎
(−2.17) (− 2.79)
PREXOW − −0.005⁎ − 0.009⁎
(− 1.71) (− 2.08)
PREXMN − −0.012 − 0.020
(− 0.11) (− 0.02)
STDRET + 0.003 0.006 0.003 0.006
(1.09) (1.43) (1.00) (1.31)
LEV ? − 0.078⁎⁎⁎ −0.079⁎⁎⁎ −0.076⁎⁎⁎ − 0.078⁎⁎⁎
(−17.57) (− 29.40) (− 16.81) (− 26.08)
LNSALE + 0.003⁎⁎⁎ 0.003⁎⁎⁎ −0.003⁎⁎⁎ 0.004⁎⁎⁎
(5.95) (7.94) (6.36) (6.38)
Adj. R2 0.403 0.404 0.399 0.395
F-value 43.11⁎⁎⁎ 32.29⁎⁎⁎
Panel B: Dependent variable is RETt+1

Intercept − 0.365⁎⁎⁎ 0.150 −0.353⁎⁎⁎ 0.121
(3.61) (0.63) (3.48) (0.55)
PREDEX − 0.030 0.000
(0.50) (0.00)
PREXOW − 0.022 0.027
(0.31) (0.20)
PREXMN − −0.116 − 0.200
(0.81) (− 1.40)
STDRET + − 0.066 −0.056 −0.062 − 0.060
(−1.30) (− 0.91) (− 1.25) (− 0.97)
LEV ? − 0.024 −0.093 −0.033 − 0.085
(−0.51) (− 1.06) (− 0.68) (− 1.08)
MB − − 0.008 −0.007 −0.008 − 0.005
(−0.87) (− 0.74) (− 0.95) (− 0.59)
LNMV − 0.010 −0.005 0.010 − 0.003
(1.31) (− 0.29) (− 1.11) (− 0.16)
Adj. R2 0.47 0.215 0.464 0.020
F-value 48.14⁎⁎⁎ 44.64⁎⁎⁎
⁎⁎⁎ (⁎⁎,⁎) Significant at the 1% (5%, 10%) level, two-tailed.
ROA is the return on assets calculated as (Net Incomet) / (Total Assetst−1). RET is the annual stock return calculated as
(Stock Pricet + Dividend Per Sharet) / (Stock Pricet−1) − 1, adjusted for stock splits and stock dividends. SALE is annual
total sales in millions yen. PREDEX is the predicted excess compensation related to both governance and ownership
mechanisms. PREXOW is the excess compensation attributable to the ownership mechanisms. PREXMN is the excess
compensation attributable to the monitoring mechanisms. STDRET is the standard deviation of annual stock returns for
3 years adjusted for dividends paid. LEV is the leverage calculated as (Total Liability) / (Total Assets). LNSALE is the
natural log of sales. MB is the market-to-book ratio at the beginning of each year. LNMV is the natural log of market value
of equity.
to the ownership structure (PREXOW), and separately to the monitoring variables (PREXMN).
These two measures have a statistically significant negative correlation of − 0.059 ( p b 0.108,
two-tailed), suggesting that the two groups of governance mechanisms are substitutes. When we
include both measures in column (5), we find that predicted excess compensation related to the
ownership (PREXOW) and the monitoring (PREXMN) mechanisms is both negatively
associated with subsequent accounting performance, although the coefficient on PREXMN
is insignificant. A one-standard deviation increase in excess compensation related to ow-
nership structure (= 0.233, untabulated) leads a decrease in annual ROA of approximately
0.12% (= − 0.005 × 0.233) per year, an implied loss of approximately 8.5% (= 0.12%/1.4%) of
the sample average ROA. This evidence suggests that inside ownership affects the extent to
which CEOs are overpaid relative to economic determinants, which predicts the manifestation of
other contracting inefficiencies within the firm that lead to poorer subsequent performance. As a
sensitivity test, we provide a summary of the annual cross-sectional regressions in column (6).
The results are substantially the same.
Panel B reports the results when the dependent variable is one-year-ahead stock returns (RETt+1).
Neither the coefficient on total predicted excess compensation (PREDEX), nor the coefficients on
predicted excess compensation related to either ownership mechanisms (PREXOW) or monitoring
mechanisms (PREXMN) are significant. The mean coefficients from annual cross-sectional
regressions are similar although the mean adjusted R2s are much lower.
In summary, we find evidence of a negative relation between the compensation predicted by
the ownership and monitoring mechanism variables and subsequent accounting performance,
but no association with future return performance. This finding suggests that the weightings of
the monitoring and ownership variables in the compensation equation are related to the
effectiveness of the firm's governance structure, rather than being proxies for omitted
determinants of the top executive's equilibrium wage. As such, our results suggest that Japanese
firms with weaker governance mechanisms have greater agency problems; that top executives at
firms with greater agency problems extract higher pay; and that firms with greater agency
problems perform worse.
7. Summary and conclusions
We investigate the association between top executive compensation and the effectiveness of
corporate governance mechanisms for Japanese firms. We use keiretsu, main bank and outside
director dummies as proxies for the strength of the monitoring mechanisms. We use aggregate
director ownership and family control as proxies for ownership control mechanisms. We find that
the average top executive pay is less for keiretsu firms, similar to Kato (1997). This result
suggests that keiretsu firms more effectively monitor their management. Alternatively, the above
result suggests that it is easier for non-keiretsu managers to entrench themselves and behave
opportunistically, and as a result, the managers extract excessive compensation. We also find a
little evidence that main banks play a role in keiretsu monitoring of excessive pay. We find that
the smaller boards and the outside director presence are associated with lower top executive pay,
consistent with monitoring arguments and prior U.S. evidence.
We find that greater stock ownership by the board is associated with higher top executive
income. Similarly, greater family influence on firms is associated with higher top executive
income. These results are consistent with managerial entrenchment, although it is possible that
they reflect higher dividend income rather than excessive pay. Overall, we find that top executive
compensation decreases as the corporate governance structures become stronger.
Augmenting this evidence, we also find evidence of a negative relation between the com-
pensation predicted by the ownership and monitoring variables and subsequent accounting
performance, but no association with future return performance. If the cross-sectional variation in
executive pay explained by the corporate governance variables reflects the effectiveness of these
mechanisms in controlling agency problems, the excess compensation predicted by the corporate
governance variables should be negatively associated with future firm performance. Thus, our
results suggest that Japanese firms with weaker governance structures have greater agency
problems; that CEOs at firms with greater agency problems are overpaid; and that firms with
greater agency problems perform worse. Our results extend prior evidence that Japanese
corporate governance mechanisms are successful adaptations to the different Japanese
institutional environment.
Recent stock market declines and evidence of managerial manipulation has focused
shareholder attention on excessive top executive pay and weak corporate governance in U.S.
firms. Several institutions are now ranking firms worldwide on their corporate governance,
usually using “best” U.S. practice as the benchmark. Our results suggest that these rankings can
be improved by incorporating unique corporate governance mechanisms that have evolved in
other countries in response to their different institutional structures.
Acknowledgements
We thank Kevin Sachs, Donald Stokes, Zoltan Matolcsy, Donal Byard, and Charles Trzcinka,
an anonymous reviewer, and workshop participants at University of Auckland, University of
Cincinnati, Glasgow University, Hunter College, University of Technology-Sydney, SUNY-
Buffalo and Hong Kong Polytechnic University for their comments. We thank Keiko Yahashi for
her research assistance. Hwang appreciates financial support by the Institute of Management
Research at Seoul National University. Early versions of this paper were presented at the 2000
AAA annual meetings.
Appendix I
The following explanation and related equations borrow extensively from Core et al. (1999,
pp. 390–393). Eq. (A1) represents CEO compensation that is computed from various board
structure and ownership variables and their coefficients from a regression similar to that in our
Table 3 Column (4). Core et al. refer to this computed value as ‘predicted excess compensation,’
because it is an estimate of CEO's pay that can be attributed to the corporate governance variables
after controlling for standard determinants. Year subscripts are omitted for brevity.
X X
Predicted excess compensation ¼ b ̂ i board structurei þ gî ownership i ; ðA1Þ
Since there are fewer mandated disclosures in Japan, we study fewer variables than
comparable U.S.-based research. This restricts our ability to directly compare our intermediate
findings with other work in this area.
The predicted excess compensation could reflect managerial entrenchment that allows the
CEO to exploit agency problems. Alternatively, the predicted excess compensation reflects the
expected superior performance arising from important economic determinants that were excluded
from our regression model. To discriminate between these two alternatives, we regress the current
predicted excess compensation on various measures of future firm performance. The maintained
hypothesis is that if there is management entrenchment (i.e. poor management), then we expect a
negative relation between current excess pay and future firm performance.16
Future firm performance is measured using either accounting or market measures. The
accounting regression specification is:
ROAi ¼ d0 þ d1 Predicted excess compensationi þ d2 Std dev of ROAi

þ d3 Salesi þ hi Year controlsi þ ki Industry controlsi þ ei ; ðA2Þ
where accounting performance is the average return on assets for the three years following the
current year. The standard deviation of ROA is the standard deviation of the return on
consolidated assets for the three years prior to the current year. Predicted excess compensation is
derived from Eq. (A1). The other variables in the equation are previously defined in the text.
The stock market performance regression is:
Stock return ¼ a0 þ a1 Predicted excess compensationi

þ a2 Std dev of stock returni
þ a3 ln ðmarket value of equityÞi þ a4 Market % to % booki
þ hi Year controlsi þ ki Industry controlsi þ ei ; ðA3Þ
where stock return is the average common stock return for the three fiscal years subsequent to the
current year. The standard deviation of stock return is the average annual stock return for the three
years prior to the current year. The market value of equity and the market-to-book ratio are
measured at the end of the fiscal year prior to the current year.
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Variable definitions
ROA: Return on assets

RET: Stock Return
PREDEX: Predicted excess compensation related to both governance and ownership mechanisms
PREXOW: Excess compensation attributable to the ownership mechanisms
PREXMN: Excess compensation attributable to the monitoring mechanisms
STDRETS: Standard deviation of annual stock returns for 3 years adjusted for dividends paid
LEV: Leverage calculated as (Total Liability) / (Total Assets)
LNSALE: Natural log of sales
MB: Market-to-book ratio at the beginning of each year
LNMV: Natural log of market value of equity

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Pacific-Basin Finance Journal 15 (2007) 56 – 79

Corporate governance, top executive compensation

JEL classification: G32; G34; J33

It remains to be examined if corporate governance mechanisms in other countries control

2. Japanese corporate governance mechanisms

2.1. The main bank

2.3. Boards of directors

Japanese boards of directors (called “torishimari-yaku” or “yakuin”) are legally appointed by

3. Japanese top executive compensation

3.1. Japanese compensation practices

3.2. Prior research on Japanese executive compensation

4. Governance variables and their hypothesized effects on top executive compensation

4.1. The main bank

4.2. Keiretsu membership

4.3. Outside directors and board size

4.4. Family influence

5.1. Sample selection

5.2. Descriptive statistics

Firm performance variables

Growth opportunity variable

Human capital variables

Human capital variables

6.1. Determinants of Japanese top executive pay

Firm performance variables

Growth opportunity variable

Human capital variables

6.1.1. Sensitivity tests

6.2. Predicted excess compensation and future performance

Panel B: Dependent variable is RETt+1

7. Summary and conclusions

ROAi ¼ d0 þ d1 Predicted excess compensationi þ d2 Std dev of ROAi

Stock return ¼ a0 þ a1 Predicted excess compensationi

ROA: Return on assets

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