Understanding Japanese Keiretsu

The structure of major companies in Japan, known as Keiretsu, is steeped in tradition and relationships. 

Japan's corporate governance system dates back to the 1600s, but was propelled by the Japanese government's newly formed Meiji Restoration in 1866 as the world entered the Industrial Revolution. These early corporate formations were termed "zaibatsu," which translates to English as "monopoly." Zaibatsus began as small, family-owned enterprises that formed in various Prefectures across Japan to specialize in the separate business needs of the nation. As Japan's economy grew, zaibatsu grew to evolve into holding companies.

When the U.S. occupied Japan and rewrote the Japanese constitution after World War II, it eliminated zaibatsu holding companies and the Japanese governmental policies that perpetuated their existence. Its rationale was the their monopolistic, undemocratic nature: Studies suggest zaibatsu holding companies bought politicians in exchange for contracts, exploited the poor in pricing mechanisms and created dysfunctional capital markets, all to perpetuate their existence. However, with Japan devastated after World War II, Japanese companies reorganized as keiretsus, which translates to "lineage" or "grouping of enterprises" in English, and structured along either a horizontal or vertical integration model.

Under a zaibatsu, the largest industrial groups allowed banks and trading companies to be the most powerful aspects of each of the cartels and sit at the top of an organizational chart. These banks and trading companies controlled all financial operations and the distribution of goods. The original founding families were in full control of all operations.

Today's keiretsu horizontal model still sees banks and trading companies at the top of the chart with significant control over each company's part of the keiretsu. Shareholders replaced the families controlling the cartel as Japanese law allowed for holding companies to become stockholding companies. Yet vertical integration is still a part of the larger horizontal structure of today's keiretsu. For example, each of Japan's six car companies belongs to one of the big six keiretsus, as do each one of Japan's major electronics companies.

Typical of a Japanese horizontal keiretsu is Mitsubishi. The Bank of Tokyo-Mitsubishi sits at the top of the keiretsu. Mitsubishi Motors and Mitsubishi Trust and Banking are also part of the core group, followed by Meiji Mutual Life Insurance Company, which provides insurance to all members of the keiretsu. Mitsubishi Shoji is the trading company for the Mitsubishi keiretsu.

Their purpose is strictly distribution of goods around the world. They may seek new markets for keiretsu companies, help incorporate keiretsu companies in other nations and sign contracts with other companies around the world to supply commodities used for Japanese industry. As you've no doubt noticed, many companies within this keiretsu have "Mitsubishi" as part of their name.

Vertical keiretsus are a group of companies within the horizontal keiretsu. Automobile giant Toyota is one such. Toyota's success is dependent on suppliers and manufacturers for parts, employees for production, real estate for dealerships, steel, plastics and electronics suppliers for cars as well as wholesalers. All ancillary companies operate within the vertical keiretsu of Toyota but are members of the larger horizontal keiretsu, although much lower on the organizational chart.

Without Toyota as the anchor company, these companies may not have a purpose for existence. Toyota exists as a major keiretsu member because of its history and relationship to major horizontal members that dates back to its early years of the Meiji government as the first exporter of silk. The Japanese focus on societal relations, as well as cross-shareholdings, allowed keiretsus to perpetuate themselves since World War II.

Banks regularly owned a small percentage of their keiretsu members' stock and members owned a portion of the bank's stock. This formed an interlocking relationship, especially if the member company borrowed from the horizontal member bank. Interlocking relationships allowed the bank to monitor borrowings, strengthen relationships, monitor customers and help with problems such as supplier networks.

This arrangement limited competition within the keiretsu and prevented company takeovers by outsiders of the keiretsu. These early arrangements would later lead to the supply of workers by keiretsu firms and a board of directors that would come directly from the keiretsu. All businesses involved need to ensure business sustainability within the keiretsu. But while some may see success of keiretsu, others see problems.

The limited competition within the keiretsu may lead to inefficient practices. Because a keiretsu company knows it can readily access capital, it could easily take on too much debt and overly risky strategies. On the other hand, the reduction of costs due to dealing with intra-keirestsu firms can increase efficiency within the supply chain: The automobile keiretsus invention of the just-in-time inventory system is a prime example.

Information sharing within the keiretsu is another argument for increased efficiency. Information is shared among customers, suppliers and employees. This leads to quicker investment decisions and suppliers, employees and customers knowing the purposes and goals of those investments. However, critics charge that, because of their size, keiretsus can't adjust to market changes quick enough for these investments to earn profits.

Some would argue the economic crisis in Japan in the late 1990s forced Japanese companies to compete for price and quality by using market-based systems instead of keiretsu relational arrangements. This occurred due to major horizontal banks' reports of profit losses. Japanese companies were forced to seek financing outside the keiretsu by borrowing from the bond and commercial paper markets.

For the first time in recent Japanese history, Japanese keiretsus found their first crack, resulting in a forced loosening of traditional standards. Globalization and technology are other aspects that would force Japanese companies to open to competition by identifying new customers, increasing the efficiency of orders and researching new markets. The major question that remains: Is this is a permanent solution, or will the keiretsu evolve into another new entity – much as the zaibatsus morphed into keiretsus a haf-century ago.

For additional reading, check out "Dragons, Samurai Warriors and Sushi on Wall Street" for a look at how East Asia influenced investing terminology.