Japan's corporate governance system known as a keiretsu 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," translated to English as monopoly. Zaibatsu's 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 later form into holding companies.

The Collapse of the Zaibatsus
When the U.S. rewrote the Japanese constitution after World War II, the United States and the Allies eliminated zaibatsu holding companies because of their undemocratic nature as monopolies, and Japanese governmental policies that perpetuated their existence. Studies suggest zaibatsu holding companies bought politicians in exchange for contracts, exploited the poor in pricing mechanisms and exploited 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" in English, and structured as 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. Banks and trading companies controlled all financial operations and the distribution of goods. The original founding families were in full control of all cartel 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 belong to one of the big six keiretsus as do each one of Japan's major electronics companies.

Modern Horizontal Keiretsus
Typical of a Japanese horizontal keiretsu is Mitsubishi where the Bank of Tokyo-Mitsubishi sits at the top of the keiretsu. Also part of the core group is Mitsubishi Motors and Mitsubishi Trust and Banking 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.

Modern Vertical Keiretsus
Vertical keiretsus are the group of companies within the horizontal keiretsu such as Toyota. 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 Downsides Of Keiretsus
The limited competition within the keiretsu may lead to an inefficient company because a keiretsu company knows they can easily access capital. This could potentially allow a company to take on too much debt and lead it into taking on overly risky strategies. Others would argue that reduction of costs would increase efficiency within the supply chain. Some point to the automobile keiretsu's invention of the just in time inventory system as 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 know the purposes and goals of those investments. Others suggest that keiretsus can't adjust to market changes quick enough for these investments to earn profits. (Learn more about efficiencies in Measuring Company Efficiency.)

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.

The Bottom Line
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 whether this is permanent or will the keiretsu reform to a new entity as they did when zaibatsus formed into keiretsus.

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

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.