JOURNAL OF THE JAPANESE AND INTERNATIONAL ECONOMIES 6,241-274 (1992) The Interaction between Financial and Employment Contracts: A Formal Model of Japanese Corporate Governance* GERALD T. GARVEY AND PETER L. SWAN Australian Graduate School of Management, University of New South Wales, PO Box 1, Kensington, New South Wales 2033, Australia Received July 1, 1991; revised March 24, 1992 Garvey, Gerald T., and Swan, Peter L.-The Interaction between Financial and Employment Contracts: A Formal Model of Japanese Corporate Governance Decision making in large Japanese corporations traditionally gives substantial weight to the interests of employees and of main bank investors, but not to those of small shareholders. This paper shows how such a governance system is uniquely suited to provide employees with incentives both to exert individual efforts and to cooperate with one another. The critical element of the system is shown to be a substantial concern for the welfare of workers and of creditors, with relatively little involvement by shareholders. The potential for overwork due to performance measurement error is also highlighted. J. Japan. Znt. Econ., September 1992,6(3), pp. 247-274. Australian Graduate School of Management, University of New South Wales, P.O. Box 1, Kensington, New South Wales 2033, Australia. B 1992 Academic Press, Inc. Journa/ of Economic Literature Classification Numbers 026, 514, 821. I. IN-I-R~DuCTI~N One of the most prominently cited reasons for the success of postwar Japanese firms is their ability to maintain valuable implicit agreements with their employees (Hashimoto, 1989; Kester, 1991; Dore, 1987). Besides * Thanks to David Allen, Masahiko Aoki, Jeff Borland, Robert Drago, three anonymous referees, and participants at the 1991 Australasian Banking and Finance Conference for useful comments and suggestions. 247 0889-1583192 $5.00 Copyrirght 6 1992 by Academic Press, Inc. All rights of reproduction in any form reserved.