Lending to Unhealthy Firms in Japan during the Lost Decade: Distinguishing between Technical and Financial Health Lending to Unhealthy Firms in Japan during the Lost Decade: Distinguishing between Technical and Financial Health

By Suparna Chakraborty and Joe Peek

The bursting of the stock market and real estate bubbles of the 1980s dramatically shocked and changed the performance of the Japanese economy and the functioning of its banking system, resulting in a prolonged period of economic malaise in Japan, commonly known as the "Lost Decade," although it extended well beyond 10 years. The conventional wisdom appears to be that Japanese banks were "evergreening" loans (for example, Peek and Rosengren 2005; Caballero, Hoshi, and Kashyap 2008), narrowly defined as extending additional credit to enable unhealthy firms to continue making interest payments on existing loans, but more generally to enable an otherwise-insolvent firm to meet its expenses to avoid default. Because evergreening would contribute to a misallocation of credit, the extent to which it occurred could account for much of the depth of the malaise and the protracted length of the Lost Decade. For the most part, the existing literature has interpreted the evidence as strongly confirming evergreening behavior by Japanese banks; however, this evidence has been primarily based on firms' financial health rather than on measures of a firm's technological efficiency. This study investigates the misallocation of credit in Japan associated with banks' evergreening loans, distinguishing between financial distress, which may be temporary, and technical distress, which reflects weak operational capabilities as indicated by low total factor productivity. The paper also distinguishes among types of lenders based on the strength of their incentives to undertake evergreening behavior and considers the relative volume of lending to healthy versus unhealthy firms as well as the extent to which loans from these lender types were prudent.

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