One of the most perplexing factors in Japanese financial crises is the persistence of the apparently non-optimal and non-rational behaviour of Japanese banks. We have provided a rational explanation for this behaviour based on a theory of community banking: the long-term relationships between banks and small to medium-sized entrepreneurs that result in rational rigidity in lending. We have identified three clear implications of community banking - a low lending rate, a low bankruptcy rate, and in particular, institutionalisation of rational rigidity (pledge of no profit maximisation) - as these prevail in the Japanese banking system. We have also argued that the community-banking-business model was sustainable so long as the economy rather continuously expanded and asset prices went up, which was the case before the asset markets crashed in 1990. Thus, the stagnation and free-falling asset prices of the 1990s imposed serious strains on the Japanese banking system. However, we have also found that banks continued their community banking role into the 1990s at least partially, although there are also indications that they failed to restructure failing enterprises in industries such as construction and real estate. So, the problem was not that paralysed banks were blocking recovery (although this might be true in some of the industries mentioned above), but that the current community-banking-business model is no longer sustainable as private enterprises in the market economy now suffer from asset price deflation and economic stagnation.
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