By a Silken Thread: Regional banking integration and pathways to financial development in Japan's Great Recession

We examine the impact of cross-prefectural differences in financial integration on the regional spread of Japan's Great Recession in the early 1990s. In prefectures with many small manufacturing firms, post-1990 growth was significantly lower if low levels of banking integration with the rest of the country before 1990 existed. The least financially integrated and most credit-dependent prefectures also saw the largest declines in lending by major banks operating nationwide. This suggests that financing frictions were more severe in less financially integrated regions. We then show that cross-prefectural differences in financial integration in the late 20th century can be explained by regionally different pathways to financial development after Japan's opening in the late 19th century. Silk reeling emerged as Japan's main export industry after 1868. The silk industry was heavily dependent on credit for working capital, but silk reelers in the mountainous regions of central Japan generally could not borrow from the large banks in Yokohama or the other major cities. Instead, they either formed local credit cooperatives or local banks were founded with the help of Yokohama silk merchants who then effectively provided the silk reelers with trade credit. The silk regions therefore embarked on a path to financial development in which banking remained centered on a largely mutual or cooperative model and in which banks borrow and lend mainly regionally. Thus, the banking system of the late 19th-century silk-exporting regions was effectively less financially integrated with the rest of the country at the onset of the Great Recession of the 1990s. Using the number of silk filatures per capita at prefecture level in 1895 as an instrumental variable, we corroborate our result that the post-1990 decline was worse in prefectures with low levels of banking integration and high credit dependence.