This paper addresses the puzzling existence and persistence of a pronounced "middle-risk gap" in Japan's interest rate structure, which reflects an underdeveloped and distorted market for small firm finance. The paper shows that a confluence of systemic reasons (including a shift away from the former reliance on real estate collateral, social constraints on bank strategies, bank capital adequacy constraints, and an underdeveloped market for securitized debt) and political pressure on banks have inhibited private bank activity in the middle market and necessitated specialized banks for small firm financing. A second concern is the overall low level of the loan interest rate structure. The paper argues that the government's small firm loan programs at greatly subsidized rates have depressed loan rates and exacerbated the "middle-risk gap", creating great impediments to banking reforms. However, these subsidized small firm loans are best understood as welfare, and while they are market-distorting they cannot simply be abolished without a substitute. The "middle-risk gap" is both, a strong indicator of, and an important reason for, the stalling of financial system reform in Japan. Successful reforms toward more market orientation in Japanese banking have to begin with the interest rate structure.
Keywords: Middle market, Interest rates, Japan, small firm financing, government lending, securitization, banking reform.
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.