The Japanese economy has undergone almost 12 years of stagnation since the burst of the ‘asset price bubble’ in 1991. This study examines in detail the main factors that allowed the asset price bubble formation and the negative consequences that its collapse had on the Japanese banking system. The present paper will then estimate an econometric model to analyze the impact that the deterioration of the Japanese banking system had on the economic recession of Japan. The nature of the relationship between various indicators of banking system development and growth will be examined using Ordinary Least Square tests based on time-series data for the period 1985-2002, while the direction of their causal relationship will be analyzed in a Granger-causality framework. The empirical results of this paper provide further support to the theory that financial development causes economic growth, and thus financial weakening causes economic recession. The almost perfectly positive relationship between economic growth and banking system development provides also the evidence that in Japan the banking system is a far stronger determinant of economic growth compared with the stock market. The main innovation of this paper, however, lays in the fact that it includes in the estimated equation a proxy for banks’ asset quality which was never used before. The inclusion of this new proxy was made in order to emphasize the key role that banks’ asset quality plays as determinant of economy growth. The new proxy for banks’ asset quality was successfully employed and its strong significance to the model provides the evidence that sound assets of banks are a determinant prerequisite if high rates of economic growth are to be achieved.