Mitsuhiro Fukao examines Japan’s zombie banks since the early 1990s. The causality of these severely undercapitalized banks runs as follows: increasing loan losses from bankrupting borrowers weaken banks’ capital base; undercapitalized banks start to hide losses and provide evergreening loans to loss-making firms; and undercapitalized banks as well as firms continue to operate with deposit taking by zombie banks under forbearance of regulators. The most important factor during Japan’s worst financial crisis (1997–2003) was the loss of confidence in the accounting and auditing system. Unreliable financial statements resulted in a vicious cycle of credit contraction and impeded the functioning of the market economy. Close relationships among bankers, regulators and accountants impeded quick resolution by allowing nonviable banks to hide loan losses. Complex debtor-creditor relationships among related companies make it difficult to ascertain the scale of the bad-loan problem. The most adverse effect is the increased risk of financial crisis.