During lung development, signaling by Fgf10 (fibroblast growth factor 10) and its receptor Fgfr2b is critical for induction of a gene network that controls proliferation, differentiation, and branching of the epithelial tubules. The downstream events triggered by Fgf10-Fgfr2b signaling during this process are still poorly understood. In a global screen for transcriptional targets of Fgf10, we identified Ctsh (cathepsin H), a gene encoding a lysosomal cysteine protease of the papain family, highly up-regulated in the developing lung epithelium. Here we show that among other cathepsin genes present in the lung, Ctsh is the only family member selectively induced by Fgf10 in the lung epithelium. We provide evidence that, during branching morphogenesis, epithelial expression of Ctsh overlaps temporally and spatially with that of Bmp4 (bone morphogenetic protein 4), another target of Fgf10. Moreover, we show that Ctsh controls the availability of mature Bmp4 protein in the embryonic lung and that inhibiting Ctsh activity leads to a marked accumulation of Bmp4 protein and disruption of branching morphogenesis. Tightly controlled levels of Bmp4 signaling are critical for patterning of the distal lung epithelium. Our study suggests a potentially novel posttranscriptional mechanism in which Ctsh rapidly removes Bmp4 from forming buds to limit Bmp4 action. The presence of both Ctsh and Bmp4 or Bmp4 signaling activity in other developing structures, such as the kidney, yolk sac, and choroid plexus, suggests a possible general role of Ctsh in regulating Bmp4 proteolysis in different morphogenetic events.