Protease-mediated signaling is an important modulator of the nervous system. However, identifying the specific signaling substrates of such proteases is limited by the rapidity with which intermediate substrate forms are cleaved and released. Here, a screening method to detect noncleaved enzyme-bound forms was developed and used to identify a novel neuropsin/neuregulin-1 (NRG-1) proteolytic signaling system, which is specifically localized in the microdomain of synaptic cleft, in the mouse hippocampus. The extracellular protease, neuropsin, cleaved mature NRG-1 (comprising the extracellular domain of the NRG-1) at three newly identified sites to remove the heparin-binding domain of NRG-1. This released the ligand moiety from the matrix-glycosaminoglycan pool and enabled it to trigger the phosphorylation of NRG-1 receptor, p185 (ErbB4). Proteolysis of mature NRG-1 by neuropsin led to colocalization of the processed NRG-1 with ErbB4 in parvalbumin-positive hippocampal interneurons and consequent phosphorylation of tyrosine residues of proteins in the cells. Moreover, neuropsin knock-out mice exhibited impairments in Schaffer collateral early phase long-term potentiation, and application of the recombinant NRG-1 lacking heparin-binding activity reversed the effects through the activation of ErbB4 and GABA(A) receptors. Thus, ErbB4 signaling induced by neuropsin-dependent processing of NRG-1 contributes to the modulation of synaptic plasticity via regulation of GABAergic transmission. This signaling system may be involved in human cognition and mental disorders, such as schizophrenia and bipolar disorder, by its dysfunction.