Financial Crisis, Economic Recovery and Banking Development in Former Soviet Union Economies

This paper provides a unified theory to explain the onset of the
financial crisis in 1998 and the striking economic recovery in
Russia and the former Soviet Union afterwards. Before the crisis,
the banking sector in these economies was stuck in a development
trap in which the banking sector is separated from the real sector
of the economy. The separation between the two sectors arises due
to a lemons lending market and due to a large government budget. In
a lemons credit market firms may find it cheaper to raise liquidity
through non-bank finance (trade credits from other firms) rather
than through bank finance. As a result non-bank finance may
generate an externality on the lending rates of banks. In
equilibrium most firms in the economy rely on non-bank finance and
the financial sector focuses on trading government securities. The
collapse of the treasury bills market in Russia in the financial
crisis of 1998 reversed this process and thus acted as a trigger to
pull the economy out of the trap. This has led to the strong
economic recovery and provided initial conditions for banking
development. Empirical evidence with firm level data from Ukraine
in 1997 and with country level data for transition economies
support the model’s predictions.