Figure 4a Figure 4b <!-- Start of picture text --> Early in the Transition ... After the Transition ...<br>High * High i. ~~~~~~~~~~ th h RiX FXo1ii iX rflerbng the e-Xd ~ ~~~~~~~~~~~~~ ~~~~~flaiie1,t<br>o 41 otiforro~~~~~~~~~~~~~ highoe-dofw ~ ~~ ~~~~~~~~ly XX<br>o Pahili otelol0rO~ ;ie g X<br>CIL thP RitFmnierflt5pd W toh, o ed5-ing di ted - . _ . ._<br>tidtt f d:il. qtt h,h.ge -/D tb.r;i- b 7I - r'ms .<br>C) prio pi ced on idf-li.o :; Oreb tr0 5dS.. .<br>elf cepebilily for ti ss i Cl<br>oplideticoted bsdieg .[cirti.es.. F-w if ssy. b opete s in tho<br>while bk. lkth- I- emsdv i pti,ttiad<br>M * SO too pmtw eeomd been. 0 O .. . while beo goohi lly hove egwvi-iott by pmtf -Il<br>7% 4? / hy.lennaagytb ioy hi.to - ft i io- Arjl oky5ldirigi .t rt a iccotood bheorcopobilnotl P- g,rdr ' in 0 ourywojory oodSorjl,0o.<br>Low X Low<br>Low Sophistication of Bank Products High Low Sophistication of Bank Products High<br><!-- End of picture text --> 27. The third dimension reflected in our diagrams, the _operating environment,_ is indicated by the shape and position of the Risk Frontier, under the influence of factors such as those described in paragraphs 19-20, above. Although the overall long term impact of these various factors over time may tend to shift the Risk Frontier upwards while also flattening the slope of the curve, this evolution is by no means certain or monotonic. Most environmental factors associated with reform can have complex effects on the risks faced by banks. The _combined_ effect of changes in several of these factors is likely at best to be unpredictable or even counter- intuitive. Thus, for example, the implementation of modem banking laws and prudential/supervisory regulations will initially raise the Risk Frontier by restricting the less information-intensive strategies, such as insider and connected lending, which, in the early transition, are the safer banking strategies (See Sections IV and V below for a fuller explanation). Similarly, the liberalization of prices, trade, etc. exposes banks to the need, formerly absent, to do a serious job of processing information in order to distinguish good from bad credit risks. Any parallel liberalization of credit gives banks the freedom, also formerly absent, to offer a greater variety of differentiated products. Thus both types of liberalization can be seen as exogenous sources of increased risk to banks. By contrast, the effective implementation of collateral and bankruptcy laws can lower the Risk Frontier, making banking generally safer, by substituting reliable legal relationships for borrower-specific business information.

28. In general, it may be said that, over the long term course of the transition, as an economy moves away from the inefficient yet predictable command structure into the efficient chaos of the market, the Risk Frontier rises and flattens, as greater information processing demands are placed on all banks. However, the short term perturbations around this longer term trend may be very considerable as individual -components of reform change the environment in which banks need to work and so the risks to which they are exposed.

29. Figure 4b depicts our hypothetical banking system after it has emerged successfully from the, possibly long and probably turbulent, Transition, with a smaller number of banks now clustered in a smaller low risk area just above the Risk Frontier, which has shifted substantially 15