3. In the unique circumstances of the Transition, however, the content, sources and uses of information relevant to bankers are all very different, as are the observed behavior patterns of bankers, their customers and bank regulators. Thus, for example, a portion of the informational advantages ascribed to banks is derived from their special relationships of trust, built on longterm, commercial connections with enterprises. In the early stages of the Transition, however, fumdamental ownership and other commercial relationships are "up for grabs" as a result of privatization and other structural reforms, as well as in the realignment of traditional trade links. Wholly new sources of finance<sup>6</sup> have become available for both privatized and new start-up enterprises, which effectively limit the basis for this trust. From this, we can surmise that the information advantages of banks will be significantly less important in the early stages of the Transition, than in more settled economics. At the same time, it can be observed that Transition banks have been forced to adopt alternative mechanisms to protect themselves from risk. It is important for us to understand these alternative mechanisms, how they arise, how they evolve as the Transition proceeds, how they are effected by various policy reforms and, ultimately, how they ought to influence the policy advice offered.

4. This paper is organized as follows. Section II sketches the main shortcomings of the traditional analyses of the financial sector in transition - particularly the limitations of current thinking on the sequencing of financial sector reforms. Section III introduces and elaborates on the basic framework proposed. Section IV uses the framework to distill some simple but important propositions about transition banking. Section V provides an initial qualitative test of the framework, by using it as a lens through which to view some of the characteristics of transition banks which we have observed. It shows that behavior patterns which, at first glance, seem curious and counterproductive, do indeed have a rational explanation when viewed in relation to the analytical framework we propose. Section VI applies the proposed analytical approach to assess the appropriateness of various interventions -- especially those which have proved popular in the World Bank -- to support the financial sector transition. Two Annexes then elaborate particular aspects of the analysis. Annex 1 assesses how our analysis might recondition thinking about the appropriate regulatory and supervisory structures for transition banking. Annex 2 provides some initial empirical results based on our proposed framework of analysis.

# **Section II: Limitations of the Conventional Analysis**

J.E. Stiglitz, "Credit Markets and the Control of Capital" _Journal of Money, Credit and Banking,_ 17 (2, May), 1985. Stiglitz argues that well functioning stock markets quickly reveal information to investors through the rapid publication of price changes. However, this _reduces_ rather than enhances incentives to commit private resources to obtain information about the financial situation of enterprises. This is partly because the benefits of that information cannot be easily confined to those who expend the effort in gathering it. Recen **t** heoretical papers have also supported earlier empirical observation that equity market development occurs relatively late in the development process. See, for example, J. Boyd and B. Smith, "The Co-Evolution of the Real and Financial Sectors in the Growth Process," _The World Bank Economic Review,_ May 1996.

**6** These new sources include not only traditional forms of funding from banks and the capital markets, but informal "funding" from the deferral of payables to employees, the tax collector, enterprise suppliers and energy providers.

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