This Paper explains both the onset of the financial crisis in
1998 and the striking economic recovery afterwards in Russia
and other Former Soviet Union (FSU) economies. Before the
crisis banks do not lend to the real sector of the economy, and
firms use non-bank finance - including trade credits and barter
trade - to finance production. The banking failure arises due to
the coexistence of adverse selection in a lemons credit market
jointly with high government borrowing. The collapse of the
treasury bills market in the financial crisis of August 1998
triggers a change in banks' lending behaviour. As a result output
recovers which provides initial conditions for banking
development.