Summary: Since August 1998, Russia has been suffering from a severe banking crisis. In finding a solution, two peculiarities of the Russian economy need to be taken into account: the substantial foreign liabilities of commercial banks and the failure of the government to service its liabilities. Apart from the externality problem of bank recapitalization, the paper discusses how to deal with the adverse selection and moral hazard problems resulting from asymmetries of information. We suggest that banks should be offered to their foreign creditors for recapitalization and that banks which cannot attract additional funds should be closed. The government should support the recapitalization process by taking over control from the banks' old shareholders. This would facilitate the transfer of control to foreign creditors. It would also serve to limit asset stripping and thereby to reduce externalities distorting the recapitalization process. Distortions could be mitigated further by bailing in investors not participating in the recapitalization.

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