Broader and Deeper Markets
Support Global Development

GARY L. PERLIN
Senior Vice President and Chief Financial Officer
The World Bank

FIFTH ANNUAL INTERNATIONAL CONFERENCE
ALTERNATIVE STRUCTURES OF SECURITIES MARKETS
SEPTEMBER 22, 1999

OPENING
David A. Walker
Director, Capital Markets Research Center

We are celebrating our fifth annual conference on Alternative Structures of Securities Markets. We have at this conference 62 international delegates from 47 countries. From the Washington area, we have representatives of international institutions, including the World Bank, the IMF, the Inter?American Development Bank, and USAID, as well as business people who are sponsors of the Capital Markets Research Center. We are able to do this only because of the generosity of The Nasdaq Stock Market.

We are honored tonight to be joined by Mary Schapiro, the President of NASD Regulation. Just recently, I learned that, at one point, about twelve years ago, I worked for Mary’s husband. I had heard that Chas Caldwell was married to a brilliant attorney, but I did not know her name.

Mary Schapiro is one of America’s most important financial regulators and is tackling the difficult tasks of resolving broker-dealer-market conflicts and enhancing the nation’s confidence in the potential for electronic markets. Mary’s impeccable reputation immediately gave the new regulatory agency an outstanding reputation. She has been appointed to important financial regulatory positions requiring Congressional confirmation following nomination by three different American presidents--Presidents Reagan, Bush, and Clinton. Being appointed by all three demonstrates the great respect that everybody has for her.

NASD Regulation regulates 5,500 member brokerage firms, almost 600,000 registered representatives, and has oversight responsibilities for The Nasdaq Stock Market. Previously Mary served as Chair of the Commodities Futures Trading Commission, following appointment by President Clinton in 1994. She has been a Commissioner of the U.S. Securities and Exchange Commission and served as the SEC’s acting chair. She is a graduate of Franklin and Marshall College in Lancaster, Pennsylvania. Later, she earned her juris doctorate with honors at the National Law Center of The George Washington University. It is a privilege to introduce her.

WELCOME Mary Schapiro
President, NASD Regulation, Inc.

It is my great pleasure to welcome this group of international market executives and regulators on behalf of the NASD and The Nasdaq-Amex Market Group. On behalf of my colleagues, and particularly Frank Zarb, who is our CEO, we are pleased to have such a distinguished group of people here. Frank and many of the senior members of the NASDAQ team are ironically out of the country right now. Since I lead NASD Regulation, which is the market’s primary regulator, I cannot brag shamelessly about Nasdaq, as I am sure Frank would. I am very pleased to join you and to see so many regulatory colleagues this evening. I expected people from markets and others from the industry directly, but I did not expect to see so many governmental regulators and self?regulators. You come from many different markets and levels of technological sophistication. I know that you share our belief in the importance of regulation to protect investors and to assure the integrity of the market place.

We are delighted to share our experiences with you in market development, operations and regulation, and this is the right place for all of us to share best practices and information that will be beneficial to oversee and manage our markets. Attracting so many senior market officials from around the world to interact makes this conference successful each year.

What does change, of course, are the issues. Five years ago, the first year of this conference, there was no on?line investing. Few of us even knew much about the Internet. There was no after hours trading, at least not retail trading, after established business hours. Few of us knew much about Electronic Communications Networks, or ECNs, which are now a prominent part of our financial landscape. There was no emerging trend in privatization of stock markets, and no capital markets in some of the countries that are represented here tonight. It is a different world of investing, trading, market operations and market regulation.

The ways we regulate have evolved, including market surveillance, licensing of industry professionals, and examination of a firm’s financial and operational capability. Sound regulation remains essential to global competitiveness. This forum has helped to build alliances and partnerships and lays the foundation for opportunities we have not yet even envisioned.

I hope that every one of you will seize the opportunity to network, to debate, and share your perspectives with each other and with all of us. We are absolutely delighted that you are here and we wish you a very rewarding week in Washington and New York. We at NASD Regulation, Nasdaq?Amex and the NASD all look forward to working with you for investor access and market confidence, but most of all, to generate trust and confidence in securities markets around the world. I would like to thank David Walker and his distinguished colleagues at the Business School, Reena Aggarwal, in particular, and Jim Angel who is the NASD academic in residence this year, for the wonderful job that you all have done with this conference. Thank you.

INTRODUCTION - David A. Walker

Our keynote speaker this evening is Gary L. Perlin, Senior Vice President and Chief Financial Officer of the World Bank. Gary’s address highlights our conference. I have been privileged to know Gary Perlin for approximately fifteen years, and the focus of the conference is related to how I met Gary. The primary theme at The McDonough School of Business at Georgetown is international business. Years ago when I was beginning to introduce international issues into my courses, a colleague encouraged me to add lectures on international institutions. I sought a guest lecturer from the World Bank. Somebody recommended Gary Perlin, who had become the Treasurer of Fannie Mae.

Gary Perlin did his undergraduate work at Georgetown in the Foreign Service School and then he completed graduate degrees at two other premier universities-- the London School of Economics and Princeton University. He spent a number of years on Wall Street and at Fannie Mae, and has returned to The World Bank and has become its Chief Financial Officer and Senior Vice President.

KEYNOTE ADDRESS - Gary L. Perlin
Senior Vice President and Chief Financial Officer
The World Bank

Georgetown awakened my passion for international finance, international economics, and international development, even though I was not a student in the business school. The message I want to deliver is the need for courage, energy, and enthusiasm for what you are doing to develop emerging markets.

Opportunity

I would like to discuss the trends that will lead us into the next century and will provide the context within which so many stock market executives and international regulators are going to develop their markets; the work of market executives and regulators is extremely important. There is a critical lesson that we have learned over the course of the last couple of years, marked by what we still call the Asian Crisis. The lesson is that we need to encourage both broader and deeper markets.

This is the way to protect one’s own market and to deter trade imbalances or public deficit imbalances. At the same time, we do need to look at how global markets are evolving, to understand the context in which emerging economies must operate. In the end, the only way to protect your economy is to make sure that you use capital efficiently. This is what markets should do; they should allocate resources efficiently. The challenge that you undertake cannot be overstated.

You are facing an exceptionally challenging environment in the years ahead. I am not a pessimist, but I believe that the period ahead is one embedded with substantial risk. Along with the risk, of course, comes opportunity. If there is a crisis, those who are better prepared will handle it more effectively — and are more likely to come out ahead.

This is the operative course in a rapidly changing world. This serves as the foundation for your own markets and the issues you are discussing this week.

Why is this market environment changing so quickly? First, the information and the communications engineers offer us immediate access to one another. The financial engineers have provided the instruments with which to transact business through these new channels. Most importantly, the policy engineers began to develop, often on a national basis, the basis for a global financial system. The changes by policy makers and regulators are not necessarily synchronized. In fact, this can often introduce friction. In turn, regulators tend to respond to crises. They respond to crises. They respond to competition, and sometimes to fashion. We should welcome the push.

Financial Flows

International finance combines three elements ?? global, regional, and national environments. At the global level the key element is capital. Capital flows are global. Markets are primarily regional. Financial institutions, by and large, are national. The challenge we face is to combine and coordinate these three levels, not necessarily assuming that we will have global institutions, or necessarily national capital markets that are protected from the international forces. From a global perspective we observe capacity for capital to flow from one market to another. The markets themselves, however, are typically regional.

Asian, Latin American, or Central European debt or equity securities increasingly constitute a recognized asset class. This makes them a market. Investors, either within or outside of these markets, are making strategic or tactical allocations to a particular region. Fund managers oblige by offering dedicated funds, often on a regional basis. Deeper regional markets encourage knowledgeable buyers to seek value, especially in market downturns. On the other hand, reasonable valuation can be left behind when major regional asset allocations are changed. We need to interpret and understand what these regional flows mean.

Financial intermediaries, as well, have begun to operate on a regional basis. International institutions often desire a regional presence, even if this is accompanied by consolidating formerly independent local firms. Market support institutions, like clearing systems and rating agencies, help define arenas for regional market action. However, underlying the global capital within the regional markets are what are still largely national institutions.

Important as they are, regulators are not the key to developing deep markets. Regulators maintain integrity, but investors, especially institutional investors, are the most critical component for developing deep markets. Institutional investors have the economies of scale to generate savings, offer professional skills, provide risk management capacities, and develop contractual liabilities that create an abiding demand for long?term investments.

The state of investment institutions reflects the regulatory and legal framework of individual countries. This is true for investors, as well as those who raise capital-- sovereigns and municipalities, project developers, and public?sector enterprises. These issuers represent particular national circumstances, as do policies and regulations affecting potential issuers from overseas. When country risk or project risk is high, the demand for capital ?? especially the long?term capital needed to promote development projects -- is unlikely to be satisfied within the market itself.

Thus, markets are often pursuing external capital.

Structural and Systemic Changes

What is the future for the emerging markets? Increasing global opportunities and international risks will shape market development. This is true for countries that are locked in boom and bust economic cycles, as well as those that seem to defy cycles. This will affect all of us because the changes are both systemic and structural.

The first systemic change is the increasing volume of investable flows within and between countries. The nature of capital flows has also changed. Today they are much less linked to trade and not even so linked as they once were to direct foreign investment. The quantity of these portfolios’ flows is rising and with it, unfortunately, comes volatility.

Within the emerging markets, the flows are not from public sector to public sector, as they once were, but from private sector to private sector, and often between countries with substantially different rates of growth. The flows shift rapidly from those countries experiencing growth in one year to those experiencing growth the following year.

Perhaps the most important systemic changes are the developing regional markets and among international investment flows. These flows have less information content about the underlying economic fundamentals than did trade flows and direct foreign investment. The changing structure of markets will create continued volatility.

The nature of investors has also changed. Much of our investment has been professionalized in response to the volatility of the 1980's and the 1990's. The demand for performance and high returns comes from both institutions and individuals.

Institutional investors, many of whom have a very short-term performance perspective, tend to dominate market expectations. Individual investors, who are now participating in savings plans and defined contribution plans, are having an increasing impact. Individuals do not necessarily have the short-term view of the institutional investors, who are accepting risk because they believe they can outperform their competitors. But as individuals are being advised to ignore short-term risks while pursuing long-term returns, they can reinforce the one-way outlook of institutional investors.

This demand for performance and high returns comes from both institutions and individuals. This is true in the United States and elsewhere.

Risk and Performance

These changes in investors’ behavior accompany real changes in their risk appetite. Investors perception of the risk and their pursuit of high yields influence their willingness to accept the risks of leverage. Risk premiums are the smallest just before a crisis, as caution which should be increasing in fact gives way to recklessness on the part of those who fear they have missed opportunities.

Investors desperate over poor relative performance often ignore the fundamentals and try to achieve high returns either through leverage or accepting excessive risk. In retrospect, we wonder: How could those spreads have declined so much? Was excessive optimism the source of the crisis? Could the market be that wrong or inefficient? Is our information that erroneous?

If the market clearing price had indicated that risk was declining, then the market was wrong. It indicated that risk appetite was increasing!

Credit Risks and Premiums

The risk premium is the most important element in tracking how markets are evolving and volatility is increasing. Increasing credit risks have become acceptable. Investors are avoiding interest rate risk because commodity-like hedging markets have driven down returns. Currency risk is not easy to capture because of one-sided markets. Investors are therefore seeking higher yields by accepting credit risk. The market structure allows investors to accept these risks and offers a sense of comfort, liquidity, and occasional euphoria.

The structural changes in the markets are largely beneficial. They encourage the accumulation of savings for investment, and transfer risk to those institutions and those savers who are best able to manage the risks. When they seek abnormal returns in poorly developed and unregulated markets, however, opportunity shows its other side--volatility. This challenges not only investors but also the newer markets they are intended to nurture.

Managing Risk and Transparency

For those of us involved in the international financial arena, risks and volatility can overwhelm the capacity of regulators and supervisors to respond. Even if it were possible, capital control is not the best way to stimulate growth and development. The challenge that faces regulators and stock market officials is how to manage what we cannot control.

At the firm level, rational behavior is likely to compound the challenge that the markets are presenting. It is reasonable for firms to lever and de-lever themselves quickly in response to changing risk premiums. Firms require liquidity, whether it is real or created by central banks.

Investors and other firms will seek returns in non-transparent markets. Although the international financial community claims that transparency is the answer to economic problems and that transparency would have prevented the recent crises, I question how many investors would have entered new markets if they were not so transparent that everybody appreciated their real value. The challenge for the public sector, whether at the international level or the national level, is to deal with the issue of transparency for the public benefit. It is not just a matter of fairness, but also one of avoiding excess optimism at a systemic level.

Recommendations

You, as regulators and leaders of developing markets, are the ones who have to deal with the liquidity and related crises. You help by giving time necessary for over?leveraged borrowers to restructure and for over-leveraged investors to unwind. You share the burden of systemic credit experience, both at the national and corporate levels. You have to reconcile long?term economic health with short-term political and corporate agendas, and many of you help other authorities and regulators within your countries.

I encourage you to deal with the exchange authorities to develop resistance to economic stress, to improve the quality of financial management, and to improve the quality of supervision of financial institutions. Risks are easier to manage before they materialize. Success in this highly volatile world will depend on the success of early warning systems and your prompt response to them.

In this environment, it seems to me, that the future growth for many countries will depend on the development of both securities markets and capital markets. Capital markets, unlike banks, can accommodate unleveraged investments. They can offer a long-term investment horizon. They tolerate risks, but sometimes they accept too much. Capital markets can be much more efficient than other kinds of financial intermediation when it comes to supplying risk capital for large-scale and non-tradable investments. But it cannot be taken for granted that securities markets will consistently reward the effective deployment of scarce risk capital.

We must work to maintain and enhance the confidence in all the actors who comprise financial markets. This includes: the underwriters and others who originate and place securities; traders and brokers, who provide liquidity in secondary markets; rating agencies, that offer credit transparency; back offices, that offer settlement and delivery systems; regulators and supervisors, who assure the integrity of information and participants in markets; and finally individual and institutional investors. In other words, the promise of markets is within our grasp if we will only reach.