Remarks at the NASD Regulation Fall Securities Conference
President and CEO
San Francisco, California
Good morning. I’m the newly elected CEO & President of the NASD, which is the parent of NASD Regulation and the American Stock Exchange. We are also the regulator of the Nasdaq Stock Market. Even though I now head up the parent of NASDR, I am not here to exercise parental supervision. I have come to this conference to find out first-hand the concerns you in the industry have and to take the opportunity to give you some of my ideas about regulation and our changing role in it. Thank you very much for inviting me to talk with you today.
Let me start by telling you a bit about myself and my views about securities regulation in general and self-regulation in particular.
In recent years, my most direct contact with the stock market was first, as Executive Director of the Brady Commission. That group, you may recall, wrote the report to President Reagan on the 1987 stock market crash, or as we more politely called it, the "precipitous decline."
After that – from 1989 to 1992 – I served as Under Secretary of the Treasury for Finance in the Bush Administration. I spent a lot of my time working on several important banking issues: restructuring the S&Ls and reforming deposit insurance for commercial banks. But I was also responsible for Treasury’s policy on SEC issues, including stock index futures and derivatives, and I handled the 1991 Salomon Brothers government bond trading scandal. Before and after my work on the Brady Commission and in Washington, I have been a professor at Harvard, both the Business School and the Kennedy School of Government. I taught banking and investment management. Since 1996, I have been a public member of the NASD and NASD Regulation boards.
View of Securities Regulation
My views on securities regulation are probably not much different from yours. I believe that the overwhelming majority of members of the NASD are honest. When they trip up, it is most often inadvertent, much like a foot fault in tennis. What we need to do is refine our systems to help members avoid foot faults, because we don’t want to play regulatory gotcha.
I also believe that for the small minority of firms that don’t want to play by the rules, the honest members want us to come down on them swiftly and firmly. And we will. We will, first, because it’s the right thing to do. And we will because integrity drives our markets, which thrive when investors put their money to work here. Investors will come here if they believe our markets are fair and honest.
I also believe that just because regulation is essential doesn’t mean that it has to be burdensome. I therefore will work to minimize unnecessary burden imposed by our rules. We are going to perform the equivalent of an Environmental Impact Analysis on our major rules to measure their costs, both direct and indirect, and benefits. Where we can, we will get the benefit at lower cost. Where the cost overwhelms the benefit, we’ll look at eliminating the rule. We have already begun this process with major retooling of the Corporate Finance Rule, the Advertising Rules, and the Free Riding and Withholding Interpretation. We will continue this review of our current rules and do the same analysis on the rules we write in the future as well.
Industry-based self-regulation is a major factor contributing the success of the U.S. securities markets. It is essentially unique to the United States and is an extraordinarily effective regulatory structure.
A self-regulatory organization brings to bear the practical understanding of the industry. It is the front-line regulator that deals with the day-to-day conduct of the securities business, and with the gray issues involved in the ethics of the industry. At the same time, self-regulation allows the government to take a step back to deal with market structure and other industry-wide issues, as well as maintain the public interest oversight through its black and white legal regulation of the industry.
Self-regulation also allows the securities industry to pay for its own regulation and devote far more resources than the government could spend on promoting the integrity of the industry. All of you want to do the right thing and compete fairly, but it makes it a lot easier if you are sure that everyone is competing fairly under rigorously enforced rules.
The key to success in self-regulation is the balance between the industry and government roles. When Senator Maloney proposed our system of self-regulation in 1938, he said the goal was to create a system of regulation "in which the members of the industry will themselves exercise as large a measure of authority as their natural genius will permit." This natural genius of the industry in the last 62 years has resulted both in the industry earning a major share of self-regulatory authority and in the success of our markets.
But the balance in self-regulation between the industry and government role is delicate. Failures of industry self-regulation in the early 90’s invited the balance to swing toward the government. Frank Zarb, my predecessor as NASD CEO, and Mary Schapiro, head of NASD Regulation, have done an extraordinary job of reestablishing investor confidence in NASD as a regulator and moving us back closer to the proper balance. My commitment is to work to complete the re-balancing process and to keep the "self" in self-regulation.
Restructuring of the NASD
I also want to update you on a major structural change in progress now at the NASD. As you know, we are completing the spin-off of the Nasdaq Stock Market – from the NASD into the hands of private owners. When the second round is completed – likely before the end of the year – NASD will own only a modest minority position in Nasdaq. The NASD will become essentially independent of Nasdaq and will be able to concentrate on its historic mission of regulating its member broker/dealers and, under contract, the Nasdaq Stock Market. With the separation of NASD and Nasdaq and with Frank Zarb moving over to run the Nasdaq Stock Market, the NASD board had to hire a new CEO. That’s how I got my job.
In recent years, competing exchanges and ECNs provide brokers with alternative places to execute a customer’s order. In an era where exchanges and their competitors act more like for-profit, public companies than traditional utilities, regulation benefits from being independent of market operations. A self-regulator will never be seen as evenhanded where it regulates both its own market and that of competitors. Keeping the stock exchange and its regulator independent – the setup we will soon have – makes sense, and is one of the major reasons that NASD Regulation is in the process now of separating from the Nasdaq Stock Market as Nasdaq restructures into a for-profit exchange.
Strategic Directions for NASD
Let me next take a few moments to share with you a few early thoughts about two strategic directions at the NASD, technology and regulatory services. Our strategy has to begin where it always has: with a commitment to continue to be a tough and evenhanded regulator. That will assure investors that U.S. markets remain the safest and fairest in the world. Investors trust our markets and know they are the most efficient and fair in the world. That gives U.S. capital markets an immense competitive advantage over markets everywhere else. I will work hard to keep it that way.
But we have to do more than simply be a tough and evenhanded regulator. One of our major strategic directions is to use technology to be smarter and more efficient than we have been in the past.
As securities transactions become more complex, the burden of regulation has grown. While all members feel regulatory burden, it falls most heavily on the small firms that are the majority of our members. For these firms, field examinations can be extraordinarily distracting, tying up the time of senior personnel and disrupting the orderly operation of their offices. To be frank, historically we haven’t done the best job of giving our examiners the cutting-edge tools and training they need to work most efficiently. And because we are tied to a routine cycle exam program, we don’t always focus our resources on the riskiest firms – those that require our attention onsite and often.
What we need to do is use smart computer technology both to train our examiners better and to support them when they go out to do field examinations for financial and sales practice compliance. We are doing this by developing a system called INSITE. First, INSITE provides computer-based training for our examiners. Second, INSITE allows the NASD to draw on data from our own monitoring systems and from clearing-firm data feeds to develop a profile of a firm’s compliance activities. From this profile, we can make a projection of the risk of non-compliance at the firm and deploy our examiners to those firms on the basis of risk. Firms with a clean record of compliance can be examined onsite less frequently or with far greater focus. For the vast majority of firms, this will mean less time in your offices. Third, INSITE gives us the ability to monitor firm activities continuously, looking for changing patterns of conduct or behavior that sets a firm apart from its peers.
INSITE and its successors will let us do a better, faster, and less burdensome job of auditing firm compliance. If our systems turn out to be as useful as we hope they will, we plan to offer them, with suitable modifications, to other regulators both here and abroad. And those systems may even prove useful to member firms that must oversee compliance at a large number of branch offices.
A second new strategic initiative we plan is to offer our regulatory services to other exchanges and regulators, again both here in the U.S. and abroad. Through our responsibility to oversee trading activity on the Nasdaq Stock Market, we are an experienced and – we believe – effective market regulator, with sophisticated computer systems to support our job.
In the U.S. many ECNs - like Nasdaq itself - are in the process of converting to exchange registration. When they do, under federal law they must take on self-regulatory obligations to police trading activity. We believe these new exchanges will find it efficient to outsource this self-regulatory task. After all, firms outsource most financial auditing activities now. NASD will seek these new exchanges as customers for our market regulation services. And building on our international reputation, we will offer these same market regulation services to exchanges and regulators in other countries.
The NASD will get a number of benefits from moving in this direction. We clearly will learn a lot from taking on these new assignments. Our experience will help us do a better job for NASD members and Nasdaq. We will earn an acceptable rate of return, which will let us cut the cost of regulation to our members. Perhaps more importantly, competing for and keeping clients holds our feet to the fire. To get and keep customers who sign up voluntarily, we have to do a good job. Our members have to face this kind of market discipline every day. NASD will benefit from the same experience.
I do want, however, to assure our members that our efforts to commercialize our regulatory services will not divert our attention from our primary responsibility: to regulate our members effectively and efficiently.
Our regulatory involvement in markets abroad, both in developed and developing countries, could also have important benefits not only for the countries where we regulate but also, more broadly, for the world economy. Strong, well functioning equity markets provide the fuel to grow businesses and produce jobs. As we have seen with Nasdaq in the U.S., most jobs are created by new, small businesses – today most often high-tech businesses – and it’s here that equity capital plays the biggest role. Startups and small, growing businesses can’t rely on debt financing; they feed on equity. And private equity investors need healthy markets where they can sell IPOs to take out their investments. This is true for the U.S, for other developed countries, and for developing countries as well.
Indeed, in the U.S. our efficient, deep, liquid equity markets provide the finance for new technology and new businesses. But our equity markets do much more; they have been a major factor in keeping the dollar strong in the face of record balance of payments deficits. Throughout this year, the U.S. balance of payments deficit has been at record levels and accelerating. In the 1st and 2nd quarters (the most recent data available), this deficit was running at a $450 billion annual rate. And yet the U.S. dollar has actually strengthened. Compare this with 1987, when the balance of payments deficit accelerated, the dollar weakened and ultimately the stock market crashed.
Why the different performance this time? This year, capital flows – net foreign direct investment and portfolio investment – have completely offset the deficit. Net equity inflows to our markets have played a major role, running at a $200 billion annual rate this year. Equity inflows have offset almost half the U.S. balance of payments deficit and kept the dollar strong. What’s attracted equity investment to the U.S.? Lots of factors – our growing economy, great, high-tech growth companies. But a major attraction is the quality of our markets. Foreign investors commit their risk capital here because they trust our markets, the fairest and the safest in the world. So, our well-regulated markets have not only provided capital for new, growing firms, they have contributed to keeping the dollar strong.
But our regulatory services also have great potential in the international arena, in both developed and developing countries.
Turning to markets in other developed countries, our involvement could smooth the regulatory frictions between the markets of different countries. With these markets, different regulatory regimes and rules stand in the way of capital flowing freely among them. To the extent NASD is able to provide regulation services to some of these countries, we are likely to be a force for harmonizing the rules under which these different markets operate, just as our CRD system harmonized the registration of securities professionals among the states in the U.S. If we succeed, we can reduce the barriers to the free flow of capital among these developed markets. That benefits investors as well as the countries that receive these investments.
What about developing countries? What contribution could our regulation make to them? Obviously, the picture varies from country to country, but an instructive one is Korea. Since I have spent much of my career as a business school professor, let me take you on a brief tour of the Korea case.
A couple of months ago, I was invited by the Korean financial regulatory authority to discuss issues of bank regulation. The Korean banking system almost collapsed in 1997. There were too many banks, financed with too little capital and too much foreign borrowing. And the banks were filled with bad loans, most to the Korean industrial conglomerates, leveraged 4 or 5 to 1 and stuck in old-economy industries like steel and shipbuilding.
Of course, like the U.S., Korea’s growth and employment will come, not in the old-economy industries, but in the new-economy businesses like chip making and telecom equipment. Korea is well positioned to grow these industries, with a hard-working, highly skilled workforce, and a remarkable 99% literacy rate.
My discussions with the Korean regulators focused on the debt markets and the banking sector. Korea has made progress in the last couple of years, closing or merging insolvent banks, pumping government capital into the banking sector, restructuring some of the major conglomerates. Employment is again rising and the economy is growing at 8-10%.
Yet restructured banks alone don’t hold the key to Korea’s growth. The new-economy companies, which will generate the bulk of income and employment growth, will need equity for finance. And the banks and the conglomerates will need equity to continue restructuring. To sustain its growth, Korea will increasingly have to look to its equity markets.
Unfortunately, the Korean equity markets resemble Las Vegas more than Wall Street. The Kosdaq, Korea’s high-tech stock market, doubled last year and is down by 70% this year. At the beginning of this year, the Kosdaq had a turnover rate of 12 times - 4 times Nasdaq and 11 times the NYSE. This market doesn’t just have some day-traders; it’s virtually all day-traders. And being a day-trader in Korea is probably the smart thing to do. With limited and ineffective regulation of Korea’s equity market, the long-term investment that Korea needs will simply go somewhere else.
Today, Korean stock markets are a regulatory no man’s land. There is limited corporate disclosure, little market transparency, toothless prohibitions on insider trading and manipulation, ineffective corporate governance and protection of minority shareholder rights. What Korea needs is a regulatory commitment to safer and fairer markets to attract the long-term equity capital it must have to sustain the growth of jobs and income. For a developing country like Korea – and Korea is in better shape than many - effective equity market regulation will be a foundation not just for equity markets, but for national economic growth.
The points I want to make in the international arena are first, that effective equity-market regulation in the U.S. has provided less obvious benefits, like reducing the dangers of our balance of payments deficit. Second, our regulatory involvement in markets abroad could encourage the freer flow of capital among developed countries and make markets in developing countries safer for long-term investment. Certainly, that means more competition for our securities markets. But that is competition we should welcome. Stronger market-based economies make the world more secure. That is the kind of foreign aid we want to extend.
What I’ve tried to do today, besides give you some of my ideas on regulation and especially self-regulation, is to set out a couple of the directions in which NASD intends to push in the near future, both in technology and regulatory services. The prospects for the NASD in its new role – independent of Nasdaq – are exhilarating. As we go down these paths, we’ll no doubt learn a lot, change our mind about some things, and decide to set out in some new directions. I look forward to talking with you all again about our experiences and evolving plans.