Editors' Summary

AMONG ITS MANY consequences, the Asian financial crisis of 1997 awakened the world to the importance of a sound financial system for economic stability. Each of the countries involved in the crisis had banks that loaned too freely, too often in foreign currencies, and too often to companies owned by bank shareholders. Furthermore, capital markets in each of the countries were poorly developed, accounting and disclosure standards were weak, bankruptcy systems were poor or effectively nonexistent, and little protection was afforded to minority shareholders.

All of this is now conventional wisdom, although how essential it is for emerging-market countries generally to move their financial infrastructure in Western directions remains hotly disputed. Skeptics point to the rapid growth of the Asian economies before the 1997 crisis and assert that the characteristics of what is now called "crony capitalism" were present throughout this period, apparently without negative consequences. Advocates of reform counter that, however impressive the previous economic track records may have been, if emerging-market countries want to be integrated into the international financial system, they will have to upgrade their legal infrastructure to something akin to Western standards or else face the kind of punishment meted out to the Asian financial markets.

If the latter view is correct--and we believe it is--then some countries may be tempted to say that they do not want to pay the price of joining the global financial marketplace. In fact, few countries have chosen this option. Instead, virtually all countries in the world want the benefits of foreign capital, goods, and services. The critical challenge is to obtain the benefits of openness without suffering the periodic disruptions that global integration may entail.

The papers in this fourth annual issue of the Brookings-Wharton Papers on Financial Services address this challenge by focusing on the measures that emerging-market economies can and should take to ensure that the legal and regulatory features of their financial systems are suitable for participation in a global financial market. Before we summarize some of the main findings, we recognize at the outset the essential contribution of one of the co-founders to the success of this annual publication in its first three years: Anthony Santomero of the Wharton School. Tony helped to conceive the idea for this publication and the annual conference when he directed Wharton's Financial Institutions Center. He has since moved on to become president of the Federal Reserve Bank of Philadelphia, and we wish him much success.

How important are emerging-market financial systems? Richard Levich tackles this threshold issue in the initial paper. Relative to developed-country financial systems, those in emerging markets--under various definitions of the term (there is no standard definition)--are quite small, but nonetheless growing as a share of total world finance. Since the 1997 crisis, there has been a dramatic shift in the nature and amount of capital flows to emerging markets, away from bank lending (which was prominent before the developing-country debt crisis of 1982 and thereafter in much of the 1990s) and toward foreign direct investment (which is inherently much more stable).

Among other things, Levich surveys the empirical evidence and reports that, on average, investments in emerging markets have contributed modestly to higher international portfolio returns, but they have not consistently lowered portfolio risk. In fact, since 1994, the correlation of returns in emerging- and developed-country markets has increased. As emerging-market stocks come gradually to be included in global return indexes, the governments in these countries have improved the incentives to upgrade their financial systems to global standards.

Relatively speaking, bond markets are less developed in emerging-market countries. For example, as of 1998, equity market capitalization in emerging markets accounted for about 8 percent of the worldwide total; for bonds, the share was a bit lower, or about 5 percent. Given their relative thinness, bond markets in emerging markets also display large spreads relative to safe securities, such as American treasury bonds. Emerging-market bond interest rates...