Israel: Selected Issues and Statistical Appendix
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International Monetary Fund
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Publication Date:
19 May 1999
eISBN:
9781451819458
Language:
English
Keywords:
ISCR; CR; derivatives transaction; transaction; bank; provident fund; nonfinancial interest; bank-managed funds; return on equity; profitability rate; Commercial banks; Bank soundness; Foreign banks; Credit; major banking groups
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This Selected Issues paper and Statistical Appendix reviews developments in the structure of the Israeli banking sector, as well as in the key indicators of soundness and profitability in recent years. The paper highlights that Israel’s financial system continues to be dominated by a small number of banking groups. By international standards, the banking system is highly concentrated, with the largest five banking groups controlling almost 95 percent of total assets. The paper also describes developments in exchange restrictions in Israel.

Abstract

This Selected Issues paper and Statistical Appendix reviews developments in the structure of the Israeli banking sector, as well as in the key indicators of soundness and profitability in recent years. The paper highlights that Israel’s financial system continues to be dominated by a small number of banking groups. By international standards, the banking system is highly concentrated, with the largest five banking groups controlling almost 95 percent of total assets. The paper also describes developments in exchange restrictions in Israel.

I. Soundness, Profitability, and Structure of the Banking Sector in Israel1

1. The Israeli banking sector has been relatively profitable in recent years, by comparison with both its own past performance and that of the banking sectors in countries with similar per capita income levels. Moreover, in spite of the challenges arising from recent financial market volatility, it seems to be broadly sound.

2. At the same time, Israel's financial system continues to be dominated by a small number of banking groups. By international standards, the banking system is highly concentrated, with the largest five banking groups controlling almost 95 percent of total assets.2 These groups are truly universal, in the sense that—in addition to their conventional commercial banking activities—they manage some of the most important institutional investors (mutual and retirement provident funds)3 and control subsidiaries that specialize in underwriting and brokerage of shares, and in mortgage activities. Finally, they also have large stakes in nonfinancial enterprises.

3. This highly concentrated financial structure does not appear to have led to striking signs of inefficiency in the banking sector. Nevertheless, it may be argued that the improved soundness and profitability of the existing banks may have been obtained in part at the expense of a slow pace in fostering competition and encouraging the banks to divest their nonbanking business interests. This note reviews developments in the structure of the Israeli banking sector, as well as in the key indicators of soundness and profitability in recent years.

A. Developments in the Structure of the Banking Sector

4. Following a major financial crisis in 1983, when the stock market lost more than half of its value and many banks went through severe difficulties, the government took over the ownership of most of the shares of Israel's major banks. At the same time, under the 1983 Bank Share Arrangement, control continued to be exercised by the banks' original management. In 1993, the Bank Share Arrangement expired. Recognizing that the financial system was excessively concentrated, and dominated by a few large banks, the government put in place a banking sector reform, whose aim was to increase competitiveness, reduce conflicts of interest, and lower the government's presence in the sector. Its current reform strategy continues to be focused on those objectives, through the following measures:

  • the speeding up of the sales of the government's shares in the banks;

  • the selling off of subsidiary banks from their parent groups, to promote competition;

  • the reduction in banks' permissible holdings of nonbank corporations;4

  • the enactment of legislation to supervise the running of the provident funds by the banks, including the imposition of limits on the size of the funds and the appointment of outside directors, to separate the running of the funds from that of the banks; and

  • the appointment of independent governors to hold the government's shares in the banks.

Privatization

5. There has been considerable progress in implementing some of these measures. Perhaps the most striking steps have been taken, after a slow start, in the area of privatization. This was particularly so in 1997, with the sale of the government's majority stake in Bank Hapoalim, the largest bank, to a group of private investors,5 and a number of smaller transactions (Table 1).

Table 1.

Privatization Revenues in 1997

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Source: National authorities.

6. The massive privatization in the banking system boosted total privatization revenues in 1997 to a level that far exceeded that observed in previous years (Table 2).

Table 2.

Overall State Revenues from Privatization

(In millions of U.S. dollars)

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Source: National authorities.

7. In spite of accelerated privatization, the government still owns a considerable share of the largest banking groups (Table 3), including majority stakes in the second and third largest groups.

Table 3.

Holdings of the Government, Parties at Interest, and the Public, December 1997

(In percent)

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Source: National authorities.

8. In 1998, privatization continued, albeit at a slower pace than in 1997. The State sold an additional 7.6 percent of the shares in Bank Hapoalim through a public offering in Israel, and another 1.8 percent through a private placement; 31.7 percent of the shares in United Mizrahi Bank; and a 2 percent stake in Bank Leumi through a private placement.

9. Existing plans envisage continued momentum in privatizing the banks. Despite the recent global financial market volatility, the government's program for 1999 includes the sale of its controlling interest in Israel Discount Bank (a 30–50 percent stake is to be sold in the first half of the year) and of a considerable stake in Bank Leumi (only 40 percent of the shares will remain in the government's hands by the end of the year).

10. The new impetus to privatization in the banking sector may help improve the efficiency of the sector. At the same time, it may pose new regulatory challenges, because the transfer from public ownership to private ownership does not alter the high degree of concentration in the sector. Lower concentration needs to be pursued through other measures.

Reducing concentration

11. An important element of the government's strategy that would help reduce concentration is the attempt to split small- and medium-sized banks from their controlling groups. However, progress has been slow in this respect thus far. In fact, only one bank (Union Bank, a medium-sized bank), has been separated from its parent group (Bank Leumi) and sold to controlling shareholders as an independent bank. A few years ago, the government decided to split another medium-sized bank, Mercantile Discount Bank, and a smaller bank, Otsar Hahayal, from their parent groups Discount Bank and Bank Hapoalim, respectively. However, those decisions have not yet been implemented.

12. Reflecting the relatively slow speed in splitting up the banking groups, concentration remains very high in the banking sector, with the five largest banking groups accounting for 93.2 percent of total assets of the commercial banks and the three largest groups accounting for 77.2 percent of total assets (Table 4).6 Little progress has therefore been made since the late 1980s, when the corresponding figures were 98 percent and 90 percent, respectively. This is confirmed by developments in the Herfindahl index, which remains high at 0.23 in 1997, having declined from 0.30 in the late 1980s.

Table 4.

Distribution of Assets of the Commercial Banks, by Groups, December 1997

(Share of the total, in percent)

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Source: Supervisor of Banks.

13. An additional feature of Israel's banking system that does not bode well for competition is the virtual absence of foreign banks in Israel Although Israel welcomes entry by foreign banks, at present there is only one branch of a foreign bank in the whole country. Nevertheless, freedom of capital movement, with the gradual removal (during the 1990s) of all constraints on borrowing abroad, imposes considerable discipline on Israeli banks.

14. In spite of its high degree of concentration and the virtual absence of foreign banks, the Israeli banking system does not show strong signs of inefficiency. By international standards, the profitability of Israeli banks is fairly high in terms of return on equity, though on the low side in terms of return on assets (Table 5).7 Operating costs (as a ratio to total assets) are on the high side, reflecting in part relatively high salaries of bank employees, but are not much higher than average. Interest rate margins, at an average of 2.3 percent, also do not differ much from those of OECD countries. At the same time, interest rate margins in Israel vary considerably depending on the type of asset, illustrating the power of international competition in reducing margins. In fact, margins are now relatively low on foreign currency assets (2.0 percentage points, 32 percent of total assets) and on foreign currency indexed assets (1.2 percentage points, 31 percent of total assets), but they remain large on unindexed assets in domestic currency (4.2 percent, 27 percent of total assets), a market segment where competition from foreign banks is rather limited (Ruthenberg, 1998). Margins on unindexed assets in domestic currency have fallen dramatically since the late 1980s, when they exceeded 15 percentage points, though part of this decline has resulted from the decline in inflation and therefore in nominal interest rates.

Table 5.

Israel: International Comparison of Bank Profitability 1/

(In percent)

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Sources: Supervisor of Banks, Bank of Israel; Bank Profitability, OECD.

Data refer to 1997 for Israel and to 1995 for other countries. All banks unless otherwise indicated.

Total net provisions to total loans.

Commercial banks,

The five largest banking groups.

Divesting other interests

15. While progress has been modest in reducing concentration, the large banking groups seem to be on track in their mandated divestment from their nonfinancial interests. The impact of this process on banks' profitability in the medium run is uncertain.8 On the one hand, the banks' nonfinancial interests tended to yield relatively high profits in the past. On the other hand, by focusing on their core business, the banks might be able to raise their overall profitability. Although the limits on the banks' nonfinancial interests have been imposed too recently to assess the experience thus far, profitability has remained high, correcting for exceptional profits made through the sale of shares in nonfinancial enterprises.

16. However, an important area where there has been no progress thus far is in reducing the banks' control over the provident funds and mutual funds. The banks currently manage about 80 percent of the assets held by provident funds, and the largest three banks manage 75 percent of the assets held by mutual funds, with another 12 percent managed by four other banks (Yafeh and Yosha, 1998). A draft law is being prepared to reduce the banks' control over the provident and mutual funds, but there is little agreement on whether, in its present form, it conforms with the original objectives set out as part of the government's reform strategy.

17. While a universal banking system has benefits that include economies of scope in information gathering, Ber, Yafeh, and Yosha (1998) argue that in the Israeli case it also generates the potential for conflicts of interest. For example, a bank that is a large debt holder and at the same time a leading underwriter of a firm that is going public might be tempted to overstate the firm's quality to ensure a successful initial public offering (IPO), and even to encourage its own affiliated mutual and provident funds to purchase equity in the offering. Ber, Yafeh, and Yosha (1998) provide evidence that banks underwrite issues of higher than average quality firms (in terms of their post-issue accounting profitability), i.e., that universal banks do have informational benefits. However, they also show that these issues tend to be overpriced (i.e., following their IPO, returns on these stocks tend to be negative on the first day and worse than average during the first year), especially when a significant portion of the issued firm's equity is sold to a bank-managed mutual or provident fund. They interpret this finding as an indication that bank-managed funds paid too much for bank underwritten IPOs. Therefore, the universal banks' informational benefits accrue to the banks (or to the firms' original shareholders), in part at the expense of the investors in the funds. Should further research lend support to these results, they would provide an example of the costs of a system dominated by a few universal banks.

B. Developments in the Profitability and Soundness of the Banking Sector

18. The profitability (after-tax return on equity) of the five largest banking groups increased from an average of 3.1 percent in 1988–91 to an average of 9.1 percent in 1992–97, and was still high in the first half of 1998 (Tables 6, 7, and 8).9 10 Some of this increase reflected sales of nonfinancial holdings by banks. Nevertheless, net of these extraordinary profits, profitability rates were 8.2 percent in 1996 and 10.2 percent in 1997. The decline in economic growth does not yet appear to have adversely affected bank profitability, but is likely to begin to have a considerable impact in the near future. Improvements in profitability over the past few years reflect in part the gradual reduction of problem loans in the agricultural sector (which had emerged in the 1980s), with a reduced need for loan loss provisions. This has more than offset the considerable increase in operating costs, which results largely from the increase in real wages of banking employees (by a cumulative 18 percent over the past four years).

Table 6.

Israel: Financial Results of the Banking System, 1992–98

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Source: Supervisor of Banks, Bank of Israel.

The five major banking groups.

The commercial banks.

Table 7.

Israel: Indicators of Profitability, the Five Major Banking Groups, 1993–June 1998

(NIS million, June 1998 prices)

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Source: Supervisor of Banks, Bank of Israel.

Including minority interests.

Capital at beginning of year plus issues weighted according to date of issue.

Ordinary pre-tax profit divided by adjusted capital.

Total net income divided by adjusted capital.

Table 8.

Israel: Profitability, Risk, and Financial Leverage, the Five Major Banking Groups, 1995–June 1998

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Source: Supervisor of Banks, Bank of Israel.

19. The standard indicators of soundness are broadly favorable. The average capital to risk-weighted assets ratio of the five largest banking groups has been fairly stable, at 9½ percent or above, over the past few years. In June 1998, none of the five largest banking groups had a ratio below 8½ percent, though most had declined slightly since June 1997 (Table 9). Problem loans11 have declined steadily over the past five years, both as a share of capital and as a share of total credit (Table 10). One of the key factors underlying this improvement is, once again, the gradual resolution of problems in the agricultural sector. Nevertheless, the riskiness of the banks' assets is increasing, as evidenced by the rise in the ratio of risk-weighted assets to total assets from 49.1 percent in December 1993 to 60.1 percent in June 1998. This development may also contribute to explaining the improvement in the banks' profitability.

Table 9.

Israel: Main Items in the Income Statements of the Five Major Banking Groups, June 1997–June 1998

(NIS million, June 1998 prices)

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Source: Supervisor of Banks, Bank of Israel.

Including profit (loss) from sales of shares.

Other profit includes the group's share of the profit of companies included on an equity basis, the share of minority interest, profit from sales of assets and investments, and net profit from exceptional activities.

Defined as net profit plus the share of minority interests and translation of adjustments imputed to capital.

Capital and minority interests at the beginning of the year plus issues weighted according to date of issue.

Table 10.

Israel: Risk Characteristic and Capital Adequacy the Five Major Banking Groups, 1993–June 1998

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Source: Supervisor of Banks, Bank of Israel.

H-index of concentration of credit to the public, by principal industry.

Data reclassified in 1996.

20. Private rating agencies view the banking system in Israel as somewhat less sound than in most industrial countries, but as fairly sound by the standards of emerging markets. In June 1997, Moody's gave ratings of “C” to two of the five major banking groups in Israel, and of “D+” to the other three, yielding an average rating of “D+”.12 Among industrial countries, only Finland, Greece, and Japan had average ratings below “C”. In August 1998, Fitch IBCA gave individual ratings of “B/C” to Bank Hapoalim and Bank Leumi (the only Israeli banks for which it produces ratings), unchanged from previous years, and only slightly below average by the standards of industrial countries.13

21. At present, the key sources of risk in Israel's banking sector seem to be the following:

  • a decline in the rate of economic growth, from 7 percent in 1994 to 2 percent in 1998;

  • an increase in the share of credit indexed to or denominated in foreign currency, from 23 percent in 1994 to 39 percent at end September 1998;14 of particular concern is the rapid increase in the share of foreign currency credit in total credit to individuals and construction companies, because their foreign exchange risk exposures are unhedged to a considerable extent (neither group has large receipts in foreign currency);15

  • the rapid increase in credit to the real estate sector, whose share in total credit to the public rose from 12 percent at end-1992 to 17 percent at end-1996, and then to 26 percent at end-1997, against the background of a slowdown in activity in this sector;16

  • a rapid increase in total credit as a share of GDP, though this seems to be a natural consequence of the gradual liberalization in the banking system in the 1990s, including the reduction in reserve requirements, which appears to have led to re-intermediation.

  • an increase in leveraged buyouts, which imply higher overall risk for the Israeli banks that finance them.17

22. Additional prudential measures have recently been undertaken in response to these risks. In 1997, the required provisions for banks whose share of lending to a single sector (typically, the real estate sector) exceeded 20 percent were increased. More recently, the reporting requirements for banks whose customers have a large exposure to exchange rate risk have been tightened.

C. Concluding Remarks

23. Israel's banking system seems to be relatively profitable and broadly sound. The recent financial market volatility, the sharp depreciation of the shekel, and the decline in economic growth pose new supervisory challenges. However, continued vigilance and perhaps additional prudential measures should be sufficient to avoid major difficulties.

24. Looking beyond the ongoing turbulence on financial markets worldwide, the key challenges for the future of Israel's financial system continue to relate to its excessively concentrated structure, and to the dominance of the largest banking groups. Thus far, the government's strategy has relied on attempts to split up small- and medium-sized banks from the largest banking groups. However, implementation of the strategy has been slow. Greater speed and greater benefits could come from encouraging additional competition from foreign banks, which might even obviate the need to split up the banking activities of the existing groups. In that regard, the recent capital account liberalization, which removed all constraints on borrowing abroad, plays a useful role. Moreover, the ongoing divestment of the banks' interests in nonfinancial enterprises will improve transparency and reduce the possibility of cross-subsidization. Early action in separating the provident funds and mutual funds from the main banking groups would also help toward those objectives.

References

  • Ber, Hedva, Yishay Yafeh, and Oved Yosha, 1998, “Conflict of Interest in Universal Banking: Bank Lending, Stock Underwriting, and Fund Management,” mimeograph, June, Hebrew University, Jerusalem.

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  • Organization for Economic Cooperation and Development, Bank Profitability, various issues.

  • Ruthenberg, David, “Key Features of Robust Banking Systems,” mimeograph, Bank of Israel, October 1998.

  • Supervisor of Banks, Israel's Banking System, Bank of Israel, various issues (full text and tables on www.bankisrael.gov.il).

  • Supervisor of Banks, Annual Information on the Banking Corporations, Bank of Israel, various issues (full text and tables on www.bankisrael.gov.il).

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  • Yafeh, Yishay, and Oved Yosha, 1998, “Financial Markets Reform, Patterns of Corporate Finance, and the Continued Dominance of Large Banks: Israel, 1985–95,” Economic Systems, Vol. 22, No. 2, June, 175–199.

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1

Prepared by Paolo Mauro.

2

In a sample of 21 industrial countries, Israel had the second most highly concentrated banking system (after Finland) in 1996, on the basis of the Herfindahl index of concentration (Ruthenberg, 1998).

3

Retirement provident funds are vehicles of long-term savings, which enjoy tax benefits and can be redeemed after no less than 15 years. Provident funds held 16.5 percent of total financial assets in Israel in December 1997, and mutual funds held 2.6 percent.

4

The limit on each bank's holdings of the capital of any nonfinancial corporation, which has amounted to 25 percent since 1996, will be cut further to 20 percent at the end of 1999. Moreover, each bank will have to reduce its total nonfinancial holdings to 15 percent of its capital by the end of 2001. The percentage of such holdings can be augmented by 5 percent of the bank's capital provided that the holding in each nonfinancial corporation is no more than 5 percent of the company's equity. Insurance companies count as nonfinancial enterprises.

5

Specifically, the sale involved 43 percent of the shares, for US$1.4 billion, and an option to buy another 20 percent of the shares.

6

Total deposits by the public with commercial banks belonging to the five (three) largest banking groups amount to 98 percent (83 percent) of total deposits by the public with all commercial banks

7

International comparisons of bank profitability must be interpreted with caution, owing to cross-country differences in cyclical position.

8

In the short run, profits are mechanically boosted by asset sales, an effect that is taken into account in assessing the banks' profitability in the next section.

9

Early data on the third quarter of 1998 also suggest high profitability.

10

The profitability differed widely among the five largest banking groups, ranging from 5.3 percent in the Discount group in 1997 to 15.9 percent in the Leumi group. At the same time, the latter benefited from special profits arising from the sale of its nonfinancial interests.

11

The definition of problem debts is fairly comprehensive, as it includes debts that are doubtful (in full or in part), nonperforming, rescheduled, overdue, or under special supervision.

12

International Capital Markets, 1997, International Monetary Fund, pages 133–134. More recent assessments are broadly similar.

13

Individual ratings are reported because there is a widespread perception that the authorities would intervene to save banks in difficulty. Israel has no formal deposit insurance scheme. At the same time, the Bank of Israel can guarantee the deposits of banks in difficulty. In all cases of bank failures over the past 30 years, the government approved the use of this power by the Bank of Israel, regardless of the size of the deposits or the identity of the holder (with the exception of the deposits of the parties connected with the failed banks).

14

High demand for foreign-currency credit seems to have reflected the large interest rate differential between foreign- and local-currency credit together with the perception of relatively low risk in the volatility of the exchange rate, at least until the sharp depreciation that began in August 1998.

15

The banks' direct exposure to exchange rate risk through their own accounts is negligible.

16

Credit to the real estate sector more than doubled as a ratio to the sector's gross product between 1992 and 1997.

17

The managers that take over the control of a firm through a leveraged buyout, i.e., by financing the purchase through bank borrowing, have an incentive to undertake risky projects, because they keep any profits, whereas the bank would bear the brunt of any losses.

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Cover IMF Staff Country Reports
Israel: Selected Issues and Statistical Appendix
Author:
International Monetary Fund
Volume/Issue:
Volume 1999: Issue 040
Publisher:
International Monetary Fund
ISBN:
9781451819458
ISSN:
1934-7685
Pages:
87
DOI:
https://doi.org/10.5089/9781451819458.002