Supervision

55. Israel has a competent and professional supervisory staff and a satisfactory legal and regulatory framework to supervise banks. Accounting and financial disclosure standards are broadly in line with international standards.

56. The BOI is the sole supervisor of banks. The net skills of its staff is reasonably adequate, with many staff having extensive supervisory experience. Salaries and other benefits within the BOI are sufficient to prevent any significant attrition to the private sector. There are no indications of significant governmental interference in the implementation of supervisory policy in recent years.

57. The legal framework applying to the supervision of banks, and to banking activity more generally, appears adequate, but is somewhat outdated and in places unclear. For example, the relationship between the Governor (of the Central Bank) and the Government, and between the BOI’s objectives, could be clearer.

58. Weaknesses in the applicable laws have not significantly hindered the supervision of problem banks, including the application of remedial action. However, the responsibility of the BOI for bank exit is compromised by the requirement to have the agreement of the Government for certain key actions. In one very important respect (the appointment of an administrator to take over a problem bank), the Banking Ordinance explicitly requires the approval of the Government for an action that the BOI should have the independence to undertake. Although in practice the system appears to have worked well for quite some time (except in the area of failed bank resolution), without firm statutory foundations, such an arrangement cannot be guaranteed under all political and economic circumstances.

59. The statutory boundaries between the three different financial regulators [the other two being the Capital Markets, Insurance and Savings Division of the Ministry of Finance (CMIS) and the Israeli Securities Authority (ISA)] are not entirely clear. It is difficult to be sure that there are no gaps or overlaps in the regulatory coverage, or that the current allocation of responsibilities is efficient. The Banking Supervision Department (BSD) of the BOI has difficulty in exchanging information with these agencies and with its overseas counterparts, due to the strength of the over-arching privacy and secrecy laws. This is especially noteworthy given the financial conglomeration in Israel. Proposals have been made to amend these laws to allow for the necessary exchange of information between supervisory agencies, but it is not yet clear when, or if, these changes will be implemented.

Failed bank resolution

60. The team expressed concern that the provisions for bank exit are inadequate. In general, bankruptcy procedures work satisfactorily for liquidating the remaining shell of a closed bank. Before getting to that point, the supervisor needs the power to take over a failing bank, to protect its assets in the interest of its creditors, and to sell its valuable assets without disruption to its operations.

61. The BOI’s policy of depositor protection in the event of a bank failure is also unclear. Israel has no deposit insurance, but in the past, the depositors (and in one crisis, the shareholders) of failing banks have been guaranteed by the BOI to ensure an orderly resolution. As an alternative, an insolvent and nonviable bank should be dealt with in several ways—by taking it from its owners and selling the bank to new owners, merging it with another bank, or closing it.

62. At this point, the Governor has the authority to revoke a bank’s license, but must seek the government’s approval before replacing management and/or appointing an administrator. The Administrator in accordance with directions received from the Governor of the BOI, may transfer some or all of the assets of the bank to another bank but only if it assumes all the liabilities of the administered bank. This aspect of the Banking Ordinance unduly limits the scope of the Administrator’s powers to resolve the bank in an efficient way (for example, it would preclude the use of a “purchase and assumption” transaction) unless all claims (other than by owners) are guaranteed (as has been the past practice).

63. The team noted that the current legal arrangements regarding failed banks have worked satisfactorily because all creditors have always been bailed out. If, because of the moral hazard involved, this practice is abandoned in the future (perhaps by adopting explicit deposit insurance), existing legal regulations will not permit an efficient failed bank resolution.

Payment systems

64. A particular weakness pertains to the BOI’s role in the payment system and its policies with regard to the settlement of payments through its books. It is not clear how the BOI would deal with the failure of a bank to provide the funds needed after the system has implicitly settled its payments. Although in theory the BOI is able to reverse a transaction for which insufficient funds are available, in the event of a major bank failure, it appears unlikely that it would be able to do so without the risk of a collapse of the system because of the “domino” effect of consequential unwinding. In practice, therefore, system participants assume that the BOI will bear all of the credit risk arising from delayed settlement. This moral hazard is undoubtedly currently giving rise to mispricing of credit within the payment systems.

65. The BOI’s recent establishment of a payment system oversight function in the Comptroller’s department and its intention to oversee the development of a modern LVTS should go a long way toward overcoming these deficiencies.

Money laundering

66. Israel is listed by the Financial Action Task Force on Money Laundering (FATF) as one of 15 noncooperating countries because of deficiencies in its anti-money laundering framework. Its status was reviewed by FATF in June 2001. Israel is now well advanced toward correcting this problem. It adopted modern legislation on anti-Money Laundering in August 2000, and on the basis of the new law, the Governor of the BOI signed the Anti-Money Laundering Order on January 16^th, 2001. The order dictates identification and reporting requirements adherent to the FATF standards. The BOI is in the process of drawing up a working plan to ensure the implementation of the Order issued by the Governor which includes ongoing monitoring and reviewing the bank’s readiness, introducing procedures in accordance with the Order, mandatory training for employees to increase conscientiousness, setting guidelines for the different bank functions, and preparing the operational and computer systems for reporting compliance. During 2001, the Governor will establish in accordance with section 13 of the Order a committee, which will be empowered to impose financial sanctions for noncompliance. The Supervisor of Banks also plans to revise Israel’s “know your customer” directive (No. 411) to reflect the new legislation and Basel committee criteria on this issue. The anti-money laundering legislation will be fully implemented by February 2002.

Conclusions and recommendations

84. The team’s conclusions on the health of the Israeli banks are as follows:

• Israeli banks seem to have enough capital to cover potential losses due to credit and market risks (i.e., inflation, currency and interest rate risks) under very extreme scenarios.

• The team was concerned about the declining net interest rate margins and fee income as a proportion of total assets. Bank assets and credit have grown at very high rates, but the contribution of those assets to total profit has not kept the same pace. Shrinking margins and modest return seem to be behind that behavior. Although large banks have found ways to maintain stable return on assets, the situation may give rise to problems in the smaller banks, in particular if the recent entry of foreign banks encourage still more competitive banking practices.

• Credit risk is, by far, the main source of risk for Israeli banks. However, the methodology and technology used by Israeli banks to measure market risk is more advanced than the methodology and the technology used to measure credit risk.

85. Based on these conclusions, the team recommended that the BOI should:

• Improve its own credit risk assessment by requiring banks to report the amount, types and value of collateral. Discussions between the BOI and the banks of such an improvement are now under way.

• Examine carefully the situation of the smaller banks in the system. It is likely that consolidation of the banking industry will need to take place in the future due to increased competition.

• Encourage the incorporation of methodologies that address the non-linear risk in derivatives portfolios.

• Encourage the improvement in credit risk measurement and management. Specifically, the BOI could encourage the use of uniform credit rating categories for banks. Based on this uniformity, and given the large amount of data that is necessary to have estimates of client risk, and the positive externality involved in estimates that can use the information available to all banks, the BOI could centralize the information available to all banks in order to measure the sensitivity of the credit quality of banks’ clients to different specific and general risk factors.

86. More generally, the legal framework in which banks operate and are supervised should be strengthened. The team recommended adopting a new modern banking law that would incorporate provisions for the administrative takeover and resolution of insolvent banks or of banks that for whatever reason have their licenses revoked. In addition, the law should provide for:

• More explicit statement of supervisory objectives and powers;

• Sharing of relevant bank data and information among domestic and foreign supervisors; and

• Authority for the Governor to appoint an administrator to a failing bank without the need for specific Government authorization.

Insurance

92. The Insurance Business Supervision Law provides substantial powers to the supervisor, either directly or through the Minister of Finance. In addition, the supervisory body is well structured and has a core of capable and committed officers who are engaged in reforming the market and in particular the introduction of genuine competition for the benefit of consumers and the economy at large. The main limiting factor is a lack of actuarial and on-site inspection capacity.¹¹ In addition, the roles of the Minister and the Israeli Parliament (Knesset) Finance Committee appear in some cases to impinge on the legitimate supervisory role of the Commissioner.¹² Examples include specification of contract forms and some of the response mechanisms when an insurer shows signs of distress. Israel is unusual by industrial (and many developing) country standards in continuing to allow the licensing of composite insurers offering both life and non-life insurance and not completely sealing these functions from one another.

93. In practice, insurance supervision is fairly well defined, although there is room for improvement. Although the 1981 Act appointing the Commissioner of Insurance does not specify objectives for insurance supervision. Meantime, what has happened is that various objectives (currently not prioritized) have been developed, all with a view to protecting the interests of policyholders. There is a pressing need for more staff to strengthen insurance supervision and for more on-site inspections in insurance and securities.

Pensions

94. The reforms introduced following the 1995 agreement have gone a long way to bringing Israel up to best practice in terms of pension supervision. The major deviations from best practice reflect history and the difficulties of changing embedded structures that have created their own constituencies. These revolve around the lack of investment freedom available to boards and managers because of a historical symbiotic relationship between the government and all long-term savings mechanisms (and which has carried over for pension funds), the lack of a legal separation of the old funds and managers from the new ones, a chronic tendency to create unfunded liabilities and limited capacity for the supervisor to conduct on-site inspections.

95. Complicating the picture are a number of side issues, including the desire of the non-union fund managers to break the union cartel with regard to new funds and possible mis-selling of manager’s pension contracts. These are relatively minor compared to the issues listed in the previous paragraph and should be resolved as soon as possible so that the major reform program which begun so auspiciously could be allowed to move on.

96. With regard to transparency of supervisory policies, the objective of supervision is not clear given continuing political controversy arising from the 1995 reform program. In its comprehensive annual reports and increasingly through its web site [double check spelling; you have it both as one word and two words; I have changed it to two words throughout], the CMIS Division provides the public with a great deal of information of high quality on its policies and activities and on the financial results of the government traded bond market, life and general insurance, provident and pension funds, and savings plans.

Insurance

97. The market is growing relative to the economy with gross premiums being equal to 6.2 percent of GDP, up from 4.7 percent in 1989. This is split roughly equally between life and non-life, but life policies are growing faster, a feature of more advanced economies. Aggregate policyholder liabilities at the end of 1999 amounted to NIS 83.2 billion, an amount equal to 19.1 percent of savings in banks.

98. Capital and surplus (NIS 5.3 billion at the end of 1999) is low by international standards, but has been adequate to date (earthquake risk aside) because of low risk. Until 1991, the government underwrote the market risk of insurers by providing guaranteed real return nontradable bonds up to 85 percent of total assets and the current product range passes market risk to the insured. Mortality assumptions have been set at very conservative levels and are well out of date. They are due to be revised in the next round of filings following the commencement of a class action and the issue of a directive by the Commissioner. Overall solvency at 6.6 percent of policy liabilities is up compared to previous years, but risk will go up as investment choice increases, the industry issues new contract styles, and more Motor Bodily Injury (MBI) risk is transferred to insurance company balance sheets. Rules of thumb for minimum solvency in normal markets are 5 percent of policy liabilities for life and 20 percent for non-life.

99. The key issue that needs to be addressed as the risk level of the industry increases is balance sheet integrity, requiring in turn the development of a life insurance policy reserve standard and an appropriate solvency and capital adequacy regime. These will need to be backed up by enforceable corporate governance requirements and proper support from the actuarial and accounting professions, including whistle-blowing responsibilities.

Pensions

100. While the pension regime introduced in 1995 is an excellent start to a necessary transition, there are a number of major outstanding matters to be dealt with. These include the conditions under which fund managers may invest in a wider range of capital market instruments, ensuring the independence and accountability of fund managers and boards (including greater competition) and explaining the nature of the new plan benefits to new plan members. This latter problem will require resolution of the question of where responsibility for extreme longevity improvement lies. Overriding all of these considerations is the need to formulate the next step of the transition strategy to deal with the unfunded liabilities in the old pension arrangements and the public sector system and to reinforce fiscal responsibility by making the costs of wage/ pension benefit tradeoffs more transparent.

101. Fiscal implications aside, the heavily regulated pension system places limits on the scope for balanced financial development. Non-tradable government bonds account for the overwhelming majority of fund assets. These earmarked bonds constrain capital market development by crowding out equity, bonds and other securities from pension fund balance sheets.

Provident funds

102. Provident funds account for total assets under management in excess of NIS 160 billion, however, those covering medium- to long-term savings objectives (that is a minimum of 15 years) amounted to NIS 116 billion at end, 1999. A majority of the members in these latter funds have satisfied the conditions to retain tax immunity and are thus able to switch at short notice. As short-term interest rates have risen and equity markets have become deeper they increasingly have done so and this vehicle is rapidly losing its share of market.

103. These unique characteristics of provident funds in Israel also impede broad financial market development. The mix of savers—some locked in and interested in solid long-term yields, others interested in high short-term yields—creates a structural contradiction in the management of the funds’ portfolios that prevents the funds from serving as important long-term institutional players in the capital markets. Moreover, competition is quite limited, with banks controlling 91 percent of fund assets (on which they take an average management fee of 1 percent) owing to their control of the distribution system. Much of the money switching out of provident funds has gone to short-term bank deposits.

104. On balance, there appear to be strong grounds at the supervisory level for placing provident funds with a retirement objective under the Pensions unit and moving other types of so-called provident funds to the Securities supervisor. For this to happen, the recommendations of the two recent reports on tax reform will need to be at least partially implemented.¹³

Main findings

131. Israel has a competent and professional supervisory staff and a satisfactory legal and regulatory framework in which to supervise banks. Accounting and financial disclosure standards are broadly in line with international standards. More broadly, macroeconomic conditions have improved in recent years, with inflation considerably reduced.

132. The BOI is the sole supervisor of banks. The number and skills of its staff are adequate, with many staff having extensive supervisory experience. Salaries and other benefits within the BOI are sufficient to prevent any significant attrition to the private sector. There are no indications of significant governmental interference in the implementation of supervisory policy in recent years. However, a detriment to effective supervision is that the BOI is subject to strict secrecy provisions, which prevent an appropriate level of information sharing with domestic and foreign supervisors. Proposals have been made to amend these laws to allow for the necessary exchange of information between supervisory agencies, but it is not yet clear when, or even if, these changes will be implemented.

133. The legal framework applying to the supervision of banks, and to banking activity more generally, appears adequate. There have been no significant hindrances to the supervision of problem banks, including the application of remedial action. Israel has no deposit insurance. In the past, failing banks have been guaranteed by the BOI to ensure an orderly resolution. However, the laws on money laundering currently are behind best practices in other industrial economies. New legislation, which will significantly improve the ability of the authorities to detect and track money-laundering activities, was adopted in August 2000. However, this will take some time to be fully implemented.

Compliance with the principles

134. Traditionally the Basel Core Principles are grouped into seven major categories: (i) preconditions for effective banking supervision; (ii) licensing and structure; (iii) prudential regulations and requirements; (iv) methods on ongoing supervision; (v) information requirements; (vi) formal powers of supervisors; and (vii) cross-border banking. The results are summarized here and in Table 8 by these groups.

Table 8.

Summary of Main Findings for Basel Core Principles Assessment

Table 8.

Summary of Main Findings for Basel Core Principles Assessment

Subject	Main Findings
CP 1 Objectives, autonomy, and powers of supervisor	All of the preconditions for effective supervision are complied with except for the ability of the supervisor to share banking information with other supervisors.
CPs 2–5 Licensing and structure	These principles are generally observed. However, the BOI should have advance information on all material investments by banks.
CPs 6–14 Prudential regulations and requirements	Compliance is generally good. However, loan classification, reporting, provisioning and disclosure requirements could be improved. In addition, more specific requirements on the analysis of country and transfer risk should be developed.
CP 15 Money Laundering	With the adoption of a new law last year and implementing regulations earlier this year, full compliance should be in place by early 2002.
CP 16–20 Methods of ongoing supervision	Supervision is generally compliant. However, the BOI should develop a “fit and proper” regime covering all banks, and extending to all directors and key senior executives. It should also explore more extensive cooperation with external auditors.
CP 21 Information requirements	The BOI meets all information requirements, and is in compliance with this principle.
CP 22 Remedial measures	The inclusion of an explicit statutory duty within legislation for prompt corrective action should be considered to prevent forbearance.
CP 23–25 Cross-border banking	The Banking Ordinance prevents adequate information sharing with domestic and foreign supervisors.

View Table

Table 8.

Summary of Main Findings for Basel Core Principles Assessment

Subject	Main Findings
CP 1 Objectives, autonomy, and powers of supervisor	All of the preconditions for effective supervision are complied with except for the ability of the supervisor to share banking information with other supervisors.
CPs 2–5 Licensing and structure	These principles are generally observed. However, the BOI should have advance information on all material investments by banks.
CPs 6–14 Prudential regulations and requirements	Compliance is generally good. However, loan classification, reporting, provisioning and disclosure requirements could be improved. In addition, more specific requirements on the analysis of country and transfer risk should be developed.
CP 15 Money Laundering	With the adoption of a new law last year and implementing regulations earlier this year, full compliance should be in place by early 2002.
CP 16–20 Methods of ongoing supervision	Supervision is generally compliant. However, the BOI should develop a “fit and proper” regime covering all banks, and extending to all directors and key senior executives. It should also explore more extensive cooperation with external auditors.
CP 21 Information requirements	The BOI meets all information requirements, and is in compliance with this principle.
CP 22 Remedial measures	The inclusion of an explicit statutory duty within legislation for prompt corrective action should be considered to prevent forbearance.
CP 23–25 Cross-border banking	The Banking Ordinance prevents adequate information sharing with domestic and foreign supervisors.

135. Preconditions for effective banking supervision and CP 1. All sub-divisions of CP 1 are in compliance, with the major exception of the secrecy laws within the Banking Ordinance, which prevent the BOI from discussing problems within an individual Israeli bank with other supervisors (domestic or foreign). The BOI has approached the Ministry of Justice about the amendment of these provisions to allow for information exchange with other supervisory bodies, but these proposals have not yet been put forward to the Knesset Finance Committee.

136. Licensing and structure, CPs 2–5. The BOI complies with these Principles, with minor exceptions. There is a general prohibition of deposit taking that prevents significant abuses by unlicensed institutions, although this could be tightened further. The BOI also needs to consider implementing arrangements that ensure all material investments and acquisitions, covering both financial and nonfinancial and domestic and foreign investments, are conveyed to the Bank Supervisory Department (BSD) in advance. Such arrangements should be structured in such a way that the BOI can satisfy itself that the bank has the organizational and financial capacity to handle the acquisition, but does not need to take responsibility for the “soundness” of the acquisition itself.

137. Prudential regulations and requirements, CPs 6–15. Israeli banks are required to maintain a risk-weighted capital ratio, calculated in accordance with the broad framework of the Basel Capital Accord, of at least 9 percent at all times (including a market risk capital charge). In some instances, the BOI has adopted tighter requirements, providing some additional comfort. There are comprehensive rules for granting credit and for the evaluation of loans and of loan-loss provisions (CPs 7 and 8). However, the present BOI directive on problem loans uses a classification system that is somewhat unique to Israel, including the reporting of problem debts solely on a net basis (i.e., after deducting provisions). Reporting to the supervisor on problem loans according to classification is also limited to an annual return, although there is a quarterly collection that gathers some data broken down by industry.

138. Large and related party exposures (CPs 9 and 10) are tightly defined and require Board approval in accordance with BOI directives. However, the Core Principles recommend additional scrutiny for related party exposures over and above the normal credit management process; in particular, the BOI should encourage independent scrutiny of related party exposures on an on-going basis. More work is also required to develop a more systematic framework for the assessment of country and transfer risks (CP 11). The BOI should set out explicit requirements for these risks, including a requirement for banks to create and maintain adequate policies and procedures. For market risks (CP 12), the BOI’s compliance is high, reflecting a strong research effort in recent years. The requirements for the supervision of other risks and internal control systems (CPs 13 and 14) are also in compliance.

139. On money laundering, existing laws are recognized as inadequate. However, new legislation, which will significantly improve the ability of the authorities to detect and track money-laundering activities, was adopted in August 2000 and an implementing Governor’s Order was issued in January 2001. The new regulations include not just “know your customer” and account opening rules within banks, but also reporting requirements to a new database of large or suspicious transactions located in the Ministry of Justice. These new arrangements will take some time to fully implement.

140. Methods of ongoing supervision, CPs 16–20. This group of principles relates to the supervisory methods that should be applied, both on-site and off-site, and the necessity to evaluate these methods qualitatively and on an ongoing basis. The group includes the necessity of supervising banks on a consolidated basis. The framework for on-site and off-site supervision at the BOI complies with CP 16. BSD management are highly conscious of the need to ensure off-site and on-site supervision is closely integrated, particularly given the former is located in Jerusalem and the latter in Tel Aviv (where the major banks are headquartered). Nevertheless, to aid on-going improvements, the BOI is encouraged to consider the development of a quality assurance function. In assessing bank management (CP 17), the BOI has begun to use the issuance of new licenses as the opportunity to impose a “fit and proper” regime. However, this needs to be expanded to cover all banks and extended to all directors and key members of management. The BOI is compliant with CPs 18, 19 and 20, although it could usefully explore closer relationships with banks’ external auditors. The BOI meets the requirements for consolidated supervision. This reflects the fact that, notwithstanding the lack of coordination among supervisory agencies, the BOI itself directly monitors all banking group entities (even those that fall under other domestic supervisors, e.g., a securities trading subsidiary), and has the legal power to do so. There is no doubt that group supervision is occurring, even if it probably involves some unnecessary duplication by the BOI and the securities regulator.

141. Information requirements, CP 21. The BOI is in compliance with CP 21, although there may be some benefit in the BOI having the power, on an ad hoc basis, to direct the scope and standard of the work of bank external auditors.

142. Remedial measures and exit, CP 22. In practice, the BOI acts promptly in all cases where there are supervisory concerns, even where this is only expectation of potential problems. However, this Principle is designed to ensure that there is a clear duty on supervisors to take action when necessary, and that forbearance is prevented wherever possible. To that end, it would be helpful to have included in legislation, an explicit statutory duty on the Supervisor of Banks (SOB) to act promptly to address supervisory issues as and when they occur, to have problems remedied as soon as is practicable. This would not restrict the options available to the SOB, but would make it clear that forbearance is not acceptable.

143. Cross-border banking, CP 23–25. These principles are all related to cross-border banking, such as cooperation between home and host country supervisors and exchange of information, consolidated supervision on a global basis, and equal treatment of foreign establishments. While the BOI practices consolidated supervision on a global basis, the secrecy provisions of the Banking Ordinance prevent the BOI from providing sufficient information on Israeli banks to foreign supervisors. While these provisions have been circumvented to some extent, by the use of license conditions for new banks, these provisions could be more comprehensive. As noted above, the BOI has sought an amendment to these provisions to allow for information exchange with other supervisory bodies, but it is not clear if or when these amendments will occur.

144. When measured against the Essential and the Additional Criteria in combination, the BOI is fully compliant with 17 CPs, largely compliant with six, and materially noncompliant with two Principles.

145. Initiatives under way, such as the proposed changes to the secrecy provisions and the new money laundering legislation, should address the two main areas of material noncompliance. Other areas where the BOI could improve its supervisory arrangements are all within the scope of the supervisor to implement.

Authorities’ response and recommended next steps

146. The authorities were in broad agreement with the assessment. In the two areas in which the BOI is materially noncompliant (money laundering and information sharing among supervisors), the BOI is taking steps that should result in full compliance. It has prepared amendments to the banking law that would allow it to share supervisory information with other banking and financial sector supervisor domestically an abroad. It has issued regulations to implement the new money laundering law and is waiting for the Ministry of Justice to establish the agency that will monitor compliance.

147. An overriding recommendation for the Israeli authorities is to make the legislation pertaining to banking more transparent. Making the laws more explicit also increases the accountability of the BOI and the SOB.

Background

151. A full summary of the structure of the banking sector and the supervisory environment can be found above, in the assessment of Israeli compliance with the Basel Core Principles for Banking Supervision.

Main findings

152. Banking supervision by and large is well defined, with clear and generally adequate responsibilities and powers given to the Banking Supervision Department of the BOI. Its policies and rules are clearly communicated to the public. It provides the public with a lot of information of high quality on its activities and on the banking sector. Responsibilities are not fully transparent in several respects, however. The main law on which the BOI’s supervision rests is outdated and the Bank’s objectives on supervision are not explicitly defined. A particular weakness pertains to the BOI’s role in the payment system and its policies with regard to the settlement of payments through its books. It is not clear how the BOI would deal with the failure of a bank to provide the funds needed after the system has implicitly settled its payments. The responsibility of the BOI for bank exit is also compromised by the requirement to have the agreement of the government to certain key actions. The Bank’s policy of depositor protection in the event of a bank failure is also unclear. A more detailed summary is given in the next section in Table 9.

Table 9.

Summary of Main Findings for Banking Supervision Transparency

Table 9.

Summary of Main Findings for Banking Supervision Transparency

Subject	Main Findings
5. Clarity of roles, responsibilities and objectives of banking supervision policy	Generally good, but the statutory relationship between the Governor and the Government, between the different objectives of the BOI, and between the three financial authorities, should be updated and clarified. Explicit responsibility for payment systems oversight should be given to a separate division of the BOI.
6. Open process for formulating and reporting of banking supervision policy	Generally good, but public consultation should be wider than just the secret hearings of the Advisory Committee.
7. Public availability of information on banking supervision policy	Generally good. After a suitable delay, information should be provided on any emergency support given to banks. Consideration should be given to introducing some form of deposit insurance scheme.
8. Accountability and assurance of integrity by banking supervision agencies	Generally good, but more detailed information on the expenditure of the Banking Supervision Department should be provided in its annual surveys.

View Table

Table 9.

Summary of Main Findings for Banking Supervision Transparency

Subject	Main Findings
5. Clarity of roles, responsibilities and objectives of banking supervision policy	Generally good, but the statutory relationship between the Governor and the Government, between the different objectives of the BOI, and between the three financial authorities, should be updated and clarified. Explicit responsibility for payment systems oversight should be given to a separate division of the BOI.
6. Open process for formulating and reporting of banking supervision policy	Generally good, but public consultation should be wider than just the secret hearings of the Advisory Committee.
7. Public availability of information on banking supervision policy	Generally good. After a suitable delay, information should be provided on any emergency support given to banks. Consideration should be given to introducing some form of deposit insurance scheme.
8. Accountability and assurance of integrity by banking supervision agencies	Generally good, but more detailed information on the expenditure of the Banking Supervision Department should be provided in its annual surveys.

Compliance with the code

153. With respect to the clarity of roles, responsibilities and objectives, the legal position of the Banking Supervision Department is somewhat ambiguous, since it derives its authority from the 1941 Ordinance, and banking supervision is not specifically included as one of the functions of the BOI in the 1954 Law. Subsequent legislation has given the Supervisor of Banks specific responsibilities with respect to bank licensing and services to the public. Nevertheless, the Governor appoints the Supervisor, a senior employee of the BOI, under the 1941 Ordinance as amended, and may remove him from this office at any time. The Supervisor is assisted in his functions by an Advisory Committee on banking business, whose members are appointed by the governor and which is quite separate from the Advisory Committee under the BOI, appointed by the government.

154. In a few respects, and through no particular fault of the BSD, governance falls short of best practices because of the weakness of the underlying legislation, which might have been entirely appropriate some fifty years ago but appears inadequate for contemporary conditions. The Knesset Finance Committee, government and official authorities are well aware of this issue, and a new BOI Law has been under active discussion for at least eight years. To date, however, little progress has apparently been made in resolving the fundamental issue of the relationship between the government and governor (and under him, the Supervisor of Banks) specifically as regards authority, independence and accountability. For the time being, therefore, the independence of the governor and the Supervisor of Banks regarding policy and its implementation is less than fully clear in law. In one very important respect (the appointment of an administrator to take over a problem bank), the Banking Ordinance explicitly requires the approval of the government for an action that the BOI should have the independence to undertake. Although in practice the system appears to have worked well for quite some time (except in the area of failed bank resolution), without firm statutory foundations, its efficient functioning can not be guaranteed under all political and economic circumstances.

155. It should also be noted that no objectives for banking supervision are specified in the original Ordinance. In practice, the Department has developed its own objectives in addition to the specific, additional duties imposed on it by the 1981 legislation. These objectives are discussed in the annual surveys, but not prioritized.

156. The statutory boundaries between the three different financial regulators (the other two being the Capital Markets, Insurance and Savings Division of the Ministry of Finance and the Israeli Securities Authority) are not entirely clear, so that it is difficult to be sure that there are no gaps or overlaps in the regulatory coverage, or that the current allocation of responsibilities is optimally efficient. The Banking Supervision Department has difficulty in exchanging information efficiently with these agencies and with its overseas counterparts, due to the strength of the over-arching privacy and secrecy laws.

157. Regarding openness in formulating and reporting policies, the Banking Supervision Department has a high public profile. The Supervisor is frequently called upon to make statements about policies to the Knesset Finance Committee and to the press. The Department produces an annual survey of Israel’s banking system, of high quality and including a large amount of information, in accessible form and style on developments in the sector, its policies and action taken during the year in pursuit of them, and recent and forthcoming regulatory changes. The only deficiency observed concerns consultation on prospective changes. These are typically discussed in secret with the Advisory Committee, and the banks and general public are not usually consulted.

158. With this one notable exception, a large amount of information on policies is publicly available, in annual reports and on the Bank’s web site. There are only two respects in which the Code is not fully observed. The first is that, respecting the strict secrecy obligation, information on emergency financial support to banks would never be disclosed. The second is that based on past experience and the absence of explicit deposit insurance, there may be a widespread assumption that in the event of a bank failure, the government would fully compensate the depositors. This is not, however, stated policy and there remains the possibility that the government would not provide such support (often described as “constructive ambiguity”). This is patently not transparent and is likely to result in either moral hazard, or mis-pricing of retail credit risk, or both.

159. With regard to accountability and assurances of integrity, the general approach taken is open and clear. The only situation in which the Code is not fully observed concerns the lack of any financial or management accounting information on the cost of banking supervision in the public domain (although, in principle, it might be available under the new Freedom of Information Act, which came into force in 1999). The total overall administrative and general expenses of the BOI, the major part being salaries, are reported annually but the Banking Supervision Department is not distinguished from all other areas and activities of the Bank.

Authorities’ response and recommended next steps

160. The authorities broadly agreed with the team’s assessments and recommendations.

161. To fully comply with best practices with regard to transparency, the relevant laws should be amended to clarify the relationship between these entities: the Governor and the Government, the Governor and the Supervisor of Banks, the different objectives of the BOI, and the three financial supervision authorities. In addition, information on any emergency support given to banks should be provided to the public (after a suitable delay), and more detailed information should be provided to the public on the Banking Supervision Department’s expenditures. Furthermore, changes to regulations should involve public consultation.

Background

213. The ISA was established in 1968 through the implementation of the Securities Law. This law was most recently amended three times in 2000 to authorize the ISA to sign Memoranda of Understandings (MOUs) (February), to make the law consistent with the recently passed Company Law regarding prospectus issues (May) and also to allow companies listed in the U.S. market to dual list on the TASE with streamlined disclosure requirements and document production (July). The ISA is a strong regulator with ample and comprehensive powers.

214. TASE: The TASE trades stocks, bonds and derivatives such as options and futures on the Tel Aviv 25 index, on the exchange rate and, since March 2000, on interest rates. The TASE has 29 members out of whom 13 are banks and the rest are security houses.

215. Israel’s stock market has grown dramatically recently. Market capitalization was 66 percent of GDP as of end-1999 (or US$65.4 billion), compared to just 38 percent three years earlier. Measured by capitalization, the stock market is broadly comparable to that of other industrial countries and exceeds that of large emerging market countries, although total value traded on the stock exchange is less than the average across both country groups. Total turnover in 1999 was US$21 billion and about 670 companies are listed.

216. A major change in the last five years is the dramatic increase in the number of firms—mostly high tech—that raised capital abroad in the United States and Europe. Over 100 Israeli companies are currently listed on NASDAQ. The capitalization of Israeli firms that trade in the United States is almost as large as the capitalization of the TASE. A recent amendment to the Securities Law encourages dual listings for those Israeli companies listed on the three major U.S. exchanges, since ISA will accept the NASDAQ disclosure requirements and not require additional documentation (or translation into Hebrew).

217. Derivatives: The OTC market for derivatives is mainly in the hands of the banks. They trade forwards, swaps and options. The BOI is also very active as a writer of calls and puts options on the exchange rate. The BOI started this activity in 1989 in order to help develop a derivatives market in Israel.

218. Debt Markets: The development of other segments of the Capital Markets in Israel has been uneven. Outstanding government bonds are equivalent to 33 percent of GDP, comparable to the level in other industrial countries. However, the volume of trade is relatively small. The corporate bond market in Israel is tiny, with market capitalization of around 3 percent of GDP, and trading in this market is thin. Trading commercial paper is now legally possible, has not been a developing trend, since companies prefer bank lending.

219. Market Infrastructure: The TASE Clearing House offers clearing, settlement, and custody services and acts as a central depository. It complies with the G-30 international standards. Securities are held in book-entry form, and the computerized systems enable fully automated trade processing. Custodian transfers are still processed manually, but automation plans are underway.

220. Settlement occurs when Clearing House members’ accounts are credited (or debited) on the trade date and trades settle on the following day (T+l), according to the delivery verses payment principle. Most Clearing House members are also members of the TASE and comply with strict capital and liquid assets requirements. A mutual guarantee mechanism enforces joint responsibility for all Clearing House members to ensure full settlement of all trades.

221. Institutional Investors: There are approximately 430 mutual funds in the Israeli market. These funds are supervised by the ISA under the Joint Investment Trusts Law. Other collective investment vehicles include provident funds and pension funds. These vehicles, along with the insurance sector, are supervised by the Ministry of Finance and described in a different chapter.

222. The venture capital industry is well developed. This started with the establishment of YOZMA, a venture capital fund sponsored by the government. In recent years venture capital has increased its role as a source of financing to the high tech sector and small and medium size enterprises. There are about 60 venture capital funds operating now in Israel. Financing is therefore readily available in Israel, though the majority of institutional investors is passive and have not spurred the development of alternative financial instruments and techniques.

223. The preconditions for effective securities supervision are numerous, but perhaps most critical include sound and sustainable macroeconomic policies conducive to investment and savings, enforceable property rights, a supportive political environment free from corruption, well developed infrastructure (such as legal and accounting practices, clearing and settlement systems, payments system) and an effective judicial system. Corporate governance and insolvency mechanisms are also necessary, which appear to be largely in place in Israel.

224. IOSCO also lists several attributes necessary for effective regulation. No unnecessary barriers to entry and exit from markets and products; markets should be open to the widest range of participants who meet specified entry criteria; regulators should consider the impact of requirements when developing policy; and all who make financial commitments or promises must bear an equal regulatory burden. These preconditions appear to be met in Israel. The one caveat is that the dominance of the largest banks in capital market activities does not exclude other participants, but makes it more difficult for others to break into these businesses.

Main findings

225. The ISA is a strong regulator with comprehensive powers, excellent capacity, and the willingness to carry out their supervisory mandate. Supervisory objectives of ISA are clear through the securities laws: the protection of investors. ISA has the authority it needs to carry out this objective as well as sufficient independence. Enforcement is excellent, since ISA has the powers it needs to ensure compliance with the securities laws. These activities include market surveillance and investigations of violations of the law. Stock watch, ISA market surveillance system, appears to be technologically advanced and thorough in allowing the regulator to see market irregularities.

226. Both ISA and the TASE continue to adapt to the dynamic situation that exists in all securities markets. The Securities Law was amended several times over the past year, including a significant amendment which will enable Israeli companies listed on the three major U.S. exchanges to become listed as well on the TASE with simplified procedures, including acceptance of U.S. disclosure and reporting requirements. Other changes in the legal and regulatory are proposed, including (i) the proposal to fund the ISA partially through a transaction fee to be paid by the TASE that would better reflect the range of the ISA’s activities; (ii) the ability to report financial statements and material information on-line; (iii) modification of regulations relating to transactions between related companies and controlling parties thereof and transactions with conflicts of interest; (iv) adoption of IASC standards for accounting; and (v) design of a new model for prospectus disclosure for companies as well as mutual funds.

227. Other areas still require improvement, such as coordination between domestic financial sector regulators. This will help the Israeli financial sector supervisors to better understand the risks that market intermediaries are taking and whether those risks are properly accounted for and insured. Another improvement would be the ability for the ISA to impose civil sanctions, rather than security violations remaining only criminal. The ISA can now impose such penalties on mutual funds, and minor securities infractions by listed companies, such as reporting late should become penalties rather than criminal violations. This may require major changes in not only the legal framework, but also supervisory philosophies.

228. Another consideration is the possibility for ISA to become the supervisor of other collective investment schemes currently supervised by the Ministry of Finance. This is discussed elsewhere in the report.

229. Several minor areas of improvement are also suggested in the detailed assessment. These include: (i) the ability for the ISA to investigate licensed or authorized market participants without necessarily having suspicion of breach, (ii) the ability for the ISA to settle cases (this is closely related to the suggestion above to move toward administrative and civil sanctions; (iii) eliminating the possibility for ISA to finance, in whole or in part, the costs to the plaintiff for class action law suits; and (iv) developing better investor and public relations through the launch of an ISA web site as well as publishing laws in English.

Compliance with the principles

230. Main findings of the detailed assessment of observance to IOSCO Principles are grouped and summarized below and in Table 12:

Table 12.

Summary of Main Findings for Securities Supervision Principles

Table 12.

Summary of Main Findings for Securities Supervision Principles

Subject	Main Findings
Principles relating to the Regulator, Ps 1–5	ISA has broad powers and is independent yet accountable, as well as self-financing.
Principles of self-regulation, Ps 6–7	The TASE operates efficiently, but does no conduct sufficient market monitoring.
Principles for the enforcement of securities regulation, Ps 8–10	Enforcement is strong; the use of the Internet and new technology may make new demands on ISA.
Principles for cooperation in regulation, Ps 11–13	There are areas of some weakness, given inherited system and respect for secrecy and privacy. Domestic coordination requires improvement.
Principles for issues, Ps 14–16	Israeli securities laws have comprehensive disclosure requirements.
Principles for collective investment Schemes, Ps 17–20	Given the strong regulation of ISA over mutual funds, policy makers may wish to consider the possibility of transferring responsibility for other collective investment schemes to ISA.
Principles for market intermediaries, Ps 21–24	The securities laws provide minimum requirements for intermediaries (whether banks or not). Market intermediaries may not properly be reflecting derivatives in their activities. The relationship between the banks and their financial intermediary subsidiaries, off-balance sheet affiliates and related parties renders these principles difficult to assess.
Principles for the Secondary market, Ps 25–30	In 1997, the TASE launched Tel Aviv Continuous Trading (or TACT). The Clearing House is modern and well established.

View Table

Table 12.

Summary of Main Findings for Securities Supervision Principles

Subject	Main Findings
Principles relating to the Regulator, Ps 1–5	ISA has broad powers and is independent yet accountable, as well as self-financing.
Principles of self-regulation, Ps 6–7	The TASE operates efficiently, but does no conduct sufficient market monitoring.
Principles for the enforcement of securities regulation, Ps 8–10	Enforcement is strong; the use of the Internet and new technology may make new demands on ISA.
Principles for cooperation in regulation, Ps 11–13	There are areas of some weakness, given inherited system and respect for secrecy and privacy. Domestic coordination requires improvement.
Principles for issues, Ps 14–16	Israeli securities laws have comprehensive disclosure requirements.
Principles for collective investment Schemes, Ps 17–20	Given the strong regulation of ISA over mutual funds, policy makers may wish to consider the possibility of transferring responsibility for other collective investment schemes to ISA.
Principles for market intermediaries, Ps 21–24	The securities laws provide minimum requirements for intermediaries (whether banks or not). Market intermediaries may not properly be reflecting derivatives in their activities. The relationship between the banks and their financial intermediary subsidiaries, off-balance sheet affiliates and related parties renders these principles difficult to assess.
Principles for the Secondary market, Ps 25–30	In 1997, the TASE launched Tel Aviv Continuous Trading (or TACT). The Clearing House is modern and well established.

Principles relating to the regulator, Ps 1–5

231. The responsibilities of the ISA are stated in the following laws: Securities Law (originally passed 1968); Joint Investment Trusts Law (1994); and the Portfolio Manager and Investment Advisor Law (1995). Regulatory authority is established under the Securities Law, which states that the function of the ISA is to protect the interests of the public when investing in securities. The ISA is operationally independent in implementing its powers. The chairperson is appointed by the Minister of Finance, as are the other 12 members. They can only be removed with good cause, and are therefore independent but yet accountable.

232. The ISA’s activities are self-financed. Currently, fees paid by public companies and mutual funds cover most of the expenses of the ISA that are incurred from its activities. The ISA has recently proposed to collect fees from TASE transactions, based on three-year historical volume so that the TASE can better predict the costs of such a levy. This new fee structure would better reflect the wide range of activities imposed by the securities laws on the ISA.

233. Anyone concerned by a decision of ISA may appeal this decision in District Court, which provides a significant measure of accountability. Finally, the ISA has several safeguards to protect commercially sensitive information from inappropriate disclosure.

234. While the ISA has all the necessary powers, resources and capacity to carry out effective supervision of the Israeli market, the capital markets are changing rapidly through both globalization and new technology, and it will be important for the ISA to maintain both resources and capacity to ensure continued successful supervision.

Principles of self-regulation, Ps 6–7

235. The TASE is a self-regulatory organization that is supervised by the ISA. It has 29 members, including the Bank of Israel. The TASE is granted with rulemaking powers. Directives must be approved by the ISA and changes in bylaws must be recommended by the ISA to the Minister of Finance for Knesset Finance Committee approval. TASE is responsible for rulemaking in regard to trading practices, fair and orderly operation of trading facilities, clearing and settlement processes, and financial responsibility of their members. The TASE is also responsible for enforcing the listing rules that are designed to guarantee fair and orderly trading and maintenance of these rules.

236. The TASE does not perform substantial market monitoring, as this is relegated to the ISA. This is unusual compared to other countries. The TASE does have responsibility to monitor its nonbanking members regarding their market activities.

Principles for the enforcement of securities regulation, Ps 8–10

237. ISA’s enforcement powers allow for a wide range of activities aimed at ensuring compliance with the securities laws. These activities include market surveillance and investigations of violations of the law. Stock watch, ISA market surveillance system, appears to be technologically advanced and thorough in allowing the regulator to see market irregularities.

238. ISA has strong enforcement powers, including the ability to request any pertinent information or documents; apply to courts for warrants to enter premises; interrogate any person, company, investment company or mutual fund connected to the issue; and obtain injunctions or temporary orders to halt suspected activities. In addition, the ISA has the power to arrest, although it is currently contained in a different law (there is a proposal to move the power to the Securities Law so that it is contained in the ISA’s primary legislative framework as the arresting powers must currently be renewed annually by the Minister of Justice).

239. It should be noted that these strong powers are necessary given that violations of the securities laws in Israel are criminal (with a few noted exceptions for administrative sanctions in the Joint Investment Trust Law). This implies that the ISA only uses these powers when there is overwhelming substantiation of a given case, given the balance of protecting civil rights with rigorous enforcement of securities laws.

240. Regarding mutual fund supervision, the Mutual Funds Department has an automatic computer program that allows any irregularities in the monthly required reporting by mutual funds to be detected automatically.

241. One issue related to enforcement that should be reconsidered is that a plaintiff may apply to the ISA to cover all or part of the expenses of a class action lawsuit. While the original intent of this policy was meant to encourage the use of class actions as a tool to maintain the integrity of market issuers and participants, there is some question as to whether or not the encouragement by ISA of such actions is appropriate. The ISA should have the ability to enforce its own civil sanctions rather than assist private individuals to pursue a class action through the offer of paying the costs of such an action.

242. Staffing which supports the ISA’s enforcement area appears adequate, although with the increasing allure of the Internet as an investment and information dissemination tool (including for fraudulent activities), the ISA may need to strengthen the areas of inspection, investigation and surveillance.

243. One final minor outstanding issue is that suspicion of breach is necessary to begin an investigation. IOSCO Principles state that suspicion of breach should not be a necessary prerequisite to use inspection powers with regard to authorized or licensed persons.

Principles for cooperation in regulation, Ps 11–13

244. These cooperation principles are partially implemented as the Israeli system should be viewed in a historical context, in which the formerly closed economy with a healthy respect for privacy has defined how authorities cooperate, both with domestic counterparts as well as foreign ones. While cooperation with domestic counterparts can occur through formal, legal processes (such as court orders), such cooperation occurs on demand rather than through planned and clearly defined mechanisms (i.e., there are no domestic MOUs between financial regulators). The different financial sector regulators do often have representation on each other’s governing bodies.

245. The ISA has only signed one MOU, albeit with a major market (the U.S. SEC) and one that has great mutual benefits. However, the ISA should consider additional MOUs in markets with mutual involvement. Without an MOU, the ISA may share only public information, providing it to foreign regulators who need such information. Under the International Legal Assistance Law (1998), foreign regulators can request nonpublic information through the Ministry of Justice without an MOU.

Principles for issuers, CPs 14–16

246. Israeli securities laws have comprehensive disclosure requirements.

247. Corporations seeking to offer their securities to the public must apply to the ISA for a permit to publish a prospectus. In the prospectus, the company must provide all pertinent information on the nature of its business, the company’s management and major shareholders and the type of security being offered. The company also must provide annual audited financial statements by an independent certified public accountant. A necessary and critical part of this financial reporting disclosure is the Management Discussion and Analysis. Prospectuses are publicly available as soon as they are approved. Such regulations are actually more stringent than the U.S. SEC.

248. Corporations whose securities have been offered to the public by prospectus are required to submit annual financial reports within 90 days after the end of the fiscal year. An independent certified public accountant must audit these reports. Companies also must submit quarterly financial reports that have been reviewed by a CPA, within 60 days after the end of each of the first three fiscal quarters. Noncompliance is a criminal violation of the law.

249. The Securities Law needs to be made consistent with the disclosure requirements now contained in the Company Law. Such changes do not introduce new concepts but rather present modifications that are necessary for consistency. The ISA also expects to amend the Securities Law to allow for internet submission of financial reports. This should assist in providing timely and public disclosure of listed companies.

250. These legal changes, which started when the Securities Law was first passed in 1968, allow continued improvement in the area of disclosure.

Principles for collective investment schemes, Ps 17–20

251. Collective investment schemes are regulated by various laws, depending upon the type of scheme. Provident funds and pension funds are regulated and supervised by the Ministry of Finance and discussed elsewhere. Mutual funds are regulated by the ISA through the Joint Investment Trusts Law (1994).

252. The ISA grants permits to mutual funds to publish their prospectuses and offer their units for sale to the public. Supervision of mutual funds is accomplished through continuous disclosure, monthly reports to the ISA and annual prospectuses. ISA routinely inspects these electronically filed monthly reports and enforces their compliance through civil fines as stated in the Joint Investment Trusts Law.

253. The question of regulatory arbitrage and the possibilities of coordinated supervision of the financial sector are discussed elsewhere, but policy makers may wish to consider the possibility of transferring responsibility for other collective investment schemes to the ISA.

254. Foreign funds are currently not allowed to offer units or shares in the State of Israel. Currently, funds must be registered in Israel and domestically owned. This domestic advantage should be eliminated, given the realities of a global economy.

Principles for market intermediaries, Ps 21–24

255. The securities laws provide minimum requirements intermediaries (whether banks or not) must meet. Many provisions in the laws are designed to minimize the potential conflict of interests between intermediaries and their clients. The ISA supervises the banks as intermediaries in the securities markets and as firms whose securities are listed on the TASE.

256. The Ministry of Finance regulates pension funds and provident funds. It licenses them and sets minimum entry requirements. The ISA regulates mutual funds. The Joint Investment Trust Law sets minimum entry standards for mutual funds to operate in the market. Mutual funds are required to file an annual prospectus, which describes its investment policy and discloses all material information on the mutual fund’s manager and trustee.

257. Under the Investment Advisors and Portfolio Managers (IAPM) Law, ISA is responsible for licensing portfolio managers and investment advisors.

258. Failure of market intermediaries are unlikely to disrupt the overall market given the legal framework, which provides for segregation of assets and the fact that securities belong to clients and not exchange members or fund managers. If a mutual fund goes bankrupt, the assets belong to the unit holders. In this situation, the fund can either be liquidated or the management transferred to another mutual fund. This is also true for portfolio managers. Another safeguard is that market intermediaries are required to have insurance. Therefore, investors appear protected to the extent possible and damage to investors would be minimized.

259. If a licensed investment advisor is advising clients, he may not select stocks/assets of his own firm or subsidiary. This regulation is meant to prevent conflicts of interest. Investor clients can easily become captive to the Israeli financial conglomerate system in which all of the banks have fund manager subsidiaries and offer investment advisory services. The law is designed to ensure the client is offered the true range of competing investments. However, practice has been for investment advisors from banks to guide clients to their own mutual funds and provide only information/brochures on their related party instruments. The ISA has informed the banks (and other investment advisors) to comply with the law, but has not yet imposed any sanctions.

260. These principles are difficult in which to achieve full implementation, especially in more complex markets, which have more sophisticated, and potentially more risky instruments and financing techniques. Given the large size of the Israeli derivatives market, it is unclear if market intermediaries properly reflect these instruments in their activities. Whether or not prudential requirements and margin levels are set appropriately are only known ex post. In addition, the relationship between the banks and their financial intermediary subsidiaries, off balance sheet affiliates and related parties renders this principle difficult to assess. However, regulation cannot remove risk from the marketplace, but only ensure that proper management of that risk occurs.

Principles for the secondary market, Ps 25–30

261. According to the Securities Law, the ISA supervises the fair and orderly operation of the TASE. The ISA must approve the directives of the TASE and recommend approval of the TASE bylaws to the Minister of Finance.

262. The TASE conducts regular audits of exchange member’s operations. In addition, the capital and liquidity requirements of Exchange members are strict.

263. In 1997, the TASE launched Tel Aviv Continuous Trading (or TACT). Equity, fixed income, and derivatives are all traded under this state-of-the-art computerized, order-driven electronic network. Trading volumes for derivatives more than doubled when this market was brought into the system in 1999. TACT has improved transparency of trading as well as liquidity and fairness as investors are guaranteed an equal opportunity with respect to entry of orders.

264. TASE Clearing House offers clearing, settlement and custody services and acts as a central securities depository. Its rules comply with the G-30 international standards.

Authorities’ response and recommended next steps

265. The authorities agreed with the teams assessments and recommendations. With regard to the mission’s recommendation that the ISA not be permitted to provide financial support for class actions suits, the Authority stated that while they agreed in principle that their practice might be reconsidered, they thought that it might be too early to do so now.

266. The FSAP team recommended several initiatives to further improve securities supervision. It recommended that the ISA improve cooperation with other financial sector supervisors by adopting more formation arrangements (such as a Council of Financial Supervisors, and MOUs). In addition, it should launch an informational web site, obtain the authority to impose civil sanctions, adopt new model prospectuses, and should consider taking over the supervision of collective investment schemes currently supervised by the Ministry of Finance.

Main findings

270. Securities supervision is well defined, with a clear fundamental law that has been regularly updated to reflect the need of the regulator to keep abreast of changing market conditions. The ISA’s policies and rules are clearly communicated to market participants, but as it already recognizes, the agency needs to do more to explain its role and responsibilities to the general public and overseas investors in particular. A web site is being developed, to be launched shortly. The ISA is directly accountable to the Minister of Finance and the Knesset Finance Committee. Changes to its regulations, including a new proposed method of funding, are therefore the subject of public hearings. Its relationship with the Tel Aviv Stock Exchange, and the by-laws and directives of the Exchange, which the ISA has to approve, is transparent.

Observance of the Code

271. Observance of the Code is summarized below and in Table 13.

Table 13.

Summary of Main Findings for Securities Regulation Transparency

Table 13.

Summary of Main Findings for Securities Regulation Transparency

Subject	Main Findings
5. Clarity of roles, responsibilities and objectives of securities supervision policy	This principle is fully observed, apart from the need to clarify the relationship between the three financial authorities.
6. Open process for formulating and reporting of securities supervision policy	Reports and consultation on policies are satisfactory; to date the ISA has not been able to devote significant resources to explaining its policies to the general public, but has plans under way to do so shortly.
7. Public availability of information on securities supervision policy	An annual report is published in Hebrew, but it does not contain market information. The ISA’s new web site will be able to include links to the TASE and other relevant web sites.
8. Accountability and assurance of integrity by securities supervision agencies	This principle is fully observed.

View Table

Table 13.

Summary of Main Findings for Securities Regulation Transparency

Subject	Main Findings
5. Clarity of roles, responsibilities and objectives of securities supervision policy	This principle is fully observed, apart from the need to clarify the relationship between the three financial authorities.
6. Open process for formulating and reporting of securities supervision policy	Reports and consultation on policies are satisfactory; to date the ISA has not been able to devote significant resources to explaining its policies to the general public, but has plans under way to do so shortly.
7. Public availability of information on securities supervision policy	An annual report is published in Hebrew, but it does not contain market information. The ISA’s new web site will be able to include links to the TASE and other relevant web sites.
8. Accountability and assurance of integrity by securities supervision agencies	This principle is fully observed.

272. The ISA observes the Code with respect to clarity of roles, responsibilities and objectives, which are clearly set out in legislation and regulations. The only aspect with which the team had some concerns was in the relationship with the two other financial regulators, the Banking Supervision Department of the Bank of Israel and the Capital Markets, Insurance and Savings Division of the Ministry of Finance. Although the ISA’s broad objective is clear and statutory—to protect the interests of the public investing in securities—it was not clear to the team how, in practice, it could be sure of fulfilling that role efficiently in cases where passing information to one of the other regulators quickly was desirable, given the strength of the privacy and secrecy laws. The team was unable to form a clear and consistent view of what happens in practice, except when there was clear evidence of criminal action or an order of the Court.

273. With regard to open process for formulating and reporting of policies, the Code is clearly observed in relation to market professionals for whom most of the work of the ISA is directly relevant, including the Tel Aviv Stock Exchange. It is less clear, however, that to date the ISA has paid adequate attention to the desirability of engaging the general public, and in particular overseas investors, in its policy formulation and reporting. The annual report has only been available in Hebrew, and the ISA has not had a web site.

274. It will however, soon have rectified the position and plans to devote more resources to public availability of information on securities supervision policies. Use of a web site will enable links to be created to the TASE web site. This already contains information on sectoral developments and aggregate data envisaged by the Code to be made readily available to the public but which the ISA has not itself made available, because it saw no point in duplicating information available from TASE or felt that there was likely to be insufficient interest its work from the general public. In so far as current practice falls short of the Code, therefore, the deficiency will soon be rectified.

275. The ISA appears fully to observe the Code on accountability and assurances of integrity by securities supervision agencies. The ISA reports at least annually to the Minister of Finance and Knesset Finance Committee. There are strong statutory restrictions on personal securities dealing and business interests by Members of the ISA, to avoid possible conflicts of interest.

Authorities’ response and recommended next steps

276. The ISA agreed with the team’s assessment and recommendations. The ISA is very transparent. However, the team recommended launching an informational web site that includes English translations of important laws and regulations. This is now planned for the summer of 2001. In addition, the ISA should establish MOUs with the other two financial sector supervisors setting out the relationship between them.

277. Little needs to done by the ISA to achieve full observance of the transparency code. The most important change is already under way, since a web site will be launched before the end of the year. In developing this new service, the ISA needs to bear in mind that there may be a very broad and diverse audience for information on its activities, certainly including foreign investors of varying degrees of sophistication.

278. Coordination among the three financial regulators should be more formalized. A Memorandum of Understanding between the three financial regulators should set out precisely the relationship between them, including a procedure for dealing with any overlaps or gaps which might arise from time to time and clarification of the circumstances in which supervisory information can be exchanged between them, or with overseas regulators. This would be worthwhile both under current legislation and after reform.

Background

282. Israel is the world’s 27^th insurance market. At the end of 1999 the private sector contained 37 licensed insurers, the majority of which were authorized to write both life and non-life contracts and a number of which are inactive. The industry is rationalizing, and by end-1999 four groups controlled 76.3 percent of the gross premiums. In 1990, the top four groups controlled only 60.4 percent of the market.

283. The industry as a whole is in transition from a solidarity-based approach to product design and pricing to a more entrepreneurial, competitive, and individualistic approach. Life insurance growth is dominated by pension-related universal life products that largely transfer market risk to the policyholder, and non-life by motor bodily injury and physical damage classes. The major sources of profit have also been life insurance and motor bodily injury (MBI) insurance. Property classes tend to be heavily reinsured. The long-term results of the MBI market have effectively been guaranteed by the government through its ability to raise premiums and the Ministry of Finance is now moving this market to a more competitive, but controlled, model. Banks cannot own insurance companies and are severely restricted in what they can distribute.¹⁴

284. Legal practices reflect British and Ottoman roots and taxation law is still based on the original British ordinance. The insurance sector (unlike provident funds) does have a substantive legislative base, and in particular the Insurance Business (Control) Law, 5471–1981. While there is an accounting standards board in Israel, insurance accounting standards for the insurance sector are set the Minister of Finance under the powers of the aforementioned statute. Except for MBI and health insurance, these do not specify standards for setting insurance technical reserves, the most important balance sheet item,. In practice, the chief actuaries of the large insurers have internationally recognized qualifications for the most part, and work to the standards of their own professional bodies. The supervisor is now beginning to take an interest in this area but advanced life insurance actuarial skills are scarce in the supervisor’s office.¹⁵ These will become more important as the market moves from a prescriptive to a competitive governance based regulatory model and specific standards need to be developed for the Israeli context to guide the industry while not inhibiting it.

285. The supervisor has 32 professional staff who are civil servants. Most of the senior officers have special contracts, which provide higher than standard civil service incomes but which are still not competitive with the private sector. Morale is reasonable but the staff are under pressure from high wages outside and the inevitable frustrations of trying to drive reform with limited resources. The supervisor does have extensive powers at the time an insurer is being set up or gets into trouble, although their exercise is often subject to approval by the Minister. Intermediate powers and sanctions are limited both at law and in practice. Staffing is inadequate, which is exacerbated by the need to deal with a number of contemporary threats. These include the need to develop a reserving methodology for earthquake exposures, establish a methodology for dealing with guaranteed annuity conversion options on some older types of life contract,¹⁶ and forestalling potential market conduct issues arising from managers’ insurance.

286. The market is growing relative to the economy with gross premiums being equal to 6.2 percent of GDP, up from 4.7 percent in 1989. This is split roughly equally between life and non-life, but life is growing faster, a feature of more advanced economies. Aggregate policyholder liabilities at December, 999 amounted to NIS 83.2 million, an amount equal to 19.1 percent of savings in banks.

287. Capital and surplus (NIS 5.3 million at December, 999) is low by international standards but has been adequate to date (earthquake risk aside) because of low risk. Until 1991, the government underwrote the market risk of insurers by providing guaranteed real return non-tradable bonds up to 85 percent of total assets, and as mentioned earlier, the current product range passes market risk to the insured. Mortality assumptions have been set at very conservative levels and are well out of date; however, they are due to be revised in the next round of filings following the commencement of a policyholder class action currently in the courts. Overall solvency at 6.6 percent of policy liabilities is up in previous years, but risk is rising as investment choice increases and the industry wishes to issue new contract styles. Rules of thumb for minimum solvency in normal markets are 5 percent of policy liabilities for life and 20 percent for non-life.

Main findings

288. The Insurance Business (Control) Law provides substantial powers to the supervisor, either directly or through the Minister of Finance. In addition the supervisory body is well structured and has a core of capable and engaged officers who are committed to reforming the market and in particular to introducing genuine competition for the benefit of consumers and the economy at large. The main limiting factor is a lack of actuarial and on-site inspection capacity. In addition, the roles of the Minister and the Knesset Finance Committee appear in some cases to impinge on the legitimate supervisory role of the Commissioner.¹⁷ Examples include specification of contract forms and some of the supervisory responses available when an insurer shows signs of distress. Israel is unusual by industrial (and many developing) country standards in continuing to allow the licensing of composite insurers offering both life and non-life insurance, and not completely sealing these from one another.

289. The main findings by category of Principle are as follows:

290. Organization, CP 1—largely observed. The supervisor is backed by strong and clear legislative powers, has a highly professional civil service staff, is able to hire and train capable recruits, and can apply third-party support. However remuneration levels are somewhat below market levels and key technical staff, such as actuaries, are hard to attract and keep. In addition, there is a complete lack of on-site inspection capacity. The supervisor is overly dependent on the approval of the Minister for various responses to perceived threats and has very limited powers to influence insurers after they are licensed and before they get into trouble (see governance).

291. Licensing and Changes in Control, CPs 2–3—observed. The Insurance (Control) Law and its method of operation satisfies virtually all criteria for these principles, including establishing appropriate definitions, enforcing fit and proper criteria, requiring a business plan, defining initial products and setting minimum capital levels. In addition, strong limits exist on the ability to transfer control. The only significant essential criterion not fully met is number 13, which prohibits composites unless strong separation of activities can be achieved.

292. Corporate Governance, CP 4—materially non-observed. The supervisor does not have the authority to require boards of directors to clearly set out their responsibilities for governance of their undertaking. The company’s law does require some corporate governance functions including setting out strategic objectives, appointment procedures, division of responsibilities and internal and external audit. However, there is no mention of the fundamental need to have in place and monitor risk management functions by nature of activity.

293. Internal Controls, CP 5—materially non-observed. The insurance supervisor has limited formal powers outside the licensing, product approval and threatened insolvency situations. In particular, the supervisor does not have the authority to require the board of directors to provide suitable prudential oversight such as setting standards and monitoring controls for underwriting risk, valuation of technical provisions, investment and liquidity management. Reinsurance is covered under a circular letter. A number of criteria relating to organization, separation of duties and audit are covered under the company’s law.

294. Prudential Rules, CPs 6–10—largely observed except for derivatives. The Insurance Business (Control) Law and regulations clearly addressed most of the criteria under the prudential heading and proposed changes in asset management requirements will reinforce compliance. The main areas where some strengthening is desirable include giving the supervisor the right to require a more specific approach to asset risk management and a more active approach to monitoring the adequacy of technical provisions through both on and off-site inspections. There appear to be no requirements in place for companies using derivatives to have established an appropriate policy for their use and risk management formulated and monitored by the board of directors.¹⁸ The supervisor does not have the resources to check that insurers have in place adequate internal controls with regard to derivatives.

295. Market Conduct, CP 11—observed. Most of the essential criteria are met under the Insurance Contracts Law and the Insurance Business (Control) Law. Further regulation is likely to be required under the seeking of information about needs before selling a product heading (Essential criterion 5). In addition it will be desirable for the supervisor to develop an on-site inspection capacity under this heading (Essential criterion 3).

296. Monitoring, Inspection and Sanctions, CPs 12 – 14—largely observed. Most of the essential criteria are satisfied by the powers granted by the Insurance Business (Control) Act. Lack of on-site inspection capacity is the main limiting factor.

297. Cross-border operations, CP 15—materially non-observed. A number of essential criteria are satisfied including the ability to control foreign insurers operating in Israel. However the key ability to exchange information with other insurance supervisors as necessary on the operations in Israel of the insurance establishments of foreign insurers is limited by current secrecy rules.

298. Supervisory coordination and cooperation, and confidentiality, CPs 16–17—largely observed. The supervisor is not able to enter into an agreement with any other supervisor both in other jurisdictions and in other sectors of the financial markets to share information or otherwise work together. On the other hand the staff of the insurance supervisor are subject to professional secrecy constraints. A unique, but undesirable feature of the supervisory scene is Israel is the necessity to share confidential information with an industry-based advisory committee.

299. The team discussed the medium-term challenges for insurance supervision. These include developing a viable on-site inspection capacity, building up actuarial capacity, developing key actuarial standards, producing a workable model for controlled competition in the MBI market, enforcing boards of directors’ accountability for risk management, developing an information exchange capacity with other financial sector supervisors and continuing the current market reform program. In addition a number of specific issues need to be dealt with including earthquake reserves and annuity conversion options.¹⁹

Authorities response and recommended next steps

300. The authorities generally agreed with the mission’s assessment and recommendations. The key and most urgent recommendation is the recruitment of additional skills in the life insurance actuarial area and the strengthening of the on-site inspection capacity of the supervisor. Introducing an on-site inspection manual based on overseas best practices (probably Canada) would support such moves, as would working with the actuarial and accounting professions to establish a formal actuarial standards setting process.

301. The Insurance Commissioner should have more independent authority. The Commissioner should be given greater and more flexible powers of intervention before an insurance company gets into serious trouble.

Main findings

305. In practice, insurance (but to a lesser extent, pension) supervision is fairly well defined. Although the 1981 Act appointing the Commissioner of Insurance does not specify objectives for insurance supervision, in practice, various objectives that are currently not prioritized have been developed, all with a view to protecting the interests of policyholders. In the case of pension funds, the objective is not clear given continuing political controversy arising from the 1995 reform program. In its comprehensive annual reports and increasingly through its web site, the Division provides the public with a lot of information of high quality on its policies and activities and on the financial results of the government traded bond market, life and general insurance, provident and pension funds and savings plans. The Code standards on open formulation of policy and accountability appear to be fully met.

306. Although current insurance and pension supervision practices observe most of the provisions of the Code, the main weakness noted is regarding clarity of roles, responsibilities and objectives. The enabling legislation, which is focused on insurance policies rather than pension funds, does not specify objectives for the Commissioner. The mission was told that the key responsibility of the Division was regarded as protecting the interests of policyholders, which could be furthered in several different ways, including minimum capital and liquidity rules, financial reporting rules, approval of premium rate bands and increased competition in the sector. A Consumer Ombudsman Unit within the Division deals with complaints and other inquiries from the public. It would be helpful if objectives could be explicitly prioritized. Responsibilities are not fully transparent in all respects. Since the formal sanctions provided for in the Law are very limited (essentially limited to revocation of licenses), the Commissioner relies heavily on the cooperation and openness of insurance companies finding themselves in difficulties.

307. With regard to pensions, the objective is less clear. Funded pensions do not obviously sit very easily within the framework of the 1981 Law. A majority of the pre-1995 semi-funded or “budgetary” pension funds are in actuarial deficit and will in due course run out of liquid assets to meet pension liabilities in payment. There are some difficult political issues with respect to the post-1995 comprehensive “accrual” pension funds and arrangements for the transfer of public employees to funded arrangements. Although this sector is currently open to competition in principle, through employees’ choice, in practice, all the large funds are controlled by the major trade unions, and independent fund managers have been able to capture only a very small share of the market. This is turn has implications for the style of regulation that have still to be developed. The situation is greatly complicated by the continuing failure of government and trade unions to reach agreement on future funding of the insolvent pre-1995 pension funds.

308. The Division also deals with the capital markets (i.e., traded government bonds), provident and training-related funds, fully funded or defined contribution “general” pension plans, and shorter-term savings in the form of term deposits. The reason is the historic one, that the Ministry of Finance appeared the most appropriate place from which to ensure that the qualifying conditions for the tax-privileged status of all these vehicles continued to be satisfied. From the point of view of public information, this organizational structure enables comparative information on rates of return to be presented in a consistent way across all products, enhancing consumer awareness and choice. It is not so clear, however, that the regulatory objectives fit well alongside the tax policing ones when professional staff resources are severely limited. The case of term deposit savings plans or provident funds provided by banks is an example of a confusing overlap between responsibilities of the Ministry of Finance and the Banking Supervision Department of the Bank of Israel.

309. Regarding an open process for formulating and reporting of insurance and pension supervision policies the Division appears fully to observe the Code. The industry and general public are kept completely informed of, and consulted on, practical developments in supervision. A great deal of information is made available through the Division’s annual reports and increasingly on its web site too. The Code on public availability of information on insurance and pension supervision policies is therefore also close to being fully observed. The only slight shortcoming is that Internet development, soon to include details of all relevant laws, regulations and directives, quarterly financial results, and interactive ranking of companies, is targeted at industry professionals, such as financial advisors, and sophisticated investors. For the benefit of first-time and relatively unsophisticated investors, many who will not have access to the Internet, it would be advisable to have a program of short, simple advisory leaflets explaining the basic features of the many different savings products available in Israel. This is particularly desirable in the case of insurance, since complaints about the selling of products or difficulties in making claims form about 90 percent of the Consumer Ombudsman Unit’s caseload.

310. Finally, as regards accountability and assurances of integrity by insurance and pension supervision agencies, the Code appears to be fully observed. The Commissioner and her senior staff frequently appear before the Knesset Finance Committee or make presentations and speeches at industry conferences or to the press. While the Division does not produce separate financial statements, the budget and results for the Ministry of Finance are analyzed by function and type of expenditure annually and presented to the Finance Committee. Further details are provided on demand under the recent Freedom of Information Act.

Recommended plan of action and supervisory response to the assessment

311. It is recommended that the adequacy of the 1981 Law be systematically reviewed in the light of practical experience and market developments since it was enacted, and reforms to the pension fund system since 1995. Objectives for both insurance and pension supervision should be specified. The range of statutory sanctions available to the Commissioner should be expanded. Consideration should also be given to the possible merits of establishing an independent authority for the supervision of financial institutions and products that depend on expert actuarial advice (i.e., principally insurance and pensions).

312. Cooperation among the three financial regulators should be more formal. A Memorandum of Understanding between the three financial regulators should set out precisely the relationship between them, including a procedure for dealing with any overlaps or gaps which might arise from time to time and for clarification of the circumstances in which supervisory information can be exchanged between them or with overseas regulators. This would be worthwhile both under current legislation and after any reform.

313. In developing its web site, the Division should take account of the needs of less sophisticated or experienced investors and make appropriate information available (also in printed form) to introduce them to the complex variety of financial products and help determine their suitability.

Table 14.

Summary of Main Findings for IAIS Supervision

Table 14.

Summary of Main Findings for IAIS Supervision

Subject	Main Findings
Organization of a supervisory body, CP 1	Resources and powers need to be expanded and made more flexible.
Licensing and changes in control, CPs 2–3	Capacity to approve of composites could be improved.
Corporate governance, CP 4	Key risk management issues are not covered.
Internal controls, CP 5	The supervisor’s powers are not attuned to ongoing enforcement of good management practices.
Prudential rules, CPs 6–10	The risk management perspective and coverage of derivatives are also lacking under these criteria.
Market conduct, CP 11	Inspection capacity need to be strengthened, with selling practices upgraded.
Monitoring, inspection and sanctions, CPs 12–14	On-site inspection capacity is limited.
Cross-border operations and cooperation, CPs 15–16	The key capacity to exchange information is not available.
Confidentiality, CP 17	Confidentiality requires excessive disclosure by firms and has inadequate sharing of information among supervisors.

View Table

Table 14.

Summary of Main Findings for IAIS Supervision

Subject	Main Findings
Organization of a supervisory body, CP 1	Resources and powers need to be expanded and made more flexible.
Licensing and changes in control, CPs 2–3	Capacity to approve of composites could be improved.
Corporate governance, CP 4	Key risk management issues are not covered.
Internal controls, CP 5	The supervisor’s powers are not attuned to ongoing enforcement of good management practices.
Prudential rules, CPs 6–10	The risk management perspective and coverage of derivatives are also lacking under these criteria.
Market conduct, CP 11	Inspection capacity need to be strengthened, with selling practices upgraded.
Monitoring, inspection and sanctions, CPs 12–14	On-site inspection capacity is limited.
Cross-border operations and cooperation, CPs 15–16	The key capacity to exchange information is not available.
Confidentiality, CP 17	Confidentiality requires excessive disclosure by firms and has inadequate sharing of information among supervisors.

Table 15.

Summary of Main Findings for Insurance and Pension Transparency

Table 15.

Summary of Main Findings for Insurance and Pension Transparency

Subject	Main Findings
5. Clarity of roles, responsibilities and objectives of insurance and pensions supervision policy	No objectives are specified in the law. Those developed for insurance in annual reports need to be prioritized. Objectives need to be established and stated for pension supervision. The relationship between the three financial authorities should be clarified in legislation.
6. Open process for formulating and reporting of insurance and pensions supervision policy	The process is open and transparent.
7. Public availability of information on insurance and pensions supervision policy	Current enhancements to the Division’s web site will provide full and detailed information. More simple, summary information could be produced in print for the public.
8. Accountability and assurance of integrity by insurance and pensions supervision agencies	The framework for accountability and assurance is fully adequate.

View Table

Table 15.

Summary of Main Findings for Insurance and Pension Transparency

Subject	Main Findings
5. Clarity of roles, responsibilities and objectives of insurance and pensions supervision policy	No objectives are specified in the law. Those developed for insurance in annual reports need to be prioritized. Objectives need to be established and stated for pension supervision. The relationship between the three financial authorities should be clarified in legislation.
6. Open process for formulating and reporting of insurance and pensions supervision policy	The process is open and transparent.
7. Public availability of information on insurance and pensions supervision policy	Current enhancements to the Division’s web site will provide full and detailed information. More simple, summary information could be produced in print for the public.
8. Accountability and assurance of integrity by insurance and pensions supervision agencies	The framework for accountability and assurance is fully adequate.