This Selected Issues paper analyzes the empirical relationship between corporate leverage—and other indicators of financial health—and investment in Israel, using dynamic panel data techniques. The results suggest that weak balance sheets may well have contributed to the investment decline of recent years. The impact of financial variables on investment is more pronounced for firms under financial pressure. However, there is little evidence that weak balance sheets’ impact on corporate investment increases during real downturns or following an equity market bust.


This Selected Issues paper analyzes the empirical relationship between corporate leverage—and other indicators of financial health—and investment in Israel, using dynamic panel data techniques. The results suggest that weak balance sheets may well have contributed to the investment decline of recent years. The impact of financial variables on investment is more pronounced for firms under financial pressure. However, there is little evidence that weak balance sheets’ impact on corporate investment increases during real downturns or following an equity market bust.

IV. The Reform of the Capital Markets in Israel1


The commercial banks have been dominant in the capital markets in Israel for some years, although this dominance has begun to decline as capital markets have developed and allowed non-bank institutions to provide credit to the business and household sector. Being concerned that the banks’ dominance was frustrating the development of capital markets and that the financial markets more generally remained subject to excessive concentration, inadequate competition, and conflicts of interest, the authorities have forced banks to divest their holdings in mutual and provident funds. Despite arguing for a long transition period in which to sell the funds, the banks have in fact successfully sold most of their interests in these funds within a few weeks of the legislation implementing the reform being enacted in 2005. The authorities have also implemented (or propose to implement) a number of other tax, legislative and regulatory changes to remove the barriers to the development of the capital markets. The government’s decision, in the 1990s, to stop requiring institutions to invest in non-tradable risk-free government bonds is having an increasingly positive effect on capital market development as institutions look for a more diverse range of instruments for risk management purposes. The result is that the recent economic recovery has been accompanied by a rapid increase in market capitalization and daily turnover in the stock market, an increase in the corporate bond market, and increased cross border investment flows. These highly desirable developments in the capital markets, together with the divestiture of banks’ interests in funds, carry risks which demand a regulatory response. The regulatory authorities are aware of this and have implemented a number of valuable reforms. The regulatory authorities should be given more resources and greater independence in order to continue the process of assessing risks, strengthening regulations and enforcing their rules.

A. The Capital Markets in Israel

1. The capital markets in Israel have been highly concentrated. The financial sector is composed of about 200 institutions. However, until 2005, most of its activity was conducted by five banking groups (made up of banking institutions and provident funds), five insurance groups and pension funds (that were owned by the Histadrut2 until pension reform)3.

2. Three banks have for many years dominated the financial markets. In 2003, the three largest banks had 78 percent of bank deposits. In 20044, the same three banks also managed 80 percent of mutual fund assets and 73 percent of provident funds assets. The banks are also the main distributors of mutual and provident funds to the public. In addition, the banks are dominant in the underwriting of new equity issues, underwriting 99 percent of all new issues. The banks are therefore in a dominant position in that most savers and most borrowers would probably have tended to look first to one of the three main banks. Put another way, the three largest banks provided 95 percent of all financing to the private sector, whether in the form of credit or investments through mutual funds, or the underwriting of corporate financing5.

3. The supervisor has been encouraging the closure or merger of smaller banks in an attempt to improve competition. The supervisor considers that smaller banks will not have the resources to improve their systems and controls in line with strengthening legislation and the implementation of an approach consistent with the new Basel agreement on capital standards (Basel 2). Smaller banks that choose to merge have been prevented from joining either of the two largest banks, in order to avoid deepening the concentration in the banking market. Instead, they have merged with other smaller banks or medium sized groups. The supervisor hopes and expects that the process will result in a total of five reasonable sized banking groups6. The Government has, in the past, owned a substantial proportion of the banking system but, in 2004 and 2005 was able to sell the remaining holdings in Bank Leumi and Discount Bank.

4. Apart from the banks, the main institutions in the financial markets are the insurance companies and the agents that sell their products. Three insurance companies dominate the market for life and general insurance and for pension funds. In addition, there are a small number of mutual and provident funds managed by independents. The following table demonstrates the concentration of the market that existed until 2004.

Table 1:

Market Share of Leading Entities According to Activity Area (December 2003)7

(In percent)

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Out of total issues (private and public) in the period between January 2002 and August 2003.

5. The dominance of the banks has been decreasing in recent years and the insurance companies have been increasing in importance. The banks’ share of total credit and financial sector assets has been steadily decreasing for several years. This has been manifested in a decline in the proportion of business sector credit coming from banks and an increase in the proportion coming from other sources. Since the banks owned most of the provident funds8 until 2005, the rate of decline in credit from banks became even sharper when they sold the funds. The non-bank sector has been able to extend credit both in the form of loans (extended by insurance companies and provident funds to the business and household sectors) and in the form of corporate bonds.

Table 2:

Share of Banks in Supply of Credit9

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6. The insurance companies’ position has been strengthened by their purchases of pension funds, provident funds and mutual funds. The purchase of new pension schemes took place in 2004. Although small at present, these funds will grow substantially in future. The purchase of provident funds and mutual funds was as a result of legislation enacted in 2005 requiring the banks to sell these funds. That legislation is discussed in more detail in the next section.

B. Concern About the Dominance of Banks in the Financial System

7. The authorities argued that the dominance of the banks was highly undesirable. The authorities took the view that the capital markets were underdeveloped because the banks acted to frustrate that development in order to preserve their market power. An Inter Ministerial Committee Report on Structural Reform in the capital market was formed, headed by Ministry of Finance Director General Bachar. Its report was published November 2004 (Inter Ministerial Committee Report). The analysis in the report is described in the following paragraphs.

8. The Inter Ministerial Committee Report (the Report) raised concerns that the dominant position of the banks created a series of actual or potential conflicts of interest including the following:

  • A bank could directly or implicitly encourage the investment managers for the mutual and provident funds it controls to invest in equity issues for which the bank was the underwriter, so as to reduce the underwriting risks;

  • Banks, despite being under a duty to offer objective advice to investors in funds, in practice persuaded the majority of customers to buy the mutual and provident funds that were managed by their own subsidiaries;

  • Banks might have been inclined to encourage additional, perhaps excessive, credit to their customers for the purpose of investment in their own funds;

  • The managers of mutual and provident funds might have been inclined to channel their investments to institutions and companies that were owned by or related to the banks;

  • The managers of mutual and provident funds might not have insisted on the lowest fees or commissions for services conducted by their parent bank;

  • Where it was concerned about the ability of a corporate customer to repay a loan, a bank might have been tempted to encourage the company to issue debt or equity as a means of raising funds to repay the loan, thus transferring the risk of default by the company from the bank to the investors in its funds;

  • If the bank’s own managed funds were to subscribe to the issue then this would compound the conflict of interest.

9. While the Report emphasized that some of these conflicts were potential, it argued that, in many cases, there was evidence of improper behavior by the banks. One example was the failed share support operation of the 1980s where the Bejski Report10, following the collapse of the banks, indicated that banks may have used their funds to support the operation, sometimes encouraging customers to extend their credit to invest further in funds. The authorities took the view that the lack of competition in Israel exacerbated the conflicts of interest that would exist in any economy where there is universal banking.11

10. The Report considered that the concentration inhibited innovation. The absence of money market funds, offered with checkbooks, and the absence of term loans or credit cards were cited by the authorities as examples of the lack of innovation in the financial markets. The authorities considered that the widespread use of overdrafts and the extensive network of payment, investment and other services effectively tied customers into the banks. It was not easy to switch banks if there was an overdraft that was financing investments or other interests—especially if, as was the case in Israel, there was limited credit information available to allow banks to judge the creditworthiness of new customers. The authorities aspired to a different model of an advanced capital market, where nonbank intermediaries play a larger part in the capital markets than do banks.12

11. The Report further considered that the banks acted to frustrate the development of capital markets. For example, the authorities noted that they had observed predatory pricing behavior by the banks in respect of corporate finance. Specifically, the authorities said that, when companies contemplated raising finance from the capital markets, the banks offered credit on particularly attractive terms, thus frustrating the development of corporate debt and equity markets. It was for this reason, according to the authorities, that total corporate debt in 2004 was only 8 percent of GDP (whereas it is 70 percent in the United States and 28 percent in the United Kingdom).

12. The Report argued that regulation and supervision had failed to solve the problem in the past and that structural reform was necessary. The Committee recommended the enforced divestiture of the banks’ interests in mutual and provident funds—a proposition that had been mooted several times over the previous twenty years by various committees but which had never been implemented. According to the Committee, the failure to implement this reform had been due to heavy pressure from the banks.

13. The Committee’s proposals included the following three main elements:

  • Banks would be prohibited from managing mutual and provident funds and would be obliged to sell their interests in such funds over a four year period. There would remain limits on the maximum share of the market that any purchaser could acquire at the time of purchase.

  • Banks would be permitted to sell, to the investing public, mutual funds, provident funds, long term insurance products and pension funds managed by others but could receive no commission or other remuneration from the managers of those funds. All income for offering advice on funds, or commission for executing instructions to buy, would have to be paid by the customer in the form of a fee.

  • Banks would not be permitted to act as pricing underwriters for public offers of securities where the issuer (or entities it controlled) owed the banks (or related parties) more than NIS 5 million or a sum equivalent to 10 percent of its total financial liabilities.13

14. In addition to these proposals, the Committee recommended supplementary measures. The largest banks would be required to sell their holdings in smaller banks. There should be a strengthening of regulation including the introduction of a law to regulate provident funds and a review of the regulatory supervisory structure to ensure consistency, better coordination and greater effectiveness. There should be a working party on the development of new capital market instruments. Other measures were also proposed.

C. The Enactment of the Inter Ministerial Committee Recommendations

15. In 2005, legislation forcing the divestiture of the banks’ holdings in mutual and provident funds was enacted and implemented. Banks were required to sell their interests in mutual and provident funds within a defined timescale. Although the banks sought an extension of the timescale within which they could sell mutual and provident funds, in fact, they sold most of the funds within three months of the legislation being enacted. Two thirds of the funds were sold to domestic insurance companies. The remainder either remain with the banks for the time being or have been sold to foreign interests. Some of the regulators and banks believe that the price received by the banks was substantially higher (perhaps up to 50 percent higher) than might have been expected on the basis of the current fee income received by the banks14.

16. The proposal to ban the payment of commissions was dropped. Instead, those who sell or advise on investment products must choose to engage either in “investment advising” or “investment marketing”:

  • Investment advisers must be independent and are required to give objective and unbiased investment advice on investment products that are suitable for their customers, given their full circumstances and risk appetite;

  • Investment marketing agents are also required to recommend suitable products for their customers but are allowed to promote products issued by companies with which they are associated and face increased disclosure obligations pertaining to their ties and biases;

  • Banking corporations can only engage in investment advising.

17. Restrictions on the banks’ underwriting capacity were enacted. Banks will still be able to act as underwriters but the legislation will prevent them from operating as costing underwriters in those cases where a potential conflict of interest arises in the course of providing the credit.

D. The Removal of Barriers to the Development of the Capital Markets.

18. While the proposals of the Inter Ministerial Group have been the subject of much debate and controversy, other important reforms have also been implemented over a number of years and further reforms are under way. The Chairman of the Israel Securities Authority (ISA) appointed a Committee to identify barriers to the development of the capital markets and has set in train a reform program designed to remove them. The following measures have been taken or proposed:

  • Tax changes implemented in January 2005 reduced the disincentive to invest in overseas capital markets, thus increasing the competition for Israeli savings;

  • The Government has proposed legislative and regulatory changes to encourage asset-backed securities, municipal bonds, corporate bonds, short term commercial paper, real estate investment trusts, funds of funds, exchange traded funds, repos, World Bank bonds, swaps and other instruments;

  • Regulations governing the issuance of prospectuses for new public offerings have been introduced, simplifying the process of raising funds through the primary market;

  • Legislation has been proposed which would facilitate the public offering in Israel of foreign mutual funds from well regulated jurisdictions;

  • Legislation has been enacted to safeguard the solvency of the clearing house in the event of the default of one of its members;

  • The removal of foreign exchange restrictions over the past decade has enhanced the ability of companies to raise capital overseas;

  • The Government is putting in place measures designed to encourage customers to switch more readily between banks;

  • The commission structure for insurance was reformed in a way that introduces an incentive for insurance companies and their agents to sell mutual and provident funds and some of them are doing so;

  • The authorities are moving towards the introduction of International Financial Reporting Standards, seeking voluntary compliance by the spring of 2006.

In many cases, where legislation is proposed, it is still under consideration either within the Government or in the Knesset.

19. In addition to the removal of barriers to capital market development, changes in the practice of the government in debt issuance have also promoted capital market development. In the past, the government directed a high proportion of the assets of the pension funds, provident funds and insurance companies into special index-linked bonds. These bonds had guaranteed returns and were held by the financial institutions until maturity. They were, essentially, risk-free (leaving aside the possibility of government default). These bonds are no longer issued but a substantial proportion of them remain in the assets of the financial institutions (see table below). Moreover, given the continuing high level of government debt, relative to GDP, the Government also has absorbed a large proportion of non-directed savings. Overall, 83 percent of non-bank financial sector assets were held in the form of government debt. In the past, the proportion has been much higher. These institutions might be expected to be active in the capital markets and to have the greatest demand for additional capital market instruments. However, in practice, the high degree of direction in the savings market meant that there was limited demand from financial institutions for new instruments and this is the most likely explanation for any lack of development in the capital markets in the past. However, the change, over a number of years in the debt issuance practice of the government is beginning to bear fruit in the increased demand by institutional investors for other financial instruments and the corresponding growth in the corporate debt market.

Table 3:

Estimated Distribution of Financial Sector Assets 200415

(NIS billion end of 2004 prices)**

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Includes deposits with Bank of Israel and holdings of Treasury Bills.

Mutual funds are not included in this table since the Bank of Israel treats them as equivalent to portfolios of private sector holdings in debt and equity.

20. The introduction of Real Time Gross Settlement (RTGS) has also prompted development of the financial markets. RTGS is an important development that will improve the stability of financial risk by reducing settlement risk. As the Bank of Israel has moved towards the introduction of RTGS, the preliminary measures have prompted an interbank money market. It will also be necessary to develop a fully functioning repo market and the authorities have proposed legislation designed to facilitate this. This legislation is currently under consideration within the government.

E. The Recent Growth of the Capital Markets

21. Even though much of the legislation necessary to remove the barriers to development has yet to be enacted, the capital markets have begun to grow rapidly.

  • The market capitalization of the equity market grew in 2005 to $110 billion as compared with $78 billion in 2004. The fixed income market capitalization was $95 billion in 2005 compared with $57 billion in 2004.

  • Daily turnover in the equity market was $204 million compared with $140 million in 2005. For the fixed income market the equivalent figures were $456 million and $207 million.

  • In 2004, government bonds accounted for 98 percent of the fixed income market but this had fallen to 77 percent in 2005.

  • There was a substantial increase in total capital raised on the Tel Aviv stock market—from NIS 12.4 billion in 2002 to NIS 63.3 billion in 2005.16

  • Increased interest in the primary market was demonstrated by the growth in the number of prospectuses submitted for ISA approval.

  • The Israeli corporate debt market has been growing rapidly—up from NIS 2.5 billion of new issuance in 2000 to an estimated NIS 21 billion in 2005.

F. The Risks Created by Capital Market Development

22. Capital market development is positive for the economy and, for the most part, the measures taken are to be supported. In particular, the care taken by the authorities to identify tax, infrastructure and legal barriers to the development of new instruments and investment opportunities has been a painstaking but worthwhile task. Regulatory simplification in certain areas, coupled with enhanced supervisory powers—to be used in a proportionate way—provides a sound basis for the future and should enable the capital markets to support continued economic growth in the future.

23. Following the divestiture of banks’ interest in mutual and provident funds and their capital market developments, it is necessary to reassess the risks in the financial markets. As a result of all the developments (not merely the forced divestiture of banks’ funds interests), participants in the capital markets are having to adapt to new roles; new instruments are becoming available; existing investment products have new risk profiles, investment advisers are operating according to different rules; and investors will need to adapt to markets with different investment opportunities.

24. Insurance companies must adapt to new roles. Israeli insurance companies have bought most of the mutual and provident funds sold by banks (see Table 4). The insurance companies are developing into general managers of money and will need to adapt their corporate governance, their policies, and controls to ensure that they understand and manage the risks that are associated with the ownership of funds. Staff will have to learn new skills. While the funds’ assets will be held separately from those of its parent insurance company and much of the investment risk will normally be borne largely by the investor, the insurance companies will still be subject to a range of operational, legal and reputational risks from their fund management activity. The insurance companies would also be at risk if the income from mutual and provident funds turned out to be less than they assumed when accepting high prices. At the same time, and quite separately from their purchase of funds, insurance companies are expected by the Insurance Supervisor17 to engage in more direct lending to businesses and households. At present this occurs only to a very small degree. However, if the practice grows, the insurance companies will have to ensure that they have the necessary credit assessment and management skills. Insurance companies are also believed by the authorities to be likely to want to offer products with a guaranteed return. Such products would be very similar to bank deposits and, if such a development proceeds, the insurance companies would be behaving like banks. The authorities will have to be prepared either to prevent this from happening, or to ensure that the supervisory arrangements are as effective as those for banks. The companies themselves would need to have the same risk management skills as banks if they are to be successful. Insurance companies may also increase their overseas interests from 10 percent of assets at present to around 20 percent in the future (a figure the Insurance Commissioner considered appropriate). The companies will also have to learn the skills, and implement proper policies and controls, to manage the associated risks.

Table 4:

Distribution of Israeli Public Assets18

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25. Insurance companies must take care in their selling practices. It is claimed by some that the insurance companies have paid a much higher price than could be justified by the present value of the fee income stream currently received by the banks. Moreover, the upward movement in interest rates since the purchase of the mutual and provident funds may increase the financing costs of money borrowed to finance the purchase of the mutual and provident funds. If so, they may be tempted to engage in aggressive selling practices in order to secure a return on their investment. The agents selling insurance products will tend to be marketing agents, who have a responsibility to provide objective advice but are allowed to favor the products of the company with which they are associated. This will be a difficult balance to strike and there is a danger that such agents may be tempted to engage in aggressive selling practices which will result in investors not being fully informed of the risks they are facing when buying their products. This in turn could lead to legal challenges to the insurance companies.

26. Banks need to compensate for the loss of their fee income and the declining quality of their borrowers. The fee income received by banks for the management of funds was not, according to the banks, as cyclical as the returns from their traditional intermediation business. The loss of this income makes the banks more dependent on their traditional business and thus increases their exposure to the risks associated with normal business cycles. At the same time (and in common with banks world-wide), the banks find that the highest quality borrowers are those best able to secure funds from the capital markets. As more credit is available from the capital markets, the best rated companies will turn to them for funds and the overall quality of remaining bank borrowers may therefore decline. The banks need to compensate for this increased risk by diversifying their business including the use of investments outside Israel. This requires particular diligence and care in ensuring that foreign investments are appropriately managed as many banks have found, to their cost, in the past.

27. Insurance companies, provident funds, pension funds and mutual funds will have additional investment opportunities which will require new management skills. As already noted, insurance companies, provident funds and pension funds have, in the past, held most of their assets in the form of government bonds, often guaranteed. In the future, they will be using a larger number of financial instruments to manage their risks. They will be competing for customers and may well be looking for investment opportunities with higher yield and risk. They have already moved substantially into corporate bonds. Provident funds have placed 28.5 percent of their assets in corporate bonds, of which 15.4 percent are untradable. The figures for insurance companies were 12.6 percent and 7.7 percent in June 200519. Corporations issuing these bonds have been surprised at the fine rates they have been able to achieve in the corporate bond market20. Insurance companies do not have the same experience as banks in evaluating credit risk of corporations and they must be careful that they do not under-price that risk. Insurance companies and provident funds make loans and provide mortgages. At present this activity is very limited, representing less than 1 percent of the assets of provident funds and 4 percent of insurance company assets. However, the intention of the authorities in liberalizing the capital markets is that these alternative sources of credit should grow and these percentages may become larger in future. If so, insurance companies will need to develop the appropriate risk management skills and controls.

28. Investors will need to understand that provident funds and insurance companies’ products may be more risky than hitherto. Provident and insurance companies used to invest almost exclusively in government bonds and thus presented a very low risk to investors. Although there were disclosure rules requiring managers to disclose their investment policies and risks, in practice these were not all followed by the banks as fund managers. Investors chose between products largely on the basis of comparative yield. This will no longer be appropriate as provident funds and insurance companies invest in a wider range of instruments and attempt to gain or retain investors by offering different levels of risk and potential yield. Given that the generic names of the provident funds and insurance products may not change, there is a danger that investors may not appreciate the different risks to which they are subject. New instruments (and particularly direct loans to businesses and households) will create new risks and it is essential that investors are informed of this change to products which have long been familiar to them as risk free investments.

29. Investment advisers will be operating in a new regime with different rules. Banks will continue to be the main distributors of funds. They will be independent investment advisers offering objective advice on all the products in the market. This will be a quite different from the previous regime when banks’ advisers sold exclusively their own products. Banks may have some links with particular funds - for example where they may have lent money to an insurance company to buy mutual and provident funds, or have entered into an agreement to sell funds and provide other services as part of the original agreement to sell the funds. Moreover, it will be straightforward for the banks to develop deposit-based products that perform in a similar manner to certain kinds of funds. Banks will still be able to offer individual portfolio management services and for higher net worth customers these services will compete directly with mutual funds for customers’ savings. Banks will be able to take a position in individual equities and it is conceivable that this could create a self interest for the bank in recommending those equities to customers when giving investment advice. Notwithstanding the banks’ own interests, the banks’ advisers will not be able to favor their own banks’ products and must give fully objective advice. Strictly speaking, this was also true under the previous regime and yet the regulators were unable to enforce the requirement. It will be essential for the credibility of the new regime that the regulators should enforce the rules vigorously in future.

G. The Response by the Regulatory Authorities

30. The regulatory authorities are well aware of the need to understand and regulate the markets in a way that protects stability and the interests of investors while avoiding stifling innovation. The Insurance Commissioner, for example, expressed the view that the international best practice in some aspects of the supervision of insurance substantially lagged behind that for banks and that this was equally true in Israel21. The regulatory authorities are taking action on this but more needs to be done.

31. The bank supervisory authority has additional powers. Bank supervisors now have further powers to assess the good standing of owners, controllers, and managers of banks. This enables the supervisors not only to check the good standing of such persons prior to their appointment (which power they held previously) but also to seek the removal of these key persons if they subsequently believe and can show that they can no longer be regarded as being of good standing. The bank supervisors’ ability to share information with other domestic regulators and foreign supervisors has now been enhanced.

32. There is a new insurance regulatory law which gives new powers and sanctions to the Insurance Commissioner. The Commissioner has used the new law to issue new regulations requiring new capital requirements, new risk management procedures, and new corporate governance practices for insurance companies. The new law provides additional powers to assess the suitability of owners, controllers, and managers of insurance companies and this power will be used to ensure that all key personnel in insurance companies have the necessary qualifications (although existing staff will have “grandfathered” rights to retain their present positions). All assets must be valued at a fair value. The regulation ensures that insurance companies follow adequate credit management practices when granting loans. The credit management rules are also based on those for banks. The Commissioner has taken new initiatives to regulate the activities of the boards of the regulated institutions and their sub-committees; to regulate the activities of the external and internal auditors; and has imposed on insurance companies a requirement to appoint an actuary and risk manager. The Commissioner has decided that he must consider insurance companies as financial conglomerates, given their expanded role in the capital markets and has, for example, implemented regulations that will require insurance companies to allocate additional capital to cover the goodwill that was included in the price paid for the mutual and provident funds.

33. The ISA also has additional powers and has enhanced its regulatory approach. The ISA is, as a result of new legislation, in a better position to assess the suitability and good standing of shareholders holding more than 30 percent control in mutual fund management firms. The ISA has been authorized to issue directives and instructions to ensure the implementation of the regulations. (This is a particularly important development as it was the absence of an unambiguous power of this kind that led to the banks challenging previous attempts to take action to enforce the rules on conflicts of interest.) The enforcement of the rules governing investment advisers’ behavior will be further enhanced by new legislation bringing the managers of investment advisers within the ISA’s regulatory reach, so that the ISA can ensure that advisers are not placed under improper pressure to depart from the code of conduct in order to increase sales. The ISA will be able to issue rules of conduct (with the prior approval of the Knesset Finance Committee) and will have additional sanctions at its disposal, including civil fines. The new law also enhances the ability of the ISA to cooperate with foreign regulatory authorities, although it is not able to sign IOSCO’s multilateral memorandum of understanding mainly because of the retention of a dual criminality requirement in its provisions. The ISA has proposed changes to rectify this. Notwithstanding the new legislation, the ISA does not have an unambiguous power to enter the premises of regulated businesses without cause or notice in order to carry out an inspection. This has never caused a problem in the past but it should be rectified when the opportunity arises.

34. The ISA has decided to broaden the supervision of mutual fund managers now that they are no longer under the control of banks22. The supervision will extend to the independent trustees who are responsible for the safe custody of mutual fund assets. There will be further on-site inspections of mutual funds and trustees to enforce the regulations, although it is intended to use external accountancy and other professional firms to carry out this work. There are enhanced disclosure requirements for mutual funds.

35. New legislation provides a proper basis for regulating provident funds. The new legislation governing the regulation of provident funds puts that regulation on a sound statutory footing (having previously been reliant on tax legislation). The regulation of the provident funds is the responsibility of the Insurance Commissioner, who is a member of the staff of the Ministry of Finance. He has instituted a review of the accounting disclosure and reporting requirements for provident funds and imposed new requirements including internet-based reporting.

H. Further Measures to Be Considered

36. In practice, at least some of the regulators are likely to need substantially more resources in order to carry out their responsibilities in the new and changing environment. The Insurance Commissioner, for example, has 50 professional staff of whom just 15 are devoted to on-site supervision. He has responsibility for 100 institutional investors (insurance companies, provident funds and pension funds). He has decided to implement a new more proactive supervisory approach, involving more on-site visits. He is seeking and should be granted new staff, not only for on-site inspections but also to carry out research, design reporting systems for the regulated bodies, collate, and analyze reports, assess the risks of different bodies, and take action to mitigate risks and enforce rules. The ISA is faced with the need to assess applications for approval from a large number of investment advisers as well as owners, controllers, and managers of regulated bodies. It has only 11 professional staff devoted to the regulation of 40 mutual fund managers. The ISA considers that it has sufficient resources because it is intending to outsource the on-site inspection process to accounting and other professional firms. While it is perfectly reasonable to deploy such firms as part of an inspection process, it would be preferable to have a substantial in-house team with on-going experience of inspections. This would enable the ISA to set the parameters for the work of outside bodies, check that they are performing the task properly, and maintain a valuable knowledge base about the behavior of regulated bodies. Equally, the ISA needs to ensure that its staff numbers are expanding sufficiently to enforce the regulations it has been developing and to respond to enquiries that are coming from market participants about the simplified prospectus requirements, the role of advisers, the new rules for foreign mutual funds, and other developments. The need for additional resources will become more acute as the legislative and other changes are made to allow an increasing number of new instruments.

37. The division of responsibilities between supervisory authorities should be reviewed. At present, the Bank of Israel is the bank supervisor, the Insurance Commissioner is the insurance supervisor and the ISA is the securities regulator. This split of responsibilities is not uncommon. However, the arrangement carries some disadvantages and risks in the Israeli context. Increasingly, the products and services developed by different financial institutions do not fit neatly into separate boxes. The responsibility for the regulation of Investment products such as bank deposits, mutual funds, provident funds, pension funds and insurance companies is split between the three regulatory authorities. The way certain kinds of deposit, mutual funds, provident funds, and insurance products behave and the risk they pose to the investor are not always very different from each other and yet the division of responsibilities could result in inconsistencies and anomalies. The Insurance Commissioner, for example, noted that accounting rules for provident funds, pension funds, and insurance companies were not consistent with each other or with those for financial institutions regulated by other bodies. The Insurance Commissioner and the bank supervisor are developing regulations for insurance companies that follow those for the banks where they are behaving in a similar fashion. All regulators should review their rules to ensure consistency. In the short to medium term there may be a case for reallocating responsibility for some products (provident funds are discussed further below). In the longer term, it would be sensible to review the structure of regulation. However, structural changes can be very disruptive and it is essential that, at this time, when there is an urgent need to upgrade the standard of regulation to respond to new and developing risks in the capital markets, that the regulatory authorities are not distracted from their prime regulatory task.

38. All regulators will have some responsibility for enforcing the new regime for investment advisers and it is essential that the rules and enforcement are consistent. Banks will employ most investment advisers and the Bank of Israel will be the supervisor. Investment advisers and marketing agents will sell provident funds (which are within the responsibility of the Insurance Commissioner) and mutual funds (regulated by the ISA). The requirement to give objective advice was present but not effectively enforced under the previous regime. The regulators now have new powers and it is important that the regulations and their enforcement are consistent. These new powers should be deployed vigorously to create and maintain credibility in the integrity of investment advice. The regulatory authorities have taken some steps to achieve this. The ISA and the Insurance Commissioner have, sensibly, cooperated in the drafting of ethics rules for investment advisers.

39. Particular attention should be paid to the responsibility for provident funds regulation. Although classified as a long term investment and therefore regulated by the Insurance Commissioner along with insurance companies and pension funds, the provident fund is, in almost every respect, a collective investment scheme and carries similar risks to other such schemes such as mutual funds. The international standard-setting body for such schemes is the International Organization of Securities Commissions (IOSCO) and the ISA follows IOSCO standards. Because he is primarily concerned with insurance, the Insurance Commissioner does not follow IOSCO standards in respect of provident funds. Thus, for example, requirements for disclosure by provident funds are being developed by the Insurance Commissioner but are not to be based on existing requirements developed by the ISA for mutual funds. So long as the regulation of provident funds rests with the Insurance Commissioner, it should follow the IOSCO principles. However, the structural review should also consider whether provident funds should be regulated separately from mutual funds.

40. Each provident fund should be required to appoint an independent custodian to safeguard its assets. IOSCO principles require that the assets of a collective investment scheme should be held by an independent custodian. This provides important safeguards, since the custodian ensures that the title to the assets is held securely, that transactions are properly completed and that investments made are within the fund’s investment policy and the law. The ISA requires an independent trustee to perform this function for mutual funds. The same should apply to provident funds.

41. The independence of the ISA and the Insurance Commissioner should also be strengthened by giving them rule-making powers that do not require the endorsement of a separate authority. Detailed and technical rules are essential to provide certainty to regulated entities and to provide a transparent basis for regulation. The Israeli regulatory authorities can and do issue regulations. Unlike the Bank of Israel, however, which has the authority to issue regulations on its own authority, the rules of the Insurance Commissioner and the ISA are subject to the approval of the Minister of Finance and the Knesset Finance Committee. This arrangement creates the danger that agreement on new rules could be delayed or could be subject to political bargaining involving unconnected matters. The Israeli capital markets are developing very quickly and it is important that the regulatory authorities should be able to issue rules in a timely fashion. There should certainly be proper consultation and accountability but it should not be necessary to receive the approval of Ministers or Knesset committees before new rules can be issued.

42. The budgets of the regulatory authorities are subject to oversight by political committees and this could also compromise independence. Each jurisdiction needs to make arrangements consistent with its own legal and constitutional traditions. Some jurisdictions give regulatory authorities their own stable source of income (often in the form of license fees from regulated institutions) which is subject to value for money reviews and accountability arrangements but not necessarily prior approval by political bodies. Other jurisdictions provide multi-year budgets to ensure stability of income and hence a degree of budgetary independence. In Israel, the annual budgets of the regulatory authorities are subject to political approval by the Knesset Finance Committee and it is difficult to reconcile this with the requirement for a stable source of income as is required by international standard setting bodies. If it is not possible for the regulatory authorities to be given total budgetary independence (subject to reviews of efficiency and transparent annual reports and accounts) it would be preferable to provide for three to five year budgets, so that there could be no danger that regulatory independence might be compromised because of concerns about budget approvals by the Minister or the Knesset Finance Committee.

I. Summary and Conclusions

43. The authorities’ actions have led to the growth of the capital markets. The growth of the corporate bond market is a positive development for Israel. It provides further opportunities for business to obtain credit and an expansion of choice for institutional and individual investors. Together with the forced divestiture of banks’ holdings of mutual and provident funds, actions that the authorities have taken, or plan to take, to remove the legal, tax, and regulatory barriers to the further development of capital markets, are already leading to growth and innovation in the creation of new instruments for investment and risk management. This action is to be commended.

44. The authorities have also recognized the risks posed by capital market development and are taking action to address them. The changes in the capital markets are having the result that there are new participants, selling new products to investors under new rules, with advisers operating under a new regime. There is a particular risk that arises because of the radically changed risk profile of provident funds which is the result of a shift in their asset portfolio away from risk-free government bonds to newer capital market instruments. Investors may not be aware of the changed risk profile and need to be properly advised and protected. The authorities should be applauded for recognizing these risks. The introduction of new laws and regulations and the development of new proactive approaches to enforcement are welcome.

45. However, more needs to be done. The legislation proposed by the authorities has yet to be enacted in many cases. Most importantly the regulatory infrastructure, although strengthened by recent legislation, needs further attention, particularly in the form of greater independence and more resources. The roles and responsibilities of the regulatory authorities could usefully be reviewed but not at the expense of creating a serious distraction to the management of the authorities at a time when their attention must remain focused on assessing and managing the risks created by the favorable development of the capital markets.


Prepared by Richard Pratt


A labor union.


Bank of Israel: Financial Stability Report 2003.


Prior to the enactment of legislation in 2005.


Inter Ministerial Committee Report on Structural Reform in the capital market headed by Dr. Yosef Bachar, Director General of the Ministry of Finance, published November 2004 (Inter Ministerial Committee Report).


Discussion with the Bank Supervisor December 2005


Inter Ministerial Committee Report.


A provident fund is a long term investment, not unlike a mutual fund but which benefits from tax incentives designed to encourage long term savings for contingencies such as hospitalization, redundancy and retirement. Currently tax advantages are only available to those who maintain their savings in the provident fund until retirement.


Bank of Israel Financial Stability Report 2004


Inquiry Commission’s Report on Bank Share Regulation (1986).


Inter Ministerial Committee Report.


Presentation to the mission by the Ministry of Finance 8 December 2004


Inter Ministerial Committee Report


Discussion with representatives of the banks and with Israel Securities Authority, the Bank of Israel and the Insurance Commissioner


Bank of Israel Financial Stability Report 2004.


Israel Securities Authority; as of October, 2005.


Discussion with the Insurance Commissioner


Insurance Commissioner


Data supplied by the Insurance Commissioner


Discussion with the National Manufactures Association


Discussion with the Insurance Commissioner


Discussion with the ISA