Abstract
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.
V. Banking Sector Developments and Issues1
Abstract
The banking industry is an essential component of the Israeli financial sector. The system holds over half of all financial assets and is highly concentrated in five banking groups. Over the past several years, the profitability and capital position of the banking system has improved, albeit from a low base following the 2001–2002 recession. In light of the past earnings volatility of Israeli banks and the concentration of credit risk in the Israeli economy, it is important that the banking system be encouraged to continue to build its capital base and strengthen its profitability in an effort to bring it more in line with international peers in other small economies.
The supervisors in the Bank of Israel (BoI) have a very important responsibility to provide a supervisory regime that is conducive to well-capitalized and profitable banks. Under such a regime, each bank would clearly understand supervisory expectations regarding capital levels and risk management systems. At the same time, healthy banks, which are meeting supervisory expectations, would be given the authority and flexibility to innovate and respond to market developments without intensive rules-based regulation.
A. Structure and Performance of the Israeli Banking System
1. Israel has a large and concentrated banking system. As of end-September, 2005, the system had assets of NIS875 billion or about US$193 billion. (Table 1 provides information on the banking system.) The system is highly concentrated, with the five largest banking groups accounting for about 95 percent of system assets. Among the five largest banking groups, Leumi and Hapoalim each controls about 30 percent of system assets. Two foreign banks, Citigroup and HSBC, have a branch each, but do not have a material asset base.
Israel: Banking System
(financial information in NIS, consolidated banking group at September 30, 2005)
Israel: Banking System
(financial information in NIS, consolidated banking group at September 30, 2005)
| Assets | Percent of total | Credit to the public | Percent of total | Deposits from the public | Percent of total | |
|---|---|---|---|---|---|---|
| Bank Leumi | 264.7 | 30.2 | 175.1 | 30.4 | 215.6 | 30.7 |
| Bank Hapoalim | 260.4 | 29.8 | 180.2 | 31.2 | 202.8 | 28.8 |
| Israel Discount | 153.0 | 17.5 | 83.2 | 14.4 | 127.4 | 18.1 |
| Mizrahi | 85.0 | 9.7 | 64.9 | 11.2 | 69.4 | 9.9 |
| First International | 70.8 | 8.1 | 43.1 | 7.5 | 60.1 | 8.5 |
| Five largest banks | 834.0 | 95.3 | 546.4 | 94.7 | 675.4 | 96.0 |
| Total Banking System | 875.3 | 100.0 | 576.8 | 100.0 | 703.2 | 100.0 |
Israel: Banking System
(financial information in NIS, consolidated banking group at September 30, 2005)
| Assets | Percent of total | Credit to the public | Percent of total | Deposits from the public | Percent of total | |
|---|---|---|---|---|---|---|
| Bank Leumi | 264.7 | 30.2 | 175.1 | 30.4 | 215.6 | 30.7 |
| Bank Hapoalim | 260.4 | 29.8 | 180.2 | 31.2 | 202.8 | 28.8 |
| Israel Discount | 153.0 | 17.5 | 83.2 | 14.4 | 127.4 | 18.1 |
| Mizrahi | 85.0 | 9.7 | 64.9 | 11.2 | 69.4 | 9.9 |
| First International | 70.8 | 8.1 | 43.1 | 7.5 | 60.1 | 8.5 |
| Five largest banks | 834.0 | 95.3 | 546.4 | 94.7 | 675.4 | 96.0 |
| Total Banking System | 875.3 | 100.0 | 576.8 | 100.0 | 703.2 | 100.0 |
2. The condition of the banking system is improving, albeit from a low base following the 2001–2002 recession. The banking system has high levels of problem loans, low profitability, and relatively low capital levels compared to its international peers. Problem loans in the system, a large share of which is in the real estate and construction sector, average about 10 percent (for the five largest banks, problem loans range from 6 percent to 13 percent of total loans).2 Through end September, the banking system reported net income of NIS5.3 billion or 0.8 percent annualized return on assets compared to a 0.6 percent ratio for 2004. Capital levels are low, with risk-based capital ratios for the five largest banks ranging from 9.7 to 12.2 percent (the regulatory minimum is 9 percent). The banking system enjoys ample liquidity provided primarily through deposit funding.
3. Banks will shortly realize gains from the divestiture of their provident and mutual funds management businesses, which will provide a one-time boost to income. The mandated divestiture followed August 2005 reforms designed to reduce the market power of the major banking groups and increase participation by non-banking companies. While intended to achieve greater competition in financial services for the economy, the divestiture by banks of the funds management business eliminates a potential source of income and income diversification for banks.
4. The financial sector, both in Israel and internationally, is becoming increasingly competitive and more complex. There is a need to ensure that well managed and healthy Israeli banks have the operational flexibility to adapt quickly to changing market conditions. Israeli banks, particularly those with international ambitions, need to be profitable and efficient to remain competitive in international markets. They need to be able to adapt to new regulatory regimes such as the Basel II capital adequacy framework and the International Financial Reporting Standard (IFRS), to meet changing customer needs, and to take full advantage of modern capital markets instruments such as derivatives and asset securitization.
5. Despite the level of concentration in the banking system, the BoI has been encouraging greater consolidation of smaller banks, which has resulted in the sale or liquidation of more than 10 banks since 2001. The consolidation reflects a supervisory concern that smaller banks have neither sufficient size to support the higher regulatory costs arising from initiatives such as Basel II, anti-money laundering rules, and accounting requirements nor the economies of scale to compete with the larger banks. At the same time, the Government has been reducing its ownership of the banking system, which in the past had been substantial.
6. The banking groups have a large number of overseas offices. At the end of 2004, there were 122 overseas offices including subsidiaries, branches, and representative offices. Assets and deposits in foreign branches and subsidiaries of Israeli banks comprise over 15 percent of system levels. On the other hand, the presence of foreign-owned banks in the Israeli market remains small despite the openness of the authorities to foreign institutions. Two foreign banks, Citigroup and HSBC, have branch operations that are limited to wholesale activities and private banking.
B. Supervision and Regulation
7. The 2001 Financial System Stability Assessment (FSSA) concluded that the Bank of Israel largely complied with the Basel Core Principles (BCP) for Effective Banking Supervision. While the mission did not conduct a reassessment of the BCP, the earlier conclusions reached during the FSSA remained consistent with the findings of the mission. The caliber of BoI supervisors is generally strong with considerable depth of quality in the department. The BoI provides continuous oversight over the systemically relevant institutions largely in line with best supervisory practices. Nonetheless, supervisory effectiveness could be strengthened further. The following areas merit further attention.
Supervisory Priorities
8. The five banking groups that dominate the banking system are each systemically relevant. The failure of a bank in any one of these groups could have serious consequences for the economy and for the payment and settlement system. In response, a supervisory philosophy of limiting the risk-taking of the banks has developed. The BoI designs prescriptive rules for a broad range of banking activities with examiners then emphasizing compliance with these rules. This approach is aimed at preventing banks from suffering financial loss, promoting transparency, and protecting the public from unpopular fees and unfair treatment. Such a prescriptive approach, however, may impose additional costs (direct and indirect) on the banking system and, ultimately, on the public.
9. To strengthen supervisory effectiveness, the BoI needs to move towards a more risk-based supervision process based on supervisory principles. The objectives of the BoI are properly aligned toward supervising the five largest institutions, consistent with the critical role of these institutions in the economy. Very important prudential issues, however, such as the high level of problem loans, the level of provisioning, the relatively low capital levels, and low earnings may receive less attention. A risk-based approach focuses supervision on reviewing bank performance against sound risk management practices rather than relying on the resource-intensive review of compliance with prescriptive rules. Such an approach would allow for greater allocation of BoI resources according to risk. Such a risk-based resource allocation would have several elements. It could include the analysis of systemic risks and focusing supervisory efforts on those activities in systemically important institutions that are perceived to be riskiest and where risk controls are weak.
10. An important element of a principles-based approach is ensuring that supervisory resources are sufficient and appropriately allocated to understand and mitigate vulnerabilities. It will be important that BoI have staff with the necessary skills to deal with the supervision of emerging areas of risk in the banking system such as foreign exchange risk, securitization, and other money market activity. Optimally, the number of staff in the Supervision Department will be increased. Banks are already engaging modestly in some of these activities and are intending to enhance their infrastructure and technology platforms to expand further in these business lines. Banks are anxious to expand their revenue drivers as growth in traditional business lines becomes constrained by competition and forced divestiture. It is important for the BoI supervisors to support these new activities, but within the parameters of safety and soundness. In line with developing a more principles-based approach, there will need to be a high level of consultation with the banking sector to ensure common understanding of risk management practices.
11. As an example, an area of vulnerability is the lower capital levels and high levels of problem loans in some banks. In line with a more principles-based approach, the BoI would set out a broad objective that banks be required to attain target capital ratios more in line with international peers within a specified timeframe. Similarly, agreement would be reached to reduce the level of problem loans and/or increase provisions in individual banks to specified targets.3 The bank management and boards of directors would then need to adopt their own strategy and develop their own plans for reaching these targeted levels over a mutually agreeable time frame. The current economic conditions and the realization of one-time gains from the divestiture of the funds management businesses by the banks could facilitate the achievement of such broader objectives.
Anti-Money Laundering (AML)
12. A vulnerability for the Israeli banking system is the risk of money laundering, particularly in foreign offices of Israeli banks. It is important that bank policies and oversight of AML requirements cover the group-wide operations, not just compliance by the domestic operations of Israeli banks. In this regard, host-country regulators (and law enforcement agencies) have identified the foreign operations of several of the larger banks as not yet complying with local laws and regulations. Some of the actions taken in response have been severe and demonstrate the need to strengthen risk-management practices over AML in foreign offices.
13. Two recommendations for the AML area would be that: (i) BoI carry out a review of the adequacy of the group-wide AML policies and the internal control processes in Israeli banks; and (ii) the authorities undertake a self-assessment of the AML regime against the revised FATF Recommendations and the revised assessment methodology. The review of bank practices by the BoI should determine whether oversight by bank management and boards of directors is sufficiently robust to ensure compliance with local legal requirements and that observed deficiencies are not more widespread. For the self-assessment of Israel’s regime, there should be a determination of the adequacy of legislative and regulatory requirements and their implementation against the Financial Action Task Force (FATF) Recommendations, which have undergone substantial revision.
Introduction of the Basel II Capital Adequacy Framework
14. The BoI is in the early stages of gearing up to implement Basel II. In 2004, the BoI issued a paper to the banking industry that set out a timetable for the adoption of the Basel II capital framework beginning in 2008. International experience suggests that preparing banks and supervisory systems for Basel II implementation is a massive undertaking and that it is important for sufficient guidance to be provided to the banking industry to meet the timetable. There are over 80 areas of national discretion that will need to be reconciled with the unique characteristics of Israeli banking practice and mapped to the supervisory process. Given the ambitious timeline for the announced implementation of Basel II, the BoI should consider: (i) a significant increase in BoI staffing resources to develop the implementation strategy and prepare regulatory guidance; and/or (ii) extending the timeline for implementation.
Introduction of Explicit Deposit Insurance
15. The authorities are considering introduction of an explicit deposit insurance regime. Because of some of the problems with implicit deposit insurance schemes, the 2001 FSSA had recommended that the government adopt explicit deposit insurance. Explicit deposit insurance would replace the current scheme that provides the BoI Governor with the authorization and discretion to guarantee deposits and other bank claims. In line with the adoption of the Basel II framework, the BoI could eventually consider a risk-based deposit insurance scheme, with insurance premiums assessed based on risk. The risk-based premiums would be a natural complement to Basel II that would reward well-managed banks and encourage weaker banks to strengthen their risk-management practices.
Accounting and Financial Reporting
16. The BoI is responsible for setting the accounting, financial reporting, and disclosure requirements for the banking system. The BoI has carried out this role in an outstanding fashion and requires banks to follow U.S. generally accepted accounting principles (US-GAAP). Reporting and disclosure requirements are in line with internationally accepted practices and the quality of that reporting is high.
17. With the adoption of International Financial Reporting Standards by the Israel Securities Authority (ISA) for all other public companies, however, there is the potential for unnecessary confusion. Absent convergence between US GAAP and IFRS, it is possible that beginning in 2008, Israeli banks will be applying US GAAP while all other public companies in Israel apply IFRS. This will make cross-sectoral comparisons of financial statements difficult. The BoI should consider developing a transition strategy for the banks to introduce IFRS by 2008 (or a more manageable timetable if that date would impose onerous system conversion problems for the banks.) The BoI may also wish to consider devolving some aspects of its accounting standard responsibilities to Israel’s Institute of CPAs, as part of the Institute’s normal standard-setting role.
Consumer Protection
18. By law, the BoI is responsible for consumer protection. This function has been delegated to the BoI’s supervision department, which has created a Bank-Customer Relations Area. The BoI has been very successful in carrying out its consumer protection mandate. This success, however, has come at the cost of drawing resources away from the BoI’s duties of ensuring the safe and sound operation of the banking system. Bank customers may file complaints directly with the BoI even before they have sought relief directly from their bank. It would be more efficient to require that customers first attempt to resolve problems directly with their banks and turn to the BoI only as a last resort when dissatisfied with their bank’s response. The advocacy role of the Bank-Customer Relations Area appears to go well beyond most consumer affairs/complaint-handling units in other central banks and supervisory agencies. This level of advocacy is often the role of independent bank ombudsmen and consumer protection agencies in other countries. While protecting consumers is an admirable goal, making it part of banking supervision has come at the price of reduced resources devoted to prudential supervision.
C. Conclusion
19. Israel has a large and highly concentrated banking system that has grown stronger in recent years following the 2001–2002 recession. Nonetheless, the level of problem loans in the banking system has remained stubbornly high, contributing to a low level of profitability. The caliber of the BoI supervisors is strong and they are highly qualified. Because of the systemic importance of the major banking groups to the Israeli economy, it is important that the supervisory function be made more efficient and that it continue to focus on ensuring a financially sound and competitive banking system.
Prepared by Jonathan L. Fiechter, Michael Moore, John Palmer, and William Ryback. This chapter provides an update on developments and issues affecting the banking system in Israel and its supervision function by the Bank of Israel.
Problem loans are loans that are under special supervision, rescheduled, overdue or otherwise non-performing, or considered doubtful either in part or in total, and problem off-balance sheet exposure. The BOI does not deduct collateral from problem debts.
High levels of problem loans create a vulnerability for banks in the event of an economic downturn and distract management attention from properly serving their customer base. Problem borrowers should be encouraged by their banks to improve their credit worthiness and enhance the collateral against their outstanding credit.