Israel: Selected Issues
Author: International Monetary Fund
Publication Date:
14 Feb 2008
eISBN:
9781451819656
Language:
English
Keywords:
ISCR; CR; bank; market; current account; capital injection; Israeli bank; trading portfolio; market indicator; banks solvent; Loans; Nonperforming loans; Stress testing; Credit risk
Download PDF (395.3 KB)

The methodologies used in this paper suggest that Israel’s real exchange rate is moderately undervalued, while gains in external competitiveness appear to have been eroded in recent years. Market-based indicators provide a useful additional dimension to the analysis of financial stability in Israel. The Israeli government has made far-reaching reforms to financial markets in recent years. Banks’ performance and financial strength have been improving. This paper proposes two rules that are based on a debt-brake concept and an alternative error-correction-mechanism toward fiscal policy in Israel.

Abstract

The methodologies used in this paper suggest that Israel’s real exchange rate is moderately undervalued, while gains in external competitiveness appear to have been eroded in recent years. Market-based indicators provide a useful additional dimension to the analysis of financial stability in Israel. The Israeli government has made far-reaching reforms to financial markets in recent years. Banks’ performance and financial strength have been improving. This paper proposes two rules that are based on a debt-brake concept and an alternative error-correction-mechanism toward fiscal policy in Israel.

II. Measuring Financial Stability: Market-based Indicators and Stress Test1

A. Introduction

1. Market-based indicators and stress tests can provide useful dimensions to the analysis of financial stability in Israel. In its work on financial stability, Bank of Israel has mostly relied on a range of standard financial soundness indicators. The aim of this paper is to illustrate that this analysis can be further enhanced by developing the more forward-looking market based indicators and performing stress tests.

B. Market-Based Indicators

2. A number of indicators can be used to gauge likelihood of default of financial institutions based on prices of financial instruments. These indicators include distance to default (DD), bond prices, and credit default swaps.2 Among their advantages is that they are available at high frequency, and incorporate market participants’ forward-looking assessment of risks (unlike the more backward-looking accounting measures). Another practical advantage is that confidentiality is generally not an issue with market data. The market-based indicators also have limitations. They may not work well if securities are not publicly traded or their trading is limited. Also, if little information is publicly disclosed but much is collected by supervisors, prudential data can be superior to market-based indicators in measuring financial sector soundness. Moreover, securities prices reflect potential losses to the security holders, which may be different from losses to depositors. Finally, the market based indicators incorporate assumptions that may not capture extreme events adequately (e.g., some basic measures assume that asset values follow a lognormal process).

3. Empirical studies show that market-based indicators can outperform traditional measures of soundness when forecasting distress in individual financial institutions. Market-based indicators have been shown to predict supervisory ratings, bond spreads, and rating agencies’ downgrades in both developed and developing economies, performing generally better than “reduced form” statistical models of default or measures relying on financial statements. For example, literature on U.S. banks finds that supervisory assessments are worse than market indicators in predicting bank performance, but supervisors may be more accurate when inspections are recent (Berger, Davies, and Flannery, 2000). Similarly, literature on European banks finds that market-based indicators improve performance of models based on banking ratios (Tudela and Young, 2003; Gropp, Vesala and Vulpes, 2006).

4. For Israel, market-based indicators for banks and insurance companies are currently around their long-run average values. Looking at the long-term developments (Figure 1), most DD observations are in the range of 3–8 standard deviations.3 Both banking and insurance saw low DD values during the macroeconomic recession of 2002–03.4 Subsequent to 2003, both sectors had a strong period, with DDs reaching or getting close to their historical maximums. This was followed by a correction towards the mean in2006–2007. Insurance companies’ DD appears more sensitive to stock market movements, as illustrated by the declining DD during the stock market decline in 2000–01 and also more recently during the turbulence of the second half of 2007.

5. The assessment of recent financial stability developments presented by the market-based indicators differs from the picture painted by the accounting ratios. Accounting indicators, such as nonperforming loans and capital adequacy ratios, suggest a continuous improvement in banking sector soundness since 2002 (see Table 1). Market indicators paint a different picture, suggesting that bank soundness, after a substantial improvement between 2003 and 2005, may have been retreating in 2006 and 2007 (Figure 1). The somewhat lower DD values in recent periods are consistent with the view that financial sector reforms are spurring rapid change. While this should make the system more resilient over the medium to long run, it comes at the expense of higher risks in the interim. Specifically, the lower DDs might reflect reform-related drops in franchise values, as banks are facing stiffer competition, and had to sell off their fund management business.

Table 1.

Israel: Standard Financial Soundness Indicators (Accounting Ratios), 2001–07

(Percent)

article image
Source: Bank of Israel.

6. The market-based indicators also suggest that the system has weathered the current global turbulence relatively well thus far. The reaction of banking DDs has been very muted, reflecting little apparent exposure to subprime mortgages. Stock market indicators for insurance companies recently have weakened as a result of the latest turbulence in equity markets, although not in a major way.

7. In a cross-country comparison, the DDs for Israeli banks support the assessment of Israel’s financial system soundness as broadly satisfactory. The DDs for Israeli banks lag behind those for comparable advanced economy banks, but are stronger than most banks in emerging markets (Figure 2). This is broadly in line with ratings agencies’ ratings for the major banks (Fitch rates systemic risk and macro prudential strength of the Israeli banking system at D1, which is the rating for countries such as Poland and Hungary).

A02ufig01

Distance to Default in Banks and Insurance Companies 1/

Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A002

Sources: Datastream; and IMF staff calculations.1/ Derived from financial institutions’ stock price data. Higher values mean more stability. Data through January 16, 2008.
A02ufig02

Portfolio Distance to Default in Banks: Cross-Country Comparison, 2000–07 1/

Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A002

Sources: Datastream; and IMF staff calculations.1/ Derived from banks’ stock price data. Higher values mean more stability.

8. Market-based indicators can also be used to examine the spillover risks among financial institutions, a topic of practical relevance for financial stability analysis and supervision. To illustrate this, two questions were analyzed: (i) to what extent are large Israeli banks exposed to market-wide shocks, affecting all of them simultaneously; and (ii) what is the scope for spillover of idiosyncratic shocks from one bank to other banks. The scope for spillovers among the Israeli banks was examined using the Extreme Value Theory framework. The methodology is characterized as follows:5

  • The data sample comprised the 5 large Israeli banks, accounting for 95percent of total Israel banking system assets. The sample period was 1999 to 2007.

  • To determine the spillover risk, a binomial logit model is applied to the distance-todefault (DD) data. The method examines the likelihood that a sizeable negative idiosyncratic shock experienced by a large Israeli bank would be followed by a similarly sizeable shock experienced by another large Israeli bank. Following the literature, such an event is called “co-exceedance,” and “sizeable” is defined as the bottom 10 percent tail of the distribution of all 5 trading-day changes in DDs.

  • Four control variables were used to account for common shocks affecting the local real economy, and domestic, global, and European markets. The calculations incorporate changes in the slope of the local term structure to represent developments in the domestic real economy; the stock price return volatility in the domestic stock market index to capture local market influences; the price return volatility in the Morgan Stanley Capital International All-Country World Index and European Index returns to account for global and European market shocks, respectively.

  • The objective is to identify potential risk concentrations among Israel’s systemically important banks, by distinguishing between the impact of common and idiosyncratic shocks. These calculations do not explore the exact nature of the links among financial institutions. Those may reflect direct financial links through the interbank market, but there may be spillovers even in the absence of explicit financial links between banks. In the presence of asymmetric information, difficulties in one bank may be perceived as a signal of possible difficulties in others, especially if market participants perceive opacity in banks’ balance sheets, and other publicly available data may be uninformative (Morgan, 2002).

9. The preliminary results suggest that the spillover risks are spread far from evenly among the large Israeli banks (Table 2). For example, the First International Bank of Israel has no significant spillover impact on other banks, while others have significant impact on a number of domestic and foreign banks at the same time. The banks with the biggest potential for spillovers are Hapolaim Bank and Mizrahi Bank. (As a side result, the tables also show the significance levels for the control variables. As expected, the local economy plays a significant role, as do global shocks. European shocks are less significant.) This analysis provides a useful additional information for assessing the systemic importance of individual banks. As expected, Hapoalim and Leumi have big effects on all others. But, the method is useful because banks with higher spillover risks for the rest of the system may have higher systemic importance than would be suggested by the more commonly used measures of size (e.g., deposits or assets), and may therefore warrant relatively more supervisory attention. Here this is the case for Mizrahi, which has significant effects on both Hapoalim and Leumi, although its assets are equivalent to less than 1/3 of those of Hapoalim or Leumi. When interpreting the results, one needs to keep in mind that the model is estimated on publicly available data, and over a relatively benign period in financial markets with little disruption to the financial sector.

Table 2.

Israel: Coexceedances among Large Israeli Banks, April 1999–September 2007

article image
Sources: Banks’ annual reports; BankScope; Bloomberg; Datastream; and IMF staff calculations.Notes: *… significant on 5 percent level; ** significant on 1 percent level.

C. Stress Testing

10. A set of basic stress tests was performed to assess the resilience of the banking sector to a variety of potential shocks. The purpose of these tests was to examine the potential effects on banks’ financial condition of a set of changes in risk factors, corresponding to a range of adverse events. The shocks can be considered extreme but with a positive, albeit small, probability of occurrence. The tests are based solely on publicly available data, which limited the extent of possible stress tests, and required a number of simplifying assumptions. Moreover, past data may capture only partly the type of extreme events that might happen in the future. The stress testing analysis therefore had to rely on a combination of experience from other countries, expert judgment, and sensitivity analysis. Therefore, the results should only be treated as approximations.

11. The tests combined single-factor sensitivity calculations and scenario analysis. The single-factor scenarios are useful since they are simple and allow analysis of the partial impacts of the various shocks over time. The macroeconomic scenarios allow to reflect better the interplay of the numerous risk factors, all influenced by macroeconomic developments.

Sensitivity Analysis

12. Sensitivity analysis confirms that credit shocks had a large and more widespread potential impact on banks than any other single-factor shock, and that the impact of credit risk has declined. A range of single-factor shocks to credit risk (i.e., general deterioration in credit quality) were carried out. The analysis was performed as a loan “migration” from the performing category to the nonperforming category, associated with an increase in provisioning. Table 3 shows some basic results, and Figure 3 illustrates the relationship between the size of an NPL shock, the provisioning ratio, and the aggregate impact. The figure suggests (i) a reasonable degree of resilience of the banking system with respect to credit shocks; (ii) an increased resilience over time. Even if the NPL ratio increased by 10percent age points, the capital injection needed to bring all banks to satisfy the regulatory minimum would be roughly 4percent. To put the 10percent age point increase in the NPL ratio in perspective, the ratio has been declining from about 2.5 percent five years ago to somewhat below 2 percent in 2007. So, this is clearly an extreme value going beyond the recent historical experience. However, it is not a completely implausible scenario, since if the NPL definition included all problem loans, according to the definition of the Banking Supervision Department, then the indicator value for mid-2007 would to about 9.5percent.

Table 3.

Israel: Summary Results of Sensitivity Analysis, End–2006

article image
Sources: Banks’ annual reports; BankScope; Datastream; and IMF staff calculations.

Injection (of new capital or additional income) to ensure that all banks have a CAR of at least 9 percent.

Standard deviation of the aggregated ratio of NPLs to total loans for the whole period for which data are available.

13. Credit risk migration has a material impact only if it implies migration from performing loans to NPLs. Credit quality migration within the three sub-categories of NPLs (substandard, doubtful, and loss) would have only a small impact, given the low NPL ratio and the high provisioning rate in Israel. Moreover, the impact gets lower over time, indicating that the system has become more resilient to this type of shocks (Figure3 4).

14. For market risks, the following sensitivity tests were carried out (Table 3):

  • Exchange rate The tests evaluated the direct (i.e., market price) effects on Israeli banks of a 15 percent and 30 percent depreciation and appreciation of the shekel against all other currencies. Direct losses arising from exchange rate shocks are negligible for most banks. That is not surprising, given that on the systemic level, the net open position in foreign exchange was -4.2 percent of capital as of end-June 2007. Even a 50 percent exchange rate change would translate to at most 2.1 percent decline in capital (about 0.2percent age point decline in capital adequacy). The impact would be differentiated among banks, but no bank would breach the minimum capital adequacy requirement.

  • Interest rate The tests considered parallel upward and downward shifts in the yield curve by 5 percentage points, respectively, and parallel upward and downward shifts in the foreign currencies yield curve by 2 percentage points. Separate tests were performed to assess the exposure to the interest rate shock on Euro and U.S. dollar denominated assets and liabilities. The test covered the direct impact on banks’ banking and trading books. The overall impact is bigger than the direct impact of the exchange rate shock, but still negligible in comparison with the credit risk impacts. As with the direct exchange rate risk, no bank would breach the 8 percent capital adequacy minimum. Banks are able to manage their interest rate risk through issuing loans that reprice very quickly.

  • Equity price risk. Banks’ exposure to equities is moderate. The overall net open position in equities has been increasing during the 2000 s, and reached 16.2percent of capital. Still, a hypothetical assumption of a rapid negative movement in stock prices would have limited direct impact on banks. For example, if the stock prices in the portfolios held by the banks declined by 50 percent (which corresponds to about 3 standard deviations, and goes beyond the experience of the last 10 years), the direct impact would decrease capital adequacy of the large 5 banks taken as a group only to about 10percent and would leave each one of the banks solvent.

  • Liquidity test. A basic liquidity test was carried out, to assess the direct impact of a bank run on liquidity in the system. The mechanism of the test was a deposit outflow; the question being asked was how long a bank can survive without borrowing from the central bank or from other banks in the system on an uncollateralized basis. The parameterization of this test was complicated by the fact that there are no system-wide data on rapid deposit withdrawals in the Israeli banking system. The exercise was therefore based on a combination of publicly available data and expert judgment based on parameters from other countries. The results of the deposit liquidity stress tests suggest that liquidity buffers are high in banks. Even in an extreme scenario assuming that 20 percent of all demand deposits are being withdrawn every day, the banks can use only their liquid assets, and have no recourse to other banks or to the lender of last resort, it would still take three days for the first bank to become illiquid, and five days for all the major banks to become illiquid.

Scenario Analysis

15. Scenario analysis focused on three hypothetical downside scenarios. The above calculations are only approximate, as individual shocks would most likely be accompanied by a broader macroeconomic stress that would impact banks also through channels other than just their direct exposures to market risks. This is addressed in scenario analysis, which considers how capital account shocks would affect the economy against a background of rising macro-financial linkages. While the scenarios have been informed by Israel’s recent experience, relationships that worked in the past generally break down during times of dislocation. Accordingly, these scenarios draw on the experience of a wide number of countries that have undergone similar exceptional scenarios.

A02ufig03

Basic Credit Risk Sensitivity Analysis, 2004–06

(Capital injection needed to bring all banks to at least 8 percent CAR; percent of GDP)

Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A002

Sources: Banks’ annual reports; BankScope; Datastream; and IMF staff calculations.
A02ufig04

Impacts of Credit Risk Migration within the Existing NPLs

(Post-shock capital adequacy ratio, percent)

Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A002

Sources: Banks’ annual reports; BankScope; Datastream; and IMF staff calculations.

16. Two scenarios attempted to measure the potential effects that a slowdown in the U.S.. economy, and a period of high political instability could have on the healthiness of Israeli banks. Scenario I assumed that the deterioration in credit quality affects only the loans in the sectors directly influenced by the recent episodes and the loans that are classified as problem loans in those sectors default. Scenario II assumed that there is a larger deterioration in the credit quality of bank loans and all problem loans default. The reasoning behind the design of Scenarios I and II is that during a slowdown, the riskier borrowers are those that are likely to suffer higher deterioration. This is the case of those loans that are already nonperforming or in a watchful status (special-mention category) both of which are included in the definition of problem loans. Given the lack of data on collateral value, the mission assumed that the recovery rate in case of default is zero, which is a strong assumption.

17. An additional scenario was based on an extensive analysis of 17 financial crises in other countries. Calibrating extreme scenarios and mapping them into Israeli data is challenging. Past data for Israel are likely to provide only very limited information about the behavioral relationships in the case of crisis. Scenario III therefore used instead data from 17 countries that actually went through major banking crises.6 In terms of the level of GDP, Israel is above the sample average, even though below the advanced economy average. Also, compared to the sample average, Israel is characterized by better governance and transparency standards (which should in principle limit the risk of crisis and its potential costs) and a higher credit to GDP ratio (which, on the other hand, indicates a higher potential for impact). The experience from these 17 crises suggested the following for the parameterization of the stress tests:

  • In the event of such a crisis, it is realistic to assume a steep exchange rate depreciation in the first few months after the shock, but some appreciation thereafter. This “overshooting” phenomenon occurs in most of the case studies considered here. The average depreciation of the exchange rate in the sample a year after the crisis was 33 percent, and many countries have experienced considerably larger depreciations

  • The average increase in the NPL ratio in the crisis countries was 9.6 percentage points a year after the crisis, with a substantial variation from country to country (the crosscountry standard deviation of the increase was 9.1). The characteristic of this approach is that it captures the whole credit risk impact conditional on the event of a crisis. It does not identify what part of the NPL increase is due to exchange rate, which part is due to interest rate, which part reflects real estate price decline, and so on. It is a more comprehensive approach of measuring the overall credit impact.

  • The recovery rates on bank assets in crises vary widely. For a sample of 10 systemic banking crises included in Hoelscher and Quintyn (2003), the average recovery rate was 59 percent, with a standard deviation of 33 percent. The bulk of the country observations is in the 10–40 percent recovery rate range, which would imply a 60–90 percent “loss given default” range. Thus, to capture a range of the crises experience, is reasonable to use a 60 percent provisioning rate as a starting parameterization, and to test how results would change if the average provisioning rate were 90 percent.

18. The three downside scenarios confirm that resilience of the financial system has improved. Not surprisingly, these extreme scenarios would have substantial impact on the banking sector. The mildest scenario, Scenario I, would reduce the aggregate Tier 1 capital by 23 percent and decrease the systemic CAR ratio to 8.4percent. Scenario II would reduce the aggregate Tier 1 capital by 58percent and decrease the systemic CAR ratio to 5.5 percent. Finally, Scenario III would completely wipe out the aggregate Tier 1 capital and turn the systemic CARratio into a negative number, roughly -3 percent. What is important to note, however, is that the impact of all the three scenarios would be appreciably smallerin2006 than if the shocks hit in earlier years (Figure 5).

19. The impact of Scenario III would be substantial, but smaller than the average impact of past crises, indicating a relative robustness of the Israeli banks. The capital injection required to bring all banks to the minimum CAR in this scenario would be equivalent to about 4 percent of GDP. That is a substantial costs, which reflects the substantial shocks assumed in this scenario. Interestingly, however, these costs are low compared to the average fiscal costs of resolving banking crises in 1994–2003, which were 18 percent of GDP (Carstens, Hardy, and Pazarbasioglu, 2004). There are reasons why the costs could be lower in Israel, such as the quality of governance and transparency standards in Israel compared to an average crisis country. However, those are not explicitly incorporated in the stress tests performed here. The reasons why the impact is relatively low in this calculation are the relatively higher capitalization and relatively lower risk exposures (including a lower credit to GDP ratio) of the Israeli banking system compared to average of actual crisis countries.

A02ufig05

Summary Results of Scenario Analysis

Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A002

Sources: Banks’ annual reports; BankScope; Datastream; and IMF staff calculations.

D. Conclusions

20. Market-based indicators provide a useful additional dimension to the analysis of financial stability in Israel. The indicators paint a more mixed picture of recent financial stability developments than the accounting ratios, which is most likely a reflection of the market assessment of challenges and risks associated with the recent reforms. In a crosscountry comparison, the indicators place Israel’s banking system close to the average of advanced and emerging countries, which is in line with the assessment based on accounting ratios and rating agencies’ ratings. The market-based indicators also allow to identify spillover risks among major Israeli banks; the key finding from this calculation is that the spillover risks are far from evenly distributed among the banks.

21. The basic stress tests suggest that resilience of the Israeli banking system has improved in recent years. A comparison over time shows that the capital injections needed to bring all banks in compliance with the minimum capital adequacy requirements have been declining appreciably over time. This reflected a combination of increasing buffers (improving capitalization and profitability) with generally decreasing exposures.

22. The stress tests confirm credit risk as the main source of risk. Banks’ exposures to direct interest rate risk are limited, as most of banks’ loan book is in floating rates, and the duration of banks’ trading portfolios is relatively short. Banks also have low direct exchange rate risk, reflecting their relatively low foreign exchange positions, and their exposures to equity risk are moderate. Banks are liquid at present, which was reflected in positive results of tests of the impact of sudden withdrawals.

23. Further work would be useful on modeling the impact of substantial stress of Israeli banks. The present note is based only on publicly available information and does not benefit from the much more detailed supervisory data. For example, supervisory information on individual bank-to-bank exposures could be used to run interbank contagion stress tests in the manner described in Čihák (2007b), and compared with the results of the spillover analysis presented in this note.

References

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1

Prepared by Martin Čihák, with inputs from Alexander Tieman, Kalin Tintchev, and Chanpheng Dara.

2

See for instance Čihák (2007a) for definitions and a survey of the various market-based indicators.

3

The use of market-based indicators is illustrated here on the DD, a measure derived from banks’ stock prices. Results derived from bond prices are similar. There are no CDS data on the Israeli banks.

4

Also, both banking and insurance saw very low DD values in 1997 (not shown here, but available upon request), reflecting concerns surrounding the Asian crisis.

5

The approach is similar to that of Čihák and Ong (2007), which provides the methodology in detail.

6

The following crises were included in the sample: Indonesia 1997, Korea 1997, Philippines 1997, Thailand 1997, Argentina 2001, Brazil 1998, Mexico 1994, Uruguay 2002, Bulgaria 1996, Czech Republic 1997, Russia 1998, Slovak Republic 1998, Turkey 2000, Finland 1991, Sweden 1992, Italy 1990, Spain 1977, and United Kingdom 1991. The dating (year of onset) is based on the database by Caprio and Klingebiel (2003).

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Cover IMF Staff Country Reports
Israel: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2008: Issue 063
Publisher:
International Monetary Fund
ISBN:
9781451819656
ISSN:
1934-7685
Pages:
70
DOI:
https://doi.org/10.5089/9781451819656.002
  • View in gallery

    Distance to Default in Banks and Insurance Companies 1/

  • View in gallery

    Portfolio Distance to Default in Banks: Cross-Country Comparison, 2000–07 1/

  • View in gallery

    Basic Credit Risk Sensitivity Analysis, 2004–06

    (Capital injection needed to bring all banks to at least 8 percent CAR; percent of GDP)

  • View in gallery

    Impacts of Credit Risk Migration within the Existing NPLs

    (Post-shock capital adequacy ratio, percent)

  • View in gallery

    Summary Results of Scenario Analysis

Distance to Default in Banks and Insurance Companies 1/

Portfolio Distance to Default in Banks: Cross-Country Comparison, 2000–07 1/

Basic Credit Risk Sensitivity Analysis, 2004–06

(Capital injection needed to bring all banks to at least 8 percent CAR; percent of GDP)

Impacts of Credit Risk Migration within the Existing NPLs

(Post-shock capital adequacy ratio, percent)

Summary Results of Scenario Analysis