A. Introduction

1. The Israeli government has made far-reaching reforms to financial markets in recent years Markets once characterized by limited product and provider choice and by restricted investment opportunities have been transformed by initiatives aimed at increasing competition. Reduced government borrowing and growing business demand for credit have led to a much enhanced role for capital markets. There are new opportunities for international investors and financial institutions. Further significant reforms are in train to provide for increased pension contributions from the workplace and greater mobility of savings between different products and providers. These ambitious reforms are producing benefits but they also call for more advanced regulatory frameworks and supervisory practices.

2. This chapter sets out recent developments in the banking and insurance sectors, takes stock of the reform program and suggests priorities for the development of regulation and supervision of the financial sector, with an emphasis on banking and insurance regulation.

B. Developments in the Banking Sector

3. Israel has a large banking system comprised mainly of established domestic-owned banks with limited foreign participation The system had assets of NIS 1,008 billion or about US$250 billion (160% of GDP) at end-September 2007. The system is concentrated, with the five largest banking groups accounting for about 95 percent of system assets. Of these five groups, Bank Leumi and Bank Hapoalim together control 60% percent of the system’s assets. Two foreign banks, Citigroup and HSBC, have long-established branches but account for less than 1 percent of total assets. In addition, branches of BNP Paribas and State Bank of India began operating in Israel in 2007 but have not yet filed reports with the Bank of Israel.

4. Banks’ performance and financial strength have been improving in recent years. (See Table 1 for key data on the banking system.) In the first half of 2007, the banking system reported a pre-tax return on assets of 1.2 percent compared with 1.0 percent in 2006. Capital ratios are also strengthening. These improvements have been driven by one-time gains from their sale of fund management businesses under recent reforms (see Section D on the reform program); sharp reductions in net new provisions for bad debts; tighter control on spending, including staff costs; and renewed growth in lending fed by a strong economy.²

Table 1.

Israel: Banking System Key Indicators, 2003–07

(Percent)

Source: Bank of Israel.

Table 1.

Israel: Banking System Key Indicators, 2003–07

(Percent)

	2003	2004	2005	2006	2007Q2
Capital ratios (capital to risk-weighted assets)	10.3	10.8	10.7	10.8	11.1
Total problem loans to total credit	10.5	10.5	9.5	8.4	7.7
Nonperforming loans to total gross loans	2.6	2.5	2.3	1.9	1.8
Nonperforming loans net of provisions to capital	33.3	31.0	27.1	21.2	18.7
Pre-tax return on assets	0.7	0.9	1.1	1.0	1.2
Pre-tax return on equity	14.1	17.9	19.4	17.6	20.2

Source: Bank of Israel.

View Table

Table 1.

Israel: Banking System Key Indicators, 2003–07

(Percent)

	2003	2004	2005	2006	2007Q2
Capital ratios (capital to risk-weighted assets)	10.3	10.8	10.7	10.8	11.1
Total problem loans to total credit	10.5	10.5	9.5	8.4	7.7
Nonperforming loans to total gross loans	2.6	2.5	2.3	1.9	1.8
Nonperforming loans net of provisions to capital	33.3	31.0	27.1	21.2	18.7
Pre-tax return on assets	0.7	0.9	1.1	1.0	1.2
Pre-tax return on equity	14.1	17.9	19.4	17.6	20.2

Source: Bank of Israel.

5. The banks enjoy ample liquidity, primarily from deposits from the public, including from foreign offices. At September 2007, they depended on other banks for less than 5 percent of their total funding. Their funding from abroad (excluding from related offices) was 14.5 percent of liabilities at the same date.

6. Although the system continues to hold high levels of problem loans, the quality of loan books is improving. Loans classified as problem loans³ amount to nearly 8% of total credit. Non-performing loans account for only a portion of problem loans, but remain significant, at 1.8% of the total. Total provisions for loan losses were NIS 31.6 billion at June 2007. Construction and real estate lending accounts for around one third of problem loans and provisions. However, new loan loss provisions (net of recoveries) have fallen sharply in 2007, to NIS 1.3 billion in the first nine months compared with NIS 2.4 billion in the same period of 2006. And the continuing high stock of non-performing loans reflects a conservative approach, partly because of regulatory requirements, to releasing provisions and writing off bad loans. Overall, it is clear that there has been a major improvement in asset quality.

7. All the banks have exposure to the turmoil in global credit markets and significant losses have been incurred by one group. The scope for further losses appears limited, provided that AAA mortgage-backed securities other than sub-prime are not significantly impaired. (Box 1 sets out a fuller discussion and data on the banks’ exposures.)

Box 1:

Major five banks’ reported exposures to and losses on US mortgage and related assets

A number of Israeli banks have significant exposure to US mortgage markets, mainly through offices in the US and Europe. In November 2007, the Bank of Israel instructed banks to disclose all their US mortgage-related assets at September 30 2007. Disclosures of nearly $10 billion were made by the five major groups, which compares with some $15 billion in aggregate equity at the same date. Some banks have written down assets (mainly structured products). But the effect on profitability and capital has been small for most. Even for the one banking group most affected, losses recognized to date do not exceed full year profits in 2006.

The scope for further losses appears limited, provided that AAA mortgage-backed securities (MBS) other than sub-prime are not significantly impaired. Across the system, there is now limited exposure to structured products, i.e. CDOs and SIVs (amounts reported by banks at end- September ranged from 3 to 12 percent of equity). The bulk of relevant assets ($7.5 billion or 51 percent of aggregate equity at end-September 2007) are MBSs, either issued or guaranteed by US federal housing finance agencies (over half the total) or AAA-rated and not exposed to US sub-prime mortgages. Banks have not been experiencing the funding pressures seen in other markets.

Table: Major five banking groups’ exposure to US mortgage and related assets, End–September 2007

(Millions of U.S. dollars)

Sources: Banks’ Q3 2007 statements; and Bank of Israel banking system database.

^1/Data for Leumi includes a subprime mortgage-backed security of $9.5 million.

^2/Since the publication of the Q3 statements, Bank Hapoalim has announced further losses of $ 260 million (on its exposure to SIVs) and charges to equity of $ 90 million (in relation to its MBS portfolios). Bank Leumi reported with its Q3 statement a further charge to equity of $22 million to the second half of November.

Table: Major five banking groups’ exposure to US mortgage and related assets, End–September 2007

(Millions of U.S. dollars)

Bank			Hapoalim	Leumi	Mizrahi	Discount	FIBI
Total exposure			4,580	1,883	35	2,350	432
	Mortgage-backed securities 1/		3,708	1,087	12	2313	306
		Of which: Federal agencies	425	1051	-	2287	159
	Collatorized debt obligations/collatorized loan obligations		218	426	-	29	24
	Strucutred investment vehicles		371	-	-	-	-
	Other structured products		-	-	-	-	102
	Other asset-backed securities		85	137	23	-	-
2007Q3 losses 2/			30	-	6	-	1
2007Q3 charges to equity2/			116	33	8	-	3
Net profits, 2006			795	837	153	197	121
Equity, 2007Q3			4,773	5,116	1,316	2,284	1,320
Structured products/equity			12%	8%	-	1%	10%
Total exposure (excl. Fed agencies)/equity			87%	16%	3%	3%	21%
Total exposure (excl. Fed agencies)/profits			523%	99%	23%	32%	226%

Sources: Banks’ Q3 2007 statements; and Bank of Israel banking system database.

^1/Data for Leumi includes a subprime mortgage-backed security of $9.5 million.

^2/Since the publication of the Q3 statements, Bank Hapoalim has announced further losses of $ 260 million (on its exposure to SIVs) and charges to equity of $ 90 million (in relation to its MBS portfolios). Bank Leumi reported with its Q3 statement a further charge to equity of $22 million to the second half of November.

View Table

Table: Major five banking groups’ exposure to US mortgage and related assets, End–September 2007

(Millions of U.S. dollars)

Bank			Hapoalim	Leumi	Mizrahi	Discount	FIBI
Total exposure			4,580	1,883	35	2,350	432
	Mortgage-backed securities 1/		3,708	1,087	12	2313	306
		Of which: Federal agencies	425	1051	-	2287	159
	Collatorized debt obligations/collatorized loan obligations		218	426	-	29	24
	Strucutred investment vehicles		371	-	-	-	-
	Other structured products		-	-	-	-	102
	Other asset-backed securities		85	137	23	-	-
2007Q3 losses 2/			30	-	6	-	1
2007Q3 charges to equity2/			116	33	8	-	3
Net profits, 2006			795	837	153	197	121
Equity, 2007Q3			4,773	5,116	1,316	2,284	1,320
Structured products/equity			12%	8%	-	1%	10%
Total exposure (excl. Fed agencies)/equity			87%	16%	3%	3%	21%
Total exposure (excl. Fed agencies)/profits			523%	99%	23%	32%	226%

Sources: Banks’ Q3 2007 statements; and Bank of Israel banking system database.

^1/Data for Leumi includes a subprime mortgage-backed security of $9.5 million.

^2/Since the publication of the Q3 statements, Bank Hapoalim has announced further losses of $ 260 million (on its exposure to SIVs) and charges to equity of $ 90 million (in relation to its MBS portfolios). Bank Leumi reported with its Q3 statement a further charge to equity of $22 million to the second half of November.

8. There remain significant challenges for the banking system:

• Capital levels remain low compared with their peers in other countries. Capital ratios for the five largest banks range from 10.3 to 12.1 percent at end-September 2007 (the regulatory minimum is 9 percent). The Bank of Israel has asked banks to increase capital ratios further against potential economic slowdown and in advance of the implementation of the new Basel II capital standards in 2009, the impact of which on bank capital adequacy remains unclear.

• The banks face strategic challenges resulting from the recent financial market reforms. Reforms of the financial sector in the past few years have required banks to divest their interests in insurance and fund management and have promoted capital markets and institutional investors as a competing source of finance for the business sector. The share of the banks in business sector financing has fallen from nearly three quarters in 2003 to just over a half in 2007. (See Table 2). Revenues of some NIS 2 billion a year (in 2006, five largest banks) from managing funds have been lost. Meanwhile, new opportunities in domestic markets, particularly in distribution of pensions and insurance, are opening up more slowly than expected. While delivering greater competition in financial services for the economy, the reforms have reduced the ability of the banks to diversify and strengthen their earnings base.

Table 2.

Israel: Credit to the Business Sector, 2003–07

(Percent of total credit)

Source: Bank of Israel.

Table 2.

Israel: Credit to the Business Sector, 2003–07

(Percent of total credit)

		2003	2004	2005	2006	2007Q3
Share of:
	Banks	73.6	67.8	61.6	56.3	53.4
	Institutional investors	10.6	13.0	18.6	22.2	24.5
	Nonresidents	15.2	17.7	16.9	17.8	16.2
	Household (mutual funds)	0.6	1.5	2.9	3.8	5.9
Share of tradable bonds		8.4	10.6	14.1	18.4	22.0
Share of non-tradable bonds		6.7	8.4	11.1	12.1	12.4

Source: Bank of Israel.

View Table

Table 2.

Israel: Credit to the Business Sector, 2003–07

(Percent of total credit)

		2003	2004	2005	2006	2007Q3
Share of:
	Banks	73.6	67.8	61.6	56.3	53.4
	Institutional investors	10.6	13.0	18.6	22.2	24.5
	Nonresidents	15.2	17.7	16.9	17.8	16.2
	Household (mutual funds)	0.6	1.5	2.9	3.8	5.9
Share of tradable bonds		8.4	10.6	14.1	18.4	22.0
Share of non-tradable bonds		6.7	8.4	11.1	12.1	12.4

Source: Bank of Israel.

9. The recent experience in US markets has underlined the need for banks to have clear strategies and strong controls over foreign operations. The banks already have a large number of overseas offices. At the end of 2006, the major five groups had 147 such offices, with assets accounting for 18% of their total assets and 10% of their earnings in the first half of 2007. Given limited scope for diversification domestically, some banks see overseas expansion as their only real strategic option. A number of acquisitions have been made in recent years (see Box 2) and there are also potential opportunities from the growing operations abroad of their major Israeli corporate customers. Overseas diversification will expose the banks to new risks, requiring them to respond to new risk-management challenges.

Box 2

Recent overseas acquisitions by Israeli banks

Bank	Date	Amount	Acquisition
Bank	May 2005	SwFr	Inter Maritime Bank, Switzerland (private banking)
Hapoalim		102mn
Bank	March	$ 30 mn	Investec United States (broker dealer)
Hapoalim	2006
Bank	August	$ 46 mn	Eurom Bank, Romania (retail and corporate banking)
Leumi	2006
Bank	November	$ 161 mn	BankPozitif, Turkey (retail and corporate banking)
Hapoalim	2006
Bank	November	$ 70 mn	Demir Kazakhstan Bank (retail and corporate banking)
Hapoalim	2007
Bank	December	$ 136 mn	75 percent of OJSC Ukrainian Innovation Bank (retail and smaller corporate banking)
Hapoalim	2007

View Table

Bank	Date	Amount	Acquisition
Bank	May 2005	SwFr	Inter Maritime Bank, Switzerland (private banking)
Hapoalim		102mn
Bank	March	$ 30 mn	Investec United States (broker dealer)
Hapoalim	2006
Bank	August	$ 46 mn	Eurom Bank, Romania (retail and corporate banking)
Leumi	2006
Bank	November	$ 161 mn	BankPozitif, Turkey (retail and corporate banking)
Hapoalim	2006
Bank	November	$ 70 mn	Demir Kazakhstan Bank (retail and corporate banking)
Hapoalim	2007
Bank	December	$ 136 mn	75 percent of OJSC Ukrainian Innovation Bank (retail and smaller corporate banking)
Hapoalim	2007

C. The Insurance Sector

10. Israel enjoys a relatively developed, although concentrated, insurance sector. At June 2007, the five largest groups accounted for nearly 80 percent of total gross premiums, and an even higher proportion in life insurance. Total assets of the sector at mid-2007 were NIS 211 billion (32% of GDP), which compares with NIS 1,008 billion for the banks. Annual premium income for life and general insurance business is broadly equal (NIS 16 billion and NIS 18 billion respectively in 2006). Rates of penetration (measured by the ratio of insurance premiums to GDP) are slightly below the average of OECD countries, more so in life business where insurers compete with other long term savings products. There is greater foreign involvement than in the banking sector: the Italian group Generali owns 70% of the Migdal Group.

11. The current shape of the industry is the product of years of reform and consolidation. Life insurance has been substantially deregulated—formerly, savings-based products carried high guarantees and had to be invested in prescribed forms of guaranteed return government bonds. Life products are now substantially “participating” (with no or low guarantees and investment risk passed to policy-holders)⁴ and firms can invest freely. However, ownership restrictions relating to insurers have been tightened. There is now a ceiling of 5 percent on insurance company holdings in banks and vice versa.

12. A key risk in general insurance business is catastrophe, particularly earthquake losses (Israel is located on the African-Syrian Rift, although there has been no major quake in the region since 1927). Around 80 percent of this risk is reinsured, mostly with major global reinsurance companies. In other respects, general insurance risks are similar to those in other markets, with motor insurance accounting for some 50 percent of premiums.

Table 3.

Israel: Insurance sector Key Indicators, 2004–07

(Percent)

Sources: Ministry of Finance; and Bank of Israel.

Table 3.

Israel: Insurance sector Key Indicators, 2004–07

(Percent)

		2004	2005	2006	2007Q2
Capital ratios (capital to assets)		5.2	5.2	5.4	6.2
Capital surplus (surplus over required capital/total capital)		…	17.5	21.2	23.8
Pre-tax return on equity		21	27	23	36
General insurance: combined ratio (losses + expenses/premiums)		0.98	1.00	0.97	0.98
Credit (share of total assets)
	Participating policies	21	16	17	…
	Others	12	29	31	…
Investments abroad (share of total assets)
	Participating policies	9	14	18	…
	Others	3	4	4	…

Sources: Ministry of Finance; and Bank of Israel.

View Table

Table 3.

Israel: Insurance sector Key Indicators, 2004–07

(Percent)

		2004	2005	2006	2007Q2
Capital ratios (capital to assets)		5.2	5.2	5.4	6.2
Capital surplus (surplus over required capital/total capital)		…	17.5	21.2	23.8
Pre-tax return on equity		21	27	23	36
General insurance: combined ratio (losses + expenses/premiums)		0.98	1.00	0.97	0.98
Credit (share of total assets)
	Participating policies	21	16	17	…
	Others	12	29	31	…
Investments abroad (share of total assets)
	Participating policies	9	14	18	…
	Others	3	4	4	…

Sources: Ministry of Finance; and Bank of Israel.

13. In life insurance business, insurers have limited market risk and the main risk is improvements in longevity. Liabilities on guaranteed return business written before 1991 (when products were reformed) were matched by holdings of fixed rate government bonds. Business written since 1991 has been entirely on a “participating” basis – all the market and credit risks on investments (although not any related operational risk, e.g. from mismanagement of investments) are borne by policyholders. Insurance risks, however, fall to the insurance company itself and there is material exposure to improvements in longevity: many participating policies are written with guaranteed annuity rates. However, most policyholders in practice take lump sums at maturity and annuities in payment are therefore limited.

14. Insurance company profitability is high, in part reflecting weak capital adequacy. Return on equity for the sector as a whole has been at or in excess of 20 percent since 2003 and reached nearly 40 percent in the first half of 2007. Relatively high gearing (measured by a simple capital to assets ratio) together with the weaknesses in the solvency regime (discussed further below) suggest that high profitability is at least partly attributable to low levels of capital. There is no material exposure to US sub-prime and related risks.

15. Insurance companies are more diversified as a result of the reforms. For example:

• Most insurers are now part of broader financial services groups with an increasing emphasis on fund management. Some NIS 120 billion in funds under management (in provident and mutual funds) have so far been transferred to insurers following recent financial sector reforms (see below), almost equal to their total life insurance assets of some NIS 140 billion. Insurers are increasingly able to engage with customers on the basis of their specific needs (for life insurance, particular types of pension cover etc) rather than simply selling from an established list of products. The management of insurers is now moving onto a group basis (often including regulated insurers and unregulated affiliates), for example with a group Chief Executive Officer and single group wide functions covering risk and internal audit.

• Insurance groups are also extending more credit – mostly to businesses via bond purchases in the capital markets but also directly from their own and from investors’ funds and via specialist unregulated affiliate companies engaged in consumer credit, factoring and leasing. However, retail lending operations remain limited, although one insurer has a significant mortgage subsidiary. Insurance companies’ share of total credit to the business sector, around 6%, remains modest.

• Some companies have been making acquisitions in insurance markets abroad, although on a more limited scale than the banks. For example, the Clal Group began operating in Romania in 2006 through a new insurance company.

16. Insurers also face new competition in fund management and in distribution and advice. While insurers acquired most of the banks’ fund management operations, others were bought by new entrants. These new firms are well-placed to compete and offer wider portfolio management services (for example to higher net worth customers) as well as established products such as mutual funds. The banks retain a large share of marketing and advisory business for long term savings products and benefit from charges paid by insurers and other product providers that are fixed by regulation. The recent reforms also provided for banks to be permitted to advise on pensions, a market considered to have strong growth potential. While the Ministry of Finance has chosen to allow only smaller banks to give such advice at present, the major banks will be permitted to enter the market this year.

17. Overall, however, developments in the Israeli financial sector appear positive for insurance. Increased diversification should reduce the overall risk profile of insurers; and added scale should lead to greater scope to invest in better systems and controls and advanced risk management. At the same time, insurance firms and their affiliates are assuming new or enhanced risks, such as credit risk, with which they have less experience.

D. The Financial Sector Reform Program

18. Although most of the scheduled financial sector reforms have been completed, important measures are outstanding. While major reforms started in the 1990s, the pace has accelerated in recent years. The main objectives of the program have been:

• To increase competition between sectors, particularly for savings. The key initiative is the 2005 Bachar Committee reforms⁵. To reduce their share of total savings, the banks were required to dispose of all their interests in fund management. But they were permitted to continue to distribute and advise on provident and mutual funds (charges have been set by regulation) and are now being allowed to advise on pension products and life insurance. The disposal of banks’ interests in fund management is largely complete but the reform of advice and distribution arrangements is continuing.

• To create new opportunities for foreign participation: foreign-owned firms were encouraged to acquire fund management interests from the banks and some of the larger funds now have foreign-owned managers; foreign-owned banks now act as underwriters in the capital markets and as primary dealers in government bonds; the Bank of Israel sees the planned sale of the remaining government interest in a bank (10% of Bank Leumi) as an opportunity to attract a significant foreign participant.

• To widen the investment choices of institutional investors⁶. Asset allocation rules have been liberalized and tax provisions favoring domestic investment removed. The money markets have been deepened through the start in late 2007 of a repo market (sale and repurchase of securities). However, issuance of asset-backed securities has been limited so far and further work is required on the legal and regulatory framework that would permit securitization to grow significantly.

• To widen the range of products and services available to users of financial markets. A key objective has been to develop the capital markets as an alternative source of credit for the business sector. For retail consumers, the reforms have enabled the creation of new savings vehicles including money market funds and funds of funds (but money market accounts are not permitted at present). Greater access to foreign fund managers and to mutual funds marketed into Israel from abroad should soon be possible under plans for the recognition of foreign regulatory regimes.

• To improve the infrastructure of financial markets: a key change has been the introduction in June 2007 of a real time gross settlement system (RTGS) for payments, bringing finality to intraday payments by banks and their customers. RTGS will facilitate the inclusion of the Israeli shekel in the Continuous Linked Settlement (CLS – the international mechanism for reducing foreign exchange settlement risk) in due course. There are also plans for enabling alternative trading systems to operate in Israel.

19. A further key objective has been to increase the number of people saving for retirement. Major reforms were carried out to the pension funds in 2003, resulting in the creation of new funds on a stronger financial basis. The priority now is to increase employee participation in occupational schemes: coverage for workers previously without such pensions has just been introduced ⁷. A related objective for 2008 is to provide for increased mobility of savings between different products and providers. (Limited portability, e.g. of savings under life insurance policies between insurers, is already possible.)

20. The authorities are committed to consolidating and extending the reforms. A new inter-ministerial committee on capital markets has been established under the leadership of the Ministry of Finance to plan the next stages of development of the markets. The focus of the committee will be on considering the international competitiveness of the financial sector. The committee will report in the summer of 2008.

21. Overall the reforms are comprehensive, have led to more diverse financial markets and appear to be generating benefits for the economy. While the full effects of the reforms, particularly the significant new extension of occupational pensions, will take time to be felt, financial markets are already deeper and more competitive and offer greater product range. There is increased scope for investors to reduce risk through diversification. The sector is now much more open to the world. The reforms should make the economy less vulnerable to domestic shocks. While it will also become more vulnerable to adverse developments abroad, the financial system should become more resilient overall.

22. It is also appropriate for the authorities to take stock of the results so far and the next stages. While an immediate priority is completion of the outstanding reforms, there are aspects on which the authorities could usefully focus, including:

• Areas where increased competition may lead to more risk, particularly as financial institutions adjust their strategies to reflect the impact of the reforms, for example, through expansion overseas. The reforms are also significantly changing the distribution of risks in the economy, from banks to capital markets and to households. There is a need for careful monitoring of these risks and for appropriate responses, through strengthening of regulation of financial market participants (see following sections) and better awareness of risk on the part of consumers

• The continued opening up of the financial sector to international markets. The experience of many other countries suggests that formulating a vision to guide the international integration of the financial system can be useful. This work could include consideration of the prospects for increasing foreign participation in domestic markets still further, especially in banking, where foreign involvement is limited.

• Elements of the reforms that impose restrictions on financial market participants to develop their business, in particular the prohibition on ownership links between banks and insurance companies and the fixing by regulation of charges for the distribution of certain savings products. The imposition of these restrictions (and the forced disposal by banks of their fund management interests) was seen by the Bachar Committee as key to addressing lack of competition and potential conflicts of interest identified with the previous dominance of the banks in the savings market. But they reduce diversification opportunities, for insurance companies and particularly for banks. They may not remain appropriate in the longer run as markets develop and competition intensifies further.

E. Recent Developments in Banking and Insurance Regulation

23. In addition to the challenges presented by the reformed domestic markets, Israel needs to keep pace with developing international standards. The Basel II capital standards for banks are now being implemented in Europe and other markets and a new solvency regime for insurers is under discussion in Europe (Solvency II). International Financial Reporting Standards are now widely used. Extensive changes are being made by the Israel Securities Authority (ISA) to improve disclosure and strengthen enforcement of standards. The ISA has made the use of International Financial Reporting Standards (IFRS) mandatory for all listed companies (except for the banks⁸) from 2008. The main focus here is on banking and insurance supervision.

F. Next Steps for the Development of Regulation

31. Regulation of banking and insurance has been strengthened by recent developments but significant challenges remain. Particularly noteworthy are:

• the strong focus on improving capital adequacy, both in the medium term through revised measurement frameworks (Basel II and Solvency II) and shorter run through measures to increase capital ratios; and

• the priority given to developing risk-based supervision for both sectors.

There has also been a clear focus on enforcing AML requirements in both sectors, although the results and recommendations of the Money Val assessment will need to be studied carefully. Regulation in both sectors now faces significant, similar challenges in the future.

32. It is critically important that regulators are able to build the expertise necessary to support the more complex regulatory system now being put in place. In both sectors, the focus on corporate governance, risk management and controls, and the development of risk-based supervision is increasing the importance of having expert supervisors with an understanding of market practice and the skills to handle relationships with all levels of a regulated firm. In addition, the development of more advanced approaches to capital and solvency standards will increase the need for particular technical skills, notwithstanding the availability of options such as outsourcing and use of consultants for certain work. Basel II makes this a particularly urgent issue for banking supervisors. Acquiring these skills requires greater recruitment flexibility and competitive pay scales, in line with the practice in most advanced countries.

33. Regulators need also to consider their broad approach to regulation, including moving away from a strongly rules-based approach. The Department’s approach is notably rules-based and prescriptive. And the CMISD, in reforming the regulation of insurance companies, is putting in place detailed rules to cover most aspects of insurance firms’ operations, including dealings with customers and handling of claims. Rules-based approaches are always well-intentioned but they may give rise to unintended consequences, because detailed rules relieve firms of the responsibility to develop practices suitable to their particular business models. Over the longer term, a less prescriptive approach will be better aligned with market forces to deliver financial services at a lower cost for consumers.

34. Regulators should also consider building into their approaches such disciplines as cost benefit analysis and consideration for the impact of regulation on international competitiveness. Both the Department and the CMISD consult on new proposals. They should consider extending this to consultation on their overall regulatory program and priorities. All regulation carries costs to consumers, firms and to regulators themselves. In a detailed, rules-based framework, the costs tend to be higher; and smaller firms, with smaller staffs and fewer resources tend to be more heavily penalized by prescriptive regulation. It is important to balance the benefits of regulation to consumers with the need to permit firms to earn competitive returns and to remain sound and well-capitalized. All this calls for regulators to submit major new initiatives to careful cost-benefit analysis.

35. Developing their approaches in these ways would bring regulators in Israel more into line with best practice in advanced economies. Regulators in such countries are now combining rules-making with greater reliance on principles and more emphasis on the regulator issuing higher level guidelines covering the behaviors expected of regulated entities. Firms and their Boards are required to put in place detailed policies and procedures to implement the regulator’s guidelines as appropriate to the firm’s particular business model. In this environment, an important supervisory task is to review a firm’s compliance with its own Board-approved policies and procedures.

36. As increased competition brings more risk, there is a need for a strong capacity to manage and resolve financial stress if and when it emerges. The growing complexity of Israel’s financial sector is adding to the challenges that would be faced in the event of a crisis affecting a major banking or insurance group. In particular, the recent growth of capital markets and of the international commitments of banks and insurance companies have added to the channels by which shocks could be transmitted and complicated the management of any crisis. And any increase in foreign participation in the domestic banking or insurance sector would bring further challenges in this area, especially in the banking sector where all the major banks are at present domestically-owned.

37. A thorough approach to preparing the ground for any crisis would include:

• Reviewing and updating relevant aspects of the legal framework. For example, regulators should have clear perspectives on their supervisory powers and procedures for intervening to limit potential losses to depositors and policyholders. And the authorities should have considered the adequacy of the insolvency law framework. Such work in Israel would include completing consideration of the need for an explicit deposit insurance scheme.

• Developing policies and procedures for handling the main practical challenges that might arise, covering, for example, the circumstances in which a bank or an insurance company may be permitted to lend to an affiliate or be granted waivers from certain rules (e.g., intra-company lending restrictions, capital and solvency requirements); and procedures for communicating with regulators overseas.

• Simulating crises to test the resilience of the crisis management framework and to identify areas for improvements; potential scenarios could range from the collapse of a single smaller bank or insurance company to the resolution of a large holding company that would require the close collaboration of all three regulatory agencies and appropriate co-ordination with authorities overseas.

38. Contingency planning should involve collaborative working between the regulators. In particular, the lines of communication and respective roles among the three regulatory agencies (the Israel Securities Authority as well as the Department and CMISD) need to be clear. The recent development of a memorandum of understanding concerning the cooperation and exchange of information among the three regulators is a positive step towards ensuring a process for cooperation, but more will be required to ensure that processes are robust.