Attachment I. Financial Sector Reform: Diversification and Credit Crunch1
1. The Israeli financial system has undergone a comprehensive transformation over the past few years. Reforms were significantly accelerated in 2005 with the introduction of various legislative measures and changes in regulatory coverage and taxation.2 Though these steps were contraversial and some mid course corrections were necessary, they led to a rapid diversification of the financial sector towards non-bank financial institutions and expanded the choice of financial products and providers. In the process, new challenges have emerged for managing risks.
2. The key pillar of the financial sector reform was the Bachar Legislation. Implemented in July 2005, the legislation’s main objective was to enhance the development of capital markets by
Increasing competition and reducing concentration of financial institutions: This was achieved mainly through decentralization of the financial system whereby banks were required to sell their holdings of mutual funds and provident funds.
Reducing conflicts of interest in the capital market: The Bachar legislation also stipulated separation between advice on financial assets and their marketing through changes in rules for employment in financial consultancy and marketing.
Increasing foreign participation: Foreign-owned firms were encouraged to acquire stakes in the fund management businesses being disposed by the banks. In addition, government bond market reforms allowed entry of foreign-owned banks in the capital markets.
3. Along with the Bachar legislation, reforms in taxation and regulatory coverage were also introduced in 2005–06. These reforms sought to increase market efficiency, encourage competition between players and enhance supervision of financial institutions and services. Specifically, reform measures were implemented to:
Widen investment choices of institutional investors: Tax provisions favoring domestic investment were removed for private and institutional investors, which encouraged foreign investment.
Strengthen investor’s choice and rights: Regulations governing long-term savings were revised, beginning in 2006, to ease mobility of savings between provident funds and insurance plans. In April 2005, institutional investors were also required to provide a more accurate fair value assessment of investor’s rights.
Improve supervision of institutional investors: In line with the change in the institutional structure, supervision of the activities of the provident funds were initiated, while regulatory coverage of insurance companies was expanded.
4. The authorities have continued to consolidate the reforms with the goal of deepening the capital markets and improving market infrastructure. To facilitate the development of competitive and liquid markets, market makers were introduced in the trading of government bonds in 2006. Repo auctions were introduced by the Bank of Israel at end-2007. Repo trading in te Tel Aviv Stock Exchange is expected to start by the end of 2009 Q1. A new underwriting law was implemented in July 2007 allowing allocation of securities at the underwriter’s discretion without an auction. Market infrastructure has been strengthened with the introduction in June 2007 of the RTGS system for settling intraday payments.
5. Mobilizing long term savings in an efficient manner remains a key priority. In December 2007, pension benefit coverage was expanded to employees without occupational pension plans. Effective 2008, changes in regulatory coverage were introduced that subjected a wide range of institutional investors to a uniform regulatory directive thereby equalizing the terms of savings on all forms of long-term savings, both domestic and foreign. It has also enabled banks to engage in pension advice and allowed a wide range of institutional investors to offer a basket of alternative products.
Attachment II. External spillovers to Israel1
1. As a small open economy, Israel is susceptible to spillovers from the global economy. Indeed, Israel’s latest economic cycle (since 2000) has to a large extent mirrored that globally. The burst of the dotcom bubble in the early 2000s—compounded by the intifada—pushed the Israeli economy into a recession.
Subsequently, notwithstanding security concerns in the mid-2000s, Israel enjoyed a period of strong economic performance alongside robust global growth and low risk aversion.