Financial System Stability Assessment

This paper discusses the Financial System Stability Assessment of Israel. The stability analysis suggests that systemic financial vulnerabilities to severe shocks in line with historical experience are manageable and in aggregate, buffers are at comparatively comfortable levels. The authorities already operate an effective, proactive, and sophisticated system of financial sector oversight, which, however, needs to be developed further in some areas. The authorities have underpinned the functioning of the financial system by enhancing the central bank liquidity framework and introducing a real-time gross settlement system.


This paper discusses the Financial System Stability Assessment of Israel. The stability analysis suggests that systemic financial vulnerabilities to severe shocks in line with historical experience are manageable and in aggregate, buffers are at comparatively comfortable levels. The authorities already operate an effective, proactive, and sophisticated system of financial sector oversight, which, however, needs to be developed further in some areas. The authorities have underpinned the functioning of the financial system by enhancing the central bank liquidity framework and introducing a real-time gross settlement system.

I. Background

A. Financial and Macroeconomic Setting

Structure of the financial system

1. The main financial institutions are banks and insurance companies; there is a large and active market in shares, corporate bonds, and government bonds; savers have available a variety of pension, provident, and mutual funds (Table 3, and Figure 1). The Bachar reform that began in mid-2005 forced banks to divest most noncommercial banking activities, such as insurance, pension, and provident funds; the banks today focus on traditional banking business. Partly as a result, the nonbank financial sector has grown rapidly, now playing a large role in credit markets. Most institutions have relatively little overseas activity; dollarization has been greatly reduced. Foreign institutions play a minor role, and, with a few exceptions, foreign ownership of Israeli institutions is limited. The banking and insurance sectors are concentrated (Box 1).

Figure 1.
Figure 1.

Israel: Structure Change in the Financial System

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Sources: Bank of Israel, Israel Central Bureau of Statistics, Haver Analytics.

2. Financial supervision responsibilities in Israel are shared among several agencies. The BOI supervises banks and is responsible for payments system oversight. The Israeli Securities Authority (ISA) oversees the securities sector, while the Capital Markets, Insurance, and Savings Division (CMISD) at the MOF is responsible mainly for oversight of the insurance and pension sector. The Tel Aviv Stock Exchange (TASE) has some supervisory responsibilities for its members. Only the BOI has an explicit mandate to promote the stability of the financial system.

Effects of the global crisis

3. The global crisis affected Israel’s economy, but no domestic financial institution got into serious difficulties during the crisis. Banks weathered the storm of the global crisis, although profitability suffered.1 In part, the relatively robust performance was due to the short-lived recession and the characteristics of Israel’s banking system, namely, banks’ conservative management; reliance on deposit funding and the small interbank and wholesale funding markets; lack of complex asset and securitized markets; and strong and intrusive bank supervision.

4. The corporate bond market and NBFIs were hard hit by the global crisis. The primary market shrank and largely “froze” in late 2008 (Figure 2). Corporate bond yields rose sharply, particularly in the real estate industry, which had larger exposures to markets abroad. Moreover, the some long-term savings products made significant losses. With public confidence in asset quality shaken, mutual and provident funds faced large redemptions.2 While the crisis was the trigger for the retrenchment, there were underlying weaknesses in the basic infrastructure, including an inadequate framework for evaluating and monitoring credit risks and poor transparency.

Figure 2.
Figure 2.

Israel: Selected Financial Market Indicators

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Sources: Bloomberg; Datastream; and Moody’s KMV.

Financial Sector Structure and Concentration

The level of concentration in both bank and nonbank financial sectors remains high:


The Structure of Israel’s Financial System

(In percent share)

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Israel’s banking system is dominated by five banking groups, which provide universal banking services and account for 95 percent of banking sector assets.3 The two largest alone constitute more than half the system. The rest of the system consists of three independent banks, and four branches of foreign banks.

Parts of the nonbank financial sector (comprising insurance companies, pension funds, and provident funds) are concentrated. In the insurance sector, the four largest groups have a dominant market share in most business lines (for example, their share in the life insurance market is over 80 percent). In comparison to the banking sector, there is greater foreign involvement, with one major insurer being foreign owned.


Structure of selected financial industries

(Percent share)

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Sources: Bank of Israel and market reports.1/ new pension funds, provident funds, and profit participating life insurance.

Israel’s corporate sector generally is dominated by large conglomerate groups.4 For example, the turnover of the six largest groups accounts for about a quarter of GDP. A notable feature of the Israeli firms is the presence of controlling shareholders. According to the ISA, 88 percent of all Israeli public companies have a controlling shareholder.

Concerns that concentrated market power and control might have adverse effect on competition led to the recent creation of the Committee on Increasing Competitiveness in the Economy. One of the key recommendations of this Committee is a prohibition of control or holding in a “significant” financial institution (over NIS 50 billion in assets) by a significant real entity or by the controlling shareholder of a significant real entity (over NIS 8 billion in sales or assets of NIS 20 billion).

5. The authorities preempted the spread of financial stress with a slew of support measures, but they went largely unused.5 The BOI aggressively cut its policy interest rates, and expanded liquidity facilities. The BOI also tightened bank supervisory measures in areas of reporting, capital, and liquidity. In areas of capital markets, the MOF established various back-stop mechanisms, such as a “safety net” program for provident fund savings, and a program offering guarantees to banks for raising capital, while the ISA set up a debt settlement framework. Furthermore, this episode led to the establishment of the Hodek committee, which in 2010 presented a set of recommendations to the government to improve market transparency, conduct, and the corporate governance of institutional investors.

Macroeconomic performance

6. Following a mild recession in early 2009, output started recovering in mid-2009 and continued to grow strongly through the first part of 2011 (see Table 4). Unemployment fell to comparatively low levels, inflationary pressures became apparent, house prices increased rapidly (more than 40 percent in real terms since 2008), and strong capital inflows continued even during periods of heightened regional tension.

7. As global growth slows down, Israel’s growth momentum is expected to weaken, and the BOI turned to a monetary easing cycle in September 2011. Israel is a small open economy and Europe and the U.S. are largest trading partners, and hence developments in those countries are likely to affect Israel strongly.6 Although Israel’s exposures to European periphery countries are negligible, financial markets turmoil in Europe in fall 2011 negatively affected Israel’s financial markets, as evidenced by rising risk premia on corporate bonds.

B. Implementation of 2001 FSAP Recommendations

8. The original FSAP found that the financial system was generally robust. At the time, the system was largely bank-based, corporate bond and money markets were nearly nonexistent, and the state assumed insurance and pension fund risks. Most components of the supervisory system were relatively strong, but coordination was weaker, and the safety of the payment and settlement system and its oversight was inadequate.

9. The general robustness of the system was demonstrated in the 2002 and 2009 recessions. Risk factors relating to high public debt and continent pension liabilities have diminished in relative importance. Many of the FSAP recommendations have been implemented (Appendix I). Supervision in all sectors including that of the payment system has been strengthened. The framework for financial crisis management still lacks certain elements (see below).

II. Vulnerability Analysis

A. Key Macroeconomic and Financial Risks

10. The Israeli economy and financial system has proven resilient in the recent past, but several risk factors can be identified (Appendix II):

  • The global economy and in particular some of Israel’s main trading partners (especially Europe but also the United States) may slip back into recession, leading to a contraction in trade. Funding conditions (including in the corporate bond market, where a substantial volume of rollover is expected in 2012) would become more difficult. Capital could flow to Israel in a search for yield and lead to a substantial appreciation, hurting the tradables sector.7 However, direct exposures to vulnerable European countries are very small.

  • Israel is unusually exposed to geopolitical risk. The economy survived well past episodes of conflict, but ongoing regional turmoil could have a more severe impact, especially if of long duration and associated with a large increase in energy prices, inflation, and a reaction of much higher real interest rates around the globe.

  • The nonfinancial, banking, and insurance sectors are concentrated, so an idiosyncratic shock to one major institution could have direct and indirect effects on others. Even an operational failure in one bank, say, could weaken confidence across the system. Difficulties in a major conglomerate would have unpredictable effects across the economy and lead to higher risk premia, which in turn would dampen investment.8

  • The rise in housing prices and the construction boom of recent years appears to have slowed, but could pose renewed risks if momentum is regained, or if housing prices fall sharply. Much of credit growth has been concentrated in these sectors. The sector could suffer a sudden reversal, resulting in nonperforming mortgages and loans to construction companies.

B. Household and Corporate Sector Vulnerabilities

The household sector and the housing market

11. Households have relatively little mortgage or consumer debt, and their financial assets have built up strongly in recent years, but house prices seem to be somewhat above their long-run equilibrium and could reverse. A large share of both assets and liabilities are indexed or carry a variable interest rate. Mortgage loans have not generated significant losses for banks in the past decade: a mortgage loan carries recourse, and loan-to-value ratios are typically low (Figure 3). Residential construction has boomed, and mortgage lending has increased rapidly. By mid-2009, there were signs of deterioration in mortgage lending standards—such as an increase in unindexed floating rate mortgage loans—and the authorities introduced prudential and other measures to contain risks that were building up, including higher capital requirements for housing loans, supplemental reserve requirements, and variable interest rate mortgage limits. House price inflation has recently leveled off, but vulnerability remains.

Figure 3.
Figure 3.

Israel: Housing Sector

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Sources: BOI, Haver, and IMF staff calculation.

The corporate sector

12. The corporate sector is recovering from the 2008–09 global crisis (Figure 4 and Table 8). Most recently, however, market indicators for corporate default probability have begun to rise, though they are still below 2008–09 levels.

Figure 4.
Figure 4.

Israel: Corporate Sector

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Sources: BOI, Haver, Moody’s KMV, and IMF staff estimates.1/ Excluding commercial real estate-related bonds.

13. Regulatory reforms have probably increased the resilience of the systemically-important corporate bond market, but a legacy of risk remains. Total corporate bonds outstanding amounts to 32 percent of GDP, of which commercial real estate-related corporate bonds amounts to 12 percent of GDP—levels far above those seen in most advanced economies. The implementation of the Hodek committee recommendations (such as the imposition of minimum covenants for new bond issues), and of related provisions that the ISA imposed on mutual fund managers, has likely improved the quality of new issues. However, bonds restructured following the 2008 crisis are falling due in the coming period. Moreover, a large fraction of the real estate-related debt is linked to overseas activities, which exposes the Israeli economy to economic and financial shocks from abroad. Furthermore, it seems that the corporate bond market is somewhat shallow relative to its size—there is little market making or foreign involvement—so there is a risk of sudden price movements and market illiquidity. Hence, for example, disruption in bond markets abroad could quickly affect corporates’ financing conditions.

C. Banking Sector Risk Assessment

14. Financial stability indicators for banks are satisfactory and broadly in line with those of comparator countries (Table 5, Figure 5). Capitalization ratios have been rising, although much of the increase has taken the form of Tier 2 capital. Nonperforming loans (NPLs) are low and well provisioned. Deposits make up over two-thirds of total liabilities and in aggregate exceed loans. Profitability has been adequate and fairly stable after allowing for exceptional items.9 However, noninterest expenses (mainly staff remuneration) make up a relatively high share of gross income, which feature may limit resilience against the compression of interest rate spreads that may occur in some phases of the cycle.

Figure 5.
Figure 5.

Israel: International Comparisons of Bank Financial Soundness Indicators

(In percent)

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Sources: BOI, Bloomberg, and staff estimates.Note: Israeli banks are colored in black; the comparator sample consists of the largest banks domiciled in Australia, Austria, UK, Canada, Chile, Czech Republic, France, Poland, Sweden and USA. Data are as of June 2011 or latest available.

15. The banking sector risk assessment includes a top-down balance sheet stress test and single factor tests carried out by the BSD and a contingent claims analysis (CCA) stress test carried out by BOI and IMF staff (Appendix III).10 The five major banks are covered, with results projected to end-2014 in order to capture the full effects of shocks. The bank solvency tests are based on three scenarios which reflect key macroeconomic and financial risks, particularly a domestic slowdown and the potential impact on the Israeli economy and banks of a European crisis and U.S. slowdown:

  • The Base scenario is based on BOI staff’s forecasted path of the economy, which relies on the BOI macro-model; it is more conservative than the IMF WEO October 2011 forecast.

  • Adverse scenario 1 assumes a domestic recession, caused by geopolitical concerns leading to economic disruption, declining demand (especially in real estate), an increase in unemployment, and a rising risk premium.

  • Adverse scenario 2 reflects a global recession and difficulties in Europe, which affect the Israeli economy sharply. Real GDP declines relative to the baseline by about 2½ standard deviations.

16. The balance sheet scenario stress test results suggest that banks’ capital would remain adequately capitalized under the Base and Adverse 1 and 2 scenarios (Figure 6).11 The reasons for the robust results, even in the Adverse scenario 2, appear to be the relatively comfortable initial capitalization and profitability, low housing default risk, and the favorable starting point for corporate credit losses, which reflects recent good corporate performance. In addition, there are no large changes in risk-weighted assets (RWA) because banks are under the standardized approach.12 However, some banks seem significantly more exposed than others to certain risk factors, suggesting that supervisory attention should be directed to such cases.

Figure 6.
Figure 6.

Israel: Bank Balance Sheet Stress Test Results

(Maximum, unweighted mean, and minimum)

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Source: BOI, and staff estimates.

17. Single factor shock results show that concentration risk has the largest potential impact on capital (see stress testing summary table in Appendix III). The largest impacts on capital come from a credit shock from each bank’s largest borrower group, and also the impact of a credit shock of the largest three individual borrowers is significant for several banks. This result confirms the concern that concentration risk is significant. Exposures to European sovereigns and banks are so small as to have a negligible impact.

18. The results of the CCA analysis are consistent with the balance sheet stress test results (Figure 7). Under the Adverse 1 scenario, estimated credit spreads—as a measure of riskiness—no not rise much above those of the baseline.13 Under the Adverse scenario 2, banks’ estimated credit spreads increase to a level (about 400 basis points, bps) somewhat higher than those seen during the worst periods of the financial crisis in 2008/09, which, for Israel, proved manageable. As in the balance-sheet test results, some banks seems rather more vulnerable than others do—at least in these scenarios. The CCA results also give an estimate of the total losses to bank creditors for the five largest banks as a percent of GDP: under the Adverse scenario 2, the total expected losses to bank creditors increases to about 1.4 percent of GDP, which is low by comparison to that seen in other advanced countries (in part because the banking system is smaller relative to GDP).14

Figure 7.
Figure 7.

Israel: CCA Stress Test Results

(Basis points maximum, unweighted mean, and minimum spreads; and percent)

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Source: BOI, and staff estimates.

19. The liquidity test results show that all the major banks would be able to maintain the liquidity ratio above unity under strong stress scenarios (Table 2). However, for foreign currency liquidity positions alone, some banks would not be able to maintain an excess of foreign currency short-term assets over liabilities. Because banks do not rely on market funding and hold relatively few securities, deposit outflows are potentially the main source of risk to liquidity.

Table 2.

Israel: Liquidity Stress Test Results

(Change in ratios unless indicated)

article image
Source: BoI, and staff estimates.

Excluding Israeli treasury bills.

The stress testing capacity built up in the BOI in recent years forms a good basis for further refinement and extension. Significant progress has been made by the BOI, although the robustness of some estimated satellite models is weakened by the shortness of available data samples. Going forward, BOI stress testing should continue to be refined and extended, including by enhanced liquidity, profitability and corporate credit risk stress testing.

D. Insurance Sector and Long-Term Savings Instruments Risk Assessment

20. Available financial soundness indicators for insurers show recovery from the effects of the global crisis, with a few firms lagging (Figures 8, 9, Tables 6, 7). Capitalization, profitability, and liquidity are now at levels comparable to those of international peers, and market-based measures of soundness are back to “normal” levels. This sector is a major holder of Israeli corporate bonds.

Figure 8:
Figure 8:

Israel: Insurance Financial Soundness Indicators

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Figure 9:
Figure 9:

Israel: Insurers’ Distance to Distress

(Selected Israeli insurance companies)

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Source: CMISD

21. The results of stress tests for long-term savings (LTS) products show manageable effects (Appendix III). Market shocks of similar magnitude as those that occurred during the fourth quarter of 2008 and a simulated scenario of a severe local shock would result in an average 7.7 percent loss on the LTS portfolio of individuals (Figure 10).

Figure 10.
Figure 10.
Figure 10.

Israel: Long-Term Savings (LTS) Stress Test Results

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Source: Israeli authorities, and staff estimates.

22. The stress test applied to the insurance business excluding the saving products did not expose large vulnerabilities (Figure 11). Some companies are positively impacted in their capital position by a deterioration of claims due to reserve release and tax credit, but two companies face challenges to meet the new, higher capital requirements.

Figure 11.
Figure 11.

Israel: Insurance Own Funds Stress Test Results

Citation: IMF Staff Country Reports 2012, 069; 10.5089/9781475502718.002.A001

Source: Israeli authorities, and staff estimates.

23. The supervisory stress tests run by the companies for internal risk analysis need to be more stringent. For example, insurance and market risks should be combined in a single stress scenario, such as a historical scenario and an insurance shock (e.g., an earthquake during a 2002 crisis scenario).

III. Financial Sector Oversight

A. Cross-Cutting Issues

Supervisory approach

24. Financial regulation and supervision is generally sophisticated and thorough. International supervisory standards are assessed to be observed to a high degree.15 Across the financial sector, the authorities take a pro-active, stability-oriented approach. Regulations are generally up to date, a great deal of information is gathered and analyzed through on-site and off-site supervision, and the authorities demand prompt correction of any deficiencies they detect.

25. The authorities’ intrusive approach is appropriate, but care needs to be taken to avoid over-complication and undue regulatory burden. Financial institutions and their clients are challenged by the complexity of regulations, and relatively frequent changes.16 It may be worth undertaking a medium-term project to streamline and systematize legislation and regulations. There is consultation on new regulations, but more detailed and publically available assessment of costs and benefits, when feasible, would be helpful.

26. Maintaining effective supervision requires that supervisors are effectively independent and have up-to-date skill sets. In practice, the supervisors appear act with consistent independence. However, certain aspects of their personnel policies and budgets are subject to government control. Furthermore, in Israel as elsewhere, supervisors face a challenge in keeping up with the innovations introduced by private institutions, meeting which requires specialized quantitative skills to understand and oversee. To acquiring these skills, which are well-remunerated in the private sector, supervisors need flexibility in their personnel policies and budgets.

Cross-sectoral cooperation and information-sharing

27. The relatively large NBFI sector and securities markets in Israel puts a premium on cooperation between supervisors. The practice of cooperation seems to be broadly satisfactory for normal times, but may be over-stretched in times of crisis or weak in anticipating and limiting the build-up of common vulnerabilities. Therefore, it may be useful to institutionalize arrangements for sharing information and analysis through more detailed, operational memorandums of understanding (MOUs), in part to define what information cannot regularly be shared because of confidentiality concerns. A more formal framework for cooperation may be advisable (see below).

28. The division of responsibilities among three supervisors seems to have led to some gaps and overlaps. For example, bank members of TASE are supervised by the BOI, while nonbank members are supervised by TASE; ensuring a level playing field requires consistency of treatment, which is not easily achieved by such a division. Bank subsidiaries underwrite securities issues; ISA has responsibility for the oversight of this activity but the BOI must also be closely involved. Currently, these gaps mainly affect market conduct and competition rather than representing direct threats to financial stability, but such threats could emerge if the gaps are not addressed.

29. Addressing these gaps and overlaps can be achieved by various means, with an overall goal of ensuring that like activities are subject to like regulation and supervision. Regulatory arbitrage can be contained by ensuring that like activities are subject to the same regime, and that the regulation (and taxation) of close substitutes is carefully coordinated. There is no global “best practice” to the architecture of supervision, but as the system develops, the case for a more integrated approach may strengthen.

B. Banking Supervision

30. Banking sector regulation and supervision is generally stringent and in line with international standards. The BOI has implemented Basel II very thoroughly, and is now in the process of making their supervisory practice more risk-based and preparing for an eventual move to Basel III. Initiated in 2008, the risk-based supervision program has enabled the supervisors to evaluate risk both on an institutional level and from the perspective of the most critical systemic banking risks. However, for capital adequacy purposes, banking institutions are still required to calculate capital under standardized approaches, which may be less risk-sensitive (for example, regarding sovereign risk and risk correlations) and forward looking.

31. The regulation and supervision of liquidity management and funding (including foreign currency liquidity; see stress testing results above) will need to be enhanced. Israeli banks currently enjoy a stable funding base, but more attention needs to be paid to these areas in the light of other countries’ experience in the global crisis. Relevant BOI supervision has focused on off-site inspection; on-site inspection resources should be utilized more. A revision to the existing directive on liquidity management is under way.

32. The supervision of interest rate risk and some aspects of market risk seems to be relatively underdeveloped, although these risks are not of highest importance given banks’ current business models. The supervisor rightly devotes much attention to possible credit risk generated by interest rate fluctuations, but more attention needs to be paid to the direct effects on earnings and capital from adverse movements in interest rates in respect of the banking book. There are some possible gaps in the supervision of securities business housed in nonbank subsidiaries.

33. The BOI recognizes that its policy of requiring each bank to have a “controlling shareholder,” who holds a significant block of equity, may become difficult to sustain. This approach has advantages, for example, because it ensures that some owners have a strong incentive to monitor management and limit risk-taking that might imperil their “franchise value.” The main disadvantage is that maintaining the controlling position limits flexibility in capital management. As a bank grows and needs more capital (or if it gets into difficulties), persisting in this approach may become increasingly difficult. In this connection, another major challenge will be the move towards Basel III, to which BOI is committed. Given the importance of Tier 2 in banks’ current capital structure and the limited range of credit risk mitigation techniques available, banks will have to raise additional equity—which may be difficult in the current global environment—or shrink their balance sheets, which may unduly restrict credit supply. The Basel III objective is appropriate, but if there are signs that credit supply is being unduly affected during the transition, offsetting measures (in terms of the monetary policy stance or conditions that support the sustainable supply of non-bank credit) should be considered.

C. Insurance and LTS Products Sector Supervision

34. The regulation and supervision of the insurance, pension fund, and provident funds is generally of a high standard, but cross-border supervisory cooperation and information-sharing needs to be strengthened. MOUs and regular communication with supervisors of jurisdictions with significant investment in the Israeli insurance sector (or where Israeli insurers operate) should be in place.

35. Current regulation lacks sufficient tools to supervise groups effectively. At present, the CMISD does not have formal policies with regard to group capital adequacy, reinsurance and risk concentration, internal control mechanisms, and risk management systems, nor are there specific requirements for group-wide reporting, and the holding companies escape supervision. Work is already underway to strengthen this aspect of the insurance supervisory system (in line with evolving international best practice).

36. The capacity of insurers and pension funds to assess credit risk may become a higher priority for supervisors. Insurers and pension funds already hold increasing amounts of corporate bonds and engage in some syndicated project lending. These trends may well continue as banks adjust to the new regulatory framework.

D. Regulation of Securities Markets

37. The regulatory regime has been strengthened in recent years, but some deficiencies remain. A potentially significant gap is that that broker-dealer activity can be undertaken outside of the regulatory framework, for example, if the activity does not involve membership of the stock exchange or the provision of advice services to retail clients, and is not undertaken by a bank. Similarly, certain over-the-counter derivatives activity, including the sale of products to retail investors, can take place outside the regulatory regime. The absence of a licensing framework for intermediaries of this kind—which seem currently to be modest in volume—could have serious implications for investor protection. If unregulated activity grew to a significant size, it could have an impact on overall market stability. For the bond market, consideration should be given to eliminating the possibility of issuing under previously filed prospectuses: some companies are using the possibility of reopening outstanding issues in order not to provide bond covenants that abide by the Hodek committee’s recommendations.17

38. TASE, as a self-regulatory organization, is responsible for the licensing and supervision of its members, but some responsibilities are closely linked to those of others and require close coordination. As mentioned, bank members of TASE are wholly supervised by the BOI. Responsibility for detecting and dealing with insider trading and market abuse remains with the ISA. Arrangements for coordination and communication are in place, but there is also a need for a high degree of practical interaction on a day-to-day basis.

E. Regulation of Payments and Settlement Systems

39. The introduction in 2007 of a real time gross settlement high-value payment system, Zahav, and the enactment of a Payment Systems Law in 2008 and the BOI Law in 2010 have transformed the system’s operations and legal framework.18 The system is now technically more efficient and stable, and better administered. However, some gaps remain, mainly in the protections available. Thus, it is important that the multilateral net settlement systems that settle in Zahav (i.e., Masav, BCH and the TASE clearing house, TASE-CH) are not a source of instability to Zahav itself, which may arise settlement on one such system is disrupted by the illiquidity of a major participant. To guard against this risk, legal provisions and oversight of could be strengthened.

40. Now that Zahav is operational, focus is switching to establishing the effective oversight of payment systems (Zahav itself, Masav, the Israeli Automated Clearing House (ACH), and the check clearing system BCH). The authorities need to ensure that this project is completed by the 2013 target date.

41. Efforts to establish more comprehensive business continuity and disaster recovery mechanisms need to be accelerated in the payments system and the BOI more generally. At a technical level, business continuity planning and practice is well advanced. Further effort is needed to coordinate, especially with other parties on which Zahav depends for its smooth running, such as the provision of intra-day liquidity via TASE-CH or BOI monetary operations.

F. Anti-Money Laundering and Combating the Financing of Terrorism Framework

42. The framework for the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) continues to be strengthened. The authorities cooperate actively with counterparts abroad and relevant international organizations. Moneyval (the relevant Financial Action Task Force (FATF)-style regional body) undertook an assessment of Israel’s compliance with the FATF 40+9 Recommendations in 2008. The evaluators found an overall working AML/CFT regime, although gaps were identified, several of which had already been addressed by the authorities, as evidenced in the progress reports they presented to Moneyval in 2009 and 2011. The authorities are in the process of amending regulations for each category of financial institution in areas such as customer due diligence, recordkeeping, and supervision. Draft legislation is pending before the Knesset to impose AML/CFT obligations on certain designated non-financial businesses and professions that are currently not covered. Consideration is also being given to ensure greater transparency with respect to beneficial ownership of legal persons and arrangements

G. Macroprudential Framework

43. The authorities have made significant efforts to develop macroprudential supervision. A Financial Stability Group consisting of representatives from the three supervisory agencies was set up in mid-2011. The group meets regularly and produce an internal report every quarter, providing an overview of macrofinancial stability issues together with policy options to be discussed by the BOI’s Monetary Committee and the other supervisory agencies.

44. Given the structure of the Israeli economy, a more coherent approach to macroprudential issues is needed. All financial regulatory agencies should be involved in macroprudential supervision, but the BOI is best positioned to play the leading role. The BOI has the requisite mandate, powers, and capacity as both central bank and bank supervisor. Other supervisory agencies too have made progress in establishing systemic risk monitoring frameworks for their respective sectors. The ISA has made progress in monitoring a build-up of risks in different market segments and instruments. The CMISD has continued to improve its stress-testing capacity, including the analysis of potential feedback effects from distress in insurance and pension funds into the rest of the financial system. Yet, currently, these activities are insufficiently coordinated.

45. Accordingly, it is suggested to establish more formally a standing FSC charged with macroprudential policy setting. The FSC should be chaired by the BOI, which should have representatives for both monetary policy and banking sector stability, and in addition comprise the ISA, CMISD, and the MOF.19 The FSC would aim to work by consensus, but, if that proves unwieldy, mechanisms to reach quick and firm decisions may have to be introduced. The mandate and functions of the FSC should comprise the monitoring of sources of systemic risk, and the establishment of a policy agenda to mitigate these risks. The FSC would have to deal with competition in the financial sector, consumer protection, and market conduct insofar as these issues are of systemic importance. Any outstanding issues related to possible legal or other impediments for information-sharing, or the use of microprudential tools for macroprudential purposes should be dealt with during the process of establishing the FSC. To ensure accountability, the framework should stipulate duties to communicate major policy decisions; joint publications such as a Financial Stability Report could be used as a vehicle for communication of key messages to the general public. The aim is to establish an animated forum for cooperation both at the policy and at the technical levels, rather than a fully autonomous agency.

46. In this context, stress testing activities should be designed to guide micro- and macroprudential policy to enhance financial stability. Integrated stress testing analysis should be expanded to analyze macroprudential risks and policies (e.g., through risk transfer among corporate groups, insurance companies, savers, and government), to which end the authorities’ current project to assemble data on inter-connectedness in the corporate and financial sectors is commendable.20 Efforts should be made to build hypothetical scenarios that incorporate experience of other countries during the crisis. Stress testing can also help analyze the potential benefits (i.e., reduced vulnerability from lower default risk and implied credit spreads) of possible new financial sector policies and other changes, such as the proposed changes in the ownership structure of conglomerates.

IV. Liquidity, Crisis Management, and Safety Nets

A. Liquidity Management

Monetary operations and money markets

47. The central bank’s liquidity operational framework has been significantly strengthened in recent years. The loan quota system was replaced with standing credit and deposit facilities, and interbank settlement practices were revamped.

48. Repurchase (repo) markets are thin, and further efforts to develop markets are merited. The lack of repo activity in part reflects currently ample liquidity in the system, resulting from the BOI’s recent large-scale foreign exchange purchase policy. While the authorities have made efforts to develop repo markets over the past years—including the introduction of a central trading and clearing facility for repos at TASE—a new tax legislation defining repo transactions as lending has yet to be enacted.

Emergency Liquidity Assistance

49. An explicit emergency liquidity assistance (ELA) policy framework needs to be established in order to avoid situations when the BOI’s liquidity assistance slips into quasi-fiscal solvency support. There is a risk that, without well-articulated criteria and procedures for providing ELA, the BOI will have to provide liquidity to (and possibly take on credit risk on) institutions of doubtful solvency or immediate systemic importance. Furthermore, the new BOI Law has broadened the central bank’s power to provide ELA in principle to all NBFIs; generally, ELA is most relevant for institutions that are directly involved in the high-value payment system, which suggests that ELA should be provided to nonbank financial institutions only under very exceptional circumstances.

B. Early Intervention and Orderly Resolution of Problem Banks

50. Establishing an efficient and effective crisis framework is especially important in Israel given the concentrated structure of the financial system, which makes it essential to deal effectively with emerging problems, and to address major problems decisively and quickly.

Early intervention

51. The ordinary enforcement powers could be enhanced in several respects: (a) by providing more flexible grounds for requiring corrective measures; (b) by ensuring that the BOI may require a bank to take specific actions to correct identified problems; and (c) by broadening the list of other measures the BOI may impose on a bank.

Going concern resolution

52. The official administration framework should provide the administrator with a broad range of resolution techniques. These include (a) mergers with a healthy bank; (b) rapid recapitalization with or without existing shareholders; (c) conversion of subordinated debt to equity; and (d) dispose of assets and liabilities. For these purposes, the law should grant the administrator considerable discretion in dealing with different assets and liabilities, unlike under current law, which requires that any transfer apply to all liabilities.

Gone concern resolution

53. The authorities should consider incorporating liquidation into the special resolution regime provided for in the Banking Ordinance. Under the current framework in Israel, banks are subject to liquidation under the general corporate insolvency law, which does not ensure continuity in the provision of financial services. A special bank resolution regime should include (a) authority of the liquidator to organize rapid transfers assets, liabilities, and combined portfolios of both (sometimes called P&A transactions) ; (b) depositor preference; and (c) power to establish a “bridge bank;” and (d) ex post judicial review so that the liquidation process is administratively handled rather than being a court-controlled process.

C. Early Intervention and Orderly Resolution of Problem Nonbank Financial Institutions

54. Existing legislation provides nonbank supervisors with powers to intervene and resolve NBFIs. Because resolution of these nonbanks is typically not as time-sensitive, the general insolvency regime can normally apply, but settlement systems and clearing houses, for example, may constitute exceptions, because their ongoing functionality is important for the wider economy, and because exposures can change greatly in a short time. Furthermore, it would be worthwhile to review in detail whether adequate legal and operational capacity is available to deal promptly with a problem NBFI, especially where the institution belongs to a conglomerate, in which case the ability to impose some form of ring-fencing may be helpful.

D. Solvency Support and Funding of Banks in Resolution

55. The current legal framework allows the BOI to guarantee public deposits, as well as other bank liabilities with the approval of the government, and thus to incur a large contingent liability—a responsibility that should rest squarely with the government and not with the monetary authority. Moreover, a precedent and expectations have been established that depositors (and often other creditors) are bailed out. For example, during the recent global crisis, the MOF and the BOI issued statements assuring the public that the government would stand behind the stability of the financial system and that the BOI would use all tool available to protect depositors. Moreover, provident fund investors were protected ex post from downside risk. Thus, the current arrangement does not protect the BOI from taking on quasi-fiscal potential liabilities, nor does it ensure adequate sharing of costs associated with solvency support and resolution of problem financial institutions between the government, the financial sector, and creditors.

56. In addition to establishing robust legal framework for bank resolution, several (in part complementary) measures could be considered:

  • amending Banking Ordinance to allow the government to guarantee public deposits, as well as other bank liabilities, after the consultations with the BOI;

  • introducing a formal DGS; or

  • introducing depositor preference.

In this connection, it should be recognized that financial institutions (and their creditors) already enjoy much implicit government support; these measures serve to make that support explicit and to shift part of the burden back to the institutions.

57. The value of introducing a formal DGS should be kept under review (the possibility has been extensively debated in the past in Israel). The main objectives of a DGS are to contribute to the stability of a financial system (by preventing panic withdrawals of bank deposits or by providing funding for certain types of resolution tools) and to protect less financially-sophisticated depositors from the loss if a bank fails. Furthermore, a DGS is supposed to contribute to creating the level-playing field between the large and the small banks. There may be disadvantages, however, in reducing flexibility in how to deal with a problem bank, and the need to pre-fund at least part of potential claims, which would require imposing premia on banks and depositors; a useful level of reserves would be comparatively large given the concentration of the banking system. Without a formal DGS, other elements of the crisis management framework need to be stronger. Depositor preference is in some regards a substitute for a DGS, and also has complementary features.

E. Coordination and Information-Sharing

58. The BOI has internal guidelines that set out the procedures for dealing with weak/troubled banks, including through the establishment of a steering committee, but further organizational preparations would be worthwhile. The mission recommends that a protocol be agreed in advance for establishing a committee for coordinating crisis management preparations and efforts, and generally for allocating crisis management responsibilities.21 Furthermore, it is worth considering the preparation of an operational crisis management MOU, covering such matters as information sharing and the allocation of specific responsibilities. On occasion, joint “fire drills” could be held, perhaps coordinated by the FSC.

59. The authorities need to strengthen their preparations for dealing with a cross-border crisis in a financial institution. While foreign operations of Israeli financial institutions are currently limited in aggregate, a few are more exposed, and interconnections with abroad may rise over time.

Statistical Appendix

Table 3.

Israel: Structure of the Financial System

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Sources: Bank of Israel, Ministry of Finance, and Israel Securities Authority.
Table 4.

Israel: Selected Economic and Social Indicators

(Percentage change, unless otherwise indicated)

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Sources: Haver Analytics; Bank of Israel, Central Bureau of Statistics; World Bank; and IMF staff estimates and projections.

Poverty rate from National Insurance Institute of Israel.

As at end-February 2012.

Table 5.

Israel: Financial Soundness Indicators: Five Major Banks 1/

(End period; in percentage points; unless otherwise indicated)

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Sources: BOI, and IMF staff estimates.

The five major banks hodl about 95 percent of total banking system assets.

From 2009, the calculation of capital base follows rules under Basel II.

Table 6.

Israel: Financial Soundness Indicators: Insurance

(End period; in billions of NIS unless otherwise indicated)

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Source: MOF, CCMISD, and IMF staff estimates.
Table 7.

Israel: Financial Soundness Indicators: Pension

(End period; in billions of NIS, unless otherwise indicated)

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Source: MOF, CCMISD, and IMF staff estimates.
Table 8.

Israel: Financial Soundness Indicators: Nonfinancial Sector

(End period; in percentage points, unless otherwise indicated)

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Sources: BOI, and IMF staff estimates.

Includes bank and nonbank debt.

2011 Q3.

2011 Q2.