Israel
Detailed Assessment of Observance of Basel Core Principles for Effective Banking Supervision

A detailed assessment of Israel’s compliance with the Basel Core Principles for effective banking supervision is presented. The Bachar reform that has been started in mid-2005 forced banks to divest most noncommercial banking activities, such as mutual funds, insurance, pension, and provident funds; the banks today focus on traditional banking business. As a result, the nonbank financial sector has grown rapidly, playing a larger role in credit markets. Financial supervision responsibilities in Israel are shared among several agencies. The Bank of Israel and specifically its Banking Supervision Department supervises banks.

Abstract

A detailed assessment of Israel’s compliance with the Basel Core Principles for effective banking supervision is presented. The Bachar reform that has been started in mid-2005 forced banks to divest most noncommercial banking activities, such as mutual funds, insurance, pension, and provident funds; the banks today focus on traditional banking business. As a result, the nonbank financial sector has grown rapidly, playing a larger role in credit markets. Financial supervision responsibilities in Israel are shared among several agencies. The Bank of Israel and specifically its Banking Supervision Department supervises banks.

I. Summary, Key Findings, and Recommendations

1. Banking sector regulation and supervision is generally in line with international standards and stringent. The authorities generally 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 detected in supervised institutions. In some areas, the authorities’ regulation and practice goes well beyond the standard. Most remaining deficiencies relative to the standard are being addressed or are of relatively low materiality. Areas for improvement include the regulation and supervision of interest-rate risk, market risk, and liquidity risk; supervision of certain securities-related activities performed in Israel or abroad; and flexibility and autonomy in personnel management and budgets to attract and retain financial sector experts with the required skill mix.

Introduction

2. The 2001 Israel FSAP undertook an assessment of compliance with the Basel Core Principles for Effective Banking Supervision based on the 1999 methodology. Based on that methodology, it was judged that Israel was compliant with 17 of the 25 Core Principles, largely compliant with 6 (Objectives, autonomy and powers; investment criteria; loan evaluation; country and transfer risk; bank management; remedial issues), and materially noncompliant with two (CP15 on the prevention of money laundering and CP 24 on information sharing with foreign supervisors). One overriding feature of that assessment was that overall, the quality of implementation of supervision, both on-site and off-site, was good. The supervisors availed themselves of broad powers both to supervise and to set regulations, and to enforce them. The general recommendation was to make the legislation pertaining to banking more transparent.

3. Since then, the Israeli banking system and the financial system more generally has been transformed (see below). Changes in the Israeli context, the external economy, and the international standards warrant the update.

4. This Detailed Assessment of Observance Report was prepared as part of the FSAP Update mission to Israel, which took place November 6-21, 2011. The assessors were Thierry Bayle (Banque de France) and Joel Shapiro (formerly of the U.S. Federal Reserve). The FSAP Update conducted assessments of compliance with the International Association of Insurance Supervisors Insurance Core Principles (IAIS ICP); the International Organization of Securities Commissions and Overseers (IOSCO) Objectives and Principles of Securities Regulation; and the Committee on Payment and Settlement Systems (CPSS) Core Principles for Systemically Important Payment Systems. Extensive analysis was undertaken of vulnerabilities of the Israeli financial system following the 2008-09 global crises and the uncertain global environment at the time of the assessment; the development of macro-prudential oversight and policies; and the crisis management system.

Information and methodology used for assessment

5. The assessment is based on several sources: (i) a comprehensive and critical self-assessment, received in October 2011; (ii) detailed interviews with staff from BOI and other government agencies on the current practice for on- and off-site supervision; (iii) reading of laws, regulations, and other documentation on the supervisory framework and on the structure and development of the Israeli financial sector, including a questionnaire response prepared by the authorities; (iv) reading of anonymous supervisory materials provided to the assessors during and after the fieldwork in Israel; (v) meetings with other authorities; and (vi) meetings with the banking industry as well as others such as academics and representatives of the accounting and audit profession. Specifically, the assessment team held extensive discussions with: staff from the BOI and in particular its Banking Supervision Department (BSD), the Ministry of Finance, other government agencies including the Capital Markets, Insurance and Savings Department (CMISD) of the MOF, the Israel Securities Authority (ISA), the Tel Aviv Stock Exchange (TASE), and the Israel Money Laundering and Terror Financing Prohibition Authority (IMPA), and private sector participants in the banking and financial markets.

6. The assessors had the full cooperation from the Israeli authorities and received all information necessary for the assessment. The team extends its thanks to the staff of the authorities for their participation in the process, their openness, and their hospitality, and to the private sector representatives with whom they had a chance to meet.

7. The assessment has been conducted in accordance with the guidelines described in the Core Principles (CP) Methodology published in October 2006 by the Basel Committee on Banking Supervision (BCBS).1 It assessed compliance with both the “essential” and the “additional” criteria, but the ratings assigned were based on compliance with the “essential” criteria only. The methodology requires that the assessment be based on (i) the legal and other documentary evidence; (ii) the work of the supervisory authority; as well as (iii) the implementation in the banking sector. Full compliance requires that all these three prerequisites are met. The guidelines allow that a country may fulfill the compliance criteria in a different manner from the ones suggested as long as it can prove that the overriding objectives of each CP are reached. Conversely, countries may sometimes be required to fulfill more than the minimum standards, e.g., due to structural weaknesses in that country. The Methodology also states that the assessment is to be made on the factual situation of the date when the assessment is completed. However, where applicable, the assessors made note of regulatory initiatives, which have yet to be completed or implemented.

8. The assessment of compliance of each principle should be made based on the following four-grade scale: compliant, largely compliant, materially noncompliant, and noncompliant. A “not applicable” grading can be used under certain circumstances.

  • Compliant – A country will be considered compliant with a Principle when all essential criteria applicable for this country are met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the Principle has been achieved by other means. Conversely, due to the specific conditions in individual countries, the essential criteria may not always be sufficient to achieve the objective of the Principle, and therefore other measures may also be needed in order for the aspect of banking supervision addressed by the Principle to be considered effective.

  • Largely compliant– A country will be considered largely compliant with a Principle whenever only minor shortcomings are observed which do not raise any concerns about the authority’s ability and clear intent to achieve full compliance with the Principle within a prescribed period of time. The assessment “largely compliant” can be used when the system does not meet all essential criteria, but the overall effectiveness is sufficiently good, and no material risks are left unaddressed.

  • Materially non-compliant– A country will be considered materially non-compliant with a Principle whenever there are severe shortcomings, despite the existence of formal rules, regulations and procedures, and there is evidence that supervision has clearly not been effective, that practical implementation is weak, or that the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance. It is acknowledged that the “gap” between “largely compliant” and “materially non-compliant” is wide, and that the choice may be difficult. On the other hand, the intention has been to force the assessors to make a clear statement.

  • Noncompliant– A country will be considered non-compliant with a Principle whenever there has been no substantive implementation of the Principle, several essential criteria are not complied with or supervision is manifestly ineffective.

  • In addition, a Principle will be considered not applicable when, in the view of the assessor, the Principle does not apply given the structural, legal and institutional features of a country.

9. An assessment of compliance with the BCPs is not, and is not intended to be, an exact science; reaching conclusions require judgments by the assessment team. Banking systems differ from one country to another, as do domestic circumstances. Also, banking activities are changing rapidly around the world after the crisis and theories, polices, and best practices are rapidly evolving. Nevertheless, by adhering to a common agreed methodology, the assessment should provide the Israeli authorities with an internationally consistent measure of quality of their banking supervision in relation to the 2006 Revision of the BCPs,2 which are internationally recognized as minimum standards.

10. For completeness’ sake, it should be noted that the ratings assigned during this assessment are not necessarily directly comparable to the ones assigned in terms of an FSAP performed using the pre-2006 BCP Methodology. Differences may stem from the fact that the bar to measure the effectiveness of a supervisory framework was raised by the 2006 update of the BCP Methodology, as well as by lessons drawn from the financial crisis that may have a bearing on supervisory practices.

Institutional and Macro-Prudential Setting, and Market Structure

11. 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. The Bachar reform that began in mid-2005 forced banks to divest most non-commercial banking activities, such as mutual funds, insurance, pension, and provident funds; the banks today focus on traditional banking business. As a result, the non-bank financial sector has grown rapidly, now playing a larger role in credit markets. Nonetheless, banks still play an important financial intermediary role, with their assets amounting to about 140 percent of GDP. Most banks 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.

12. Financial supervision responsibilities in Israel are shared among several agencies. The Bank of Israel (BOI) and specifically its Banking Supervision Department (BSD) supervises banks. BOI is responsible also for payments system oversight. The Israel Securities Authority (ISA) oversees the securities sector, while the Commissioner of Capital Markets, Insurance, and Savings (CCMIS) at the Ministry of Finance (MOF) mainly deals with the insurance and pension sector. The Tel Aviv Stock Exchange (TASE) has some supervisory responsibilities for its members.

13. The supervisors cooperate on a regular basis. There exists memorandum of understandings (MOUs) among BOI, ISA, and CCMIS, but it only outlines basic information sharing agreement without reference to specifics, and does not specify supervisory corporation arrangements more broadly. The practice of cooperation, for example seems to be broadly satisfactory for normal times, but may be over-stretched in times of crisis or weak in anticipating common vulnerabilities. Cooperation and information exchange were indeed intensified during the global crisis.

Recent developments

14. The global crisis affected Israel’s economy, but no domestic financial institution got into serious difficulties during the crisis. Banks have weathered the storm of the global crisis, although profitability suffered. In part, this reflected the characteristics of Israel’s banking system, namely, banks’ conservative management; limited inter-connectedness due to the small interbank and wholesale funding markets; lack of complex asset and securitized markets; and strong and intrusive bank supervision. Some insurance companies made losses, as did many investors in the various funds. The corporate bond market suffered especially large falls in prices, and new issuance came to a halt.

15. The authorities preempted the spread of financial stress with a slew of crisis-intervention measures. BOI aggressively cut its policy interest rates, and expanded liquidity facilities. BSD 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, a guarantee program to banks for raising capital, and the creation of the government-established investment funds (“Manof” funds); the ISA set up a debt settlement framework. Furthermore, this episode led to the establishment of the Hodek committee, which in February 2010 presented a set of recommendations to the government to improve market transparency, conduct, and the corporate government of institutional investors.

16. At the time of the mission, the health of the financial sector was generally satisfactory. The average capital ratio for major Israeli banks reached 14 percent, while the Tier 1 capital ratio stood at around 8.5 percent. Banks profitability declined sharply in 2008, but has since recovered as loan loss provisions have decreased and net interest income has increased. Banks remain mainly deposit-funded, with customer deposits exceeding loans. Financial soundness indicators for insurance companies are currently generally satisfactory.

Preconditions for Effective Banking Supervision

Sound and sustainable macroeconomic policies

17. Israel has a solid institutional framework supporting the conduct of sound macro-economic policies. Monetary policy is based on an inflation targeting framework, and the BOI’s independence has been recently strengthened following the enactment of the 2010 BOI Law. Budgetary policy too has been strengthened in recent years, with the establishment of a fiscal rule that gives credibility to the authorities’ fiscal consolidation plan.

A well-developed public infrastructure

18. The Israeli legal framework for the financial sector and more generally is comprehensive and regularly updated.

19. The auditing and accounting rules applicable to financial institutions generally comply with international standards. Listed companies and most nonbank financial institutions have applied International Financial Reporting Standards (IFRS) since 2008. The Israeli banking system reports under BSD’s directives and Israeli General Accepted Accounting Principles (GAAP), which is close to U.S. GAAP, with some IFRS elements for non-core activities.

20. The Israeli legislative framework with regard to the audit profession requires internal and external auditors to be independent in both fact and appearance. The Banking Ordinance, 1941 requires the appointment of internal auditor in a banking corporation, and stipulates the governance of the internal auditor, who is subjected to specific sections of the Internal Audit Law. Furthermore, the Companies Law and the Accountants Law assure the independence of external auditors, including qualification requirements. However, the audit profession is self-regulating.

21. The judicial system, including that for bankruptcy and the enforcement of property rights, is well-developed. The Israeli legal tradition is based mostly on English common law, which is reflected both in the nature of its corporate legislation and the role of the judiciary. The legal background and regulatory and institutional framework dealing with weak banks are stipulated in the Banking Ordinance, 1941, although there is no legal provision dedicated to bank bankruptcy.

22. The payment and settlement system is reliable and efficient. The BOI regulates Israel’s payment systems. It operates the Zahav system (a real time gross settlement system), which is considered to be secure and fast. The Zahav system is linked to banks’ paper-based clearing house (BCH), the automated clearing house (Masav), and the Tel Aviv Stock Exchange (TASE) clearing house.

Effective market discipline

23. Competition is encouraged and the market is open to foreign participation. There are no significant non-prudential barriers to entry by domestic or foreign firms.

24. A freeze in capital markets in late 2008 revealed weaknesses in disclosure and transparency in non-bank financial institutions. Efforts to improve the quality and timeliness of disclosure are underway, for example, through the amendments to the Companies Law in August 2011 that strengthens corporate governance requirements, aimed at enhancing bondholder protection. Also, the implementation of the “Hodek committee” recommendations (such as the imposition of minimum covenants for new bond issues), and of similar provisions that the ISA imposed on mutual fund managers, should have improved the resilience of new corporate bond issues.

25. The corporate governance of financial institutions in Israel is governed by the Companies Law and the Securities Law. In addition, sectoral legislation has been introduced to regulate the operation of each financial sector, such as banks (the Banking Licensing Law, the Banking Ordinance, 1941, the Banking (Service to Costumer) Law and the BOI Law), mutual funds (Joint Investment Trust Law), provident funds (Provident Funds), and pension funds (Pension Counseling and Pension Market Law).

26. The basic principles of financial reporting are laid out in the Securities Law. The law addresses the contest of a prospectus, the prohibition against the use of insider information, and the penalties applicable for the breach of the law. The law also sets out the contents of annual reporting requirements for non-bank listed companies. To facilitate the disclosure in line with those required by the Securities Law, the ISA provides an online filing system which is accessible to the public. The Banking Ordinance, 1941 and BSD directives set out the contents of annual and quarterly financial reporting by banks.

Public safety nets

27. Israel does not have formal deposit insurance. However, in the past, the government and the BOI provided an extensive degree of de facto protection to depositors. For example, in response to the public’s increasing concern about deposits during the latest global crisis, the MOF stated that the BOI and the government would protect depositors. For the non-systemic bank failure cases in 1985 and 2001, the BOI compensated depositors almost in full. In the severe financial crisis of the early 1980s, the government nationalized the entire system, and depositors did not suffer any losses.

Legal framework for supervision

28. The Israeli legal framework for banking supervision comprises legislation and regulation at various levels. The primary legislation that underpins the power of BOI Governor and Supervisor to supervise and regulate banks is the BOI law, the Banking Ordinance, 1941, the Banking Licensing Law, and the Banking Service to Customer Law. To implement prudential requirements, BOI Supervisor has the power to issue Proper Conduct of Banking Business Directives, instructions, and letters.

Main findings

29. Table 1 provides an overview of the assessment on a principle by principle basis.

Table 1.

Israel: Summary Compliance with the Basel Core Principles

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30. Objectives, independence, powers, transparency, and cooperation (CP1): There is a comprehensive set of laws and directives governing the supervision of the banking industry, although some of the legislation is old. The BOI has a great deal of de jure and de facto independence, and accountability mechanisms are in place. The influence of the MOF in the salary scale of BOI employees compromises its independence and raises questions about the long term capacity of the banking supervision staff.

31. Licensing and structure (CPs 2–5): The legal framework is clear relative to the types of banking and non-banking activities in which banking corporations may engage. While there have been few license applications in recent years, the legal framework, policies and processes are in place to evaluate the application for a bank license. The transfer of ownership is well defined in the law, and there are explicit definitions for controlling interests, although these are contained in a policy rather than in law. The conditions for the acquisition of a non-bank financial institution in Israel could be set out more formally.

32. Prudential regulation and requirements (CPs 6–18): The regulatory framework is fairly comprehensive, but dense and complex. The capital adequacy framework is based on international standards for standardized approaches to credit, market and operational risk in Pillar I. Pillar II is a significant component of the capital adequacy requirements, though the process is somewhat informal. Credit and most other risks are subject to close and intensive scrutiny. BOI exerts close oversight of concentrations (single name, sectorial, geographic, collateral, and product). Areas for improvement include the regulation and supervision of interest-rate risk in the banking book, market risk, and liquidity risk.

33. Methods of ongoing banking supervision (CPs 19–21): BOI has implemented a risk-based approach to supervision, which is evolving as the supervisors gain experience with it. There is a mix of on-site and off-site supervision, with an extensive level of communication and cooperation between the two groups. There is an extensive array of reporting requirements for banks that provides a wide range of data and risk management information, both on a consolidated and unconsolidated basis. Appropriately, the information is used in the supervision process to evaluate risk and for other objectives.

34. Accounting and disclosure (CP 22): Disclosure requirements are very strict, and external auditors are employed to ensure that disclosure rules are adhered to. The authorities are planning to transition the banking system solely to IFRS standards by 2013 or later.

35. Corrective and remedial powers of supervisors (CP 23): At present there is a restrictive list of available remedies in the law, such as eliminating dividends, but the supervisor should be able to apply remedial measures that reflect the level and severity of the deficiencies. Expansion of powers and strategies concerning the resolution of a problem bank is under consideration, which would enable BOI to have the time and the power to develop more creative approaches to resolving a bank than exists in the law at present.

36. Consolidated and cross-border banking supervision (CPs 24–25): The BOI has developed an overall satisfactory program of consolidated supervision, but there is a gap in the supervision of certain securities-related activities engaged in by banking corporations. The BOI engages in host-home country relationships commensurate with the size and complexity of the operations of Israeli banks operating abroad. Foreign bank operations in Israel are at a relatively low level, and home-host relations are more ad hoc in nature, reflecting the size and materiality of these banking operations.

Recommended action plan and authorities’ response

Recommended action plan

37. Table 2 summarizes the recommendations formulated in the course of the assessment. Note that some recommendations are included under core principles that are rated as fully compliant.

Table 2.

Israel: Recommended Action Plan to Improve Compliance with the Basel Core Principles

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Authorities’ response to the assessment

38. The Israeli authorities want to express their appreciation to the IMF and the assessment team for their comprehensive work. The FSAP has been a useful exercise. The worldwide experience of the IMF and the use of a common methodology have delivered a useful insight into the current state of banking regulation and supervision of the banking sector in Israel.

39. The authorities welcome the overall assessment that indicates a high level of observance of the BCP in Israel. Notwithstanding this good result, the developments in the global financial sector, in general, and in the Israeli financial and banking sectors, in particular, continue to call for supervisory actions. The recommendations of the IMF are therefore well received and will be considered carefully by the authorities in their continuous efforts for strengthening supervision.

40. Generally, the authorities share the views expressed in the assessments of the BCP. With regard to market risk (CP 13) and interest-rate risk in the banking book (CP 16), the authorities acknowledge the gaps between Israeli regulatory practices in these risk areas and the Basel methodology and accept the recommendations. However, the authorities believe that their practices are effective and commensurate with the low volumes and the characteristic of the activity in the trading books of Israeli banks. It should be emphasized that the BSD covers interest-rate risk, though the coverage does not necessarily differentiate between the banking book and the trading book. The authorities will devote more supervisory attention to market risk and to interest-rate risk through the on-site process, and will issue a regulation specifically concerning interest-rate risk in the banking book.

41. Furthermore there are a number of recommendations and comments where the authorities would like to respond as follows:

  • CP 1, regarding principle-based approach or rule-based approach; the authorities seek to reach a right balance between these approaches. Experience shows that the principle-based approach is not right in some areas as it leaves too much discretion to the banks. The authorities adopt the principle-based approach in all areas that are suitable to this approach.

  • CP 5, regarding investment limitation in non-financial companies; the authorities will consider the recommendation to set a lower regulatory limit on the investment in one such company.

  • CP 6, regarding capital adequacy; while authorities agree with the recommendations, they would like to respond that the Supervisor of Banks announced that he will adopt Basel III; even before the formal adoption, BSD required that hybrid instrument should already comply with Basel III. The work on Basel 2.5 is in process. Until now, BSD has preferred not to issue a formal request to a bank to strengthen its capital base following supervisory review of bank’s internal assessment. However, following this supervisory review, BSD conducted a dialogue with some banks which resulted in strengthening the capital adequacy of those banks. The authorities feel comfortable from the capital adequacy perspective with the implementation of the standardized approach in pillar I calculation complemented by a rigorous implementation of risk sensitive forward-looking pillar II calculation. In addition, BSD encourages banks to continue their progress in implementing Basel II standards for internal rating systems.

  • CPs 10, 11, 23, and 24, regarding intra-group transaction and related parties; the Supervisor is empowered to regulate such transactions. Furthermore, the current regulation and supervision covers these issues adequately, considering other limitations on banking groups’ structure and ownership. Nevertheless, the authorities will consider strengthening the regulation in this area including relevant ring-fencing arrangements.

  • CP 14, regarding liquidity risk; updating regulation will soon be issued and will refer to the issues raised in the assessment, although most of these issues are already covered by BSD’s supervisory practices. In particular, BSD currently examines through the on-site process the quality of the data used by banks for their internal models, and checks their logic through off-site process. Moreover, BSD will devote more resources to the validation of reported data in the liquidity as well as in other areas.

  • CP 15, regarding operational risk; shortly after the mission a new regulation concerning operational risk management was issued, implementing the recommendation to streamline the regulatory framework. However, even after issuing the new regulation, other regulations continue to include elements of operational risk due to the nature of these risks, and so will Basel’s paper on this issue, as it refers to Basel’s other documents. BSD covers various operational risk aspects through off-site and on-site processes. Moreover, staff from the designated operational risk on-site unit will strengthen its participation in other on-site units’ examinations in order to cover operational risk aspects of these examinations.

  • CP 23, regarding corrective and remedial powers of the Supervisor; the authorities share the assessors’ recommendations and comments. The Supervisor operates under very old legislation that clearly needs to be updated to the best practice standards. BSD is in the process of preparing proposals to amend a legal framework for bank resolution, giving the BOI flexible resolution tools in dealing with banks that have reached a level of significant deterioration but are still solvent.

  • CP 24, regarding consolidated supervision; the authorities accept the comments related to securities activities (those performed by asset management and underwriting subsidiaries). BSD will map the existing gaps and will act to close them in cooperation with the Israeli Security Authority.

II. Detailed Assessment

Table 3.

Israel: Detailed Assessment of Compliance with the Basel Core Principles

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