Israel
Detailed Assessment of Observance of Basel Committee on Payments and Settlement Systems Core Principles for Systemically Important Payment Systems

This paper presents detailed assessment of Israel’s compliance with Basel Committee on Payments and Settlement Systems Core Principles for Systemically Important Payment Systems. A significant improvement in the payments landscape has been noted, with the high value payment system meeting most international standards. Together with the creation of the Zahav system, as part of the reform in the payment and settlement systems, the Bank of Israel has also introduced a series of other changes and improvements into the existing payments systems, to bring them into line with accepted international standards.

Abstract

This paper presents detailed assessment of Israel’s compliance with Basel Committee on Payments and Settlement Systems Core Principles for Systemically Important Payment Systems. A significant improvement in the payments landscape has been noted, with the high value payment system meeting most international standards. Together with the creation of the Zahav system, as part of the reform in the payment and settlement systems, the Bank of Israel has also introduced a series of other changes and improvements into the existing payments systems, to bring them into line with accepted international standards.

I. Summary, Key Findings, and Recommendations

A. General

1. Following the previous Financial Sector Assessment Program (FSAP) report in 2001, a number of shortfalls from the Committee on Payments and Settlement Systems (CPSS) Core Principles for Systemically Important Payment Systems (CPSIPS) were identified and a number of recommendations made. This assessment considers the progress made toward implementing those recommendations and present compliance. The assessment was carried out of the single, central bank owned and operated high value payment system, Zahav (a Hebrew acronym for Real Time Credits and Transfers). However, the opportunity was taken to look at the payment and settlement systems, which make their final settlement in Zahav, from the point of view of a potential threat to the stability of Zahav (whether from participant liquidity, solvency, or operational problems).

2. A significant improvement in the payments landscape was noted, with the high value payment system now meeting most international standards. The underlying infrastructure, both contractual and operational, including contingency and risk management, is in place; and the system is stable and meets participants’ needs. There is, nevertheless, room for improvement of the overall legal framework. Now that the initial phase of the introduction of Zahav is over, steps should be taken to create a superstructure of strategic planning, control, governance, and risk management, which will ensure the system can meet most eventualities, as befits this systemically important Israeli payment system. Most of the findings are in that vein.

3. The Zahav system was implemented in 2007 and the Payment Systems Law, which provides protection for the real time finality offered by Zahav, shortly afterward. The Payment Systems Law provides the legal underpinnings for central bank payment system oversight, which has been recognized in the new legislation for the Bank of Israel (BOI), which came into effect in 2010. As a result the setting up of a separate payment systems oversight function in the BOI, which was previously carried out within the ambit of banking supervision and subsequently in the Comptroller’s Office, is still very much work in progress, and working to a project plan which will complete in 2013. As a result, the “Responsibilities of the Central Bank in Applying the Core Principles for SIPS” have not been formally assessed. Nevertheless, some observations are made and recommendations offered in this key area.

B. Information and Methodology Used for Assessment

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 Israeli Securities Settlement System, which is the Stock Exchange Clearing House (TASE-CH), has not been formally assessed as part of this FSAP; nor has it been subject to a self assessment. More specifically, the legal framework governing the issuance and holding of intermediated securities was not reviewed. Nevertheless, some ancillary investigations were carried out in order to better understand potential risks to Zahav stemming from it. This was true also for the Masav (direct debit and credit automatic clearing house (ACH) plus card company settlement) and the BOI owned and operated paper-based clearing house (BCH). The assessment was carried out by Christopher Mann, an external technical expert in payments and settlement systems.

5. Because the oversight function is in the process of being set up, it was agreed that a self-assessment of the principles guiding Central Bank Responsibilities in applying the Core Principles for Systemically Important Payment Systems (CPSIPS) would not be offered and a full assessment would be premature. Nevertheless, where issues arose elsewhere that were relevant to the creation of that function they have been noted. The Authorities are encouraged to move forward with the setting up of oversight with all possible haste and to consider seeking a full assessment once it is complete, or is nearing completion.

6. The approach taken to the assessment of Zahav against the CPSS Core Principles was to review, in this specific context, an extensive list of documents provided by the BOI, which included a thorough and transparent self-assessment. Cooperation with the assessment was complete and open. Discussions were also held with participants of Zahav, including the foreign currency settlement system (CLS), which settles in Zahav the shekel side of foreign exchange trades settled by CLS.

7. The main laws supporting the Israeli legal framework were reviewed, in conjunction with IMF legal resources and discussions with legal counsels where appropriate. The mission members also reviewed the rules of Zahav, its participation agreements, pledge and other agreements, business continuity plans and risk assessments. The central bank website provides good summaries of a number of payment system aspects in particular, it provides access to annual reports on “Payment Systems in Israel,” those for 2009 and 2010 in particular being reviewed. The “Red Book 2010—Israel’s Payment and Settlement Systems” was also reviewed. Presentations were received from market participants and other bodies, such as the Israeli Securities Authority. All documents asked for were provided. The approach taken in the time available was to review the documents, raise in discussion issues arising from the review, follow up with discussions on issues arising from the discussions and a “cross-check” against third parties’ views such as external users of the system.

C. Institutional and Macro-Prudential Setting, and Market Structure

8. 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. At the time of the mission, the health of the financial sector was generally satisfactory.

9. The BOI supervises banks and is responsible 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.

10. Zahav is the only real time gross settlement (RTGS) system in Israel. Four payment systems participate in the Zahav system: the Stock Exchange Clearing Houses (the Maof Clearinghouse and the Securities Clearinghouse), the Bank Settlement Center (Masav) (an ACH), the Paper Clearinghouse (BCH) and the CLS system. In addition to the BOI, the Postal Company, and CLS Banks, and the 15 commercial banks are direct participants, either as online or offline participants.1 In 2010, Zahav handled over a quarter of a million payments to an aggregate value of NIS 75 billion (compared to a GDP of over NIS 800 billion), which represents about 87 percent of total amount of activity in the system (Table 1). The BOI’s monetary and foreign exchange operations (and for its customers, largely public sector) have come to dominate the picture, accounting for 87 percent of total value owing to the very relative high value of their transactions. The activity in the Zahav system is characterized by a high degree of concentration, since the inter-bank activity of the two largest participants in the system is about 57 percent of the total value of payments. The inter-bank activity of the five largest participants in the system is about 78 percent of the total value of payments in Zahav (excluding BOI activities). The clearing houses’ volume of trade in the Zahav system in 2010 stood at about 7 percent of the total amount of settlement in the system. The multilateral net settlement of the automated credits and debits in Masav, the checks in the check clearing, and securities and derivatives settlement in TASE-CH accounted in 2010 for the same value of settlement as all interbank transactions. In conclusion, the safe and robust operation of Zahav is crucial to the overall stability of the system.

Table 1:

Israel: Volumes and Value of Payments in Israeli Payment Systems

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Source: BOI, TASE-CH, and staff estimates.Value of nominal GDP in 2010: NIS 814 billion.1. In 2010, TASE-CH accounted for NIS 579 billion in multilateral net settlement, NIS 137 billion of individual gross transactions settled directly and NIS 2.8 trillion of ICL transactions; MASAV accounted for NIS 566 billion and BCH NIS 229 billion.

11. The jump in the volume of interbank settlements in Zahav by 40 percent in 2010 compared with only small growth in the volumes of checks and credits can be attributed to several factors: the awareness campaign for Zahav approved by the Bank of Israel, as well as to the reduction in the maximum amount which can be paid in the Masav multilateral net settlement payment systems to NIS 1 million (there is no lower limit on payments in Zahav and no upper limit in the Paper Based Clearing House) and, finally, the significant reduction in fees charged by banks to their customers for the use of Zahav. Much of the 40 percent growth in volume in interbank Zahav payments was in the lower value range, leading to a significant fall in the average value of interbank payments, which now stands at NIS 21 million compared with NIS 32 million at the start of the system.

Legal and institutional framework

12. In 2010, a new law came into effect for the BOI (“the BOI Law”). Among other changes, it followed up the requirements on the central bank enshrined in the 2008 Payments Systems Law. The 2008 Payment Systems Law established the oversight function of the BOI and provided for the finality and irrevocability rules applicable to payment systems; the new BOI Law requires, more widely, the BOI to “regulate the payment and settlement systems in the economy, with the goal of ensuring their efficiency and stability, including in accordance with the Payment Systems Law.” The Payments System Law specifically excludes the multilateral net payment system embedded in the Stock Exchange Clearing House and includes an indirect amendment to the Securities Law in consequence of which the ISA has responsibility for the oversight of TASE-CH according to principles which reflect those in the Payment Systems Law. There is a MOU between the BOI and the ISA covering coordination between them.

13. Together with the creation of the Zahav system, as part of the reform in the payment and settlement systems, the BOI also introduced a series of other changes and improvements into the existing payments systems, in order to bring them into line with accepted international standards. The principal changes, according to the BOI’s Annual Report on Payment Systems, were:

  • Cancellation of retroactive recording of transactions in the banks’ accounts so that balances in the banks’ accounts are final.2

  • Extending the business day from 15:00 to 18:30, so that transactions can be performed in the Zahav system in the afternoons and evenings as well.

  • Creation of an interbank arrangement to handle the failure of one of the participants in the multilateral Masav clearing or check clearing house to ensure that Clearing House payments are settled by the Zahav System houses by the end of the day at the latest. 3

  • Implementing the improvements in the check clearance process, including mandatory electronic settlement for all banks, cancellation of retroactive check clearing, check imaging and transfer of files between banks, and initiation of a law for check truncation. In 2009 a memorandum of law “Electronic Check Clearing, 5768–2008” was published.

  • Implementing the improvements in the Masav [ACH] clearing process, including a change in the order of operations so that sending of the files to the banks (clearing) takes place only after settlement in the Zahav system, cancellation of retroactive settlement of returns and the creation of two settlement windows during the day (morning and evening).

  • The TASE Clearing Houses settles on a Model 3 DvP basis (multilateral net settlement of cash and multilateral net settlement of the associated securities if, and only, the cash leg settles). It has been taking steps to re-engineer the settlement process so that the time gap between these two related settlement events occur within no more than 15 minutes of each other. Equities will move to this timetable shortly.

  • In addition, work has commenced on deciding on the future of check clearing.

14. There is a National Payments Council, where are represented the various stakeholders in the payments industry.

D. Prerequisites for Effective Payment Settlement Systems

15. Israel has a solid institutional framework supporting the conduct of macro-economic policies. The Israeli legal framework for the financial sector is comprehensive and regularly updated. The auditing and accounting rules applicable to financial institutions generally comply with international standards. The judicial system is well-developed. The legal and institutional framework is in place for the resolution of bankruptcy cases, but needs development in respect of special resolutions frameworks for failing or failed banks. 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 and the Banking Ordinance), mutual funds (Joint Investment Trust Law), provident funds (Provident Funds), and pension funds (Pension Counseling and Pension Market Law).

II. Assessment of the Core Principles and Central Bank Responsibilities

16. In the following assessment a core principle (CP) is considered observed whenever all assessment criteria are generally met without any significant deficiencies. A CP is considered broadly observed whenever only minor shortcomings are observed, which do not raise major concerns and when corrective actions to achieve full observance with the CP are scheduled and realistically achievable within a prescribed period of time. A CP Is considered partly observed whenever the shortcomings are sufficient to raise doubts about the system’s ability to achieve observance within a reasonable time frame. A CP is considered non-observed whenever major shortcomings are found in observing the assessment criteria. A CP is considered not applicable whenever it does not apply given the structural, legal and institutional conditions.

17. Note that a full assessment of central bank responsibilities and transparency of payment system oversight was not part of the scope of this assessment. Only summary comments have been made about the first and none about the second. The development of the Oversight Function is in its early days in a project to be completed in 2013.

Table 2

Israel: Detailed Assessment of Observance of CPSS Core Principles for SIPS and Central Bank Responsibilities in Applying the CPs—Zahav

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Table 3.

Israel: Summary Observance of CPSS Core Principles and Central Bank Responsibilities in Applying the CPs—Zahav

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III. Recommendations and Authorities’ Response

A. Recommendations

18. Great strides have been taken in the past decade in implementing a robust high value settlement landscape. The challenge now is to bed down the system’s risk management, operational controls, and business continuity arrangements to a challenging standard as appropriate for the Israeli context. There is a need, too, to ensure that all systemically important systems in Israel benefit from the full protection of the law, and that the net settlement systems have suitable loss sharing agreements, backed up by the means of realizing the risk fund in emergency. Work needs to be done to ensure that any subsidy for Zahav is as small as possible, via a rigorous identification and control of costs and a passing on of costs where reasonable. The high values still permitted to settle in BCH should be reviewed with a view to their settlement in Zahav. Finally, work needs to be done to ensure that the system can be operationally liquid in stressed circumstances, including via tools such as start of day “pump priming” and “throughput” rules, and that the banks retain their skills in managing in a tight liquidity environment. All specific recommendations below are for the BOI unless indicated otherwise.

19. The authorities need to press ahead with their plans to establish and operate an effective oversight function in keeping with the international standard in this area. Progress has already been made, and the project is due to be completed in 2013, at which point a dedicated assessment would be valuable.

CP1—well founded legal basis

  • Widen the Payment System Law to cover insolvency action emanating from foreign laws;

  • Widen the Payment System Law to capture the full range of events which could have retroactive effects;

  • Clarify the wording of Article 15 of the Payment Systems Law;

  • Specify that the Israeli law shall govern the rights and obligations of all (domestic and foreign) participants, including upon issuance of liquidation order;

  • Organize the cross-border communication with other authorities to be informed of the liquidation order issued in respect of foreign participants;

  • Require a legal opinion prior to connecting any foreign participant;

  • Establish a general legal framework capturing all financial collateral arrangements entered into between financial institutions (including private international law rules);

  • Complete considerations concerning the type of declaration in respect of Masav and BCH as, until they are protected by the Law, they remain a potential source of risk for Zahav;

  • Increase finality benefits from the protection of the Payment Systems Law when payments are settled in the BOI’s General Ledger in a contingency situation, either by designation, or more simply, via the GL being declared a part of the Zahav Payment System in contingency situations, and consider costs and benefits of technical adjustments to the General Ledger to enable finality to be achieved; and

  • Make explicit the equivalent protection available to TASE-CH in respect of its multilateral net settlement by changing paragraph 2 (a) of the Payment Systems Law, which would have no impact on the supervisory arrangements (BOI, ISA);

CP3—Clearly defined procedures to manage credit and liquidity risks

  • Consider what can be done to encourage banks to actively manage their liquidity, including by the use of a secured interbank market, against the day that liquidity is less plentiful;

  • Model the minimum amount of liquidity needed to enable all payments in Zahav to settle in a day and consider imposing a ‘start up’ liquidity requirement on participants, again against the day of tighter liquidity conditions;

  • Consider “throughput” limits to ensure a steady flow of payments throughout the day;

  • Review the basis on which the BOI provides ELA to elements of the payment system, normally against outright purchase of pledged assets to ensure risk is borne in the right quarter, as part of a general review of it ELA policy (see the accompanying Financial System Stability Assessment).

  • Review the Masav/BCH Loss Sharing Agreements and encourage collateral to be set aside ex ante according to some measure of the risk members bring to the system, under a pledge protected by either or all of the Payments Systems, Securities or BOI Laws. Consider whether the BOI’s contribution to a default fund should be anything other than zero;

  • Review prudential requirements on banks’ liquidity, taking into account overall liquidity requirements and banks’ intraday use of liquid assets to meet payment system requirements;

CP7—high degree of security and operational stability

  • Give a high priority to agreeing definition of what the optimal contingency arrangements should look like across all stakeholders, a ladder of increasingly demanding tests capable of delivering that state, a timetable for the achievement of each rung on the ladder and the allocation of the resources needed for a successful outcome;

  • Ensure the Risk Register includes all risks, from within and without Zahav, and is proactively managed and fully integrated into the business continuity arrangements, with clear governance on ownership of and responsibility for agreed actions to reject, reduce, or mitigate risks;

  • Draw up a set of Internal Control Objectives with a view to their ultimate assessment to international standards for systems and controls;

CP8—a practical and efficient means of payment

  • Continue with the identification of all dedicated and shared costs of Zahav, to facilitate the review of the policy for the present not to recover any costs from users;

CP9—objective and publicly disclosed criteria for participation

  • Consider extracting the high level membership and eligibility requirements in a general statement which can be posted to the website and made publically available;

CP10—effective, accountable and transparent governance arrangements

  • Consider sharing the breakdown of costs with users, for example by staff, floor space, third party charges, IT charges and so on to improve transparency and enable an effective challenge process;

Recommendations A and B—define and disclose oversight objectives and policies and ensure systems central bank operates comply with core principles

  • Bring Oversight function up to full strength with all possible haste. Consider its location within the organization to enable it to be fully objective about Zahav and Check Clearing, both of which systems are owned and operated by the central bank itself. Accord this function the highest priority and track progress at a senior level;

Table 4.

Israel: Recommended Actions to Improve Observance of CPSS Core Principles and Central Bank Responsibilities in Applying the CPs—Zahav

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B. Authorities’ response

20. We would like to express our appreciation to the IMF and the assessment team for their comprehensive report, and we welcome the recommendations for the Zahav (RTGS) system. The Bank of Israel (BOI) has learned from the FSAP process, and we believe that it will contribute to the stability of Israel’s financial system infrastructure in general, and to the stability of the Zahav system in particular. We are in the process of establishing an oversight function that will oversee the payment and settlement systems in Israel, and expect the process to be completed in 2013. We are confident that the recommendations of the IMF will assist the oversight team in its work.

21. As part of the evaluation of the Zahav system, recommendations were also made regarding other systems, such as the Paper-based Clearing House, Masav, and the Tel Aviv Stock Exchange Clearing Houses. We will be undertaking a detailed review of these issues as well and will adopt any changes necessary.

22. The Bank of Israel’s response to the detailed recommendations follows:

  • CP1: The BOI will thoroughly study all the recommendations for amending the Payment Systems Law and other legal topics. After the necessity to accept the suggested recommendations is determined, the Bank will act toward their implementation. It should be emphasized that changes of this type require long periods of time for implementation. The General Ledger system serves as the last resort in the event of an application failure in the Zahav system. This is not a near real time automated system but rather a system that works in batches at the end of the day. Furthermore it does not include all the settlement mechanisms that exist in the Israeli RTGS system. Therefore it does not ensure final settlement at the end of the batch process.

  • CP3: We will examine and weigh the various issues raised in the recommendations and will implement any changes as needed. Please note that the Zahav system has a variety of tools that enable participants to manage liquidity, as well as tools that allow the Bank of Israel to regulate the transactions in the system during the day, such as variable pricing over the course of the day. We will ensure that the participants will be familiar with the liquidity management tools that exist in the Zahav system along with the practical ways in which they can be used.

  • As is recommended, we will consider the size and management of intraday credit limits offered by direct participants to their customers. We will study what has been done in other countries in this area and will work to ensure that the implementation of the recommendation does not increase liquidity risk in the system.

  • CP7: The Bank of Israel has already begun implementing the main recommendations in this Principle.

  • A review and evaluation of all the controls—including, among other things, their quality, effectiveness and integration in the Zahav system—is carried out periodically by Internal Audit, in accordance with up-to-date and generally accepted standards and methodologies.

  • CP8: The Bank of Israel prepared a pricing module that includes all the activities of the Bank, and specifically the RTGS operation activities. The pricing module will be used as a basis for a justified pricing tariff when we change our current pricing policy.

  • CP9: We accept the recommendation and will work to implement it.

  • CP10: We accept the recommendation in principle. If, for example, we decide to collect hardware replacement costs from the participants, then we will proceed to implementing it.

1

Compared with online participants, offline participants lack the SWIFT Fin Y-Copy infrastructure and so submit and receive their payments via an on-line member. In all other respects, including the settlement account, access to intraday liquidity and the ability to manage their payments they are as any other direct participant. The three offline members are Dexia Public Finance Israel, Bank Yahav for Government Employees Ltd, and Arab Israel Bank Ltd.

2

Before the advent of Zahav, the outcome of batch settlement in the BOI’s General Ledger was known only with a day’s delay, so that banks had to back value payments in their own books and any interbank loans needed to ensure settlement.

3

But not due to the default of that member: the rules of this arrangements specifically rule out its use in the event or even the likely event of a default, making it more of a liquidity mechanism to facilitate settlement in the event of problems other than of a solvency nature.

4

Checks which a bank decides not to pay and ACH payments which cannot be applied by the recipient bank need to be returned. This is normally a process which takes place after multilateral net settlement has taken place and settled in an RTGS system with finality. Monies are returned and settled in a subsequent multilateral net settlement, rather than the original multilateral net settlement being unwound or finality of it held up for the days it takes for monies to be returned. What the arrangements are for returns and recourse between banks and their customers are a private matter to them and not normally considered a part of the Payment System’s Rules. The arrangements according to which a credit stemming from a check is final between the bank and its customer are set in the legislation

5

A net send limit prevents a drain of liquidity to another participant; a net receive limit prevents a system drain to oneself, if for example one has sending problems but can continue to receive payments, and so cannot recycle liquidity into the system.

6

There are no annual fixed charges, only per item charges.

Israel: Detailed Assessment of Observance of Basel Committee on Payments and Settlement Systems Core Principles for Systemically Important Payment Systems
Author: International Monetary Fund