Financial Stability Report 2004

All Press Releases In Subject:
The Financial Markets and Financial Stability
Financial Stability Report 2004
Chapter 1
For Chapter 1 of the Report - click here.
In 2004 the stability of Israel's financial system grew, continuing the positive trend that had begun in 2003. This was due to the continued improvement in the environment in which the system operates, alongside an increase in its resilience, due inter alia to the reforms implemented in the financial infrastructure in the past. Nonetheless, future stability is not guaranteed: the reforms have led to significant changes in the system, and in a period of transition such changes augment risks, especially the credit risk of institutional investors, requiring changes in the regulation and deployment of the supervisory authorities. The global imbalance arising from the large deficits in the US budget and balance of payments may also constitute a source of international instability which will affect Israel.
The increase in stability in 2004
There was a positive turnaround in the economic fundamentals in 2003, and this trend persisted in 2004: the recovery in real global activity became entrenched, macroeconomic policy continued to improve, as was reflected in the reduction of the budget deficit and interest rates in Israel, alongside price stability, and Israel's security situation also continued to improve. All these factors served to establish the recovery in Israel's economic situation, too.
The improvement in these fundamentals served to boost the stability of Israel's financial system in two main channels: in the first, the continued recovery of real global activity was reflected in the augmentation of capital flows to emerging markets and continued reduction of their risk premium, against the backdrop of the decline in long-term yields in the developed countries. These positive global developments, together with the economic improvement in Israel as regards both its macroeconomic policy and its security situation, helped to reduce its risk premium and improve its internal and external government debt indices-changes which mean an increase in Israel's financial strength-as well as to moderate the volatility of assets traded in Israel's financial markets, alongside a modest rise in their value; in other words, the markets were calm.
The second channel, the continuation of Israel's economic growth, was reflected in the greater financial robustness of the private sector: all the indices of the financial strength of the business sector (according to data from companies traded on the stock market only), headed by the debt burden and the return on capital, improved further in 2004. The improvement is particularly evident in the manufacturing sector, less so in the commerce and services sector, and not at all in the real-estate sector. There was a slight improvement in the financial strength of households, as is indicated by the decline in the credit burden and cessation of the decline in the saving rate.
The results of the improvement in these two channels, i.e., the rise in the value of financial assets in Israel and the rise in the financial strength of the country as well as in the robustness of the private sector, served to augment the profitability of the banks and insurance companies, and to improve the quality of their credit to some extent, and therefore to make them more resilient (Figure 1.1). In the banking system the improvement in capital adequacy persisted and credit risks contracted somewhat. In the insurance companies, too, capital adequacy improved, alongside a slight dip in the systemic risks implicit in their activity. The resilience of the financial markets also continued to grow: the perfection and liquidity of the foreign-currency, bond, and share markets rose, and developments in the prices of financial assets also appear to have been consistent with the increase in their economic value, reflecting developments in the environment.
Various reforms and changes in the infrastructure, implemented in previous years, contributed to the increased resilience of the financial system in 2004, and their cumulative effect began to be felt in the form of palpable shifts in financial activity in Israel. Continuing the trend of the last few years, there was a steep increase in 2004 in nonbank credit-both tradable and nontradable-to the business sector, at the expense of bank credit to that sector, which declined. The contraction of bank credit, reflected in the continued downward trend in banks' share of credit to the private sector, is connected with the declining trend in the share of other financial aggregates, headed by the total financial assets of the private sector ('the public'). The downward trend in the share of the government in the asset portfolios of institutional investors, in the context of the fall in earmarked bond issues and increase in flexibility of the rules governing investment in them, also persisted. Despite the ongoing decline in the share of the banks and the government in financial activity, it is still too high.
Two main developments in 2004 supplemented the reforms and changes made to date: the sale of the new pension funds to the insurance companies and the approval of the reform of the capital market (the Bachar Committee), which was intended to reduce concentration in the capital market, particularly by detaching the provident and mutual funds from the banks. These developments have given rise to a revolutionary change in the financial system, accelerating trends in it: a competitive and perfect market of credit to the private sector is emerging, and a long-term savings industry (insurance, pensions, provident funds) that is private and separate from the banking system has been created.
Future risks
In the wake of the reforms, the revolutionary changes in the financial system have long-term effects on various aspects of financial stability, and these work in opposite directions even though the reforms are extremely beneficial. Notwithstanding, during the transition period the impact of these changes is clearer: they increase the risks facing the stability of the financial system. Experience in Israel and elsewhere has shown that in order to prevent disruption of the financial system in the period following liberalization and reform of the system, the authorities must undergo changes in accordance with the changes in the behavior of the financial institutions and the general public. Coping successfully with the challenge presented by the transition period requires the authorities to take preemptive action in the areas of regulation and supervision, and the imposition of adherence to the appropriate and cautious management of credit risk by the long-term savings institutions is essential.
Additional threats to financial stability may be learned from its rise in the last two years; since this was contingent to a considerable extent on an improvement in both the global and the domestic environment, changes for the worse in the environment, and especially a steep rise in the risk premium of emerging economies and sharp shifts in world exchange and interest rates, could have an adverse effect on financial stability in Israel.
Chapter 2
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The Operating Environment of the Financial System
The developments in the environment in which the financial system operates are a significant factor in its stability. This includes real developments both globally and domestically; developments in the international financial markets and changes in macroeconomic policy. All these have an impact on the activities, returns and risk of the financial institutions and the traded financial assets in Israel. The frequency and magnitude of shocks in the global and domestic environments influence the financial system's degree of stability.
This chapter briefly describes the main developments during 2004 in the global environment--in real activity and in international financial markets--and in the local environment, in real activity and macroeconomic policy. This year we have somewhat expanded the discussion of the stability of the international financial system as a result of the unique developments that have taken place within it. The chapter also analyzes the changes that have occurred in the financial robustness of the private sector (the business sector and households) and the financial strength of Israel's economy. It is through these two channels that the global and domestic environments influence the financial system. Thus, the repayment ability of the private sector directly influences the credit risk and stability of the financial institutions while the rate of saving among households has a direct influence on the financial system. Households also have an indirect influence on financial stability through their impact on the activity of the business sector and its direct raising of capital. The financial strength of the economy, as measured by the indices of external and government debt and its credit rating and credit risk, will serve as the starting point for examining the stability of the financial system.
Chapter 3
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The Resilience of the Financial System
This chapter presents the principal developments in the resilience of the financial system in 2004 with respect to two areas: the first and main one concerns the resilience of the financial institutions and markets, namely, the ability of financial institutions to absorb losses and of financial markets to continue functioning appropriately when either the environment or the financial system are subject to shocks. The second area concerns the structural characteristics of financial activity in Israel, which have implications for the resilience of the financial system, and is based on a combined analysis of the balance sheets of the principal economic sectors.
The next three sections deal with the resilience of the financial institutions and markets:
Section 2 concerns the resilience of the banking system, and deals in particular with its two principal elements: capital adequacy, which measures the banking system's ability to absorb losses if risks are realized, and its exposure to credit risk, which constitutes the main threat to banking activity. The analysis of capital adequacy is based on capital ratios and the potential for accumulating capital in the future. The analysis of credit risk exposure deals with three main aspects: total exposure to credit risk, the composition of this exposure, and problem loans.
Section 3 deals with the resilience of institutional investors, and in practice only of insurance companies and provident funds. The section deals specifically with the capital adequacy of the insurance companies and the systemic risks endemic in their activity and in that of the provident funds (see note 1). Systemic risks derive from the possibility that several financial institutions may be adversely affected within a single financial sphere or simultaneously in different components of the financial system. This may be inter alia the result of an uncontrollable chain reaction between institutions and other components of the system, a phenomenon known as contagion. The closer the ties and connections between the institutions and components of the system, the greater the danger that this might occur. The section analyses different kinds of systemic risk in the insurance companies and provident funds, including liquidity risk, their dependence on markets, and the risk that contagion will spread from them to the markets and the banks. All this is undertaken on the basis of indicators developed in the Financial Stability Area in the Bank of Israel (with the aid of the list of indicators issued by the IMF as helpful for analyzing the financial stability of insurance companies) and the data available to us, despite their limitations.
Section 4 is concerned with the resilience of the financial markets, especially with the efficiency and liquidity of the foreign-currency market, the bond and share markets, and the possibilities of a substantive change in the value of the financial assets traded in them, without any shift in the economic fundamentals (beyond the natural price fluctuations which accompany trading in the financial markets). These two conditions together determine the ability of the markets to continue functioning adequately: the more efficient and liquid a financial market, the more significant the amount of the financial asset traded in it that may be made liquid, and vice versa, rapidly and without notably affecting its price. A liquid market is also a necessary condition for the tradability of an asset at any time at its economic value, reflecting all the information existing about it, and hence also a condition for ensuring that the value of the asset will not change substantially without a shift in the fundamentals. There are many other factors which affect the extent to which a financial asset's price is appropriate to its economic value, but it is difficult to measure them. Hence, in addition to examining various indices of market liquidity, the section endeavors to grapple with the question of the existence of bubbles in the value of assets, i.e., over-estimation of an asset's value or under-estimation of risks, by means of several indicators. The discussion of this topic is presented after an account of the changes that occurred in 2004 in the value of financial assets, namely, in the risks, volatility, prices, and yields of shares, bonds, and the exchange rate-changes which attest to the tranquility of the market (actual stability).
The final section, Section 5, deals with the characteristics of financial activity in Israel, and in particular analyzes the main trends in the development of financial activity from the viewpoint of financial stability, such as changes in financial aggregates, including the total assets of the financial sector, total assets of the private sector ("the public"), and total credit, and the share of the banks, nonbanks, and the government in these aggregates. The analysis is based on a combined analysis of the data of Israel's partial balance sheets for 1999-2004, which were processed for the Financial Stability Area. The partial financial statement includes the statement of assets and liabilities of the main components of the financial sector (the banking system, the various institutional investors), the partial balance sheet of the private sector, and sectoral breakdown of total credit by borrowers, lenders, and credit (see appendix). The financial balance sheet is part of the national balance sheet, which constitutes the necessary infrastructure of data for analyzing financial stability according to the 'balance-sheet approach' (see Box 3.2).
Chapter 4
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The Institutional and Market Infrastructure
A major component of financial stability is the resilience of the financial system, that is to say, the ability of the financial markets and institutions to continue functioning in a proper manner in the wake of threats to and shocks in the operating environment of the financial system or from those arising within the system. One of the crucial factors affecting the resilience of the financial system is the quality of the institutional and market infrastructure.
The term institutional and market infrastructure refers to all the conditions and structural factors impinging on the activity of the financial system and affecting its functioning and efficiency. Included in this broad definition of the term institutional and market infrastructure are the following: the structure of the financial institutions, including the reciprocal relations between them, relations whose intensity affects the intensity of system risks, i.e., the possibility that a number of financial institutions, of one or more types, will be simultaneously affected because of a joint external shock, or because of the spillover of problems from one institution to others ("contagion"); the arrangements connected to the payment and settlement system, which could expose its users to systemic risks that are liable to spill over into countries and between countries; the regulation of financial activity (legislation, rules, regulations and by-laws) and supervisory mechanisms dealing with the financial system; the structure of incentives for all the players in the system (including taxation and guarantees); the rules of proper disclosure and the accounting rules that influence the transparency of the activity and the financial risks.
This broad definition of the institutional and market infrastructure is highly compatible with the definition anchored in the 12 Key Standards for Sound Financial Systems adopted by the Financial Stability Forum as desirable principles and conditions for promoting financial stability (Box 4.2). The promotion of reforms and improvements in the institutional and market infrastructure is one of the major channels through which the authorities influence the resilience of the financial system.
This chapter analyzes the salient developments in the institutional and market infrastructure this year, developments that are likely to have significant implications for the resilience of the financial system. Section 2 focuses on the structure of the system of financial institutions, and Section 3 on reforms and changes in the regulation of the financial system as a whole as well as its components: the financial institutions, the financial markets, and the payments and settlement system. Section 4 deals with the implications of the major reforms on financial stability. As in other parts of the report, the emphasis in this chapter is on changes in the infrastructure, and not on an assessment of its level and on the array of factors determining this level.