Israel's Banking System - Annual Survey, 2000

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The Banking System
Israel's Banking System - Annual Survey 2000
Letter from the Supervisor of Banks

The activity of Israel’s banking system and its financial results rose in 2000, continuing the upward trend evident in the previous few years. The persistent rapid (12 percent) expansion of credit and the deepening of financial activity in the local-currency unindexed segment, on both the deposits and the credit side, were the most notable aspects of the increase in banking activity. Return on equity in the five major banking groups rose from an average of 11.2 percent in 1996-99 to 11.7 percent in 2000, due mainly to the increase in demand for credit (with no significant change in margins), a rise in income from capital-market activity, and extraordinary profit from the sales of companies.

As banks’ activity and profitability increased, so did the risks to which banks were exposed, particularly credit risk, with the rapid expansion of credit and the direction of a significant part of it into relatively risky channels. For example, credit was advanced for the purchase of the means of control-sometimes without recourse to the borrower-and to industries which encountered difficulties owing to the slowdown in the advanced economies and in economic activity in Israel, such as high-tech, tourism, and construction. Other indications regarding the deterioration in the quality of credit in most banking groups included a further rise in the credit/GDP ratio, which shows a decline in borrowers’ repayment ability, a rise in banks’ loan-loss provision, a greater concentration in credit, and an increase in the ratio of bank finance to companies’ equity.

The slowdown in economic activity and the fall in capital markets in Israel and abroad since the last quarter of 2000 reduced banks’ profitability, as can be seen from data relating to the first quarter of 2001; this increased banks’ credit risk, particularly in the industries mentioned above which were experiencing difficulties.

Loan-loss provision increased in 2000, after falling for four years in succession. Nevertheless, the rate of provision remained at the same level as in 1999, only 0.5 percent, significantly below the accepted level in the banking systems of advanced economies. In the light of the rapid expansion of bank credit in the last few years and the rise in the risks it entails, outlined above, and against the background of the persistent slack in economic activity and the slowdown in industrialized countries, headed by that of the US, the loan-loss provision may have to be raised in the next few years.

As banks’ credit risk rose, capital adequacy in most of them declined. The risk-based capital ratio went down, following the trend of the last few years, and at the end of 2000 it stood at average of 9.2 percent for the whole banking system, slightly higher than the required 9 percent minimum capital ratio. Moreover, the share of Tier 2 capital, the less stable element of capital, rose in 2000, and in some banks the share of this capital in the total came close to the maximum limit permitted by the regulations. It should be noted that capital adequacy in Israel’s banking system is lower than that in the banking systems of the industrialized countries, despite the fact that the minimum capital ratio in most of them is only 8 percent.

The above developments impose a greater responsibility on banks’ management than in the past for a prudent approach to dealing with assets and liabilities and the whole range of risks that they must face, particularly in the light of the difficulties in raising Tier 1 capital in current market conditions. Specifically, they must be more stringent in controlling the rise in risk assets, in employing proper standards for checking customers’ soundness, and in applying differential risk premiums adjusted to customers’ risk levels.

As in the past, commercial banks’ investments in mortgage banks yielded the highest returns. Certain developments, however, raise some doubt as to whether this trend will continue for long, among them increased competition, the shortage of indexed long-term sources, and the expected decline in the next few years in mortgage banks’ central sources of profit-income from insurance and from intermediation on behalf of the government. The persistent slowdown in economic activity, which is expected to increase the arrears in mortgage repayments over and above its rise in 2000, is likely to act in the same direction.

One partial solution to the problem of sources for the mortgage banks derives from the increase in local-currency unindexed short-term sources, which finance long-term local-currency unindexed credit. Although the margin in this segment is higher than that in the indexed segment, the differential between the average duration of these sources and that of their uses requires more cautious management of financial risks.

Net profit of the overseas offices (in dollar terms) fell sharply in 2000, continuing its decline in 1999. The return on investment in overseas offices over the years has been below that in other subsidiaries, and also lower than the normal return on investment in domestic banking institutions of a similar size. The overseas offices may however be contributing to the activity and profitability of the banks in Israel by providing Israeli customers abroad special services which encourage them to maintain their activity with the parent banks in Israel.

Despite the efforts invested in the search for profitable and less risky channels of activity and in streamlining, the banks have not yet reached the optimal structure or deployment of their overseas offices. Bank Leumi’s losses in its Swiss offices in 2000, following considerable losses in many overseas offices in the past, once again drive home the difficulty in maintaining constant control and strict supervision of overseas offices. The performance of these offices over several years highlights the need to formulate and implement a clear and prudent strategy for the way they are run, to be derived from the business aims of the banking corporations, and it should include the closure of offices incurring losses over a long period; this should take place side by side with tightening of the control and supervision over them.

The expansion of services offered by banks via the internet continued in 2000, particularly in the area of securities trading; this activity was boosted by the boom in this trading in the first nine months of 2000. The Banking Supervision Department extended the permit for internet trading to include the issue of instructions for transfers to third parties; some banks have already put this into practice.

Over the last few years foreign banks have shown growing interest in opening representative offices or branches in Israel, against the background of the liberalization and globalization processes the economy was undergoing, reduced inflation, and greater fiscal discipline. Two foreign banks-Citibank and HSBC-officially opened branches in Israel in 2000. At the beginning of 2001 Otzar Hashilton Hamkomi was sold to a controlling group headed by the French bank Dexia. The continuation and extension of this process will help improve banking services in Israel, increase competition, and make the international capital market more readily accessible to companies and individuals in Israel.

Jerusalem                                                                          Dr. Yitzhak Tal
December 2001                                                                       Supervisor of Banks

Chapter 1 - Israel's Banking System: A Long-Term View
The full Chapter, in PDF format - 209KB

The total profit of the five major banking groups (including minority interests) rose from NIS 3,580 million in 1999 to NIS 3,836 million in 2000. This increase reflects a growth in the average return on equity, from 11.2 percent in 1999 to 11.7 percent in 2000, even exceeding the average of the last four years (11.2 percent).

In the last decade there have been changes in the environment in which Israel’s banking system operates: years of economic growth have been followed by years of economic slowdown; periods of boom in the money and capital markets have been interspersed by periods of slump; at times the process of economic liberalization proceeded apace, leading to intensified competition but also to hrisks to the banking system; at times there were sharp shifts in the various exchange and interest rates, as well as a persistent decline in actual and expected inflation. The process of globalization has augmented international capital flows, making the markets more efficient but also increasing the banking system’s exposure to risks deriving from international crises.

The two main reasons for the rise in the return on equity in 2000 are the expansion of banking activity, as expressed in the continued increase in the demand for credit, and the growth in income from capital market activities.

Bank credit expanded by 12 percent in 2000, similar to its rate in the two previous years (13 percent). This year, too, the expansion of credit outstripped GDP growth, although in contrast with the last three years, in 2000 economic activity surged (mainly in the first three quarters).

Additional causes of the increased demand for credit in recent years have been the need to finance purchases of corporations in the framework of the privatization process, the accelerated growth of capital stock, structural economic changes expressed in the rapid expansion of the services and high-tech industries, and a rise in firms’ financing needs due to the economic slowdown.

Note, however, that alongside the increased return on equity in recent years, in our opinion, there has been an increase in the various risks to which the banks are exposed, primarily credit risk. This assessment is based on the persistently steep rise in the total credit/GDP ratio that has characterized most industries (and real-estate in particular), the growth in the problem loans/capital ratio (adjusting for agriculture), the increase in the risk-based capital ratio, and the greater concentration of credit by borrowers.

Since 1991 the banking groups’ capital adequacy has been declining, alongside an increase in the share of Tier 2 capital. These developments, together with the rise in risks, diminishes banks’ ability to contend with the realization of risks in the future.


Chapter 2 - Financial Activity of the Commercial Banks
The full Chapter, in PDF format - 125KB

The commercial banks’ activity continued expanding in 2000, at a rapid rate of 6 percent. This occurred against the background of accelerated economic activity in the first nine months of the year, albeit at a more moderate rate of increase than in 1998 and 1999. The most notable features evident during the year were the persistent rapid growth of credit (12 percent), expanded activity in the unindexed local-currency segment and contraction of activity in the indexed segment, mainly in the form of withdrawals of almost NIS 10 billion from indexed savings schemes, as the low-inflation environment became more firmly established.

Since 1992 commercial banks’ credit has been expanding rapidly, reaching an average increase of 12 percent a year. Credit growth was reflected by a constant rise in the credit/GDP ratio and by an increase of the ratio of bank finance to companies’ equity in the last few years.

The main reasons for the increase in total credit since 1997 include: the significant expansion of credit granted for the purpose of takeovers of corporations; a marked rise in the stock of gross capital in the economy resulting from the need to reestablish the capital/GDP ratio following its decline in the first half of the 1990s in the wake of the influx of immigrants; accelerated growth of high-tech industries, mainly in manufacturing and communications; and a greater need for financing companies’ working capital related to the slowdown in economic activity, mainly in construction, commerce, and the traditional industries.

Lower rates of interest on the monetary loans during the year were reflected by reductions in short-term market rates of real interest on both credit and deposits, but they remained high relative to past rates and were similar to those in 1998 and 1999. In the unindexed local-currency segment the interest-rate spread continued along its downward path. Long-term interest rates continued to rise, as indexed assets became less attractive with the establishment of a low inflation environment. This development, combined with the reduction in demand for unindexed credit, was expressed inter alia in a contraction of the interest-rate spread in the segment. Despite the rise in the Libor dollar interest rate, the interest-rate spread in the foreign-currency segment remained stable in dollar terms. Real interest in this segment in NIS terms did not change significantly during the year either, in spite of the uncertainty regarding the security situation and the reduction in the inflow of capital from foreign investors which resulted from it and from the worldwide financial crises. The relative stability of the real rates of interest in the segment reflect the stabilizing activity of the business sector in the foreign-currency market, which prevented more severe fluctuations in the exchange rate.

From the long-term aspect a trend of convergence of interest rates on both deposits and credit in the different segments is evident, against the background of extensive liberalization and more intense competition in the money markets.


Chapter 3 - Financial Results
The full Chapter, in PDF format - 464KB

Total profit of the five major banking groups, including net income from extraordinary activities and minority interests, rose by about 7 percent in 2000, to NIS 3.8 billion, reflecting a total return on equity of 11.7 percent, up from 11.3 percent in 1999. The rise was mainly due to increased financial activity, particularly in the unindexed local-currency segment (while the total net interest margin remained stable), which led to a rise in banks’ net interest income. Lively trade in securities in Israel and abroad, which increased banks’ income from customers’ capital-market activities by a significant 40 percent, and a rise in banks extraordinary income arising from the sale of several companies also played a role in improving banks’ profitability.

The improvement in banks’ profits was partly offset by a rise in salaries and related expenses—particularly those associated with early retirement, part of the streamlining process which some banks are implementing—and by an increase in loan-loss provisions, indicating some deterioration in the quality of credit.

The economic slowdown and the security situation started affecting banks’ financial results in the last quarter of 2000, and to a greater extent in the first half of 2001. It would thus appear that the long-term trend of an improvement in banks’ profitability will not continue in 2001, and their profit may even decline.


Chapter 4 - The Main Companies in which the Five Major Banks Have a Holding
The full Chapter, in PDF format - 153KB

The five major banking groups have many subsidiaries; the extent of their investment in them is massive and the subsidiaries’ contribution to the banks’ income is substantial. The main areas of activity of the subsidiaries are mortgages, activities abroad, and holdings in nonfinancial companies. Investment in subsidiaries yielded an income of some NIS 1.7 billion in 2000, constituting a return of 8.0 percent, the same as the rate in 1999. This income, which was slightly higher than in 1999, derived primarily from the continued rise in profitability of the mortgage banks, as well as from the increased local-currency contribution of the subsidiaries abroad, even though in dollar terms the profitability of the latter plummeted. By contrast, the contribution of the nonfinancial and insurance companies to the groups’ profitability declined.

As in previous years, the mortgage banks were very profitable in 2000, and their net income rose by 11 percent. Nevertheless, the business environment in which the mortgage banks function became more risky because of the economic slowdown, especially in construction.

In local-currency terms the income of the overseas offices rose in 2000, (after conversions and accounting adjustments), but investments in subsidiaries abroad were characterized by a relatively low return. In dollar terms, income declined by a substantial 19 percent, because of an event in the Bank Leumi-Switzerland. Deducting the losses due to incident, the dollar income of the overseas offices rose.

In contrast with the increased contribution to income of the mortgage banks and overseas offices, that of the nonfinancial companies declined in 2000. Most of this derived from Hapoalim Bank’s losses on Koor, the result of the losses incurred by ECI Telecom Ltd.


Chapter 5 - Risks and Capital Adequacy
The full Chapter, in PDF format - 252KB

In the last few years liberalization and globalization have made Israel’s economy more sensitive to shocks and changes in the international financial markets. In 2000 banks’ exposure to credit risk and market risk rose. Capital adequacy, the purpose of which is to enable banks to absorb losses which may arise following the realization of some of the risks, declined. The marked upward trend in the five major banking groups’ Tier 2 capital, which is characteristically less stable than Tier 1, persisted.

Exposure to credit risk rose in 2000 due to the continued marked increase in bank credit, which exceeded the rise in GDP. Credit to the construction and real estate industry rose considerably despite the slowdown in activity which has endured for four years. The increase in foreign-currency credit continued, but more slowly than in 1999. In most banking groups the ratio of loan loss provision to outstanding credit to the public went up, and concentration of the bank credit portfolio by borrower rose, as did the ratio of risk-weighted assets to total assets.

In the first quarter of 2001 economic activity remained at a low level, similar to that in the last quarter of 2000. Against the background of the significant slowdown in economic activity and the uncertainty as to the future caused by the security-related events and world wide economic trends, banks’ credit risk rose in the first half of 2001. Most of the slowdown seems to be in the high-tech industries, construction and real estate, and tourism and related industries, all of which showed signs that they were encountering difficulties in the last quarter of 2000.

Banks’ exposure to market risks also rose in 2000, mainly due to the increase in interest risk in most of the banking groups, although the risk level is still fairly low. Indexation-base risk (exposure to changes in the inflation and exchange rates) did not follow a uniform path in the large banking groups.


Chapter 6 - The Structure of the Banking System, and the Activities of
                    the Banking Supervision Department

The full Chapter, in PDF format - 100KB

Much of the work of the Banking Supervision Department consists of monitoring the banking corporations’ exposure to actual and potential risks in the banking system, and ensuring that proper bank-customer relations are maintained. In addition to these activities, the Banking Supervision Department also engaged in the following in 2000: examining the eligibility of groups of candidates for the purchase of controlling interests in banks, and active involvement in the legislative process concerning money laundering; this includes the promulgation of the Prohibition of Money Laundering Order whose main objective is to prevent the banking system from being used for this purpose.

During 2000 the services provided by banks via the internet, especially in connection with the surge in share prices in the first nine months of the year, continued to grow. The Supervisor of Banks expanded the permit for activities extended over the internet to include third-party transfers, and several banks have already begun to utilize this facility. The decline in the number of branches evident in 1999 persisted in 2000. This trend accompanies the ongoing process of technological change, and is expected to continue in the future.

Foreign representative offices and investment banks continued their activity, and this year two foreign commercial banks opened branches in Israel.

The credit card market has been characterized by structural changes since mid-1998, when First International Bank’s Alpha Card entered the credit card market, thus abolishing the duopoly formed by Isracard (fully owned by Bank Hapoalim) and Visa C.A.L. (owned jointly by Leumi and Discount banks). The structural changes gave rise to increased competition in issuance and clearing in 2000, reduced fees, and strategic alliances in the areas of consumer clubs and chains.