Israel's Banking System - Annual Survey, 2001

All Press Releases In Subject:
The Banking System
Israel's Banking System - Annual Survey 2001
Letter from the Supervisor of Banks

In 2001 there was a significant deterioration in the financial results of the banking corporations, and a rise in their risk exposure. The total profit of the five major banking groups fell from about NIS 3.9 billion in 2000 to some NIS 2.1 billion. As a result, the return on capital plummeted-from 11.7 percent in 2000 to 5.9 percent, compared with an average of 11.2 percent in 1997–2000. The backdrop to the fall in profitability this year was the recession in Israel, expressed by a decline of 0.6 percent in GDP and 1.9 percent in business-sector product, crises in the capital and money markets in Israel and the rest of the world, and the exacerbation of the security situation, which increased uncertainty. The decline in banks’ profits in 2001 was due largely to the marked increase in loan-loss provision, from NIS 2.3 billion to NIS 4.4 billion, as well as to the decline in the contribution to profit of companies in which banks have a holding as well as in non-interest income-primarily that associated with capital-market activities. The marked increase in loan-loss provision derived from the worsening of the economic and security situation, which called for exceptional intervention on the part of the Supervisor of Banks in the form of the requirement that the specific provision be increased or special loan-loss provision be made.

The performance of the banking groups continued to decline in 2002:I, too, with a further fall in the return on capital, which stood at only 4.2 percent. The deterioration in the banks’ performance could persist if the security and economic difficulties continue during 2002.

By contrast with the deterioration in economic activity and financial results, the activity of Israel’s banking system expanded in 2001. The total assets of the banks rose by 7 percent, mainly as a result of the 11 percent increase in credit to the public, similar to its growth rate in the last few years. The expansion of bank credit extended to the public despite the drop in the total credit from all sources expresses the effect of substitution in the composition of sources of finance-a switch from financing taken from outside the domestic banking system to bank finance. The crises in the money and capital markets in Israel and abroad as well as in the high-tech industry, and the security situation in Israel, reduced the ability of Israeli firms to raise capital on stock markets in Israel and elsewhere and to take direct credit from abroad or from venture capital funds. Credit seekers were consequently obliged to resort to the domestic banking system. The effect of the substitution in the composition of firms’ sources of finance is therefore the main reason for the expansion of bank credit in 2001.

The switch to bank financing by firms rejected by nonbank sources, the recession in Israel and elsewhere, and the aggravation of the security situation in Israel all combined to increase banks’ exposure to risk in 2001, and primarily to credit risk. The credit/business-sector product ratio rose, indicating a reduction in borrowers’ repayment ability; the risk-weighted assets ratio also rose-a development reflecting a shift to a more risky asset mix-so that the ratio of annual expenditure on loan-loss provision to outstanding credit to the public rose (from 0.5 percent in 2000 to 0.85 percent in 2001 and 0.95 percent in 2002:I). The deterioration in the quality of the credit portfolio was evident in most industries, especially those connected with communications and computer services, construction and real estate, and hotels and catering. Borrowers with large exposure-especially in communications and computer services-experienced financial difficulties in 2001, and this explains a significant part of the increase in loan-loss provision. In view of the exacerbation of the economic situation and the diversion to the banking system of financing by firms which have been turned down by nonbank sources, the banks’ policy of continuing to expand bank credit appreciably is particularly problematic.

Capital adequacy, which serves to cushion losses due to the possible realization of risks, rose slightly in 2001, and stood at 9.4 percent. In most of the major banking groups the capital ratio is very close to the 9 percent minimum capital ratio that is required of the banks in Israel, however. In addition, as in previous years, the slight increase in the capital ratio in 2001 was accompanied by a deterioration of the composition of capital, with a decline in Tier-1 capital, reflecting the more stable element of capital, and a rise in Tier-2 capital, reflecting its less stable component. The rise in Tier-2 capital derived from a marked increase in subordinated notes, approaching the maximum limit permitted by the Supervisor of Banks (up to 50 percent of Tier-1 capital). Reaching the permitted limit of subordinated notes, the difficulty of raising Tier-1 capital because of the state of the market, and the possibility that the banks’ net profit in 2002 will be lower than in 2001 all serve to hamper the ability to expand bank credit in the future. In 2002:I the annual growth rate of bank credit, which is an important source of the groups’ profit, fell significantly, and stood at only 3 percent. This might indicate caution in the expansion of bank credit and the imposition of tougher criteria on firms because of the slump, but the slowdown in the growth rate of bank credit could equally signal difficulty in expanding it because the actual capital ratio is very close to the required minimum.

Profits deriving from investment in companies in which banks have a holding in Israel plunged in 2001 due to the fall in profitability of nonfinancial companies, of companies operating in the capital market, and of credit card companies. As in the past few years, in 2001, too, mortgage banks displayed a handsome profit, albeit below the average of the last decade. Note in this context that the business environment in which the mortgage banks operate has become more risky in recent years because of the ongoing recession, especially the slump that has prevailed for several years in the construction and real-estate industry. The deterioration in the economic environment in which the mortgage banks operate was expressed by a sharp rise in the share of arrears in outstanding credit-of both home-buyers and contractors-and the consequent increase in current expenditure on loan losses.

The contribution of subsidiaries abroad in local-currency terms soared in 2001-mainly because of real local-currency depreciation against both the dollar and the European currencies, but also as a result of a slight improvement in the subsidiaries’ profitability. Note, however, that the considerable risks still embodied in the activities of the subsidiaries, and the problems associated with the processes of supervising and monitoring activities which are geographically distant from the parent bank mean that special care should be exercised in operating subsidiaries abroad.

At the end of April 2002 large-scale embezzlement was uncovered in Trade Bank, one of the smaller banks in the system. This embezzlement, estimated at an amount in excess of the bank’s capital, forced the Bank of Israel to seize the bank and, at a later stage, to place it in receivership. At the beginning of July the Bank of Israel, acting in accordance with the government’s decision, extended guarantees to deposit-holders who were not connected with either the controlling interests, the board of directors, or the manager of the bank. The investigation of the various aspects of the affair will still take some time, and conclusions will have to be drawn, inter alia regarding the appropriate supervisory mechanisms, the desired structure of the banking system, and the introduction of a system of deposit insurance in Israel.


Dr. Yitzhak Tal
Supervisor of Banks

Chapter 1 - Israel’s Banking System: A Long-Term View
The full Chapter, in PDF format - 1.85MB

The total profit of the five major banking gro(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 heightened risks 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 - The Financial Activity of the Commercial Banks1
The full Chapter, in PDF format - 1.75MB

The activity of the commercial banks in 2001 was characterized by rapid growth, relative to both 2000 and general economic activity. Total assets of the commercial banks rose by 7 percent (compared with 6 percent in 2000)-an increase of about NIS 45 billion-and their end-of-year balance was NIS 661 billion2 (Figure 2.1, Table 2.1). The rise in banks’ assets was led mainly by the accelerated expansion of credit to the public, which grew by 11 percent in 2001-similar to its rate in 2000-and the upward trend in its share of total assets also persisted, to reach 60 percent. The accelerated expansion of banks’ activity requires an explanation in view of macroeconomic developments-primarily the recession, the contraction of GDP by 0.6 percent and of business-sector product by 1.9 percent, and the rise of the unemployment rate to over 10 percent at the end of the year. The recession, which began in 2000:IV and worsened during 2001, stemmed from a sharp drop in demand. This was the result of three main developments: 1. The intifada, which increased uncertainty in the political and security sphere as well as in the business environment, and primarily affected tourism, construction, exports to the Palestinian Authority, and investment from abroad; 2. The global economic slowdown, which caused demand for high-tech products to plummet, so that their exports fell; 3. The slump in the capital markets in Israel and abroad, which increased the cost of raising capital in the primary market, and thus reduced the extent of substitutes for bank credit.

Domestic and global economic variables affected the behavior of firms and households, and hence the activity of banks and other financial intermediaries. The security situation and the crisis in the high-tech industry vastly reduced foreign investors’ interest in Israel (nonresidents’ investment was down by 63 percent), as well as the ability of Israeli firms to raise money in Israel and abroad or to obtain financing from venture capital funds. This led to a decline in the share of financial intermediation extended by nonbanks in providing financing, so that entities seeking credit returned to the financial intermediation (reintermediation) provided by the banking system. This shift in the composition of sources of finance explains most of the expansion of bank credit in 2001. Note that credit flows from all sources (from the domestic banking system and other sources) were down by 23 percent from 2000. The diversion of firms’ financing to the banking system increased the banks’ exposure to credit risk and caused the quality of credit to deteriorate. This was expressed in several indices (the share of problem loans, the proportion of loan-loss provision in total credit, the risk-weighted assets ratio, etc.). There are three main sources of credit from outside the banking system: the capital markets in Israel and abroad, whose extent of capital raised went down by some 50 percent in 2001; venture capital funds, the extent of whose financing contracted by 35 percent; and direct credit from abroad, which grew by about 26 percent (Table 2.2).

With regard to credit by indexation segment, it appears that half the growth of credit was in the foreign-currency segment, which expanded in the wake of real local-currency depreciation against the dollar3-by 9 percent in dollar terms and by 17 percent in local-currency terms. The expansion of credit was channeled to residents, some of whose activity is conducted abroad, as well as to nonresidents, who have business ties with local firms. In the past these consumers of credit tended to resort to financing from banks abroad, but in 2001 this contracted, so that demand was diverted to the domestic banking system. Foreign-currency credit continued to grow until 2001:III-as long as real local-currency interest rates on this kind of credit were in line with those on other credit channels and expectations of exchange-rate shifts were low. Since September 2001 the extent of foreign-currency credit has been declining, however, because of local-currency depreciation and the rise in uncertainty regarding the future trend of the exchange rate, as the variance of the exchange rate of the NIS against the dollar in this period shows. Developments with regard to credit served to increase the share of foreign-currency credit and unindexed local-currency credit in total credit by 1 percentage point each, at the expense of CPI-indexed credit, whose share dipped (Table 2.3).

The credit aggregate, incorporating both on- and off-balance-sheet credit, rose by about NIS 52 billion in 2001.4 Regarding the by-industry distribution of credit, some 80 percent of the rise in it was in four principal industries. Credit to the financial services industry rose by about NIS 12 billion (21 percent), most of it off-balance-sheet and credit for the purchase of a controlling interest.5 Credit to manufacturing expanded by NIS 11 billion (10 percent), most of it directed to the high-tech industries of machinery, electronics, and electrical equipment. Credit to construction and real estate grew by NIS 7 billion (6 percent). This industry was hard by the high-tech slump, which caused demand for rental of commercial property to fall, and by the transfer abroad of the activity of property developers, as reflected by the rise in credit for real estate activity abroad. All this occurred against the backdrop of the slump that has prevailed in this industry for several years. Credit to households rose by NIS 10 billion (10 percent); some of it appears to have served to finance private consumption, which continued to rise in 2001 (by 1.5 percent), despite the recession and the decline in per capita income.

There was a turnaround in the development of business-sector product, which declined by 1.9 percent in 2001 after rising by 8.5 percent in 2000. This development, which was unexpected in its intensity, helps to explain the expansion of credit, as the contraction of demand-and the consequent fall in sales-appears to have left many firms with large inventories. These firms had to borrow from banks in order to finance current expenditure, inventories, and working capital.

In addition to the rise in the assets of the commercial banks and accelerated expansion of their credit aggregate, there were several notable developments in the banking system in 2001.


The public’s financial assets grew by only 4 percent-after an annual average growth rate of 15 percent in the last five years-because of the decline in per capita income, which caused private saving to contract. Greater economic uncertainty and the stabilization of inflation at a lower rate reduced the need for instruments to hedge against inflation, and hence served to increase the share of short-term assets at the expense of long-term ones. Another shift in the composition of the public’s assets relates to their distribution inside and outside banks. In view of the slump and the low yields that characterized the stock market for most of the year, the value of the public’s assets held in shares declined, while the relatively high yields on unindexed local-currency assets caused their weight in the public’s asset portfolio to rise, so that the proportion of the public’s assets in banks rose slightly, at the expense of those outside banks (Table 2.4).


The Bank of Israel’s monetary policy of reducing interest by a cumulative 2.4 percentage points during 2001, and by another 2 percentage points in the last week of the year, served to bring down short- and long-term nominal interest rates as well as those on local-currency activity (unindexed and CPI-indexed). Concurrently, the decline in the Libor rate brought interest down in the foreign-currency segment. The deviation of the budget deficit from its target and the increased need for net borrowing by the government served to increase long-term yields after 2001:III, on the other hand,. In spite of the immediate adjustment of the interest rate on unindexed deposits to the changes in the Bank of Israel’s key interest rate, the decline in the real interest on these deposits was smaller than in nominal interest, because of the low level of inflation expectations. These developments affected the supply of deposits from the public, and the supply of unindexed deposits rose by some 13 percent, mainly in the second half of the year. This increase, and the preference for liquid channels, is characteristic of a period of uncertainty, when the public prefers assets that are more liquid, as they afford it greater flexibility in adapting its investments to economic developments. At the same time, CPI-indexed deposits fell due to the decline in inflation and its variance, while foreign-currency deposits rose in real local-currency terms, due to local-currency depreciation vis-à-vis the dollar.


Alongside the reduction of interest in all channels of activity (unindexed, indexed, and foreign-currency), interest spreads and margins declined in the various indexed segments with regard to activity in Israel. The contraction of the interest margin was particularly prominent in the unindexed local-currency segment (where it dipped from 3.0 percent to 2.8 percent), largely due to a change in the composition of sources and uses-a rise in the share of expensive sources at the expense of others, and a decline in the share of profitable uses at the expense of others. Interest margins declined in the CPI-indexed and foreign-currency segments, too, due to the scarcity of sources in these segments which led to the more moderate reduction of interest on sources than on uses.


The total interest margin remained at the same level in 2001 as in 2000-2 percent. Its stability stemmed from several developments which offset one another: the interest margins on domestic activity contracted, as stated, while those on foreign-currency activity abroad rose. The latter development is the result of lower interest rates in the countries where overseas branches operate, which led to a similar decline in income from and expenditure on financial intermediation activity but did not affect income from activity in securities. Thus, the yield on investment in bonds, which accounts for 22 percent of the overseas branches’ uses, remained unchanged, and explains part of the rise in the segment’s margin. The increase in the share of the unindexed local-currency segment, which has the highest margin, at the expense of the share of the other, less profitable segments, was offset by the decline in the margin on domestic activity.


A long-term review shows a trend of convergence of the interest rates in the various segments, as regards both deposits and credit, with the exception of temporary deviations at times of sharp exchange-rate shifts.



Unless specified otherwise, this chapter refers to the activities in Israel of the commercial banks.


Unless specified otherwise, data in this chapter are for end-year balances.


A rough estimate indicates that the revaluation component explains about NIS 10 billion of the rise in credit in 2001, comprising 25 percent of the rise in the balance-sheet credit extended to the public by all the commercial banking corporations.


The balance is weighted by credit risk.


This credit category grew by NIS 4.5 billion in 2001, and amounted to NIS 27.8 billion.

Chapter 3 - Financial Results
The full Chapter, in PDF format - 1.37MB

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 - 2.07MB

This chapter focuses on an analysis of the main investments in subsidiaries in Israel and abroad1 of the five major banks heading the groups. These investments account for 89 percent of the entire banking system’s total invin subsidiaries.

Most of the investment in subsidiaries in Israel is in commercial banks, mortgage banks, and other specialized banks. The banks also have holdings in companies that operate in areas similar or complementary to banking intermediation, such as financial leasing, credit card issuing and clearing companies, and capital market companies.2 The banks have additional holdings that are not connected with financial activities (henceforth, ‘equity-basis investees’). These include non-financial companies, such as Koor, the Israel Corporation, Migdal Insurance Holdings, Africa

Israel Investments and Clal Insurance. The banks also have holdings in companies that operate abroad, principally in local commercial banks and other financial companies.3

The (gross4) sheqel contribution of banking subsidiaries abroad increased greatly during 2001 due to a rise in profitability, a growth in activity and in particular, the real depreciation of the sheqel against the dollar and the European currencies in the course of the year (Figure 4.3). In 2001, this investment group was the largest in sheqel terms and in terms of the banks’ shareholders’ equity, and the investments in these companies increased by NIS 1.3 billion during the year. A large part of the increase derived from the sheqel revaluation of foreign currency denominated investments in respect of the depreciation, while part of the increase also derived from new investments, the most notable of which was the Hapoalim group’s establishment of a new subsidiary for an investment of NIS 359 million.

The mortgage banking industry presented a high level of profitability in 2001 as in previous years, although the rate of profitability recorded was lower than the average for the past decade (Figure 4.12). This level of profitability is attributed to a growth in financing income and an increase in operational efficiency. However, the level of risk inherent in the business environment in which the mortgage banks operate has also increased, due to the continued recession in the economy and the stagnant level of activity that has been typical of the construction and real estate for several years now. In 2001, this situation was reflected by a rise in the proportion to outstanding credit of arrears in loan repayments by home-buyers and building contractors, and by an increase in current expenditure on loan losses in respect of the mortgage banks’ activities.

The contribution of principal subsidiaries to the incomes of the five largest banks is presented in Section 2. A distinction is made between the subsidiaries’ main areas of activity, and between consolidated companies and equity-basis investees. Section 3 analyzes the activity and profitability of the mortgage banks, which are a key profit center for their parent banking groups. Section 4 analyzes the business activity and financial results of overseas offices, including in this respect banking subsidiaries and overseas offices of local banks that operate abroad.



The principal subsidiaries are companies that in the opinion of a bank’s management have a material affect on its activity and financial results, or in which in its investment accounts for at least one percent of shareholders’ equity, or whose share in the bank’s ordinary income exceeds 5 percent of its net income from these activities. These investments totaled NIS 23.1 billion on December 31, 2001. The banking system’s total investments in subsidiaries amounted to NIS 26.2 billion on the same date.


Mutual fund management, underwriting, investment portfolio management and investment banking.


The analysis in this chapter is centered on the principal corporate holdings of the five largest banks alone. Data on the following items are taken from published financial statements and notes therein that relate to the details of the banks’ principal holdings. The average coefficient of deviation and Sharp index take into account companies that were included in the banks’ holdings in the past, in accordance with the size of the investment and the timing of the holding


This income is after conversions and adjustments to sheqels, with the offset or addition of expenses for income in respect of the banks' coverage of investments against exposure to fluctuations in sheqel exchange rate differentials against the dollar and/or the principal European currencies. In 2001, the depreciation of the sheqel against the dollar and the other major currencies had the affect of offsetting this income to some extent, and is recorded and attributed in the banks' statement of income.

Chapter 5 - Risks and Capital Adequacy
The full Chapter, in PDF format - 1.37MB

A bank is exposed to a wide range of risks in the course of its activity. These risks include financial risks and non-financial risks. Financial risks are: (1) credit risks; (2) market risks (interest-rate risks, inflation risks, exchange rate risks and share price risks); (3) liquidity risks. Non-financial risks include: (1) operational risk (including risk in respect of acts of embezzlement and fraud); (2) legal risks; (3) image risk. We will focus in this chapter1 on the banks’ financial risk exposure, and will address the question as to whether the banks hold enough capital in order to absorb expected and unexpected losses in the course of their activity, that is, the question of their capital adequacy.

Of all the financial risks to which a bank is exposed in the course of its activity, credit risk is the principal form of risk. This is because the majority of the banks’ financial activity is based on the extension of credit. The rapid expansion of the credit portfolio of the five banking groups (outstanding credit and credit equivalents in off-balance-sheet items) continued in 2001. This was despite the fall in GDP and business-sector product during the year, which reflected a decline in borrowers’ repayment ability. Bank credit to the public increased by NIS 45.6 billion or 9.8 percent, and its proportion to the total balance sheet rose from 66.4 percent in 2000 to 68.3 percent in 2001. The ratio between the five largest banking groups’ credit portfolio and their shareholders’ equity2 also rose appreciably, from 12.7 at the end of 2000 to 13.4 at the end of 2001. The growth in credit encompassed all segments-unindexed, CPI-indexed and foreign currency, and a particularly large increase was recorded in dollar credit due to the growth in the average interest rate gap between sheqel and dollar credit and the relative stability of the exchange rate during most months of 2001. The rise in the proportion of credit to the public during 2001 was part of a multi-year trend apparent since the end of the 1980’s, which mainly resulted from the liberalization of the financial markets and structural changes in the Israeli economy and in recent years, also apparently from decisions to increase credit that were not fully based on a proper analysis. This trend is apparent from the banks’ expansion of activity that involves relatively high credit risk (credit to the public) at the expense of less risk-oriented activity, such as the extension of credit to the government (Figure 5.1).

The growth recorded in the five banking groups’ off-balance-sheet activity during 2001 is attributed to the climate of uncertainty prevailing in the money and capital markets and in the foreign currency market. In the continuation of a multi-year trend, futures transactions increased by 71.2 percent in notional value terms, and outstanding guarantees and other liabilities rose by 4.2 percent.

The indexes of credit portfolio quality, which reflect the probability that a borrower or borrower group will not repay part of their liabilities to the banks and are mainly affected by borrowers’ repayment ability,3 reveal a substantial deterioration in the quality of the credit portfolio at the five banking groups in 2001. This deterioration encompassed most sectors of the economy, and particularly the telecommunications and computer services industry, the construction and real estate industry, and the hotels, catering, and accommodation services industry. The decline in borrowers’ repayment ability was apparent from the rise in the ratio between credit and business-sector product, from 1.6 in 2000 to 1.8 in 2001. The ratio between total risk assets and total assets (before weighting) increased by two percentagepoints in 2001, reflecting the move to a higher risk asset mix. Annual expenditure on loan-loss provision rose by 85.7 percent in 2001, and the ratio between this expense and outstanding credit to the public increased from 0.5 in 2000 to 0.85 in 2001. Total problem loans (except for debts under special supervision and realized real-estate collateral) increased by NIS 1.6 billion. The deterioration in the quality of the credit portfolio during 2001, and especially the large growth in problem loans and the specific loan-loss provision resulted from a number of main factors: (1) the economic recession, which derived from the worldwide recession and the security situation in Israel, was reflected by a 0.6 decrease in aggregate GDP and a 1.9 percent drop in business-sector product, leading to a decline in borrowers’ debt repayment ability; (2) a number of large borrowers in the telecommunications and computer services industry encountered financial distress.

A special directive issued by the Supervisor of Banks in 2001 concerning the need to create special loan-loss provision due to the recession served as a catalyst for a re-examination of the banks’ credit portfolios and an increase in the specific provision in respect of these portfolios. The need for a special provision also resulted from the relatively low rate of provisions in previous years. This need was particularly apparent in view of the rapid expansion in bank credit and the increased risks inherent in it, against the background of the slowdown in economic activity in Israel and the Western economies during recent years. The Supervisor of Banks’ directive enabled banks that had made a particularly large specific provision to receive an exemption from the requirement for the special provision.

The concentration of the credit portfolio by economic sector (H index) and by borrower size (Gini index) remained relatively stable at the five banking groups. However, the credit portfolio was again characterized by relatively high concentration and large differences between the banking groups. The proportion of credit to borrowers with outstanding indebtedness of over NIS 33 million rose at the two largest banking groups (Leumi and Hapoalim), and fell at the other groups. Although the proportion of credit to the construction and real estate industry is still creating a high level of concentration in the banks’ credit portfolio, the proportion of this credit fell slightly during 2001 and amounted to 16.9 percent of outstanding credit compared with 17.6 percent in 2000.

According to the calculations of the five banking groups, which are based on standard models (as prescribed by the Basle Accord of 1996), the total capital that the groups are required to hold against their exposure to market risks amounted to a billion sheqels in 2001. Translated into risk asset terms for the purpose of integrating market risks in the overall capital ratio, this amount reached NIS 11.3 billion4 compared with NIS 8.8 billion in 2000. The proportion of this amount to the banks’ total risk assets reached only 1.8 percent, and in terms of the overall minimum capital ratio, its inclusion contributed only 0.17 percentage points.

Total value subject to credit risk, VaR (1 percent): amounted to NIS 2.1 billion at the five banking groups in 2001. In the area of interest-rate risks, it was found that all five banking groups were exposed to a rise in interest rates in the three indexation segments-unindexed sheqel, CPI-indexed and foreign currency (with the exception of the Hapoalim group, which is exposed to a decline in interest rates in the unindexed segment). Total value subject to indexation-basis risks (exchange rate and inflation risks)-VaR (1 percent) amounted to NIS 203.2 million in 2001 compared with NIS 103.9 million in 2000. This increase mainly resulted from a growth at the two largest banking groups. Most of the banking groups were exposed to an unexpected decline in the inflation rate and to an unexpected rise in the real $/NIS exchange rate.

Total value subject to indexation-basis risk (exchange rate and inflation risk) accounted for only 10 percent of total value subject to interest-rate risk due to the banks’ extensive use of financial derivatives. In the area of interest-rate risks (principally in the CPI-indexed segment) however, activity in derivatives is relatively low because the market for these instruments is still in its infancy.

The ratio of capital to risk assets at the five banking groups rose slightly, from 9.24 percent at the end of 2000 to 9.38 percent at the end of 2001. At the Hapoalim and Mizrahi groups, the ratio fell slightly and amounted to 9.1 percent at the end of the year. Since this ratio is very close to the minimum capital ratio required of the banks in Israel (9 percent), a decline in it could reduce the banks’ ability to cope with the potential realization of credit and market risks. It should be noted that the slight increase in the capital to risk assets ratio at the five banking groups in 2001 was accompanied by a change in the characteristics of this ratio: The ratio of Tier 1 capital, which reflects the more stable portion of capital, fell at all five banking groups from 6.6 percent in 2000 to 6.22 percent in 2001. The ratio of Tier 2 capital, which reflects the less stable portion of capital, rose at all the banking groups (except for the Mizrahi group) from 2.58 percent in 2000 to 3.16 percent in 2001. The changes in opposing directions in the capital components during the year marked the continuation of a trend that became apparent during the last five years. The increased share of Tier 2 capital resulted from the decision of the banks’ management to adhere to the capital adequacy requirement by raising deferred notes. It is much quicker and easier to issue deferred notes than to raise Tier 1 capital (ordinary shares and preference shares that have been approved by the Supervisor of Banks), especially in periods of recession and uncertainty in the financial markets. The issue of these notes provides the issuing corporation with leverage, increases the return on equity, and also has tax advantages because interest expenses on capital notes-unlike dividend payments on shares-are recognized for tax purposes. The issue of deferred notes therefore increases the issuer’s profitability. However, the closer a bank is to the Supervisor of Banks’ restriction, whereby deferred notes must not exceed 50 percent of total Tier 1 capital, the less are its opportunities for using this capital instrument to expand bank credit. Apart from that, deferred notes are less stable than Tier 1 capital. This is because they are cumulative (the interest payments of them cannot be delayed), are issued for a limited period, there is no certainty regarding their availability (beyond a particular period defined in the directives) and the cost of renewing them, and they do not participate in the issuing corporation’s losses on an ongoing basis.

The ratio of deferred notes (which are recognized for calculating Tier 2 capital) to Tier 1 capital at the five banking groups rose by 11.2 percentage points to 44.5 percent in 2001. At the First International and Mizrahi groups, the proportion of deferred notes to total Tier 1 capital amounted to 47.7 percent and 48.6 percent respectively-very close to the Supervisor of Banks’ restriction (of up to 50 percent of total Tier 1 capital). The Discount group fully exhausted the total extent of the restriction in 2001, preventing it from using this capital instrument at a time of financial distress. At the Leumi and Hapoalim groups, the ratio rose considerably, by 15 and 9.1 percentage points respectively, and amounted to 43 percent at both groups.

The large NIS 5 billion growth in Tier 2 capital during 2001 derived not only from an increase in total risk assets, but also from the issuing requirements that resulted from the decline in net income. The five banking groups raised NIS 4.4 billion of capital in 2001 for capital adequacy purposes (due to the shortfall in annual net income), compared with NIS 2.8 and 0.4 billion i2000 and 1999 respectively.5

The fact that the upper limit of the ratio of deferred notes to Tier 1 capital permitted under the Supervisor of Banks’ restrictions was reached, and the possibility that the banks’ net income in 2002 will be lower than in 2001, could reduce the ability to expand bank credit or increase the need for raising Tier 1 capital. As stated, the situation in the capital market during recent years has made it difficult to raise Tier 1 capital. However, the Hapoalim group was permitted to issue deferred notes with a notional value of NIS 2 billion for the first time in 2001. These capital notes (which are regarded as ‘sophisticated capital instruments’) enable the bank to cope with a loss-absorption scenario because under certain conditions, the notes are to be converted to Tier 1 capital.

In this chapter we will examine the financial risks to which the banks are exposed, and will focus on the five largest banking groups. It is difficult to quantify the overall level of risks due to the fact that the banks are exposed to diverse risks, which sometimes develop in opposing directions. Moreover, the measurement instruments employed for this purpose are not uniform and are not comprehensive. Nevertheless, we will describe the development of several indexes, which reflect the different risks and the method of managing these risks during recent years.



The data presented in this chapter are based on the published financial statements of the five largest banking groups, unless stated otherwise.


Plus minority interest.


Without taking into account collateral that has been placed against the credit.


This amount was calculated by dividing the capital requirement in respect of exposure to market risks by the minimum capital ratio required of the banking corporations (1.017/0.09 = NIS 11.3 billion).


The increased issue of Tier 2 capital in 1999 and 2000 resulted inter alia from the respective NIS 1.5 billion and NIS 2.5 billion increase in dividends that were distributed, principally at the Leumi and Hapoalim groups.

Chapter 6 - Structure of the Banking System and Activities of the Banking Supervision Department
The full Chapter, in PDF format - 861KB

The first part of the chapter surveys changes and main developments in the structure of the banking system in 2001 and from a long-term perspective. The second part describes the Department’s main activities this year in its areas of responsibility-regulation, bank-customer relations, information and reporting by banking corporations, applied research in banking fields, and inspection and evaluation of banking corporations’ activity. The second part also describes the Department’s activities in international relations, licensing, checks without cover, credit-card companies, and prevention of money laundering.