Israel's Banking System - Annual Survey, 2003

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The Banking System
Israel's Banking System - Annual Survey 2003
Letter from the Supervisor of Banks

The financial results of the banking corporations improved in 2003, after two very difficult years for the banking system. At the same time, with the decline in the amount of credit, the capital adequacy of the banks also showed marked improvement, indicating greater robustness of the banking system. The trend of improved financial results that started in 2003 continued in the first half of 2004, when high profits were recorded, while the amount of credit remained stable.

It is important to note, however, that part of the steep rise in the banks' profits was due to cyclical factors, particularly the profits deriving from the capital market; these included the profits in the nostro portfolios arising from the fall in interest rates during the year. As profitability and efficiency indices improved, due to the rise in interest and non-interest income, direct salary expenses increased by a real 6 percent. This was all the more notable in the light of the fact that the average number of staff employed by the banks was 1,135 lower in 2003 than in 2002, the result of difficult streamlining programs whose contribution was in effect offset by salary increases.

The modest recovery in economic activity which started in the second half of 2003 led to a reduction in the annual loan-loss provision, and this also served to raise the banks' profits. Nonetheless, the level of loan-loss provisions, together with a further rise in the balance of banks' problem loans and their share in total credit, indicate that credit risk in the banking system remains high. The recovery in economic activity at the end of 2003 has not yet been reflected by an improvement in the repayment ability of the banks' customers. This applies in particular to the construction and real estate industry, which continues to constitute a major credit risk to the banking industry.

All the above make it incumbent on the banks to exercise great caution in their credit-risk management and to maintain a high level of capital adequacy, as despite the improvement in capital adequacy in Israel, it is still below the internationally accepted norms.

The Basel 2 Framework, formulated after a lengthy international consultation process and finally published on 26 June 2004, is intended to reinforce the management of banking system risks and of capital adequacy to cover against them, and thus to boost financial stability. The new framework requires the formulation of methodologies and advanced information and risk-management systems for all aspects of banking activity. Israel's Banking Supervision considers the promotion of the Basel 2 principles––with improved risk management by banks––a major supervisory target in the next few years.

Another important objective confronting the banks is to prepare themselves for a more competitive environment within the banking system itself, and in the money and capital markets. The Bachar Committee recently completed its recommendations for the structural reform of Israel's money and capital markets to make them more competitive. It is expected that the recommendations, when implemented, will affect the structure of the banking groups and the way they act in the capital markets, and hence, will affect the composition of their income. At the same time the authorities will focus on promoting instruments that will enable the markets to improve and diversify further, such as repurchase agreements (Repos), short selling, issues of commercial paper, encouraging securitization in different markets, and speeding up the procedure for issuing corporate bonds. The development of these instruments and markets will present new opportunities for the banks to manage their activities and risks, on the one hand, and will expose them to greater competition for credit and deposits, on the other. The adoption of the Bachar Committee's recommendations will also allow banks to sell insurance and pension policies which today they are prohibited from selling.

In 2003 the public, the Knesset and the various supervision authorities strongly demanded greater competition within the banking system itself. The Banking Supervision reviewed its overall policy regarding banks' fees and commissions. As a result of this review, the Bank of Israel proposed that the responsibility and authority of the Banking Supervision to deal with this aspect be given a proper legal basis. In order to minimize the involvement in banking management, it was proposed that the legislation should define the grounds that would justify intervention in the fees and commissions tariffs. The main grounds for such intervention would arise in a situation where the tariffs adversely affected competition, or where competition is lacking, or with regard to duplicate fees and commissions, or charges for which no real service is provided, and those relating to a small group of essential banking services. The Banking Supervision Department is also looking into ways of making it easier for customers to switch from one bank to another in order to enhance competition.

A sophisticated information-technology (IT) system is a prerequisite for the management of modern banking. Continued technological development, growing use of direct banking services and of outsourcing have intensified operational risk and have even revealed new sources of risk. The banks' must minimize these risks via strict management procedures and make intelligent use of advanced control and monitoring tools. In 2003 the supervisory standards governing the management of banks' IT systems were expanded to help minimize the above risks. Technological progress in the last few years and the revolution in the use of PCs and the internet enabled banks to offer an increased range of services other than in the branches, and thereby enabled them to reduce the number of branches and staff and to streamline their operations. These processes, however, also entail a measure of sacrifice of customer service and are likely to erode the banks' main comparative advantage in selling their financial instruments-their contact with customers.

To summarize: the combination of the developments outlined above will require the banks to become more sophisticated and efficient in managing their activities, risks and resources, and in allocating their capital in a more competitive and demanding environment.


Yoav Lehman
Supervisor of Banks

Chapter 1 - Israel's Banking System - Activity, Risks and Performance in 2003 and a Long-Term View
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The performance of Israel’s banking system improved in 2003, following the two difficult years that preceded it. This improved performance was reflected in a sharp rise in the return on equity (ROE), while the risks facing the banking system—and in particular credit risks, which remained high-did not change significantly. Return on equity in the five major banking groups rose dramatically, from 2.8 percent in 2002 to 8.4 percent in 2003. The significant increase in profits for the five major banking groups was the result of two main factors, which characterized each group separately: a sharp rise in profits from financial activity before loan-loss provision, from NIS 16.8 billion to NIS 18.5 billion, coupled with a sharp drop in loan-loss provision, from NIS 7.2 billion to NIS 6.0 billion.

The major contribution to the increase in profit from financial activities before loan-loss provision came from the banks’ profits from developments in the stock market, including profits from bond revaluations and sales. These profits derived from the decline in interest rates in 2003, both short-term (the Bank of Israel interest rate dropped during the year from 9.1 percent to 5.2 percent) and long-term (the real return on government bond yields dropped from 5.7 percent to 4.3 percent). This occurred after a year in which these interest rates had gradually increased which, in turn, had a negative impact on bank profits.

The contribution of the banks’ profits from stock market developments to the increased profit from financial activity before loan-loss provision was about NIS 1.3 billion. Commercial banks' net interest margin rose from 2.19 percent in 2002 to 2.48 percent in 2003. In spite of the increased net interest margin, it would appear that this development did not have a positive effect on the increased profits from financial activity, since the amount of credit dropped during that year (for reasons that will be outlined below).

Furthermore, the financial results of Israel’s banking system were positively influenced by improvements in Israel’s economic activity. Following two years of severe recession, the second half of 2003 was marked by a recovery in economic activity in Israel, which was reflected in a rise in GDP of around 1.3 percent and an increase in the State-of-the-Economy (Composite) Index by around 1.1 percent, following two consecutive years in which these indices had dropped. These positive developments were reflected, if only partially, in a sharp decline in loan-loss provision (a total of about NIS 1.2 billion) in the five major banking groups, although their levels remained relatively high. Non-interest income too was positively affected by the economic recovery, and also by the boom in the capital market, both of which contributed towards increasing the banks’ revenue from fees charged for their customers’ stock market activities, and higher profits from stock sales compared with losses from such sales in 2002.

Chapter 2 - The Structure of the Banking System in Israel and Competition,From a Long-Term Perspective
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Chapter 3 - Main Developments in the Activity and Financial Results of the Banking System
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The total balance-sheet assets of the commercial banks operating in Israel increased by a moderate 1 percent in 2003 compared with 2002 and amounted to NIS 689 billion (Table 3.1). The ratio of assets to GDP remained static at a level of 1.67 during the last three years (Figure 3.1). On the liabilities side, relative stability was recorded in 2003 in the raising of deposits of the public (a moderate increase of 0.9 percent). On the assets side, an NIS 13 million (3 percent) decrease was recorded in outstanding credit to the public (which accounted for 60 percent of total assets). Due to the decrease in outstanding bank credit concurrent with the relative stability in deposits of the public, the banks were faced with a surplus of funds. The banks channeled the surpluses into the purchase of bonds—principally Shahar and Gilon unindexed government bonds. The banks’ investments in these bonds totaled NIS 27 billion, an increase of 52 percent compared with 2002. The change in the banks’ mix of uses together with the large interest rate cuts in the economy, had the effect of increasing their profits in 2003 and thereby raised the banking system's value added. The ratio of the banks’ value added to GDP rose from 3.4 in 2002 to 4.1 in 2003.

A particularly large decrease of 61 percent was recorded in 2003 in total requirement for credit in the economy, including direct bank credit and credit substitutes such as issues in the capital market. The downturn in demand for credit began in 2001 as a result of the recession in the economy. In the record year of 2000, demand for credit in the economy was eight times higher than in 2003 and in 2003, for the first time, the amount of bank credit raised was negative.

An increase was recorded in the public's asset portfolio, which reached NIS 1,400 billion, its highest level for the past decade. The growth in the public's asset portfolio resulted mainly from the buoyant level of the capital markets in Israel and abroad, which increased the value of securities.

Chapter 4 - Risks and Capital Adequacy
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Chapter 5 - Activities of the Banking Supervision Department
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