This paper examines how the financial strength of the real business sector (the borrowers) is reflected by the balance sheets of the banking system (the lenders) in the period 1994–2007. Three econometric models are employed: one is a model of levels, one uses stationary variables, and the third, cointegration. The results show that weakness of the business sector is reflected, after some delay, on the level of the banks’ problem loans, so that indicators of such weakness can serve as early warning indicators of a rise in this level. The main finding is that the dominant variable in explaining banks’ problem loans is operating profitability–– viewed via different moments of the distribution, i.e., average, volatility, and variability among the businesses––which accounts for 85 percent of the fluctuations in the ratio of problem loans. It is interesting to note that it is this profitability, which reflects solvency and real activity, which has the greatest effect on credit risk, whereas the structure of companies’ balance sheets, represented by other financial indicators such as the current ratio (liquidity) and the debt/capital ratio (leverage), explains only 5 percent of the fluctuations in the banks’ ratios of problem loans. It was also found that the results obtained by using indicators from the business sector were better than those derived from macroeconomic indicators. A model that traces the long-term development of problem loans suggests that at the outbreak of the current global crisis, which started in the US in the middle of 2007 (the end of this study’s sample period), Israel’s banks were more resilient than they were at the onset of the previous recession of 2001–02.

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