Financial Stability Report 2003

20/07/2004 |  Bank of Israel
All Press Releases In Subject:
Finacial Markets and Financial Stability

Financial Stability Report 2003

Chapter 1

For Chapter 1 of the Report - click here.

Introduction

The economic concept ‘financial stability’ deals mainly with the conditions that contribute to the proper functioning of the entire financial system and those that create financial crises-conditions that relate to the system’s components, the environment in which it operates, and the mutual relations between the system’s elements themselves and between them and the environment.

The financial system comprises three main components: 1) the financial institutions, with the financial sector at its center-the banking system and institutional investors (pension funds, insurance companies and provident funds) and other financial institutions (such as investment companies, credit companies, mutual funds, portfolio managers, underwriters and consultants); 2) the financial markets, i.e., the bond market, the foreign-currency market and the stock market; and 3) the payment and settlement systems, i.e., the systems for transferring cash and those for clearing checks, payment orders, debits and credits, banknotes and securities between banks and other financial institutions, and between them and the central bank.

The financial system occupies a central position in the economy, reflected by its close relations with the environment in which it operates. First, it is closely connected with real economic activity; it is greatly affected by the level of real activity, and it also has an effect on that level. Second, it is affected by monetary and fiscal policy and serves as a two-way transmission mechanism between the policy and the public through which the essential information required for decision making is transferred. Third, very close ties exist between the domestic financial system and the international one. Moreover the various elements of the system and the participants in it are interdependent, and this affects the functioning of the entire system. Thus it is very clear why the proper functioning of the financial system and its stability are vital for the development of the economy and the full realization of its growth potential.

Financial stability is the situation in which the financial system is operating properly and efficiently, without crises and financial disruptions. Such a situation enables the economy’s full growth potential to be realized, and is expressed in the system’s three components mentioned above: 1) in a high degree of confidence in the ability of the central financial institutions to meet their contractual obligations without external involvement or assistance; 2) in the ability of the players in the financial markets to trade in financial assets at prices that reflect economic fundamentals, i.e., prices that do not change substantially unless there are changes in the fundamentals; 3) in the continuous and efficient operation of the payment and settlement systems that enables immediate and secure implementation of payment transactions.

The degree of stability of a financial system is determined according to the level of threats it faces from the global and domestic environment in which it operates and its resilience, i.e., the ability of the financial markets to continue to function properly and the ability of the financial institutions to absorb losses when the threats it faced are realized and shocks occur in the environment or within the system. Improvements of the financial markets and the quality of the infrastructure of the system in which they operate make them more resilient. The soundness of the financial institutions also depends on the quality of the financial infrastructure and on the degree of the financial sector’s exposure to risks and the amount of capital held against it. The many aspects affecting the quality of the system’s infrastructure include the structure of the financial institutions and the quality of the payment and settlement system, the nature of the regulation and supervision of the financial system and the structure of incentives facing all its participants. Financial stability is thus a many-faceted concept, and no single index reflects it satisfactorily.

The growing discussion on financial stability is largely based on significant developments in the financial systems of many countries and on the frequency of international financial crises, particularly in the last decade. These gave sharper focus to the question, among others, regarding the relation between an economy’s exposure to abroad and financial stability. International organizations, central banks and other authorities that engage in economic issues, particularly in the financial area, are showing great interest in financial stability and are adding it to the list of issues they deal with. The Bank of Israel is also deeply engaged in making the necessary adjustments to deal with the subject of financial stability.

The Financial Stability Report, 2003 is the first to be issued by the new entity established in the Bank of Israel in mid-2003 responsible for financial stability (the Financial Stability Area). Formulating a method of analyzing the stability of a financial system is a long and complex process, and in the last few years countries throughout the world, Israel among them, have engaged in this process. This report is based on data accumulated till now, and does not pretend to be comprehensive or to present a consensus.

The report concentrates on an analysis of developments in the environment in which the financial system operated in 2003, developments that affect the system’s stability, and on the main changes in its resilience. Hence it does not analyze the situation in the system, nor does it undertake a detailed examination of the sources of the resilience and vulnerability of the financial infrastructure, nor a comprehensive analysis of the reciprocity of the relation between financial stability and economic policy and its aims, for example in the realm of price stability.

The report analyzes the following aspects of financial stability:

    a.   The main overall developments in financial stability in 2003, and future challenges and risks (Chapter 1).

    b.   The main developments in 2003 in the environment in which the financial system operates in Israel and world wide, i.e., the developments that affect its stability (Chapter 2).

    c.   The main developments in 2003 relating to the stability of the major components of the financial system-the financial markets, the banking system and institutional investors-and the developments in credit and the public’s financial assets (Chapter 3).

    d.   The central features of the financial system: the structure of the financial sector-banks and institutional investors-and the main changes to the financial infrastructure in 2003 (Chapter 4).

As this is the first Financial Stability report, it includes an appendix that defines the main concepts relevant to this subject. The appendix also contains a description of the changes in the perception of the roles of the authorities in maintaining financial stability and in the actual functions of international bodies and of central banks in various countries, as well as the functions of the newly established Financial Stability Area in the Bank of Israel.

2. MAIN DEVELOPMENTS

In 2003 there was an improvement in the stability of Israel's financial system, due mainly to the considerable reduction in the threats facing the system from the environment in which it operates, but also due to the greater resilience of the financial sector.

The reduction in the threats facing the system derived from the positive change in the economic environment-the global economy, Israel's economy and its economic policy-against the background of the easing of the uncertainty regarding security world wide and in Israel. This followed the introduction of macroeconomic policy measures in mid-2002 that stopped negative developments in the financial system that were threatening to undermine its stability, developments that took place against the background of the recession in the global economy and in Israel, the sharp rise in uncertainty related to security, and the delay in the implementation of the planned adjustments to macroeconomic policy.

Developments in the last few years indicate that the relationship between the financial system in Israel and the environment in which it operates has grown stronger in three main areas: 1) the global and domestic environment have a greater effect on the stability of the system; 2) the system and in particular the financial markets have become more important as a means of rapidly updating policymakers of economic developments, and thus they create pressure for the implementation of the required policy adjustments; 3) macroeconomic policy is more able to affect the stability of the system by means of relatively moderate measures. This closer relationship is the result of the strategy of deregulation and liberalization of financial activity pursued over the last two decades. This strategy was clearly reflected in the financial institutions' greater freedom of action and their move towards the tradable market; in the gradual move to a floating exchange rate determined by the market with complete freedom to perform transactions in foreign currency and with nonresidents; in the deepening of financial market; and recently also in the reduction of the discrimination and distortions in the taxation of different financial assets. These developments helped to provide a firm basis for financial stability in Israel, and especially to increase the resilience of the financial markets.

The positive change in the environment and in the level of threats at the beginning of 2003 was immediately and strongly reflected, as expected, in the financial markets (the foreign-currency, bond and stock markets). Its effect in the financial sector, mainly on the banking system, was more limited because of the continued economic recession. The domestic financial markets in 2003 were affected by the positive turnaround in the international financial markets due to the high degree of integration with the world markets and the marked rise in capital flows into emerging markets, Israel among them. The markets were also affected by the change in the macroeconomic policy mix which boosted confidence in the economic leadership, i.e., the reduction in the deficit and the easing of monetary policy, and by the improvement in the economy's financial resilience. This improvement was reflected by a positive change in nonresidents' investment in Israel, among other things, with a sharp decline in Israel's risk premiums-as measured by the CDS market-from 180 basis points at the end of 2002 to about 60 basis points at the end of 2003. These developments enabled the gradual and continual reduction of the Bank of Israel interest rate, which helped boost the credibility of the policy and improve financial stability.

The reduction in threats from the environment in 2003 had only a limited effect on the stability of the financial sector, as stated. What was notable was the marked effect of the persistently low level of economic activity on the stability of the banking system, and, as expected, the initial signs of increased activity and of recovered financial strength of the business sector have not really been expressed felt yet in the banks or in the rest of the financial sector.

The increased resilience of the financial sector in 2003 was most evident in the improvement in banks' capital adequacy, due to the appropriate steps taken by the Supervisor of Banks and the banks themselves.

Despite the improvement in the stability of the financial system in 2003, the structural problem of the dominance of the banks across the whole range of financial activity still casts a shadow over its resilience. This dominance, and the control exercised by the largest two banking groups in the field of financial activity, increases the interdependence of the economy and the banks and causes imperfect market conditions, thereby having an adverse effect on the stability of the financial system. One indication of the banks' dominance in the context of the activity of the financial sector is the fact that they, together with the provident funds they control, hold the lion's share of three major financial aggregates: total credit to the private sector, total assets of the financial sector, and the public's financial assets portfolio (Table 1.1). This is the case despite the modest reduction in these aggregates in 2003, following the trend evident since the end of 2001.

This structural problem presents an important challenge for policy makers and the authorities, alongside other goals and risks that policy makers, the supervisory authorities and the financial institutions have to face, mainly in the area of enhancing the financial infrastructure, and making preparations to deal with the situation should the optimistic predictions regarding continued economic recovery not be realized in full.

For Chapter 1 of the Report - click here.

Chapter 2

For Chapter 2 of the Report - click here.

THE OPERATING ENVIRONMENT OF THE FINANCIAL SYSTEM

1. SUMMARY

Developments in the financial system's operating environment helped to enhance system stability during 2003, in contrast to their effect in 2002. Table 2.a.1 shows how the external and domestic developments in various fields, described and analyzed in the sections that follow, affected the stability of the financial system.

The global economy-real activity and financial markets alike-took a turn for the better during 2003, mainly due to the swift conclusion of the war in Iraq, which in one stroke mitigated the severe uncertainty that had overshadowed the economy for months. The rapid effect of the global developments was evident on the financial front, as risk indicators declined and assets traded in domestic financial markets appreciated due to the strong integration of domestic markets into the international financial system and, especially, the perceptible increase in capital flows to emerging-market economies generally and Israel specifically. Real external developments also affected the domestic financial system, albeit indirectly and more slowly. Thus, the acceleration of global growth helped to boost global trade, to the benefit of Israel's exports and domestic activity.

Domestic developments also helped to improve the stability of the financial system. In particular, the mix of economic policy began to improve in March. After a new and more stable government took office and unveiled its economic plan, confidence in the economic leadership and its ability to control the deficit and the debt increased. Indeed, government deficits declined and the expected trajectory of the debt changed direction in the second half of the year, although the deficit for the year all told was high and aberrant. The turnaround in fiscal policy, coupled with the receipt of loan guarantees from the US Government, were the most important underlying factors in the improvement of domestic financial strength. They combined with some improvement in the security situation in Israel and, despite socioeconomic turbulence, helped to bring down risks and to allow the financial markets to improve to an extent that exceeded the effect of global developments. These positive developments made it possible to apply less monetary restraint. Thus, the Bank of Israel lowered the key rate-gradually and cautiously but to a significant cumulative extent, and this, along with declining inflation, helped to bolster financial stability.

The combined effect of these developments was to create a favorable turnaround in Israel's real activity. Business-sector gross product expanded by 1.8 percent after declining by 3 percent in each of the two previous years. Exports increased, the current-account deficit contracted, and unemployment neither worsened nor improved. The direct effect of the change of trend in real activity on the financial system was weak in 2003. However, the turnaround, together with some of the other aforementioned factors, had the indirect effect of improving the financial strength of the business sector, i.e., firms' ability to repay debt. This improvement, although limited to certain industries, helped to enhance the stability of creditors, i.e., the financial sector, especially the banks.

From a longer-term perspective, the worsening of the domestic and global environment after late 2000 (harm to high-tech industries, security problems, and economic downturn) subjected the financial system to greater risks that were only partly offset by the improvement during 2003. Thus, the risks had not receded to the 2000 level by year's end. In particular, real activity remained lethargic and the security threat was still severe. These risks, in view of the high level of government debt and use of the entire budget reserve to cope with macroeconomic shocks, still threaten the stability of the financial system.

For Chapter 2 of the Report - click here.

Chapter 3

For Chapter 3 of the Report - click here.

DEVELOPMENTS IN FINANCIAL-SYSTEM STABILITY

1. STABILITY OF THE FINANCIAL MARKETS

a. Main Developments

The negative dynamic that was typical of Israel's financial markets in 2002 turned around in 2003. The risk indicators in these markets declined significantly since March 2003, financial assets rose in value, and bond yields sank to historical lows. In the sense of transition from volatility to calm, developments this year show that the markets improved relative to the previous year.

In respect to financial stability, the developments in the past two years, both negative and positive, seem to indicate that the markets have been performing quite soundly because they aptly reflect the changes in macroeconomic and other external forces-even though the correspondence between the intensity of changes in the market and the intensity of changes in the market environment is difficult to measure. The existence of efficient markets that function soundly even in the midst of exceptional developments-negative and positive-is the outcome of the liberalization of Israel's capital and forex markets and of financial deepening. Market performance, however, is still unsatisfactory, especially in the bond and stock markets. Furthermore, it does not seem to have improved perceptibly during the year reviewed, except for two developments: the balance of Treasury bills was raised at the expense of bank deposits, contributing to the development of the financial markets, and the favorable effect of the tax reform began to make itself felt.

Market risk indicators declined from their mid-2002 peak as domestic economic uncertainty ebbed. By the middle of 2002, market jitters eased somewhat pursuant to changes in monetary and fiscal policies, but the main change occurred only after additional significant domestic and international developments, mainly the American occupation of Iraq, the establishment of a new Government in Israel, the adoption of a new economic plan, and the approval of American guarantees for Israel by the U.S. Government. The change of trend in risk indicators was abetted by the activities of foreign investors. The indicators continued to trend down in early 2004.

The NIS appreciated against the dollar by 7.6 percent during 2003. Yields to maturity fell by 1.5 percentage point on indexed bonds and by 4.2 percentage points on unindexed Shahar bonds. Share prices rose markedly as the general share price index gained 58 percent. This surge, related to expectations of resumed economic growth and higher corporate earnings, was not coupled with an upturn in lending for the acquisition of shares in the private sector, nor was it reflected by a massive public influx to the share market and a profusion of issues in the primary market-developments that have been associated with "bubble" processes in the past. The share indices continued to rise in the first few months of 2004.

For Chapter 3 of the Report - click here.

Chapter 4

For Chapter 4 of the Report - click here.

STABILITY OF FINANCIAL MARKETS

1. THE STRUCTURE OF ISRAEL'S FINANCIAL SECTOR

* The financial sector-made up of banks, insurance companies, pension funds, and provident funds-is the mainstay of Israel's financial system. Although the sector is composed of about 200 institutions, most of its activity is conducted by five banking groups (made up of banking institutions and provident funds), five insurance groups, and pension funds that were owned by the Histadrut (until the pension reform).

* The balance sheet of the financial sector at the end of 2003 was NIS 1.25 trillion-2.5 times GDP.

* The financial sector is conspicuously dominated by banks. Banks accounted for 62 percent of the total financial sector balance sheet at the end of 2003 and 77 percent together with provident funds, most of which are controlled by banks. The share of banks in the financial-sector balance sheet decreased in 2003, for the first time since 1999, by 2.5 percentage points, and the share of provident funds returned to the 1999 level, albeit at a slower pace. Banks are even more dominant in the activities of the financial system at large because the percentages shown above do not include their holdings in various financial corporations that provide securities, credit, and foreign-exchange services, including mutual funds and portfolio-management companies.

* The financial sector and its constituents are highly concentrated. The balance sheet of the five largest financial entities in each type of financial institution accounts for a large majority of the total balance sheet of entities of that type. In 2003, this parameter ranged from 78 percent to 98 percent and the two largest entities constituted 48-94 percent of the balance sheet. At year's end, the share of the five largest entities-four of which are banking groups (including provident funds)-in the total balance sheet of the entire financial sector was 78 percent and that of the two largest entities-the two largest banking groups-was 49 percent.

* The four types of financial institutions that make up the financial sector are interrelated at the business level and in ownership. The main business relationship is depositing activity by institutional entities-mainly provident funds and insurance companies-with banks. Nearly 20 percent of these institutions' total assets are kept in bank deposits and the banks earn 9 percent of their total operating revenues by managing provident funds. Ownership relations focus on the banks' nearly total control of the provident funds and on interlocking holdings of banks and insurance companies. These powerful relationships, especially between banks and provident funds, amplify systemic risk.

* The classic intermediation that the financial sector performs-between households and the business sector-accounts for only about one-half of the sector's balance sheet. Intermediation between the public and the government is another fourth and about half of sector activity takes place away from the open market and is dictated by the Ministry of Finance (earmarked bonds).

Introduction

Israel's financial sector is composed of four types of financial institutions: banks, provident funds, pension funds, and insurance companies. (The three last-mentioned are called institutional investors.) The financial sector accounts for almost all activities of the main constituent of the financial system, the array of financial institutions. (See Appendix to this Report.) Other financial institutions, such as mutual funds, portfolio managers, and providers of securities, credit, and foreign-exchange services, are not discussed here.

In addition to a general description of the types of financial institutions, this chapter takes up four issues in the structure of the financial sector that affect the sound performance of the financial system: (1) the distribution of the financial-sector balance sheet among types of financial institutions and the changes in distribution in recent years; (2) concentration in the array of financial institutions-each type of institution separately-and in the financial sector at large; (3) ownership and business relations among types of financial institutions; and (4) the structure of the financial-sector balance sheet, i.e., the distribution of sector assets and liabilities by counter-sectors, an indicator that sheds light on the characteristics of financial intermediation in Israel. In addition to these topics, which pertain to the structure of the financial sector, Box 4.a analyzes the structure of the country's payment and clearing system and the risks that it faces.

The structure of the financial sector is one of the most important factors in financial stability, although the relationship between structural characteristics and stability is complex (see Appendix). One of the most conspicuous attributes of the structure of Israel's financial sector is the grid-like nature of its internal relations, including identical, complementary, or substitutional activities among the four types of institutions, similar exposures to risks and shocks, and relationships at the business, capital, ownership, and management levels. The stronger these relations are, the greater the concern about the abuse of conflicts of interest among financial activities and about the realization of systemic risk, i.e., concern that an external shock will harm different financial institutions or that problems at one form of institution will spread to others by means of the "contagion effect." Another salient characteristic of Israel's financial sector is the high concentration in the banking industry, which, when coupled with the interrelations between banks and other components of and activities in the financial system, gives the large banks a dominant position in the system at large.

There is a complex relationship between these structural characteristics of the financial system in Israel, which affect the competitiveness and efficiency in the system's performance, and financial stability. Thorough analysis of these relations, as a basis for identifying sources of vulnerability and recommendations to deal with them, exceeds the limits of the discussion in this annual report. Here we content ourselves with describing and quantifying the main structural characteristics of the financial system. Importantly, for practical reasons the discussion in this chapter covers only some of the interesting issues in the structure of the financial system at large, and even here the approach taken is descriptive and not normative. For example, the report does not discuss relations between banks and other financial corporations, such as mutual funds, and business relations among institutions of each type separately. Neither does it draw a comprehensive map of the control of various financial institutions.

For Chapter 4 of the Report - click here.