THE FINANCIAL SYSTEM
Bank of Israel
The Bank of Israel is the country's central bank and functions independently of the Government. It is responsible for formulating and implementing Israel's monetary policy. The Bank of Israel also manages foreign exchange reserves, supervises Israel's banking system, issues bank notes and coins, and acts as the sole fiscal agent for the Government with respect to domestic indebtedness. The Governor of the Bank of Israel acts as an economic advisor to the Government. In addition, the Bank of Israel works jointly with the Government in formulating and implementing foreign exchange policy. See "Balance of Payments and Foreign Trade-Foreign Exchange Rates."
As stipulated in the Bank of Israel Law, the Bank of Israel is not allowed to finance Government deficits or to lend the Government money to finance its expenditures in any fiscal year, except to provide temporary advances to the Government to cover seasonal cash flow requirements when expenditures exceed revenues during the fiscal year (provided that the outstanding amount of such temporary advances at any time does not exceed 1.6% of the Government's current expenditures budget for the year in which the advances are made). Twice a year, such advances are permitted to equal up to 3.2% of the current expenditure budget for a period of up to 30 days.
The Government is required to deposit all Government revenues, including proceeds of foreign debt (except for certain earmarked funds deposited with commercial banks), in the Bank of Israel, which is responsible for managing the Government's foreign exchange reserves. The Bank of Israel is prohibited by law from investing in equity securities or private bonds, and is subject to internal limitations on the amount of investments it May make in a single country or financial institution. The majority of the Bank of Israel's reserves is held in securities issued by foreign sovereign issuers.
At the end of 1997, the Prime Minister appointed a committee of outside experts to suggest changes in the Bank of Israel Law, in light of the considerable institutional and economic changes that have taken place in Israel since the Bank was set up in 1954, and similar actions taken in many countries in recent years. The committee report was submitted to the Government in December 1998. It was adopted by the Government and action on the issue is still pending. In keeping with its wide mandate, the committee made far-reaching recommendations, including changes in the Bank's objectives, its independence, and its structure.
Monetary Policy
Since 1985, when the Economic Stabilization Plan was adopted, Israel has made significant progress in stabilizing inflation through effective implementation of monetary policy by the Bank of Israel, and fiscal restraint and trade liberalization by the Government. In recent years, the primary objective of Israel's monetary and exchange rate policy has been to gradually reduce inflation to attain levels of inflation similar to those prevailing in other industrialized countries. See "The Economy-Wages and Prices."
The Bank of Israel's principal instruments of monetary control are monetary loans and deposits and a discount window facility. Auctions for interest-bearing deposits are currently the main tool for implementing monetary policy and are similar to repurchase agreements. The interest rate received by the banks is determined in the auction. Initially, these deposits were offered with a three-month maturity with a view towards enabling continued operation of the daily monetary loan auction as the key instrument for offsetting very short-run flows into and out of the monetary base. More recently, one-month, one-week and overnight deposits have been added, and the auctioned loans have been eliminated. In the past, the Bank of Israel used monetary collateralized loans to banks which were allocated to the banking system by periodic auctions of a predetermined amount and were used in a manner similar to reverse repurchase agreements. The auction of overnight funds and deposits of various maturities, and the rate of interest determined therein is the key determinant of short-term interest rates in Israel. The Bank of Israel utilizes the daily auctions primarily to offset flows from Government activities and the balance of payments. Through the discount window, Israeli banks can obtain overnight loans to fill temporary funding needs.
In order to offset capital inflows, the Bank of Israel operates shekel/dollar swaps, absorbing shekels in return for dollars for a given period of time. Allocation of the swaps is made by auction on the difference between the shekel interest rate and the going dollar interestrate, provided it is available on the foreign currency acquired.
Although the Bank of Israel does not issue its own securities, it may effect monetary policy by selling unlinked fixed-rate Treasury bills of up to one year maturity. In recent years, the Bank of Israel has increasingly utilized such issuances. In 1995, Government raised the ceiling on the outstanding amount of Treasury bills available to the Bank of Israel for purposes of effecting monetary policy to a total of NIS 15.5 billion, and provided for the automatic adjustment of that ceiling twice annually. Recently, however, the adjustments have only proved sufficient for rolling over principal and interest on the Treasury bills, so they are not currently an effective monetary tool.
At the end of 1991, the Bank of Israel and the Ministry of Finance began publicly announcing annual inflation targets, with an intention to gradually reduce inflation in Israel to levels prevailing in other developed countries. In 1994, in the wake of inflation significantly exceeding that year's target, the Bank of Israel began implementing more restrictive measures. The Bank of Israel's restrictive policy led to a slowdown in the rate of growth of the money supply (M1), and has been a key factor in preventing inflation from reaching 1994 levels.
Table No. 22
Selected Interest Rates
|
Short-Term Local-
Currency to the Public |
|
|
|
Overdraft Facilities |
Term
Credit |
Average Cost of Monetary Loans(1) |
SROs
(CDs)(2) |
|
1993 |
18.1 |
15.0 |
11.3 |
9.7 |
|
1994 |
19.8 |
15.6 |
13.4 |
11.6 |
|
1995 |
22.5 |
18.4 |
15.5 |
13.3 |
|
1996 |
23.0 |
18.8 |
16.2 |
13.8 |
|
1997 |
20.8 |
17.0 |
14.3 |
12.2 |
|
1998 |
18.3 |
14.8 |
12.0 |
10.2 |
____________________
(1) The weighted average of the
marginal cost of the monetary loans of various maturities.
(2) Excluding large negotiable SROs
(self-renewing overnight, local currency, interest-bearing deposits).
Source: Bank of Israel.
During the first seven months of 1997, inflation slightly exceeded the upper bound of the 7 to 10 percent target range set by the Government at the end of 1996. Accordingly, in mid-1997 the Bank of Israel halted its earlier policy of gradually reducing short-term nominal shekel interest rates from the relatively high levels that had been set in 1996, in order to address that year's surge in inflation. Short-term rates were maintained at a level of 14 to 14.5 percent (effective annual yield) from June 1997 through February 1998. In August 1997, with reported inflation (through June) exceeding 10 percent, the government set the inflation target for 1998 at 7 to 10 percent.
In combination with falling commodity prices world-wide and the overall slack in the economy, the restrictive monetary policy brought about a sharp drop in inflation from August 1997 through August 1998. Inflation (at an annual rate) for this period was just over 3 percent. Inflation expectations, as measured in the capital markets by the difference between yields on non-indexed and indexed bonds for similar maturities, and as set by professional forecasters, came down from levels in excess of 7 percent during the second half of 1997 to a range of 4 to 5 percent by mid-1998. Responding to these developments, the Bank of Israel began to reduce interest rates in February 1998 at a gradual pace, although somewhat slower than the pace of reduction of inflation expectations. Furthermore, with inflation appearing to head below 5 percent, the Government announced an inflation target of 4% for 1999. At the same time, the rate of increase of the lower bound of the currency band for the exchange rate was lowered from 4 to 2 percent. Immediately thereafter, the Bank of Israel lowered its interest rate by 1.5 percent, setting an effective yield on its deposits at just over 10 percent.
Monetary and inflationary developments changed drastically in the last five months of 1998, following the world financial crisis. These developments posed a major challenge for monetary policy by creating a potential for a sharp increase in inflation. By now it appears that this challenge has been successfully met as the effects of the crisis have been contained to a one-time price level increase, rather than a continuing inflationary process.
The initial phase of the crisis following the Russian default on part of its foreign debt in August 1998 had a significant effect on Israeli capital and foreign exchange markets and on inflation. The shekel/dollar exchange rate depreciated by 4.1 percent during August, the TA100 stock price index fell by nearly 8 percent and the CPI price rise for September was 1.3 percent. The later phase, following the near-default and bailout of the LTCM hedge fund, had a far larger effect on the exchange rate and consumer prices, and a smaller effect on stock prices, as the shekel/dollar exchange rate depreciated by 10.5 percent and the CPI rose by 3 percent in October. The depreciation of the currency basket from the beginning of August through October totaled 17 percent and resulted in consumer price increases of 5.8 percent (not in annual terms) between September and November.
The initial response of monetary policy to the depreciation was "wait-and-see." In light of the Bank of Israel's ongoing strategy of drastically reducing its foreign exchange market intervention, the Bank of Israel has allowed market forces to determine the new equilibrium on their own, and did not intervene directly during this period. Furthermore, in view of the slack in the economy, the Bank of Israel felt there was room for a significant real depreciation, so it initially refrained from taking active restrictive measures. However, as incidental evidence of significant price increase mounted during the last two weeks of October, the Bank raised the benchmark interest rate by two percent at the end of October. When future evidence suggested that price increases were continuing, the Bank of Israel increased rates by a further 2 percent in mid-November. These measures turned the tide on both the foreign exchange and inflation fronts, as the exchange rate began to appreciate and price increases mitigated.
The NIS exchange rate has appreciated by approximately 7.2% since the first week of November 1998, when it stood at NIS 4.30/dollar. CPI increases were 0.1% and -0.5% in December 1998 and January 1999, respectively. Nearly all reported inflation expectations for 1999 are back to the range of 4% to 6%, typical of the period just prior to August 1998, yet above the inflation target rate of 4%. Market-derived inflation expectations for the next 5 years range between 6% and 8%, reflecting a higher inflation rate than the 2% long-term inflation goals of most western economies. In summary, while policy has successfully prevented the exchange rate and price shocks of 1998 from causing higher levels of ongoing inflation, the long-term goal of inflation reduction will require further monetary restraint.
Table No. 23
Monetary Indicators
|
Year |
|
1993 |
1994 |
1995 |
1996 |
1997 |
1998 |
|
Monetary aggregates (average)(1) |
|
|
|
|
|
|
| M1(2) |
23.7% |
20.6% |
8.4% |
14.9% |
14.3% |
12.1% |
| M2(3) |
37.7 |
32.8 |
35.2 |
27.0 |
25.8 |
22.6 |
| M3(4) |
19.9 |
28.4 |
25.2 |
27.2 |
25.3 |
22.1 |
|
Public sector injection/GDP(5) |
1.4 |
2.2 |
1.1 |
2.8 |
1.0 |
0.9 |
|
Bank of Israel injection/GDP |
2.0 |
(1.9) |
(8.4) |
(3.5) |
( 6.7) |
(1.1) |
|
Private sector foreign currency sales/GDP |
(2.5) |
0.5 |
7.0 |
1.9 |
6.7 |
0.3 |
|
Nominal interest |
|
|
|
|
|
|
| SRO (CD)(6) |
9.7 |
11.6 |
13.3 |
13.8 |
12.2 |
10.2 |
| Unrestricted credit(7) |
16.5 |
17.4 |
20.2 |
20.7 |
18.7 |
16.2 |
| Currency-basket interest rate (average)(8) |
4.5 |
4.6 |
5.3 |
4.6 |
4.9 |
4.9 |
|
NIS/currency-basket (during period)(1) |
8.0 |
5.4 |
5.8 |
3.0 |
3.7 |
20.6 |
|
Real yield to maturity on 5-year bonds |
2.8 |
2.9 |
4.1 |
4.4 |
3.9 |
5.0 |
|
Nominal yield on equities (during period)(9) |
41.0 |
(39.4) |
14.0 |
(1.0) |
35.2 |
3.0 |
|
Nominal GDP (average)(1) |
15.4 |
20.5 |
16.3 |
16.5 |
11.6 |
10.7 |
____________________
(1) Percentage change over previous
period
(2) Currency in circulation plus demand
deposits.
(3) M1 plus interest-bearing, local
currency deposits and treasury bills.
(4) M2 plus foreign
currency-denominated deposits.
(5) Contributions to monetary
expansion.
(6) Self-renewing overnight deposit.
(7) In local currency.
(8) Three month LIBOR.
Source: Bank of Israel.
Banking Institutions
Israel has a highly developed banking system. In 1998 there were 45 banking corporations operating in Israel, including 23 commercial banks, eight mortgage banks, three investment-finance banks, eight financial institutions, two joint-service companies and one foreign bank. The total assets of banking corporations rose to NIS 563 billion by the end of 1998 (a 10% annual increase over the previous year), while the number of domestic branches was reduced from 1,076 in 1997 to 1,071 in 1998.
Israeli banks maintained a growing and relatively high rate of profitability from 1992 through 1997. In 1997, Israeli banks had a lower profitability of approximately 9.5%.
Bank Leumi Le-Israel, Bank Hapoalim, and Israel Discount Bank (including their subsidiaries) account for approximately 80% of the banking business in Israel. Prior to 1993, Israeli banks were permitted to conduct (in addition to traditional banking activities) a variety of non-banking activities, including underwriting securities, operating provident funds, intermediation, and trading in securities. Currently, banks are only permitted to conduct such activities through segregated non-bank subsidiaries. As part of recent banking reforms, distinctions between commercial banks and specialized banks (such as mortgage banks) are gradually being eliminated. Until the mid-1980s, the role of financial intermediation by banks and other private-sector financial institutions was limited due to large Government borrowings, which severely limited the availability of capital resources. The reduction in Government deficits and borrowings since that time, along with capital market reforms, have significantly increased the availability of capital resources to the private sector, giving the banks a larger role in the financial system.
Since October 1983, the main banking groups have shifted their emphasis from size to profitability. The performance of the banks, however, has been volatile and has been affected by the need for large write-offs of debts owed by industry, and the kibbutzim and moshavim. See "The Economy-Role of State in Economy." However, currently all Israeli banking groups and every banking corporation satisfies the minimum capital adequacy requirement of 8% prescribed by the Bank of Israel in accordance with international standards.
The banking reform included the reduction of reserve requirements to which the public's deposits are subject. Since the end of 1992, all types of deposits are subject to an unlinked reserve requirement of 6% on deposits with maturity up to 6 days, 3% on deposits with maturity up to a year and 0% on longer-term deposits. In addition, the banking reform included the elimination of most of the restrictions on interest rates and minimum terms of indexed deposits and credit, and the removal of the prohibition against the issuance and trading of certain types of derivatives. The deregulation of bank activity, together with the liberalization of foreign exchange, has helped to reduce the segmentation between different types of financial intermediation and augmented the substitutability between different types of financial intermediation and between different types of credit.
The liberalization of foreign exchange narrows the gaps between domestic interest rates on foreign-currency denominated instruments and interest rates prevailing abroad, and also works indirectly to lower interest rate spreads in the local currency sectors. As a result, the cost of credit in Israel has decreased faster than has interest on deposits, causing interest-rate spreads to contract significantly in recent years.
Another main aspect of the banking reform is the privatization process, which received special emphasis in the past three years. In October 1997, the State sold 43% of its shares in Bank Hapoalim, the largest bank in the Israeli banking system. It also sold an option to buy another 20% of the shares. In addition to the initial selling of 25% of its stocks in Bank Mizrahi, the government sold this year an additional 42% of its holdings in the bank. Also, in 1998 the government sold stocks and options on its holdings in Bank Leumi, and 4.8% of its remaining holdings in Bank Hapoalim.
In past years, Israeli banks have had a large number of significant non-bank holdings in various sectors of the Israeli economy. Yet, for the last three years they have been engaged in a process of reducing their holdings in non-financial firms. As a direct result of a joint report issued by three committees in December 1995, the Knesset approved an amendment to the banking licensing law in May 1996 which, inter alia, provided for the following: (a) total non-financial holdings by the banks will be restricted to 15% of each bank's capital after 2001; (b) the percentage of such holdings can be augmented by an additional 5%, provided the holdings in each non-financial corporation is no more than 5% of the bank's capital, and can be augmented by an additional 5% if the investment is in a foreign corporation; and (c) the bank is authorized to hold a controlling interest in only one non-banking corporation whose capital exceeds NIS 1.25 billion after 1997.
Table No. 24
Assets, Liabilities and Equity Capital of the Five Largest
Banking Groups
(in millions of NIS at constant December 1997 prices)
|
At Year End |
|
1994 |
1995 |
1996 |
1997 |
1998 |
|
Assets |
|
|
|
|
|
| In Israeli currency |
280,788 |
296,436 |
309,923 |
337,148 |
351,823 |
| In foreign currency |
158,331 |
158,341 |
172,883 |
174,895 |
211,671 |
|
Total assets
|
439,119 |
454,777 |
482,806 |
512,043 |
563,495 |
|
Liabilities and Equity Capital |
|
|
|
|
|
| In Israeli currency. |
284,972 |
301,553 |
325,108 |
346,567 |
363,606 |
| In foreign currency |
154,147 |
153,224 |
157,697 |
165,476 |
199,889 |
|
Total liabilities and equity capital
|
439,119 |
454,777 |
482,806 |
512,043 |
563,495 |
|
Equity capital |
23,955 |
25,337 |
26,803 |
29,015 |
29,972 |
____________________
Source: Bank of Israel;
Supervisor of Banks.
Capital Markets
Israel's capital markets and the laws regulating them are highly developed. The principal regulatory body responsible for administering the Israeli securities laws is the Israel Securities Authority ("ISA"). ISA's main function is to protect the interests of investors by overseeing the activities of the TASE, supervising public securities offerings, and mandating disclosure of material information by listed companies by means of publications such as prospectuses, financial reports, and other periodic reports. A company whose securities have been offered to the public in Israel by prospectus or whose securities are traded or listed for trading on the TASE is required to file quarterly and annual reports and certain current event reports with the ISA, the TASE, and the Registrar of Companies. These reporting requirements are enforceable by the Israeli courts upon the application of the ISA, which also has the power (under certain conditions) to direct the TASE to suspend trading of a company's securities.
The TASE is the only stock exchange and the only public market for the trading of securities in Israel. The TASE has 28 members, and as of December 31, 1998, 662 companies had equity securities listed on the TASE. The total market value of all listed equity securities as of December 31, 1998, was $40.9 billion, whereas the annual trading volume for equity securities in 1998 was $15.2 billion.
The private bond market in Israel has not been a significant source of capital for Israeli corporations, despite several measures introduced by the Government in the late 1980s designed to expand this market. Although provident funds were permitted to invest in private bonds, until 1996 total bond issues were negligible. In 1998, the amount of capital raised through 7 issues by the corporate sector totaled $590 million. The Government bond market in Israel is highly developed, and Government bonds account for the vast majority of publicly issued debt securities.
In recent years, the role of institutional investors in the Israeli capital markets has increasedsignificantly. The principal types of institutional investors are provident funds (long-term savings), severance pay funds (special funds established to hold assets set aside by employers for the payment of severance obligations owed to their employees), advanced study funds, mutual funds, and a variety of life insurance savings schemes. As of December 31, 1998, assets held by provident funds, severance pay funds, and advanced study funds totaled $33.5 billion, and the assets of mutual funds totaled $5.5 billion. In recent years, portfolio managers have begun to play a significant role in directing the investment of the public's savings.
The active involvement of foreign investors in the TASE began approximately three years ago and increased in the first half of 1998. Though the crisis in Russia's capital market in August took its toll, the TASE was affected much less than other markets. The state-of-the-art TACT (Tel-Aviv Continuous Trading) system and simultaneous trading in dollar-shekel options enabled the TASE to function smoothly and efficiently in a volatile environment. By the end of the year, all shares, convertibles, treasury bills, and government bonds were transferred to the TACT system. Derivatives are still traded on the floor, but preparations have begun to computerize their trading as well. Continuous efforts to reconcile listing regulations with other advanced exchanges have gained strong support in 1998. A public commission recommended a series of alleviations in requirements for dual listing on the TASE of Israeli companies currently traded only in U.S. markets. In addition, the authorities approved new maintenance rules for listed companies, bringing the TASE regulation framework in line with the world's leading stock exchanges.
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