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| No. 31 |
The Israeli Banking Market by Shlomi Shuv |
January 1998 |
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Introduction Banking is one of Israel's largest industries. In 1996, the banking industry (1) generated NIS 15,250 million ($4,690 million) in added value,(2) accounting for 8 percent of business sector product and 20 percent of total product in trade and services.
Israel's banking system reflects the structure of a ramified oligopoly and is the most centralized in the Western world in both financial and nonfinancial terms. Competition in this industry takes place among a small number of players and reflects not only the dearth of competition in banking but the absence of competition throughout the financial sector and in extensive nonfinancial economic domains.(3) As of December 31, 1996, the two largest banks in Israel held 65 percent of total bank assets and the three largest held 81 percent.
Beyond infringing on the freedom and wallets of private and business consumers, this state of affairs hinders economic growth. The by-products of the system's current structure -- nonperformance of the capital market, which should serve as the engine of a modern economy, and centralization in extensive sectors of financial and business activity -- significantly limit the economy's growth potential.
Since it was established in 1954, the Bank of Israel (Israel's central bank) has subjected banks to regulations and restrictions as one of its preeminent tactics in pursuit of its economic goals. In most years before 1985, the banks served as the government's brokers in two directions,
raising money from the public to finance government deficits, and administering government development budgets. The banks also functioned as conduits through which the Bank of Israel controlled inflows of foreign currency. Instead of engaging in financial intermediation among households and firms in the conventional manner of Western banks, Israel's banks had to intermediate between the private and the governmental sectors.
The Bank of Israel's policy in this regard, which included a welter of controls in excess of the level needed to assure the banks' stability, caused -- directly and indirectly -- the structure of the Israeli banking system to change significantly over the years. The large banks benefited from the government policy because it helped perpetuate their centralization. The government's involvement virtually destroyed the ability of other financial markets to compete with the banks. The upturn in centralization occurred with the Bank of Israel's knowledge and, in some cases, with its support. The central bank assisted in this process, inter alia, by withholding licenses for new banks, by approving takeovers of small and medium banks by the large banking groups, and by allowing the banks to spread their financial and nonfinancial tentacles throughout the economy. So far have matters gone that the accrued might and cartelization of the banking system currently represent, in themselves, an entrance barrier to new competitors in banking and other financial markets.
The public did not become aware of the close relationship between the government and the banks until the early 1980s, when a grave crisis erupted in the matter of the banks' shares and the government attempted to whitewash the involvement of the banks' leading executives. The interrelationship that evolved also led to a regular outflux of high-ranking officials from the Ministry of Finance and the Bank of Israel to executive positions at the large banks. For example, the chief executive officers and chairmen of the board at Israel's two largest banks, as of December 31, 1996, all had held very high positions at the Ministry of Finance and the Bank of Israel.(4) Many senior officials in these two government agencies regard their posts as springboards to subsequent lofty appointments at the banks. This rules out the separation of powers between regulators and banks that an enlightened country should have.
This Policy Studies describes the development of banking centralization and the relationship between Israel's governing institutions and Israel since the country was established. It does so by illuminating key points and episodes in the banking system, explaining how these banks amassed their financial and nonfinancial clout, and analyzing the damage that the lack of competition in the banking market has inflicted on the Israeli economy and its consumers. The analysis focuses on the Israeli banking market and compares it to those in developed countries.
Finally, this paper recommends measures that must be taken -- concurrent with steps toward privatization -- to introduce competition in the Israeli banking market and to terminate the banks' deep interrelationship with Israel's governing institutions. |
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Corporations Holding Commercial Banking Licenses as of December 31, 1996*
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Review of The Israeli Banking System
Most of today's banking institutions predate the state. The oldest is Bank Leumi le-Israel, established in the early twentieth century. Most of the banks were founded by public institutions associated with the political parties of the time.(7) Table 1 above lists Israel's existing commercial banks in chronological order of their formation.
Centralization in the Banking Industry: the Result of Bank of Israel Policy
Israel's banks were established during the British Mandate, and one would have expected them to adopt the narrowly focused banking model applied in Great Britain. However, the large commercial banks did not content themselves with providing their customers with credit services. They preferred the German model, in which banks also intermediate in stocks and negotiable bonds, underwrite securities, manage mutual funds and provide investment consulting.
Israeli banks further emulated their German counterparts by taking over nonfinancial institutions, directly and through investment funds. This expansion became possible because Israeli law did not limit the fields of activity in which banks might engage and because scanty competition in financial services allowed them to branch into other operations.
The banking sector has become increasingly centralized since Israel was founded, as shown in Table 2.
Table 2 Development of the Israeli Banking System Since Statehood
The table shows that the number of banking institutions has decreased gradually since the Bank of Israel was founded and cooperative credit associations have become almost extinct. The number of independent commercial banks dwindled from twenty-three in 1948 to twelve in 1996 (the 1948 figure does not include Israel Bank of Agriculture, which does not function as a commercial bank, and omits ten banks that belong to the five large banking groups). The seven independent banks (those not affiliated with the five large groups) account for an inconsequential share of the system all told. Most of the mergers were encouraged by the Bank of Israel, in direct opposition to the American situation, for example, in which bank mergers are rigorously controlled.(11)
Another circumstance that emerges from the table is that the centralization in this system until 1973 was typically at the branch level, as demonstrated by a strong uptrend in the number of branches of the large groups. Since then, the centralization has been characterized by expansion of the branches' floorspace, not their numbers. The change in trend was prompted by the Bank of Israel, which considered an increase in the number of branches adverse to the public's well-being.(12) The large banks circumvented constraints in licensing of branches by increasing the branches' floorspace, thus bolstering their advantage over the small banks. When we examine per-capita floorspace of banks at times of rising ratios of population per branch, for example, we find 20.9 inhabitants per square meter in late 1973, 11.7 in 1980, and 10.8 in late 1996.(13) Bank Licensing
Between 1954 and 1986, the grand total of recipients of banking licenses was six (14) -- none of which was a foreign bank.(15) In Banking in Israel, Meir Heth, formerly Examiner of Banks at the Bank of Israel, writes: "The short list of license recipients reflects the Bank of Israel's policy, which assumed that Israel has enough banking institutions and should add no more except under special circumstances."(16)
The Mandate-era Banking Ordinance (1936) gave the Governor of the Bank of Israel broad discretion in issuing banking licenses.(17) The Banking (Licensing) Law, 5741-1981, which replaced the ordinance, listed several considerations to bear in mind in issuing such licenses but also gave the governor much maneuvering room.(18) An official policy in the matter of limiting licenses was never proclaimed, and the Bank of Israel itself has never disclosed how many license applicants it has turned away.
Meir Heth has the following to say in this matter: "Quite a few domestic and foreign investors showed interest in obtaining a banking license over the years, but for some reason most of them failed to meet the Bank of Israel's 'criteria.'"(19)
Notably, six of the seven license recipients since the state was founded merged into or were acquired by the large banking groups. Only the Foreign Trade Bank, its ownership reconstituted, has managed to consolidate itself as the First International Bank of Israel.
The seven years between 1954 and 1960 were the key period for drastic changes in the banking system. To slow the pace of monetary expansion, the Bank of Israel set rather high liquidity ratios that restricted the amount of credit the banks could extend. Furthermore, the Interest Law, 5717-1957, enshrined an interest rate ceiling in statute. These two processes hastened the demise of the small banks. The cooperative credit union sector contracted swiftly, most such entities merging with large banks. In late 1956, for example, twenty-one workers' savings and loan funds merged with Bank Hapoalim.(20) Indexation arrangements (selling indexed bonds), first introduced in the early 1950s to cope with the problem of savings in inflationary conditions together with the existence of an interest rate ceiling, turned the banks into the country's only capital-raising agencies. Proceeds were channeled to the government.(21)
The Israeli economy grew rapidly during these years (at more than 10 percent per year, from 1962 to 1964), and banks' profits grew as well. The stock market burgeoned from 1962 to early 1964. Most of the banks began to invest in nonbanking sectors. Of the thirty-four companies traded on the exchange during these years, approximately twenty belonged to the large banking groups.(22) The banks' equity issues boosted the share of equity in total bank assets from less than 3 percent in 1962 to 5 percent in 1964.
Again the Bank of Israel attempted to slow the pace of monetary expansion by raising liquidity ratios substantially.(23) The number of banks increased by one with the formation of Poaley Agudat Israel Bank and the dwindling of cocredit unions slowed. New branches opened at a very rapid pace in 1960 and 1961, but this activity slowed when a law requiring licensing of new branches went into effect.
Until 1966, the merger process in the banking system focused on cooperative credit unions. From then on, another trend became evident: certain banks continued to function as separate legal entities but were taken over by banking groups. These were years of economic recession and slower rates of monetary expansion. The volume and profitability of the banks' activities contracted. The banking crisis occasioned by the 1965-1967 recession revealed the riskiness of the banks' investments in business activity outside the financial markets.(24) These activities proved to be the main factor in their predicament.
Consequently, several bank mergers took place with the assistance and mediation of the Bank of Israel.(25) Mizrahi Bank with Hapoel Hamizrahi Bank; Export Bank and Israel Industry Bank with the Foreign Trade Bank; and Zerubavel Bank and Israel Savings and Loan Bank with Bank Hapoalim. The Bank of Israel also helped Bank Hapoalim acquire control of Yefet Bank (subsequently renamed American Israel Bank). After having slowed in the first half of the decade, the pace of centralization stepped up. Meir Heth describes the Bank of Israel's guiding considerations at this time: "The policy of the central bank clearly preferred considerations of business stability and sound management over considerations of the competitive structure of the banking system."(26)
These years were noted for rapid economic development and inflationary pressure that mounted in the wake of the Yom Kippur War. The Bank of Israel acted vigorously to restrain the pace of monetary expansion and hiked liquidity ratios to drastic levels.(27) The large banking groups continued to consolidate and small and medium independent institutions continued to disappear. Bank Leumi le-Israel took over Arab Israel Bank from The Foreign Trade Bank (1971). The British-owned Barclay's Bank transferred its branches to Barclay's Discount Bank in partnership with Israel Discount Bank (1972), making it the third-largest banking group. The Foreign Trade Bank and Export Bank merged into The First International Bank (established in 1972), which subsequently swallowed up Israel Industry Bank and Lemelacha Bank. The investors in the new bank included the government, the Manufacturers' Association of Israel, and First Pennsylvania National Bank, a large American institution. These changes gave Israel a much more centralized banking system.
After the Likud acceded to power in 1977 and affected an "economic revolution," the currency was devalued considerably and the dollar exchange rate was allowed to slide. These actions were taken to reduce the balance-of-payments deficit, which had triggered a severe inflationary spiral.(28) They were accompanied by an upturn in financial activity and another bull market on the stock exchange, beginning in 1977 and peaking in 1980.(29)
The government's influence on the structure of the banking institutions' asset portfolios continued to rise. The banks served as the government's brokers, intermediating between the public sector and the private sector. Most of all, the government's continuing control of the capital market verged on outright nationalization. Most financial assets of the public during those years constituted credit to the government, directly or indirectly.(30) The banks invested the public's middle- and long-term financial assets in accordance with instructions given them by the government, and funneled most of these monies to the government to finance its expenditures in return for government bonds.(31)
As for the structure of the financial institutions, centralization trends continued to accelerate and the number of independent banking institutions continued to diminish. In 1976, the banking business of Kupat Am Bank and two cooperative associations -- Mizrahi Savings and Loan Fund, and Loan Fund for Immigrants from Iraq -- was handed over to Bank Leumi. The First International Bank acquired the branches of General Bank for Industry and took over Lemelacha Bank. In 1977, Bank Hapoalim acquired the assets of Otsar Amammi (a cooperative association), Bank Massad (a cooperative association until then), and Bank Otsar Hahayal. Yahav Cooperative Association, controlled by Bank Hapoalim, was given a banking license. In 1980, United Mizrahi Bank acquired control of Tefahot Israel Mortgage Bank, the largest mortgage bank in the country.
When the issues market expanded greatly between 1977 and 1980, the banks seized the moment to raise money by issuing their shares -- money that was not subject to the government's directives and controls. Under the existing inflationary conditions, the banks' shares had to compete with guaranteed rates of return on assets linked to either the Consumer Price Index or to currency exchange rates. This necessity prompted the banks to begin "regulating," i.e., fixing, the prices of their shares.(32)
"Regulation" of Bank Shares
The price regulation affair blew up in October 1983, triggering the greatest and most serious financial crisis in Israeli history and causing lasting harm to the capital market.
In the "regulation" method, the large banks bought up each other's shares to boost their prices artificially. This manipulation, having begun in the 1970s, was made possible because the banks were allowed to issue credit without government restrictions on the basis of their own capital. This gave the banks an interest in maintaining the prices of their shares at levels that would assure their investors a high return. The proportion of bank shares in the total public portfolio of shares and bonds ballooned from 7.6 percent on average in 1976 to 33.6 percent in September 1983.(33) Consequently, the gap between the artificial and inflated market value of the shares and their market value climbed into the billions of dollars.
Apart from the use of money from provident and mutual funds, the banks financed this shares regulation by injecting dollars from their overseas extensions and converting this money into shekels. This was to take advantage of the government's devaluation policy. In October 1983, however, the scheme collapsed when the government failed to carry out a devaluation that the public had expected and on which the banks had relied. The bank share collapse toppled the entire stock market and inflicted financial losses on hundreds of thousands of citizens who held bank shares at that time. At the time the crisis erupted, the portfolio of bank shares held by the banks for "regulation" purposes was equivalent to 44 percent of their capital.(34)
In early 1985, after immense public outrage, the government appointed a state commission of investigation under retired Supreme Court Justice Moshe Bejski. The commission's conclusions, tendered about a year later, forced all the country's leading bankers to resign. Their successors allowed them to "retire" under spectacular wage and pension terms -- an episode that in itself rocked the country.
The commission's conclusions (1986) included recommendations to prohibit direct or indirect involvement of banks in trading in shares for their own account; to bar the banks from managing mutual funds specializing exclusively or partly in shares; to prohibit them from managing provident funds, and to separate the system that handles share consultancy and sales from all other activities of the bank.(35) At the present writing, more than ten years after the state commission of investigation released its report, these conclusions have not been implemented.
In December 1988, the police recommended that the bankers involved in the price manipulation affair be prosecuted. In response, the attorney general at the time, Yosef Harish, found no "public interest" in subjecting the bankers to criminal prosecution. In May 1990, the High Court of Justice, in an exceptional and unprecedented ruling, overturned the attorney general's decision on grounds of "substantive unreasonability." In February 1994, Jerusalem District Court convicted thebankers on exceedingly grave charges and sentenced them to prison terms. In February 1996, the Supreme Court, hearing the bankers' appeal, lessened these penalties because the government authorities had been aware of the manipulation and had aided it. Before it issued this ruling, the Supreme Court was shown that the authorities had assured the banks of their backing in the manipulation scheme and had drawn up a comprehensive economic plan that combined a currency devaluation with termination of the price fixing.(36)
Fearful about the political price it would have to pay for the bank share debacle, the government took action to bail out the holders of these shares. In a process called the "bank share arrangement," the government bought out the public's stake in bank shares at a total cost of $9.1 billion without becoming the legal owner of the securities. Not until late 1993, after attempting to enable the banks to reacquire their shares, did the government assume ownership of the stock.
According to the Arrangement Bank Shares Law (Ad Hoc Provision), 5754-1993, "until the banks are privatized," each bank was to be represented in dealings with the state by a five-member committee that would neither exert political influence nor possess the power to intervene in the banks' ongoing management. It is important to note that the government never sought formal ownership of the banks because its arrangement with the banks was satisfactory to both sides. Because the de facto nationalization of the banks was a by-product of the method used to compensate the public, it may be misleading to use the expression "privatization of the banks" in the connotation of introducing competition. The process of privatizing these banks, which gathered momentum in 1997 through issues on the Tel Aviv Stock Exchange and auctions of controlling equity, is but the culmination of the technical process of compensating the public for the share-fixing episode. As such, it actually represents an attempt to restore the pre-manipulation status quo.
In 1983, the Examiner of Banks, Galia Maor, appointed a subcommittee to the Bank of Israel Advisory Committee on Banking Business Affairs, headed by Meir Heth, to elaborate principles by which the prices of banking services in Israel might be examined. The committee recommended the introduction of price control for a few services that may be regarded as vital and the imposition of several restrictions concerning the structure of bank commissions. In its report, the committee stated the following:
1. Charging a separate commission for each phase of a complex
transaction that cannot be carried out step-by-step. (When the bank incurs certain standard expenses in carrying
out the transaction, we do 2. The commission is computed on the basis of the financial magnitude of the subject of the service, without a maximum charge or a reasonable gradation for the rate of commission set. (40)
Pursuant to the committee's recommendations, submitted in 1984, commissions were gradually decontrolled over a six-year period starting in 1985. The analysis to follow will show that the committee's recommendations with respect to "unfair" commissions have not been applied, and that many commissions are reckoned today as a percent of the sum of the banking transaction or as several commissions applied to a single transaction.
At the present writing, only twelve types of commissions are still subject to price control, under a regime that requires approval of rate increases by the price control unit of the Ministry of Industry and Trade. However, practically speaking, the decontrol prompted an increase in the share of the banks' total operating expenses covered by commissions: from 30.7 percent in 1988 to 44.3 percent in 1996. (Notably, net of commissions on securities transactions, the coverage ratio rose from 25.7 percent to 33.3 percent between the respective years.) Furthermore, the share of commissions in the banks' total income (41) climbed from 16.9 percent in 1988 to 31.6 percent in 1996 (net of commissions on securities transactions: from 15 percent to 28.4 percent).(42) This demonstrates the inefficacy of decontrol in itself, in the absence of concurrent measures to privatize.
The government's attitude toward the banking system turned around in 1985 under the reforms of the National Unity Government, which had been formed against the background of several years of triple-digit inflation. The new government resolved to liberalize the banking laws in order to revive the private sector by means of a free capital market in which competing financial institutions would be more active. The measures included abolition of the earmarked bonds that the government had been issuing to the provident funds. The results of the liberalization were quite substantial: the proportion of undirected credit (i.e., credit that the banks could issue at their own discretion, not by government dictate) in the banks' credit portfolio rose from 32 percent in 1985 to 80 percent in 1995.(43) The banks' intimate relationship with the government lessened, resulting in a slight decrease in the level of banking system centralization during this time.
The years after 1985 were typified by a lessening of inflation, perceptible expansion of undirected credit to the public, economic growth, and the beginnings of a stock market recovery. Issuance of undirected credit, coupled with the prevailing high level of centralization, created a large gap, in favor of the banks, between lending rates and interest paid on local currency deposits. Interest spreads climbed to double-digit percentage from 1984 to 1989 and did not recede to single-digit levels until May 1989, after the Governor of the Bank of Israel threatened publicly to lower lending rates by administrative order.
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Securities Credit and "Junk Issue" Affairs
The affair of "easy" credit for purchase of securities, which peaked in late 1993, typifies the behavior of the banking system in the early 1990s. The affair touched upon the relationship between the banks' ordinary activities and their management of investments in provident and mutual funds. The conflicts of interest about which the Bejski Commission had warned now dealt customers a direct blow to their wallets, as bank employees tempted customers to take credit for the purchase of securities -- usually through the bank's own mutual funds -- with no collateral other than the "asset acquired."
The easy-credit giveaway, carried out by aggressive marketing, nondisclosure of risk, and issue of credit sums disproportionate to customers' solvency,(44) led to an inflation of securities prices on the exchange that the Governor of the Bank of Israel, Jacob Frenkel, subsequently termed a "financial bubble."
But the mammoth quantities of credit in the system were not the banks' only source of profits. They also gained from the fail-safe field of "junk issues." The banks encouraged floundering companies to "go public" in order to repay their bank debts.(45) Most of the shares were bought up by the banks' provident and mutual funds, which, as stated, were luring customers by offering them easy credit. In this fashion, the banks, practically speaking, turned their high-risk liabilities into the public's bad assets, which, because of the credit trap, eventually also became the public's de facto liabilities.
The collapse of share prices in early 1994 left many customers with mounting debts and triggered an acute crisis of public confidence in the stock exchange -- a crisis that, as these lines were being written, kept the public at arm's length from the exchange. According to the Public Inquiries Unit of the Bank of Israel, the most frequent complaint expressed by citizens in 1995 had to do with misleading marketing of credit for the purchase of securities in late 1993, and 30 percent of such complaints, a relatively high number, wershown to be unequivocally justified.(46)
Another example of the government-bank relationship, in which the purported defenders of Israelis' rights did not do their job, occurred when the banks decided to close their branches on Fridays. In early 1996, after prolonged pressure from the banks' 35,000 employees to switch to a five-day work week, the banks decided jointly to shut all of their branches on Fridays in the faces of their three million customers.
When Antitrust Court took up this decision for discussion, the banks explained that if their employees went over to a five-day work week, it would not be profitable for them to stay open on Fridays, and if their joint decision were not approved, they would be "forced" to roll the operating damages onto their customers by hiking commissions by 20 percent.(47) The argument rests upon the banks' protection from competition by the state and the assumption of both banks and the state that customer abuse is an acceptable price to pay for this collusion.
The Supervisor of Banks and the head of the Antitrust Authority, the public's purported representatives, both officially favored the closure of branches on Fridays, under certain restrictions.(48) This again reflects the immense strength of Israel's banking cartel and its special relationship with the institutions of government.
The arguments cited by the Director of Antitrust and the Supervisor of Banks in this regard made no reference whatsoever to consumers' well-being. In his response to Antitrust Court, the head of the Antitrust Authority, Dr. Yoram Turbowicz, wrote the following: The data available to the Director show that closing the banks on different days may throw the system into chaos, to the significant detriment of the capital and foreign currency markets and sound commercial life.(49)
The Supervisor of Banks, addressing the Knesset Finance Committee, predicted a similar outcome:
Notably, in Western countries the value day, the inter-bank clearing day,
and the banks' business days are not necessarily coterminous. Indeed, this is an accepted state of affairs. In
its ruling in early 1997, Antitrust Court described the banks' decision as tantamount to a cartel. The court
so ruled even though the head of the Antitrust Authority disagreed. The banks appealed the ruling to the
Supreme Court, which, at the present writing, has not yet heard the case. Structure of the Industry
General
The table below describes the total capital and assets held by the two largest banks and the five largest banking groups, relative to the total equity and assets of the entire banking system.
Table 3 Israel's Large Banking Groups as of December 31, 1996 $ billions (exchange rate of December 31, 1996)
The table shows that the two largest commercial banks held 65 percent of total commercial banking assets as of December 31, 1996. The three largest commercial banks held 81 percent. Independent corporations -- those unaffiliated with the five large banking groups -- held only 6 percent of commercial bank assets. Notably, the five large groups also control investment finance banks and have sizable holdings in other financial agencies such as credit companies.
Israel's banking system is typified by two principal types of control. The first is vertical integration, in which banks control businesses that use their services. This control is characterized by nonfinancial centralization. The second type is horizontal control, in which the banks control competitors such as other commercial banks, mortgage banks, and provident funds. This control is characterized by financial centralization.
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The Nonfinancial Centralization(51) The entire Israeli economy is noted for extreme centralization, including specific industries such as fuel, dairy, insurance, banking, cement, public transport and health care. In this context, four powerful groups control large segments of the economy: the two leading banking groups -- Bank Hapoalim and Bank Leumi le-Israel -- and IDB Holdings (52) and the Israel Corporation (the Eisenberg group).
The more intensive a conglomerate is in complementary primary inputs such as human capital, technological know-how, and financial resources, the more clout it wields.(53) Financial resources represent a homogeneous input of vast importance for the investments and the current activities of any economic sector. Hence, a bank that also functions as a conglomerate attains even greater power and economic advantages; by the same token, it lowers the level of competitive potential in the economy, flirts with conflicts of interest, gives bank-affiliated nonfinancial enterprises an edge over other companies, and distorts resource allocation throughout the economy.
It was found, for example, that although Bank Hapoalim accounts for one-third of the banking system, it provided 43 to 77 percent of bank credit for the main companies under its control.(54) The larger the bank's share in financial intermediation and the broader the variety of means of financial intermediation that it controls, the greater the advantages that the conglomerate derives from this situation. In the end, the economy as a whole and the banking public are the losers.
The following table illustrates the meaning of "nonfinancial centralization" in Israeli banking by enumerating the nonfinancial holdings of Bank Hapoalim by industries.
As of December 31, 1994, Bank Hapoalim was involved in almost every possible field of economic activity in Israel, not to mention its extensive financial activities. The bank controlled ten monopolies: cement, paint, tubing, iron, glass, communications switchboards, paper, rolled cardboard and containers, margarine, and chemical storage.(55) In all, the bank's nonbanking activities embraced more than 770 Israeli companies in all fields, including 26 of the hundred leading firms.(56) As of December 1994, the market value of nonbanking companies listed for trade on the Multi-Sided Index (the "heavyweights") that were directly or indirectly controlled by the Bank Hapoalim group came to one-third of the total market value of traded companies on the Multi-Sided list.(57)
Table 4 Share of Bank Hapoalim Group Companies in Selected Industries, 1994 $ millions (exchange rate on December 31, 1994)
The Banking (Licensing) Law, 5741-1981, prohibits control of nonbanking companies (including insurance companies) by banks but does not outlaw the practice in which a holding company owns banking and nonbanking enterprises simultaneously. The large banks found it "difficult," for particular reasons, to restructure in order to circumvent the law. After they applied pressure, the deadline for compliance was extended to 1989. In 1989, at the initiative of the Bank of Israel, the intent of the law was revised and the only limit was applied to a maximum of 25 percent of the bank's capital. This limit was far from effective, since the banks' average holdings as a proportion of their capital fell short of 10 percent at that time. Thus the Bank of Israel, in response to pressure from the banks, effectively struck down the restrictions set forth in 1981.
The Brodet Commission, formed by the Government of Israel and chaired by David Brodet (Director-General of the Finance Ministry at the time) (58) to discuss aspects of banks' holdings in nonbanking corporations, released its report in December 1995. In its main recommendations, the commission ruled that the banks should divest themselves of holdings of greater than 25 percent in any nonbanking corporation by the end of 1996 and greater than 20 percent by the end of 1999.
The commission also recommended that, by the end of 2002, the total nonbanking holdings of any banking corporation not exceed 15 percent of its capital. Furthermore, by the end of 1998, a banking corporation may hold up to 20 percent control in only one conglomerate. In other words, Bank Hapoalim was to unload its entire stake in Koor or in Clal. In May 1996 the Brodet Commission recommendations on the downscaling of nonbanking holdings were enshrined in statute by means of Amendment No. 11 to the Banking (Licensing) Law.
The Brodet recommendations were toothless in every possible respect -- relative to other countries' restrictions on nonbanking holdings (59) and relative to the state of affairs in Israel. For example, the recommendations pertaining to the rate of holdings in nonbanking corporations stipulated that the holdings of bank-owned provident and mutual funds would not be counted. As we know, these funds have mammoth holdings in nonbanking corporations.(60) Furthermore, the relatively high threshold of nonbanking holdings as a share of a banking corporation's capital is ridiculous in the context of the Israeli banks, which had invested only 10 percent of their capital in such holdings, on average, as of the date of the committee's decision. This cannot but encourage them to expand their nonbanking holdings.
The story of the practical implementation of the Brodet recommendations is interesting in itself. The banks' holdings in Clal provide an example. In early 1996, Bank Hapoalim was Clal’s largest shareholder at 37 percent of control; the IDB group held 30 percent; and Discount Investment held 6.7 percent. In late 1995, when the Brodet Commission recommendations were released, Bank Hapoalim began gradually to sell packages of shares in Clal on and off the stock exchange -- 12 percent of Clal shares in all, for $80 million. The purchaser of the shares, directly and indirectly, was none other than the IDB group, controlled by the Recanati family (which held the shares of Israel Discount Bank), which emerged as Clal’s largest shareholder.
It is worth noting that the Brodet report referred to this sale specifically: "The sale shall not be made to any of the large conglomerates, such as the Bank Hapoalim group, Bank Leumi, IDB, and the Israel Corporation."(61)
Thus we see that the Israeli banks applied the recommendations of the Brodet Commission, like those of the Heth Committee, in the way most expedient to them.
At first glance, Bank Leumi seems to represent an example of auspicious behavior for the economy, but it too, as we shall see, has engaged in activities to aggrandize its nonbanking holdings without overstepping the law. First, the bank sold Africa Israel Investments (in which it held a 50-percent stake) to Migdal Insurance Company. Afterwards, a controlling stake in Migdal was sold to Assicurazioni Generali S.p.A., an Italian insurance company -- a minority shareholder up to that point -- and the remaining control of Africa Israel was divested to diamond dealer Lev Leviev. It stands to reason that the foreign company's entry, as with the acquisition of control in Africa Israel by an Israeli investor not affiliated with any conglomerate, may improve competition. It is important to note, however, the bank's aim was clearly to enhance its power.
For example, immediately after Bank Leumi reduced its stake in Africa Israel and Migdal, its chairman swiftly unveiled the bank’s business plan for 1997, which envisaged an expansion of nonbanking investments in insurance, communications, energy, and real estate acquisitions.(62) The bank decided to acquire 20 percent of Direct Insurance, Ltd., for $5.6 million. (63) After all, the law allows banks to invest 15 percent of their capital in nonbanking assets, and the liquidation of investments in 1996 left Leumi with only 5 percent of capital in such investments. Since the bank's capital today stands at $2.3 billion, simple arithmetic shows that it may invest another $230 million in nonbanking ventures without breaking the law. Notably, according to the board resolution, a hefty share of profits, including those from the sale of nonbanking assets, shall not be distributed as a dividend to the shareholder (the state). Instead, the bank will retain them to build up its capital, thus permitting further nonbanking investments with no legal violation.(64)
Financial Centralization
Israel's five largest banking groups dominate a broad spectrum of activities. Apart from control of other commercial banks, these activities include operations in the mortgage and credit card markets and most activity in the primary capital market (securities underwriting) and the secondary capital market (buying and selling real estate, investment consulting, and management of the lion's share of the provident and mutual funds of Israel's citizens).
As stated, the large commercial banks have stakes in small commercial banks that are separate legal entities. As a rule, one may distinguish between the terms "merger" and "acquisition of control." In a merger, the acquired entity loses its legal identity and becomes an integral part of the acquiring entity, making the two indistinguishable. In acquisition of control, the acquired entity maintains its legal identity and remains a separate business. Thus, its capital, assets, and results are shown separately in its own financial statements, not only in those of the acquiring entity.
When illustrating the difference, the weight of the many enterprises acquired by the large banking groups by merger cannot be determined. Therefore, the table below expresses only the holdings of large banks in commercial banks that were separate legal entities on December 31, 1996.
Table 5 Commercial Banks Held by the Three Largest Banking Groups on December 31, 1996
The holdings of the three largest banks in other commercial banks account for 11 percent of their total capital. These holdings stifle potential competition between the large banks and ten other banks that were separate legal entities as of December 31, 1996. Were it not for these holdings in commercial banks, 27 percent of the banking market (net of the three large groups) would be free to compete.
Mortgage Market
Another derivative of the commercial banks' oligopoly is the structure of the Israeli mortgage market. The banks' domination of the mortgage industry not only leads to exorbitant commissions but affects the entire housing market and its price level. The table below describes the structure of the mortgage bank industry, as derived from the control of the large commercial banks:
Table 6 Structure of the Israeli Mortgage Bank System, by Affiliation with Banking Groups NIS billions, December 1996 prices
The mortgage banks conventionally charge the following commissions: fee for opening an account; commission for issue of mortgage eligibility certificate on behalf of the Ministry of Construction and Housing, and commission for transfers of funds to other banks. One of the best-kept secrets in the mortgage bank system is the level of income from intermediation in sale of life insurance and real estate insurance services, which the banks incorporate into their statements under "commission income." According to estimates, this kind of intermediation accounts for 50 to 70 percent of the mortgage banks' commission income.(65)
The Israel Council of Economists sponsored a report on the mortgage banks, under a team headed by Professors Ezra Sadan and David Levhari. The report, issued in 1996, rules unequivocally that Israel's mortgage banks exhibit blatant cartel behavior (66) and accuses them of uniformly forcing their customers to purchase related services, persuading customers to accept mortgages within the profit range that the banks desire, inducing customers to take their mortgages from a bank belonging to the group that finances the building contractor, and so on. The report notes that the mortgage banks retain about half of the life insurance proceeds that they collect as an intermediation commission, forwarding only the remainder to the insurance companies. The government, which subsidizes about one-third of mortgage turnover in Israel, overpays the banks for their services in marketing mortgages to Housing Ministry eligibles (an estimated 0.75 percent of mortgage level).
Furthermore, the Israeli mortgage banks have made "errors" in computing customers' monthly installments and arrears interest.(67) Some of these errors were corrected, but even then in a manner detrimental to the customers. An expert opinion presented by Ms. Ruth Loewenthal, Director-General of the National Planning Authority at the erstwhile Ministry of Economics, to Tel Aviv Magistrates Court in February 1996 in the course of a lawsuit against the mortgage banks, stated that the mortgage banks have for years used an economically illogical computation technique and abused their power. The opinion recommended that the computations be corrected and the difference refunded to the customers.(68)
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The Credit Card Market
The share of credit cards in total retail spending was 35 percent in 1996, exceeding for the first time the proportion of cash or checks in the total retail "basket."(69) The Israeli credit card market is a duopoly, in another derivative of the banking oligopoly. Israel's only two credit card companies (as of December 31, 1996), which dominate the market, are controlled by the three largest banks. Visa K.A.L. (owned 65 percent by Bank Leumi and 35 percent by Israel Discount) held a 51-percent market share in credit card use, and Isracard (fully owned by Bank Hapoalim) held 42 percent (as of December 31, 1996).(70)
In a manner reminiscent of the large banks' competition-throttling takeover of small commercial banks, Visa K.A.L. took over Diners' business (5 percent of the market) and Isracard acquired that of American Express (2 percent). The casualties of these actions included consumers and businesses alike: beyond annual use fees for the cards,(71) the companies charge small businesses annual credit interest of 3.75 to 6.5 percent, as against 1.39 to 1.69 percent in the United States.(72)
Furthermore, the bank-controlled credit card companies prohibit businesses, by contract, from giving customers a discount for payment in cash. This gives their cards an artificial advantage and, practically speaking, forces businesses to pay the high interest. Consequently, businesses roll some of the interest onto their prices and absorb the rest themselves.
In the course of this writing in 1997, a third credit card company, Alphacard, Ltd., entered the market. The likelihood that this company will dent the two dominant players' market share is considered slight, because the three largest banks do not intend to allow their customers to choose a card offered by the new company. Moreover, since Alphacard belongs to the First International group, its advent cannot be likened to the entry of an outside player unaffiliated with the five large banking groups.
The Primary and Secondary Capital Markets
The large banking groups control a substantial portion of Israel's underwriting activity. An underwriter helps a company that issues its shares or bonds to make technical preparations for the issue, and guarantees the sale of securities under terms concluded with the issuer. The underwriter incurs a risk in this function, for which it charges an appropriate premium. In Israel, revenues from underwriting and distributing securities decreased from 5 percent of the banks' total commission income in 1994 to 2 percent in 1996, following the capital market crisis. Until the end of 1996, the banks controlled 80 to 90 percent of the domestic underwriting market. In the first half of 1997, as the stock exchange revived after three years of crisis, the banks' share in underwriting dwindled to 30 percent, mainly because, in contrast to their flexible private competitors, they had not foreseen the bull market.
The banks in Israel function as brokers who buy and sell securities for customers. Only members of the Tel Aviv Stock Exchange may buy and selsecurities there, and most of the members are commercial banks.(73) More than 80 percent of stock exchange activity in Israel is conducted by the commercial banks.(74) On average from 1993 to 1996, securities acquisitions and sales generated 22.4 percent of the commercial banks' total commission income. This occurred even though the capital market crisis caused commission income on securities transactions to plummet by 80 percent during those years -- from $482 million to $104 million (from NIS 1,566 million to NIS 339 million, in December 1996 currency).(75)
Investment Consulting and Portfolio Management
As stock exchange brokers, the banks in Israel also provide investment consulting services and are almost the only brokers countrywide who do so. The banks' gains on account of these services are usually indirect only. As stated, the Bejski Commission (1986) warned about the intrinsic conflicts of interest that beset this field of activity.
In August 1995, under pressure of the Securities Authority and to regulate this occupation and prevent capital market crises, the Knesset passed a law subjecting investment consulting and portfolio management to regulation. The law stipulates a minimum level of capital for brokers who wish to manage portfolios and requires licensing for portfolio managers and investment consultants, the criteria for which include a considerable number of tests. Under the law, banking corporations are not allowed to manage portfolios but may control subsidiaries that perform this service and that provide investment consulting. The new legislation has further infringed on the private portfolio managers' ability to recruit staff and has effectively obliterated the share of the small investment consultants who cannot meet the capital requirement.
Provident and Mutual Funds
As of December 31, 1996, the public had $33.5 billion (NIS 109 billion), 19 percent of its portfolio of financial assets, on deposit with provident funds.(76) According to Finance Ministry data, 88 percent of the assets of Israel's provident funds are held by banks, 11 percent by enterprise-level provident funds,(77) and only 1 percent by private funds. In various countries including Israel (Bejski Commission), it has been shown that bank ownership of provident funds increases the possibility of these funds being used contrary to customers' well-being.(78)
In principle, a provident fund functions much like a commercial bank. Members contribute to the fund for the long term and the fund managers use these sources for investments, primarily stocks and bonds. Wherever provident funds are controlled by banks, there is no likelihood of their being allowed to compete with the banks in lending to large businesses -- competition that could, for example, bring down domestic interest rates.
The table below expresses the tremendous market potential of the revenues of the bank-owned provident and mutual funds and the vast importance of this potential in the banks' income.
Table 7 Income of Israeli Banks from Management of Provident and Mutual Funds (December 1996 prices, exchange rate as of December 31, 1996) $ millions
On average over the past few years, the market of bank-controlled provident and mutual funds has been generating $300 million (about NIS 1 billion) per year. The banks' income from managing these funds amounts to 15 to 20 percent of their total operating income. This in itself may explain the banks' ardent desire to maintain their grip on provident funds.
However, the banks have further reasons to maintain tight control of provident and mutual funds. These funds allow the large banks to control nonbanking companies and the capital market. According to data from Meitav, Ltd., for the end of 1996, provident funds collectively held 9.5 percent of the market value of the Tel Aviv Stock Exchange (with the component of stock in their assets at 11.5 percent), and the bank-owned funds alone held 7.3 percent of the total market value of stock.
In February 1996, the Knesset passed a provident funds bill on its first reading,(79) pursuant to a government resolution in 1993. The resolution, prompted by recommendations from the Bank of Israel and the Capital Market Division of the Ministry of Finance, aimed to mitigate centralization in the Israeli capital market. In essence, the law expands the regulation of provident funds and their management, inter alia, by appointing representatives of the public to the funds' boards. The bill is bureaucracy-intensive, entailing the formation of director-appointed committees, enforcement of licensing procedures for management companies, and introduction of regulatory measures that verge on interference with the funds' very management.
An absolute majority of leading economic personalities have objected to separating the banks and the funds by regulatory mechanisms as opposed to separation of ownership. Nevertheless, the Bank of Israel and the Finance Ministry were resolved to set this Israeli invention, unparalleled in any Western country, into motion.
For this very reason, retired justice Moshe Bejski, chairman of the state commission of investigation, expressed the following warning in response to those who consider the bill consistent with his commission's conclusions:
The banks must divest themselves of the provident and mutual funds before they are privatized....The Bank Supervision Division cannot control temptation, and the system is severely tempted to take actions contrary to customers' well-being.(80)
In a memorandum to the attorney general in August 1994, Dr. Avi Ben-Bassat, head of the Bank of Israel Research Department at the time, justified the bill and explained why:
Full separation of ownership, leaving each market intermediator to engage in one activity only, would reduce the efficiency and profitability of the financial intermediators' activities, especially in a small market such as Israel's, and may make customer service less convenient, because of the banks' extensive countrywide network of branches.(81)
This view represents the continuation of the central bank's policy from the time it was formed: to strengthen the banks and make the system more centralized. In this state of affairs, one fears that the Ministry of Finance and the Bank of Israel favor the continued massive sale of government bonds to provident funds, in the absence of competition, in order to continue financing the state deficit at the public's expense.
The policies of the government and the Bank of Israel over the years have caused banking centralization to mount substantially and enabled the banks to expand their financial and nonfinancial grip on the economy, mostly by weakening existing competitors and withholding licenses from new competitors. The banks have exploited the resulting monopolistic infrastructure to take over other financial domains and to overshadow potential competitors in these fields. The centralized structure of Israel's commercial banks is in itself a barrier to the entry of competitors in commercial banking and other financial domains.
Damage Caused by the Structure and Distortions of the Banking System
The centralized structure of the Israeli banking system, as reviewed here, has caused many kinds of damage both to private and business consumers and to the economy at large.
Damage to Consumers and the Economy
The oligopolistic structure of the Israeli banking market causes the banks to collaborate, formally and informally, in setting the prices of services such as interest spreads and commissions on the one hand, and bank outputs such as the length of queues, minimum requirements for credit, bureaucracy, business , civility and quality of service, on the other hand.
Studies in other countries, especially those of G. J. Stigler in 1964 (82) and S. A. Rhoades in 1982, (83) show that the more centralized a market structure is, the more companies tend to cluster, formally and informally, to set prices that will elicit extraordinary profits. Furthermore, when system centralization contracts or when the number of firms grows, some firms will violate the explicit or tacit agreement by moving their prices toward those warranted by a state of competition.
A 1994 study on the structure of the Israeli banking system by Rikki Elias and Tsippi Samet,(84) for the Bank Supervision Division at the Bank of Israel, found a positive correlation between the H-index (85)-- an indicator of banking centralization -- and the interest spread in non-indexed local currency activity in Israel. Analysis of the results of a regression performed in this study led to the following conclusion: when the centralization index rises by one-thousandth (e.g., a shift from 0.220 to 0.221), the interest spread expands by 0.3 percent. The illustration below theoretically shows the damage caused to Israeli consumers and the entire economy by the oligopolistic structure of the banking system, in comparison with a state of perfect competition.
Figure 1
S represents supply and reflects the marginal cost to banks of producing banking output. D represents consumers' demand for banking services. MR represents the banks' marginal return in providing banking services (derived from the demand function D). Equilibrium in an oligopoly is attained at point E1. The oligopolistic manufacturer will produce a quantity of S at which the marginal return charged to consumers is equal to marginal cost (point B, at which his profits are maximized). Equilibrium in a competitive industry is attained at point E2, where the marginal cost of supply is equal to consumers' demand.
Because of the oligopolistic market structure, consumers pay price P1 for banking services and obtain quantity Q1 of banking services. In other words, consumers pay more for services in an oligopoly (P2, Q2) than they would in a competitive structure -- the difference is P1 minus P2 -- and obtain fewer banking services, at the difference of Q2 minus Q1. Producers earn more than they would in a competitive structure. The direct damage to the economy, assuming that the banks do not use the excess profit to subsidize their operating inefficiency, is the total damage to consumers less the banks' total excess profits. This indicator is manifested in the area (E1; E2; B) in the figure above.
The following table shows the effect of banking centralization on the cost of banking services. This cost is rolled onto consumers in various countries and is expressed in the average rate of rollover of banks' operating expenses. The table expresses these matters in terms of GNP in order to reflect suitably the level of business development in each country, as manifested in use of banking services.
The most intriguing inference in the table is that the net profit rate is not necessarily higher in Israel than overseas. In other words, most damage to consumers is caused by the banks' rollover of operating expenses onto them, and not in the banks' own profits. Israel's banks resemble a monopoly that functions with operational inefficiency, using operating expenses to build strength, and maintains reasonable profitability by employing a cost-plus method.
Thus, if we again consult the oligopoly market graph above, we find that since the Israeli banks have used their oligopoly structure to cover their operational inefficiency, the damage to the economy is maximized. It is equal to the total damage to the consumer plus the total profit to the producer from the oligopolistic market. In other words, not only do Israeli consumers pay more for fewer banking services, but the banks use their added profit to subsidize operational inefficiency -- itself harmful to the economy and wasteful of human and capital resources.
To compare appropriately the operating costs in Israel with those in other selected countries, we should neutralize operating costs for services that banks in other countries do not provide, such as securities transactions and management in provident and mutual funds. Since we cannot separate out these operating costs, we shall estimate the added operating costs of Israeli banks on account of these services under two highly conservative assumptions:
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