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Middle EastAugust 29 2010

Bank of Israel's tough love pays off

Tough love: Bank of Israel supervisor of banks, Rony Hizkiyahu The Bank of Israel's authority to regulate the country's banking sector is something that other supervisors can only dream of, and the benefits of it holding such power were seen during the credit crisis. Writer Philip Alexander
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Bank of Israel's tough love pays off

The bank supervisory department at the Bank of Israel (BoI) had identified a new trend. Groups of individuals were coming together, obtaining mortgages to buy empty plots of land then hiring a developer to build new properties on it. Rony Hizkiyahu, the BoI supervisor of banks since November 2006, did not like what he saw.

"When banks finance a real estate developer, they have industry concentration limits. But because they were financing these developments through retail mortgages, there were no limits. And under Basel II, banks have 65% capital relief on mortgages, so they could charge low interest rates. It was cheap money - low capital costs, low rates - fuelling the construction industry," he says.

Mr Hizkiyahu moved quickly, changing the rules on such lending so that mortgages for buying properties 'off-plan' would be treated as loans to developers, requiring 100% capital reserves. This episode is characteristic of the supervisor's relatively free hand to use macroprudential regulation, at a time when a BoI base rate of just 1.75% might otherwise lead to the formation of asset bubbles. Mr Hizkiyahu explains that the concentration of Israel's banking sector, in a small domestic market of 7.6 million people, is the reason for the BoI's tough approach.

"The top five banks account for 94% of the market, so all banks are systemically important. We cannot afford the failure of even a single bank and we look very carefully to avoid this possibility," says Mr Hizkiyahu.

It is a mentality that has undoubtedly rubbed off on the banks themselves, with former regulators and government officials prominent among senior management and board members.

Galia Maor, CEO of Bank Leumi since 1995, was one of Mr Hizkiyahu's predecessors as BoI bank supervisor in the 1980s. Yair Seroussi, the former head of Morgan Stanley in Israel who became chairman of Bank Hapoalim from August 2009, had spent a decade as a finance ministry official. And in January 2010, Israel Discount Bank appointed as its chairman Yossi Bachar, former director-general at the finance ministry and architect of the 2005 capital market reforms that forced commercial banks to spin off their asset management arms.

"The reforms enabled a situation in which banks were less exposed to the changes in global financial markets. They also made the local capital markets much deeper than at the start of the decade. Debt and equity finance is now widely available in Israel, so Israeli companies rely less on international markets or bank lending," says Mr Bachar.

Hapoalim turnaround

This is not to say all banks escaped unscathed. Bank Hapoalim had exposure to US mortgage-backed securities, and these resulted in the bank recording a net loss of NIS895m ($235m) in 2008.

Mr Seroussi was appointed to Hapoalim as deputy chairman in June, then chairman in August when the previous chairman, Dan Dankner, resigned, citing differences with the BoI over how to respond to the bank's weakened finances. Mr Seroussi's first action was to step up the recapitalisation of Hapoalim, issuing Tier 2 notes for NIS1.5bn.

"We needed to build capital adequacy first of all, to allow employees and clients to work together without hitting limits that come from constrained capital. In the notion of going back to a solid and confident bank and clients, I also spent a lot of time dealing with the financing area and with how to build the best management team that Hapoalim deserved," says Mr Seroussi.

In particular, he found what he regarded as a strong pool of talent among the middle-management of the bank, and this included one or two eye-catching appointments. The new head of human resources, logistics and procurement on the board, Efrat Yavetz, had previously been a divisional manager in the bank's securities brokerage. The emerging management board put together a three-year plan in which Mr Seroussi encouraged them to consider every possible subject of discussion, including many that had fallen by the wayside at earlier board meetings.

One central development to fit with clearer client segmentation and a stronger service-led model is the adaptation of different types of branches, including boutiques for high-income neighbourhoods and express centres providing rapid automated basic services in locations with high footfall.

Hapoalim is also seeking to profit from Israel's strong savings culture - net savings rates are as high as 15%, the fifth highest in the world behind only a handful of affluent continental European countries. This has allowed the largest Israeli banks to maintain very healthy loan-to-deposit ratios of 100% or less.

In response, Hapoalim revived a marketing campaign from 40 years ago, called 'Dan the Saver'. This encourages parents to open accounts on behalf of their children and save monthly pocket money to prepare for major life events such as weddings and property purchases. This could help boost the bank's share of wallet, and establish loyalty among a new generation of customers.

Mortgage market prospects

It is a sign of how different the Israeli market has been compared to the US that many bankers consider its mortgage segment among the world's most promising. Israel is one of the few jurisdictions in the world where mortgage lenders have recourse to the borrower, rather than just the property. This discourages borrowers from overleveraging or walking away if they fall into negative equity on their property.

"If you look at pricing, on average in the past decade there was only a very slight rise, most of it in the past 18 months, because there was actually a price decline at the start of the decade in real terms," says Eli Yones, CEO of Mizrahi Tefahot, which has the largest share of the mortgage market.

Ms Maor says it is natural for prices to rise as there has been an annual supply shortfall of about 10,000 residential units. She adds the note of caution that, with local interest rates low and global capital markets unattractive to Israeli investors at present, funds will migrate into property assets.

Mr Hizkiyahu is already keeping a watchful eye on developments. Noting that average loan-to-value (LTV) ratios have risen over the past few years from 40% to 60% (still modest by international standards), he has introduced extra capital requirements on any mortgages with LTVs of more than 60%.

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Galia Maor, CEO, Bank Leumi

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Eli Yones, CEO, Mizrahi Tefahot

Niche opportunities

Although Israel has avoided the worst of the financial crisis, Mr Bachar believes its economy remains fragile, in line with the global situation. Consequently, Israeli Discount Bank is formulating a three-part strategy with an emphasis on greater efficiency in human resources, IT, and relationship between different parts of the group - which includes a New York subsidiary with assets of $10bn and a 70% stake in an Israeli credit card company.

At just over 12% for the end of 2009, Discount Bank has a lower BIS capital adequacy ratio than its three largest competitors, which all have ratios of about 14%. Mr Bachar says his bank's strategy, therefore, aims to be less capital-intensive.

"We have a certain level of capital and design our operations according to that, meaning we will do less corporate lending and direct investment in companies, and more private banking and capital market activity," says Mr Bachar. He believes that investments in IT over the past few years have given Discount Bank the chance to strengthen its position in investment bank advisory and brokerage business, which also places little strain on the bank's capital.

Avner Mendelson, head of group strategy for Bank Leumi, also identifies brokerage as a key area of opportunity, especially as the bank is aiming to increase the proportion of non-interest income. In the wake of the Bachar reforms, the sale of banks' asset management arms led to a reduced share for commercial banks in brokerage activities.

"The new institutional asset managers also became the dominant brokerage players. But the regulator is uncomfortable with this because of potential conflicts of interest, and our enhanced capabilities in capital markets mean we should be able to recapture some of this business," says Mr Mendelson.

The decision by major index compiler MSCI to move Israel from emerging to developed market status in 2009 has brought new investors to the country - Leumi recently made its first roadshow among Japanese institutional investors who are mostly required to invest only in developed markets. Ms Maor believes the growing sophistication of Israeli companies and their exposure to more foreign investors will lead to greater demand for capital market services.

And even in a crowded market for retail banking, there may be some opportunities for growth. Mizrahi Tefahot completed the purchase of a 50% stake in Bank Yahav in 2008. Other shareholders include the Histadrut trade union association, which also contributes the bulk of the bank's customers.

"This was an untapped market that had been neglected. We have retained Yahav's deep understanding of its niche market, while integrating its IT systems, cash management and asset and liability management with that of Mizrahi," says Mr Yones. The integration has cut Yahav's IT costs in particular, while Mizrahi has begun to distribute its mortgage products to a new customer base through dedicated offices in Yahav branches.

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