Banks are the central component in financial system of most countries and are particularly important in emerging markets where non-bank financial institutions are not developed. In both emerging markets and developed economies, banks play are playing critical role for transmission of monetary policy in the economy. With addition, the efficient provision of banking services creates such an environment that is conducive for long-term economic growth. In recent years many economists have increased recognition to the economic role of the banks and the broad importance for the payments and intermediary services provided by banks. At the same time, the banking industry all around the world has undergone dramatic changes in structure and activities. There are several global trends in banking -
_ government disengagement from the business of financial services,
_ increasing concentration in the banking sector,
_ spreading universal banking,
_ increment in cross-national banking and foreign bank ownership,
_ Substantial disintermediation as an non-bank financial institutions which become more active in financial markets. Thus, this is an opportune time to examine these changes and to explore the future of banking.
An examination of the Israeli banking industry is particularly timed. In many ways it is always been where other countries are going; Israel has always had a concentrated, universal banking system. In other aspects it was not been affected by some of the global trends, and was probably on the verge of some major changes. For example, government disengagement and successful privatization of the Israeli banks is in process or underway but not complete. Although the nationalized Israeli banks were managed independently, once privatization is complete, significant changes in industry structure are likely to happen. Moreover, the growing interest of foreign banks in the Israeli financial sector is likely to affect the Israeli industry. Finally, progressing financial liberalization and extensive changes in the Israeli regulatory environment were under discussion and will affect the future financial system.
The global trend towards highly concentrated universal banking systems was very strong in previous years. But in recent years it is been seen waves of mergers and acquisitions, particularly across national borders, which have increased concentration in both small and large countries. In emerging markets, acquisitions by foreign financial firms have become common place and a majority of bank assets are owned by foreign countries. In Europe, monetary union provides a strong push towards a single banking market and cross-border activities have accelerated. In the U.S. historical restrictions on inter-state banking had been disappeared, leading to a rapid reduction in the number of banks. In addition, arguments in favor of restrictions on bank activities are rarely heard and its involvement in all such aspects of the financial system (universal banking) is quickly becoming the global norm. Even in the U.S. legislation has recently repealed the Depression era restrictions on bank activities. Most countries are headed towards a financial system dominated by a small number of universal banks with significant international ownership.
In Israel the banking system and even the whole financial market is dominated by a handful or numerous of universal banks. The one of the major characteristic that distinguishes Israeli banking from other countries is that the relatively small involvement is done by foreigners in the banking system and the other distinguishing feature of the Israeli financial system is that the major banks face some competition from non-bank financial intermediaries and capital markets or money market. In emerging market countries, there is often competition for deposit taking from postal savings institutions that continue to be important. In more developed countries, banks face competition from commercial paper markets or private placements by institutional investors and also public bond and equity markets. Competition from institutional investors, pension funds, insurance companies and others, is less intense in Israel than in many developed countries. In addition, with the exception of the equity markets, capital markets are not particularly well developed in Israel so these were the two distinguishing features of the Israeli financial system - the structure of banking and the role of the non-bank components of the financial sector.
II. The Structure of the Israeli Banking Sector
The starting point for any discussion of Israeli banking is the 1983 banks shares crisis which led to government ownership for most of the banking sector. Although, the government was controlling the banks, and the banking institutions were left in tact and there had been somr direct government intervention with banking management. The banks continued to be private sector institutions, with government ownership of most shares, and the government expressed its desire to divest itself of share ownership quickly. However, privatization of the banking sector became a painfull and a slow process. The government's commitment to disengagement from the banking system has simply been weak. Many other countries (such as Mexico, Argentina and Poland) with equally complex political constraints were able to privatize their banking sectors more quickly. However in any way, substantial progress had been made in previous four years. In the near future or at a later stage many will be able to take government withdrawal from the banking sector for granted.
Many persons will not dwell on the torturous history of bank privatization in Israel but instead of it they will focus on the current and future status of the industry.
Banking Sector Indicators
The countries are all small (population less than 15 million) and well off (GNP per capital in excess of $12,000 in 1997) in below table. (We eliminated the wealthiest small country, oil rich Norway.) Additional comparative indicators, including measures of bank operations, were in the 1998 Annual Survey of the Supervisor of Banks, Israel's Banking System. Overall, the data available suggest more similarities than differences between Israeli banks and banks in similar countries.
The Israeli banking industry is very concentrated with the five largest groups which have controlled 93% of bank assets and the three largest banks which have controlled 77%. Competition in banking system has intensified in the last decade. The change was not made due to the entrance of new banks but rather than that the increase in the market share of the existing medium sized banks. Banking in many of these countries is just as concentrated as in Israel; the Israeli concentration ratio is around the median value. However, the trend in Israel has been down while it has increased in many other places in recent years.
Interest rate spreads is often used to measure the efficiency of the banking system or the
degree of competition. Bank scope data (Table 1) on the net interest margin is showing that the spread in Israel was slightly larger than the median for the group of comparative countries. An alternative data source (World Bank, World Development Indicators) showing that the spread between lending rates and deposit rates in Israel in 1997 was about a percentage point higher than the median for the group. Nevertheless, both such measures of the Israeli spread have fallen substantially during the 1990's. A factor that inhibits significant change in the banking industry was about Israel which is by some measures over banked. There was one bank branch for every 5,700 people and an ATM for every 5,080. However, the data in Table 1 indicates that the total number of persons per bank is comparable to other countries and a few banks will continue to collect most deposits because any effort to build a deposit base in the relatively small Israeli market would be prohibitively expensive.
B) Concentration and Competition in Banking.
Preclude competition is not been concentrated in banking. Without a large number of banking institutions it is not possible to have a highly competitive banking industry. The threat of entry by new institutions and the provision of bank services and products by other institutions are two sources of competition in banking. Since banking could be a multi- product industry, the threat of entry does not have to come from establishment of a new large comprehensive banking firm. Instead of it the competition was likely to be come from small banks or non-banks innovating or competing in particular product markets. New entrants or fresher in banking industry, foreign banks or non-bank financial institutions are likely to develop niche markets or targeted market and new financial service products. The absence of extensive branch networks and deposits is not preventing them from competing for many fee based financial services that are the source of revenue growth in banking across the world. The competition from non-banking financial sector institutions would be including a private and public capital markets, while non-bank financial intermediaries and foreign financial markets and institutions.
Into the Israeli markets since the mid-1990's there have been no formal restrictions on the entry of foreign banks and non-banking financial institutions. In the Israeli market for several reasons, there has been little interest for banking. First, political risk of investment in Israel has historically been thought to be high. Second, and perhaps more important, is that the international market centered in Israel is very small because Israel's isolation and the absence of significant economic relations with neighboring countries. The failure of regulators to create an inviting environment was the main reason for the failure of foreign commercial banks to enter Israel. Finally, it was already noted that the extent to which Israel is 'over-banked' discourages foreign entry.
However, when expanding financial markets create new business opportunities, the other countries banks were willing to enter a crowded field. Most of the comparison countries have a larger number of foreign banks operating than in Israel although their share of total bank assets is often as small as it is in Israel (about 3%).
Some recent developments do suggest that changes are possible. For the first time, some
major foreign commercial banks were starting operations in Israel (Citibank and Republic Bank are opening branches this year). The announcement of Citibank's plans was supported by intensive talks between bank officials and the Governor of the Bank of Israel on flexible criteria for establishing activities in Israel. There are rumors that Citibank might buy an Israeli bank and there have been discussions between Citi and the Arison group that controls Bank Hapoalim. It has been suggested that Bank Hapoalim
C) The Traditional and Non-traditional Activities of Banks.
There are wide differences in the degree to which bank activities are restricted even though universal banking has become the worldwide norm, Table 2 provides a brief of restrictions on bank activities in the most important non-traditional activities - insurance, real estate and securities. It also indicates whether there are restrictions on direct bank investments in non-financial firms and in the ownership of banks by non-financial firms. The summary indicates that the degree of restrictions in Israel is somewhat greater than in many comparable countries.
Although the Israeli approach to organizing the banking industry has always emphasized the universal nature of the banks, significant restrictions on bank activities have been an element of regulatory policy. In Israel and elsewhere, the development of other financial institutions and instruments will increase the competition with the banks and lead them to react by increasing non-traditional activities - as we already see in many places around the world
Although capital market development will be very important as restrictions on banks are removed in Israel, the financial system will remain bank-based. In fact, the difference between bank based and market based financial systems are diminishing around the world. Restrictions on bank activities are a form of competition policy. That is, a motivation to restrict bank activities is to reduce the power of the banks and to foster competition. An alternative approach is to foster the development of nonbank institutions and capital markets that will provide competition the banks have wide powers.
III. The Development of Capital Markets in Israel
In a small country it will tend to have a concentrated banking sector, which comes from the robust development of other capital market institutions which would be the main reason for interest in capital market institutions and about a competitive banking environment, particularly For the banking sector capital market instruments and institutions are the primary source of competition. The private sector will be effected by the dominant role of the banks and even due to development of capital markets and a richer variety of capital market instruments. In fact, it can be believed that the under development of the capital markets in Israel is the most significant factor in holding back overall the financial sector and it has a major influence on the lack of competition to the banking sector.
The extent of concentration in the banking sector is less important than the role of the capital markets. Non-banking provides a banking services and intermediation by capital market institutions which are the sources of a competitive financial sector Regulatory restrictions on the activities of the banks which dominate the financial sector does less foster competition than the development of such institutions
For example, financial assets of all institutional investors (insurance companies, pension funds, investment companies, etc.) increased from 44% of GDP in 1990 to 63% in 1996 in Belgium and from 16% to 45% in Spain. The market institutions have been growing in recent year in many countries with a history of universal banking. In many small European countries non-bank avenues for investments by individuals did not exist till today. In recent years, there has been substantial disintermediation in countries like Spain and Belgium resulting in sharp declines in the bank's share of total financial assets and rapid increases in the growth of other financial intermediaries.
In Israel it has not been a similar disintermediation process or any rapid growth in the importance of non-bank intermediaries. Such countries have experienced increased competition in the banking sector, which reduced spreads and consolidations in the industry. The assets of institutional investors (pension funds, insurance companies and provident funds but excluding mutual funds) to GDP declined from 88% in 1990 to 78% in 1996 due to withdrawals from provident funds. A unique aspect of the Israeli financial structure was about financial intermediaries and institutional investors which are mostly bank-controlled entities or bank managed; about 83% of provident funds and 60% of mutual funds are affiliated to the banks. Thus, there was little competitive pressure from disintermediation in the sense seen in other countries. In countries which are well-developed with capital markets, banks are only one part of a broad spectrum of institutions which can contribute in the process of financial intermediation between investors and savers. The entrepreneur and extends to the large public firm that raises capital in a variety of ways, ranging from the issuance of publicly traded equity to internationally an enterprise's financing arrangements fall along a continuum that starts with syndicated loans and private placements
Fully developed capital markets, banks are the single most important financial institutions. Entrepreneurial financing starts with the efforts of starting up to utilize self-financing, e.g., the personal saving of the entrepreneurs' friends and family. It includes government 'incubator' projects and the inter-firm provision of trade credit. Finally, Bank lending. Even with. This is often because credit rating by banks and the relationships between firms and other financial institutions their banks is important sources of information to capital markets.
Capital market financing. There are a wide variety of capital market institutions that take part in the process of financial intermediation. They include non-bank financial institutions such as merchant banks and institutional investors, and both private and public bond and equity markets. Our interest here is the growth of capital market financing in Israel and the absence of some capital market institutions. As capital markets develop, the banking sector's share of total credit declines for the simple reason that lenders have other places to go. In the last ten years there were some large changes in the sources of funds for Israeli firms. First, government sources were reduced dramatically and "directed credit" is now relatively small. Second, local stock market (equity) sources have increased in some years, and from 1995 there was a major increase in funds raised by firms in stock markets abroad. Third, in 1999 there was a dramatic increase in venture-capital funds raised, especially for high-tech firms.
Although these trends have increased the forces of competition in the local financial market, banks continue to dominate as the primary source of funds. There is some clear segmentation to the capital markets. Larger firms can go abroad for funds while banks dominate the domestic markets. There are some challenges to bank dominance: in some years firms have used the equity markets to raise working capital and recently, the rapidly growing venture capital industry is very important for high tech firms.
Most importantly, there are still some conspicuously absent components to the Israeli capital markets. The absent components are related to another important factor: the involvement of the government with institutional investors that has inhibited the development of capital market institutions and instruments. This involvement enables the banks to retain market power and influence over firms, particularly those without access to foreign sources of financing.
We will briefly examine the major components of the spectrum of capital market sources in order to understand the forces that are competing with the banks and those that can develop in the future.
IV. Prospects for Israeli Banking and Capital Markets
Israeli banking will continue to share many of the trends found around the world -universal banks in a concentrated banking system. However, the nation's financial structure can still change long way to imposing competitive pressures on a small number of universal banks. The changes that will occur in the banking system will be due to capital market developments that reduce the importance of banks in financing. Among the developments underway are: raising capital abroad (from foreign banks as well as capital markets), growth of mutual and provident funds foreign investments, growth of commercial paper and bond markets, the increased activity of foreign banks and inter-dramatically if foreign participation is encouraged and if impediments to the development of capital markets are removed. Both of these their banks are important sources of information. However, true government disengagement from the banking sector extends beyond ownership. The government should be less involved with planning and overseeing industry developments.
It is clear that the banking sector is rapidly moving towards zero government ownership, a welcome and long overdue set standards for bank ownership and avoid the politicization has made the approval process so long and drawn out.
The term "universal" bank is probably on its way to extinction. Even banks in the U.S.
That faced broad activity The gaps in the capital markets will not be filled by restricting the banks but instead by encouraging entry of other institutions.
in the past are well on their way to becoming universal. Banking systems will differ around the world in the degree of restrictions. In small economies like Israel, The gaps in the capital markets will not be filled by restricting the banks but instead by encouraging entry of other institutions.
of activities should not be viewed as a permanent substitute for the development of non-bank institutions and foreign competition. Competition policy should focus on the development of non-bank financial institutions and capital markets.
In the past, banking policy has emphasized restrictions to foster competition rather than institutional development. It is now time to place the emphasis on institutional development. For example, the Brodet committee reforms in 1996 prohibited the banks from controlling a non-bank entity, and by the end of 1998 they had to reduce their holdings in such firms to a maximum 20 percent of their equity. A better approach than such portfolio restrictions would be improvements to corporate governance and an enlarged role for institutional investors.
The Role of Banks in Israel's Financial Structure
It is believed that as a result of the reform, and additional complementary steps, particularly those pertaining to supervision and corporate governance, the future Israeli financial structure will be composed of three major pillars:
(a) Classical commercial banking, which will also include financial advice and the distribution of
pension and life insurance products.
(b) Life insurance companies, which will be the main producers of pension and annuity products.
(c) Investment banking, which will mainly be responsible for helping businesses to raise funds in
the capital market.
In addition, it is believed that the reform will contribute greatly to the already deepening secondary markets for FX, bonds, shares and derivatives. The effects of these changes on the future of the Israeli banking system are of course uncertain, but the following observations can nevertheless be made;
First, the growth of non-bank sources of finance relative to bank credit is set to continue Second, the high concentration of bank credit is likely to be reduced, affording small and medium sized businesses greater access to such credit.
Third, it is likely that the presence of foreign financial institutions, including foreign banks, will increase.At present, there are two foreign banks in Israel, servicing mostly large corporations and offering private banking services.
Fourth, the growth in the secondary markets will increase the risk sharing capacity of the economy as a whole and that of the banking system in particular. Israeli banks are beginning to look for ways to securitize part of their loans portfolio.
Fifth, as the business sector is likely to raise more funds through the capital market, banks will turn greater attention to the household sector.
Sixth, banks' role in consulting on and distributing pension and life insurance products is likely to grow considerably. This will require them to develop new skills and greater internal supervision. It should be noted that the law in Israel requires licensing for both financial and pension advisers.
Seventh, mark to market accounting practices are likely to become more prevalent, which will increase the discipline imposed on banks by the financial markets.
