KORET FELLOWS A PROGRAM OF KIEDF

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1 KORET FELLOWS A PROGRAM OF KIEDF Economic Reform Studies 2005 No. 4-6 Editor in Chief: Glenn Yago Koret Israel Economic Development Funds 1

2 KORET ISRAEL ECONOMIC DEVELOPMENT FUNDS KIEDF was established in 1994 to demonstrate that deploying philanthropy efficiently and effectively can stimulate private sector economic expansion and create employment opportunity in Israel. KIEDF Small Business Loan Fund: Leveraging loan guarantees and providing interest subsidies to facilitate more than $80 million of financing to more than 2,200 small businesses lacking access to credit on reasonable terms in partnership with Bank Otzar Hachayal. KIEDF Micro Enterprise Fund: Providing microfinance and microenterprise loan guarantees to economically disadvantaged populations seeking to establish home-based and other small businesses in partnership with Bank Hapoalim and Bank Otzar Hachayal. KIEDF Israel Arab Loan Fund: Leveraging loan guarantees to Israeli Arab and jointly owned Israeli-Israeli Arab small businesses lacking credit access in partnership with The Center for Jewish Arab Economic Development (CJAED) and Mercantile Discount Bank. KIEDF - Koret Fellows: Fellowships to post graduates serving as economic policy analysts in the Knesset, and to senior private sector economists to focus on issues impeding small business, employment expansion and private sector economic growth. KIEDF offers philanthropists a unique combination - leveraging contributions as if investing in their own business, helping people help themselves achieve self sufficiency and personal dignity, and contributing to a stronger private sector economy in Israel

3 The KIEDF Koret Fellows Program We are pleased to present a compendium of abstracts of independent research completed by the KIEDF Koret Fellows. The Koret Fellows Program provides annual fellowships to exemplary students to serve as economic research assistants and to complete independent economic research on issues impeding small business development, employment expansion and private sector economic growth in Israel. The program is funded by the American Friends of KIEDF through a grant from the Koret Foundation, San Francisco, California. The program is an extension of KIEDF programs that demonstrate how philanthropy can be deployed efficiently to help expand economic development and employment opportunity in the private sector in Israel. For more information about KIEDF visit Outstanding Israeli postgraduate students with degrees or academic experience in economics are eligible for program fellowships. The Fellows receive intense training in economic policy, parliamentary and government operations and practical policy research throughout the year. Fellows are assigned to, and assist a member of Knesset or government ministerial office with, policy research on economic issues and related matters for a period of one year. Interested and qualified Fellows may receive fellowships for a second or third year. In addition, each Fellow is required to independently research and complete a policy study on a matter deemed to be in need of reform that has a major economic impact on the development of a market-based economy in general and small business in particular. The studies are designed to focus on practical solutions that can facilitate reform and economic growth. Since inception, over 50 program fellowships have been awarded. Many program graduates have assumed leadership roles in the private sector and academia, and have served or now serve as economic policy advisors to government ministers and ministries. Over 30 published policy studies have influenced reforms that have expanded competition, eliminated bureaucracy, spurred economic growth and improved the quality of life of every Israeli. The KIEDF Koret Fellows Program has awarded 11 fellowships from among approximately 80 serious applications received. KIEDF welcomes the Abraham Fund, the Rosalinde and Arthur Gilbert Foundation and the Milken Family Foundation as fellows funding partners. Dr. Glenn Yago, Director of Capital Studies at the Milken Institute, Santa Monica, California, continues to serve as the Senior Koret Fellow funded by AFKIEDF to work with the Fellows on their research initiatives. Information about the Koret Fellows and how to obtain their research papers in full follows. We are proud of the accomplishments of this year s Fellows and wish them well in their next endeavors. Carl H. Kaplan KIEDF Managing Director Tel Aviv, Israel Zev Golan Fellows Program Director Jerusalem, Israel 3

4 Table of Contents Introduction: Financing Israel s Economic Independence 5 By Prof. Glenn Yago Credit Discrimination in Israel: A Proposal for Reform 10 By Aharon Mohliver and Eyal Seri Securitization: Bringing a Modern Financial Instrument to Israel 16 By David Dvir and Yohay Terri Urban Revitalization in Israel: Emergency Care for Israel s Inner Cities 26 By Shelly Hassan and Diana Zaks Full Hebrew copies of these studies can be read on the KIEDF website. Koret Fellows Profiles David Dvir is completing his Master s in Business Administration, with a Bachelor s in Law at Hebrew University. He completed a first year fellowship serving in the office of MK Daniel Benlolo, the coalition coordinator of the Knesset Finance Committee. Shelly Hassan is studying for her Master s in Economics at Hebrew University, after earning her Bachelor s in Economics at the College of Judea and Samaria in Ariel. She completed her first year fellowship serving in the office of MK Ilan Leibowitz and has been awarded a second year fellowship. Aharon Cohen Mohliver earned his B.A. in Philosophy, Economics and Political Science at Hebrew University. He completed his first year as a Koret Fellow serving in the office of MK Amnon Cohen, the chairman of the Knesset Economics Committee, and has been awarded a second year fellowship. Eyal Seri earned a Master s in Economics at Hebrew University, and a Bachelor s in Computer Science and Mathematics at Bar-Ilan University. He completed a first year fellowship in the offices of MK Orit Noked and MK Itzhak Cohen, both of the Knesset Finance Committee. Yohay Terri (Moits) earned a Bachelor s in Economics and Accounting at Bar-Ilan University. He completed a first year fellowship in the office of MK Ehud Rassabi of the Knesset Finance Committee. Diana Zaks is completing her M.B.A. at Tel-Aviv University, and earned her Bachelor s in Economics at Tel-Hai College. She completed a first year fellowship serving in the offices of MK Gilad Erdan of the Finance Committee, and MK Dr. Yuri Stern, Chairman of the Government Oversight Committee. 4

5 Introduction Financing Israel s Economic Independence Prof. Glenn Yago* Senior Koret Fellow Israel s national economic security is inescapably linked to overcoming acute internal threats to its prosperity. From Herzl s Old New Land onward, Zionist literature focused on Israel s promise not only as a refuge from anti-semitism, but as a country of choice for all committed to a democratic Jewish State. 1 Ben-Gurion was always careful to link the struggle for political with economic independence:... there is also a mutual influence between our economic position and our political status on one hand, and our capacity for spiritual and social advancement on the other... matter and spirit are not two separate realms. 2 To sustain immigration, build and retain its human capital, Israel must address the challenges of financial and policy innovation to sustain growth. Currently, the objective of establishing Israel as one of the top ten countries in terms of GDP per capita and quality of life is achievable. How to help achieve these important national goals is the subject of the research papers in this publication offering important program and policy innovations. As the following charts demonstrate, over the past thirty years Israel has experienced inadequate growth shared unequally. In order to complete the unfinished business of economic independence, the economic growth gap demonstrated below must be closed. The inability to sustain adequate levels of aggregate demand for economic expansion is demonstrated in these graphs. GDP Per Capita in Israel GDP Per Capita Growth in Israel Source: Rafi Melnick, A Peek into the Governor s Chamber: The Israeli Case, Journal of Economic Literature, website working paper, February 2003; Rafi Melnick, The State of the Israeli Economy, Milken Institute Global Conference, April Source: Bank of Israel, various years. * Prof. Glenn Yago is Director of Capital Studies, Milken Institute, Santa Monica, California. 5

6 Had Israel been able to maintain levels of growth at 50 percent of pre-1973 levels, current conditions of poverty, income polarization, infrastructure underdevelopment, and social and economic gaps that threaten the country s social cohesion would have been much less severe, if not ameliorated. Israel s uneven and insufficient growth pattern has been deep, particularly in the technology sector, but not broad. The rate of growth of the high tech sector is Israel s long, and deservedly, heralded success story. But, a more discerning analysis of Israel s economic performance based upon disaggregating performance data suggests that victory laps should be premature. Over the past decade, the high tech sector grew from 5 percent to 13.1 percent of GDP and from 14 percent to 33 percent of exports, but only grew from 3 percent to 6 percent of total employment. Over the past decade, the average growth rate of economic sectors other than information and communications technology (which still comprise the bulk of the Israeli economy) was only 2.3 percent annually (less than the rate of population growth, which was 2.4 percent), while the rate of growth of the information communications technology sector was 10.5 percent annually. High tech productivity growth rates averaged 5 percent annually over the past decade, while construction, services, and commercial sectors experienced 2-3 percent productivity growth and other sectors exhibited productivity declines. Structural problems in productivity growth have enormous economic and social consequences. The gaps in labor productivity, education and income that have emerged from these structural problems make growth unsustainable. It will be impossible to attain rapid or even moderate economic growth over time without growth in revenue and productivity in the economy outside of the high tech sector. 3 As Governor of the Bank of Israel Stanley Fischer recently noted, Growth is the most important issue - not simply growth, but sustained growth. Without it we cannot ensure a rise in the standard of living and in the welfare of the population. 4 The ability of Israel to strengthen its economy and achieve national economic security is now directly linked to the country s ability to encourage enterprise, innovation and competitive, sustainable markets. This requires the democratization of capital in Israel. The unfulfilled promise of national economic independence and security can only be achieved if the ideas of people who can labor to fulfill their hopes and dreams can be financed efficiently. Today, Israel unfortunately still lacks the effective and efficient financial institutions, capital markets and financial tools to realize these goals. Israel is certainly on the right track of financial and economic reform, but, as the saying goes, you can still get run over on the right track if you do not move fast enough. Much remains to be done. The Koret Israel Economic Development Funds (KIEDF) Knesset Fellows research herein builds upon recent positive initiatives in economic and financial reform, by demonstrating much needed next steps in several important areas - securitization, urban revitalization, and community economic investment and development - steps that will increase the availability of credit and improve the functioning of capital markets in managing enterprise and project financing risk for economic development. Recent initiatives of financial reform have been positive. But fiscal changes and financial reform will not suffice. In order for Israel to achieve its economic potential, 6

7 it must move more swiftly down the path of structural reforms that will enhance competitiveness and raise productivity. This requires structural reforms that include reducing the dominant and distorting government role transmitted through budget and regulatory policies, disincentives for entrepreneurs to enter the financial markets and continued ownership and regulatory interference in many economic sectors. Many industries are still cartelized or monopolized. Barriers to entry, many enforced by the government, effectively keep competitors out. Privatization, capital market reforms, and small and medium sized business growth are crucial for reducing the government s role in the economy. They can mitigate the distortions that follow from flawed strategies and promote economic growth through various channels of entrepreneurial innovation. Privatization and expansion of the business sector enables government to shift its economic activity out of economic areas in which the private sector can perform better, freeing resources for those areas that are the basic responsibilities of government, thereby improving competitiveness and efficiency. Capital market reforms support economic growth by channeling savings to long-term productive investment on the basis of market signals and prospects of risk and return rather than government fiat. Thus, they can provide profitable savings opportunities for households for the long term, since in an efficient market, the savings of individuals are directed to firms, subject to shareholder monitoring and market competition, that can make the best use of them. Beyond right and left, a consensus is emerging in Israel about the importance of economic policies promoting entrepreneurial led growth and financial innovations less dependent on aid and fundraising and more on investment and productivity of financial, human and social capital. This consensus was best demonstrated in the near unanimous support in the Knesset for the financial reform package passed this year. Building upon past research, this year s Knesset Fellows provided valuable research assistance to members of both the Economics and Finance Committees of the Knesset supporting their deliberations on these reforms. The first steps of financial reform are being taken, but the critical tasks of market building, a necessary condition for nation building, remain ahead. More measures, as suggested in this research, need to be implemented to increase the availability of credit, as well as the function of capital markets, to support entrepreneurial growth. The means and methods of state building (highly centralized government control supported by Diaspora and U.S. aid) that purported to support Israel s creation and survival since its inception have long since become costly, burdensome, and largely obsolete. As the research herein demonstrates, as a result of political, not market forces, Israel suffers from an extraordinarily high rate of concentration of credit, wealth and ownership that undermines its long term growth objectives. This has given Israel the dubious distinction of having the highest poverty rate and greatest income polarization (the biggest gap as a multiple of average wage between the top and bottom 10 percent of earners) in the developed world. 5 The chart on page 11 of this publication indicates a near perfect concentration of credit distribution, which undermines future growth. Israel s capital markets suffer from acute structural problems. The combination of banking sector concentration and capital market underdevelopment 7

8 is full of potential and real conflicts of interest. Macroeconomic performance will vastly improve only with a resolution of these problems. Tax, regulatory and accounting obstacles to the development of capital markets instruments need to be removed. Entrepreneurial growth is constrained by the triple impact of capital market underdevelopment, banking concentration and low liquidity. Over 90 percent of listed companies are closely held by majority shareholders holding close to 70 percent of a company s shares. Only Finland and Switzerland have higher rates of banking concentration. The corporate bond market in Israel is only 3 percent of GDP compared with 70 percent in the U. S., 28 percent in the UK, and 40 percent in Japan. Only 30 percent of listed equity is floating and turnover velocity is extraordinarily low (volume/ market capitalization is 33 percent in Israel versus percent in London or percent for the NASDAQ). 6 The development of Israeli capital markets and increased competition in its financial system are necessary prerequisites for achieving sustained higher growth. Without an increased investor base, the introduction of new financial products, and improved corporate control, the contribution of the financial system will continue to be insufficient and fail to accelerate required economic growth. Structural changes must be achieved swiftly, in order to reduce concentration of economic power and the government s restraints and interference in capital markets and price stability. The largest threat to Israel is not external. Israel has well demonstrated its defense capabilities in dealing with existential threats and must continue to do so. But, the internal threat that investors, entrepreneurs and the country s valuable human capital could vote with their feet in the face of deficits, taxation, and income polarization could truly undermine the country s future. With customers, investors and markets abroad, and tax and financial reforms awaiting implementation, the centrifugal forces driving capital flight and emigration could become overwhelming, weakening Israel further from within. As long as restrictive tax and regulatory regimes maintain a bureaucratic chokehold on local capital markets, the vast majority of wealth created by Israeli firms and foreign firms investing in Israel will be realized abroad. The ability of the country to become selffinancing in this generation is threatened. Moreover, the absence of financial innovation has politicized financing and funding decisions, polarizing interest groups and exacerbating social conflicts. Aligning interests through financial structures and policies that create common benefits is the essence of modern finance. The Koret Israel Economic Development Funds (KIEDF) Knesset Fellows research in this compendium provides a careful demonstration of economic and financial analysis applied to long-standing policy problems. This research provides important recommendations for program and policy innovation necessary for sustained economic development in Israel. Whether it is the issue of financing urban revitalization and infrastructure, securitizing small business loans, or establishing the basis for bank regulation that ends credit discrimination, the KIEDF Knesset Fellows have applied the best of empirical analysis with established international practices to provide practical proposals to solve problems that threaten Israel s economic future. Hopefully, the force of observation will help change circumstances on the ground in the Israeli economy. Practical lessons and real financial tools forged from global 8

9 experience create a policy and financial tool chest that can help build the country and finance its future. We hope that the Knesset and policy innovators throughout the government and business sector who wish to be the successful agents of change will find the results of this research helpful in fulfilling the goals of Israel s national and economic renewal. We look forward to the continued and expanded research work of the Fellows program in 2006 to support implementation of financial innovations and reforms to help finance Israel s future. 1. Daniel J. Elazar, Land, State, and Diaspora in the History of the Jewish Polity, Jerusalem Center for Public Affairs, see also Shlomo Avineri, Theodor Herzl s Diaries as Bildungsroman, Jewish Social Studies, 5/3 (Spring-Summer, 1999): 1-42; see also S. Ilan Toren, Imagining Zion: Dreams, Designs, Realities in a Century of Jewish Settlement (New Haven: Yale University Press, 2003). 2. David Ben-Gurion, Independence Day Address to the Knesset, Elhanan Helfman and Amit Sklar, Small Economy Global Economy, Caesaria Conference Prof. Stanley Fischer, Governor of the Bank of Israel, to the Knesset Finance Committee, Jerusalem, May 30, Leah Ahdut (ed.), Annual Survey 2004, National Insurance Institute, Research and Planning Administration, Jerusalem, March Moshe Tery, Chairman, Israel Securities Authority, To the ISA s Vision for Israel s Capital Markets, Milken Global Conference, April See also, Capital Market Reforms and the Privatization Process, Forum Proceedings, Jerusalem Center for Public Affairs/Milken Institute, September

10 Credit Discrimination in Israel: A Proposal for Reform Aharon Mohliver and Eyal Seri The study recommends: Adopting a form of Community Reinvestment Act (CRA) legislation to remedy credit discrimination in Israel. In the United States, CRA, without adversely affecting bank profitability: enhanced credit availability on reasonable terms to thousands of small businesses; facilitated credit for low and moderate income neighborhood rehabilitation; provided substantial financing to third sector non-profit organizations; and resulted cumulatively in over $1 trillion in new lending to previously underserved low and moderate income neighborhoods, small businesses, and non-profits that had suffered credit discrimination. Seventy-one percent of the credit provided by banks in Israel in 2003 was given to less than one percent (0.9) of the borrowers. 1 This astonishing figure underscores one of the core structural problems of the Israeli economy: the credit crunch faced by small and medium-sized businesses, perceived by many to be especially difficult in communities in the country s periphery. The Importance of Small Business Small businesses are a vital element of a growing economy for three reasons: 1. They represent the business sector with the largest growth potential. 2. They are the best income distributors because of geographical and sectorial dispersion. 3. They are the best and least expensive source of job creation. In spite of the importance of small business, data on the distribution of credit in Israel paints a despairing picture: small borrowers of less than NIS 1 million (approximately $220,000) or 99.1 percent of all borrowers in Israel, received less than 29 percent of all credit in The remaining credit went to a small select few; 0.11 percent of all the borrowers in the country received 54 percent of the credit in 2002 and 53 percent of the credit in 2003, the most current year for which data is available. The Historical Evolution of Credit Imbalances in Israel Israel s economy has been highly centralized since the state was founded. Through massive intervention in capital markets, the state - both as a large owner and as a 10

11 regulator - created a credit market based almost exclusively on the banking system. Using financial tools such as dedicated, non-tradable, high-yielding, inflation-indexed bonds to absorb long-term savings, the state precluded others from accessing the capital markets. As a result, the stock exchange remained very small and handicapped, since most assets were not available for funding non-governmental activities. Companies that wanted to issue bonds were forced, by law, to be approved by the Finance Ministry, an approval that was rarely given. The government thus made businesses totally dependent on bank credit, a dependence that essentially persists to this day. 3 Within the banking system the state again acted, both as a dominant player and as a regulator, by directing the credit that was within the banking system. The state selected the companies and organizations that would receive loans, and used only a few banks as vehicles to fund them. This use of specific banks, the lack of strict limitations on mergers and acquisitions, and other governmental interventions encouraged consolidation and concentration within the banking sector. The assets of the three largest banks as a percentage of whole banking system assets grew from 50 percent in 1948 to 81 percent in the late 1990s, peaking at a high of 93 percent. 4 The two largest banks, Leumi and Hapoalim ( the duopoly ), control 63 percent of all the public s deposits and provide a similar share of all credit. The impact of the duopoly is exacerbated by the lack of credit alternatives to the banking system. In 2004, the banking system provided 93 percent of the entire credit market in Israel, and nearly 100 percent of the credit to small businesses and households. 5 This banking system concentration has led to non-competitive behavior such as nearly identical bank services commissions, banking fees and rates, and conditions for credit allocation. Whole sectors of the economy suf fer from the skewed creditallocation policies of the banks, as can be demonstrated by the astounding Gini Credit-Allocation Index of over the last 10 years - indicating close to a perfect concentration of credit allocation. Figure no. 1 Lorenz Curve for the Banking System s Credit Allocation in Israel 2002 Source: Michael Tavor, Small business credit - Market failure or an economical equilibrium? Tavor Institution, Version 3, October 2004, Credit.pdf (May 25, 2005). 11

12 When compared with GDP output, employment impact and small business as a percentage of the business sector, the curve underscores the tendency of the banking system to allocate an inordinate amount of credit to the largest firms in the economy. A small minority of borrowers percent - receive a staggering 73 percent of total credit, employ roughly 40 percent of the work force and produce 50 percent of the GDP. Small and medium businesses - approximately 96.5 percent of all Israeli businesses - produce almost 50 percent of Israel s GDP and employ 60 percent of Israel s workforce (not including government employees), but receive only 23 percent of the credit allocated by the banking system. 7 This data can be seen graphically in Figure 2. Figure no. 2 Credit, GDP, Employment and Share of Businesses: Small and Medium vs. Large Businesses Further, the exercise of market power by the banks regarding the small business sector is perceived to be differential. The banks may be treating small businesses in the country s outskirts worse than small businesses in the center. Credit Discrimination in the United States In 1975 the U.S. Congress enacted The Home Mortgage Disclosure Act authorizing the collection and monitoring of data on home ownership and home improvement loans. The data collected revealed that certain areas were red-lined by lending institutions effectively prohibiting allocation of credit. Since such an activity is unlawful, different methods were used to deprive these communities of credit. 8 In 1977 Congress enacted the Community Reinvestment Act (CRA), which made federal regulatory approvals (e.g., renewal of Federal banking licenses) dependent on allocation of credit to these specific communities. The CRA provided a regulatory framework for rating each bank according to the amount and quality of credit provided to formerly red-lined communities. Minimum CRA ratings are required for receiving 12

13 certain regulatory approvals such as the authority to open or close branches or to acquire or merge with another banking institution. Thus, the industrial organization of the banking system depends upon the positive demonstration of the absence of systemic discrimination in credit allocation. The CRA was extensively revised in Today banks are required to report performance in three fields: the service test, the credit test and the investment test. The definition of relevant loans and investments also was broadened to include businesses within the bank s geographically defined area. 9 Impact of the CRA on the U.S. Economy Despite dire warnings of adverse effects of the CRA from the American banking system, evidence today shows that CRA loans are as profitable as regular loans and are not, on average, riskier. Despite higher costs per loan, 82 percent of CRA loans were found to be as profitable as regular loans and 99 percent were found to be either slightly more profitable or slightly less profitable than regular loans. Only 1 percent of CRA loans were found to be substantially less profitable than other loans. Lastly, the evidence demonstrates lower aggregated risk for the lending body when loans are more broadly dispersed geographically. 10 The CRA led directly to increased credit allocation to formerly deprived Low and Medium Income Communities (LMI). The effects of the act are very clear, especially after the 1995 revision: Loans for housing in LMI communities in CRA areas in Indiana, for example, increased by more than 300 percent between 1994 and Overall, the Federal Reserve Board estimated that CRA resulted in billions of dollars of annual additional lending to neighborhoods and individuals that had previously suffered from systematic credit discrimination by lending institutions. Hence, the CRA has made a real difference in revitalizing neighborhoods and creating financial flows exceeding $1 trillion to those previously underserved low- and moderate-income businesses and communities. 12 A Fair Credit Act in Israel Macro-economic data demonstrates clearly that there are severe credit concentration problems in Israel. The Bank of Israel s Research Department s data on local businesses shows that small and medium businesses suf fer from substantially higher financing difficulties. 13 The Israeli Small and Medium Business Authority states: This data points to a severe credit crunch facing small businesses; this narrows the growth potential of small businesses and hinders, in our view, the growth potential of the Israeli economy; this is, undoubtedly, one of the core issues for future policy change. 14 We believe the Israeli banking system has the capacity and capability to ameliorate existing distortions, discriminations and imbalances in the distribution of credit. We 13

14 further believe that the most efficient and effective method to ensure that the banking system does in fact achieve these objectives is through CRA-type legislation and regulation by the Bank of Israel that creates reward incentives for banks that meet the standards established and penalties for non-compliance. The CRA framework is far more effective, efficient and transparent than creating new government, tax-dependent redistribution mechanisms operating within inefficient government bureaucracies. We therefore recommend: 1. That the appropriate government authority should define what information regarding clearly perceived credit discrimination should be gathered by the Supervisor of Banks in the Bank of Israel. The appropriate government authority, in consultation with the Bank of Israel, should also establish credit thresholds that define discrimination in credit allocation to geographic areas, and small businesses and non-profit organizations in such geographic areas. 2. The Bank of Israel should recommend which banking activities will be subject to CRA-type ratings. 3. The General Accountant s Office should be authorized and required to establish activities that are dependent upon achieving positive CRA ratings. 4. The Research Department of the Bank of Israel or the Central Bureau of Statistics should be authorized and required to collect demand-side data for determining the credit needs of the geographic areas defined by the appropriate government authority. 5. The Bank of Israel should be required to collect data regarding credit dispersion, based on the criteria set by the appropriate government authority. 6. The Bank of Israel should be required to issue an annual CRA rating for each bank in Israel. 7. The appropriate government authority should be authorized and required to condition financial transactions with Israeli banking institutions, and the Bank of Israel, regulatory approvals, on achieving certain minimum CRA ratings. 8. Banking institutions should be given the possibility of investing in specific CRA-community development projects, either directly or via third party entities, that are approved in advance by the Ministry of Finance. Conclusion Billions of dollars of loan-supported investments in LMI communities in distressed areas in the U.S. are a very clear barometer of the likely outcome of similar legislation in Israel. The need for fair credit for small businesses is very clear. The profitability of small business loans to high risk small business borrowers can be verified by the lending record of some philanthropic funds facilitating small businesses loans via the banking system. For example, the default rate for the Koret Israel Economic Development Funds (KIEDF), the dominant private philanthropic fund engaged providing loan guarantees, is only one percent while half of its loans 14

15 have been to small businesses in the periphery. More than 2,200 businesses have been initiated or expanded facilitated by loans of more than NIS 300 million (approximately $80 million) at near market rates which have helped create and support more than 13,500 jobs. The government Small Business Fund, patterned after the KIEDF program, is now providing approximately NIS 500 million of guaranteed revolving funds for small business assistance. However, neither private philanthropic funds nor government small business loan programs will remedy existing distortions, discriminations and imbalances in the distribution of credit in Israel. The diversion of but one percentile of credit from the banking system to small business would create a credit stream 200 times as large as existing small business assistance programs each year. CRA is the preferred, effective and efficient way to address the problem directly. 1. Bank of Israel, press release, June 15, 2003 [Hebrew], (August 8, 2005). 2. Ibid. 3. Asher Blass and Oved Yusha, Pension Reform in Israel and Money Flows or Publicly Traded Industrial Firms, in The Israeli Economy : From Government Intervention to Market Economy, Essays in Memory of Prof. Michael Bruno (Tel-Aviv: Am-Oved, 2001), p. 209 [Hebrew]. 4. Shlomi Shuv, The Israeli Banking Market (Jerusalem: Institute for Advanced Strategic and Political Studies, 1998), 5. Ministry of Finance, Summary of the report on the reform in capital markets, asp/tamtzit2.asp (May 52, 2004). 6. Bank of Israel, press release, June 15, Small and Medium Business Authority, Data Summary, January 2005, received from Itzik Akiva, aide to Lilach Nechemya, Small and Medium Business Authority, June 5, 2005 [Hebrew]; Michael Tavor, Small business credit - Market failure or an economical equilibrium (Ra anana: Tavor Institution, October 2004), Version 3 [Hebrew]; (May 25, 2005); 8. Eric S.Belskey, Michael Schill and Anthony Yezer The Effect of the Community Reinvestment Act on Bank and Thrift Home Purchase Mortgage Lending (Boston: Harvard University, Joint Center for Housing Studies, August 2001), (May 19, 2005); FFIEC s Community Reinvestment Act (CRA); The Federal Reserve Board - Community Reinvestment Act, ; Comptroller of the Currency Administrator of National Banks - Community Reinvestment Act, Federal Deposit Insurance Corporation, Insuring America s future - CRA Statute & Tools, regulations/community/community/ 9. Community Reinvestment Act and Bank CDCs, Financing Community Economic Development Class 11, pp BC79C9E78F0E/0/class_11_cra_and_banks_cdcs.pdf (May 19, 2005). 10. CRA Survey, Financial Service RoundTable p. 11, CRA%20results%20small%20business (May 23, 2005). 11. Richard Williams, Reynold Nesiba, Eileen Dias McConnel, The changing face of inequality in home mortgage lending in Indiana, revised July 2001, p. 43, (May 19, 2005). 12. See Michael S. Barr, et. al., The Community Reinvestment Act: Its Impact on Lending in Low-Income Communities in the United States, in Christophe Guene and Edward Mayo, eds., Banking and Social Cohesion: Alternative Responses to a Global Market (Carpenter Books, 2001), pp ; The 25th Anniversary of the Community Reinvestment Act: Access to Capital in an Evolving Financial Services System (Cambridge, MA: Joint Center for Housing Studies, Harvard University, 2002); Edward M. Gramlich, Governor, The Federal Reserve Board, CRA at Twenty Five, Remarks at Consumer Bankers Association Community Reinvestment Act Conference, Arlington, Virginia, April 8, Karnit Flug, Director of Research Department, Bank of Israel, Statistical Analysis of Corporate Data, Presentation to Annual Small Business Conference, Tel Aviv, March 2005 [Hebrew], neum174h.pps (April 20, 2005). 14. Small and Medium Business Authority, Data Summary. 15

16 Securitization: Bringing a Modern Financial Instrument to Israel David Dvir and Yohay Terri This study recommends: Enacting a comprehensive national securitization law to define the legal norms for the operation of a secondary capital market for the sale of existing credit portfolios; Using philanthropic loan guarantees to facilitate the sale of existing small business loan portfolios, thereby increasing the availability of small business credit, encouraging the use of securitization and developing the secondary credit market. Introduction It is no secret that there is a credit crunch in Israel. Seventy-one percent of the credit in Israel is allocated to less than one percent of the population, and 93 percent of all bonds are government bonds; there is no doubt that the credit market in Israel is failing to adequately function as a means to accelerate economic growth, capital formation and job creation. Financial resources must be accessible to investors and businessmen in order for any economy to grow. The lack of such resources puts many private and public projects in doubt and leads to economic stagnation. In Israel today, this stagnation can be seen in the large number of small businesses unable to get credit, and in the large number of municipalities and local authorities unable to raise funds. One of the ways to increase credit availability is a secondary credit market. This consists of packaging debt, its capital and interest, 1 or a future stream of income based on a business venture, 2 as a new financial instrument. This new instrument is purchased by investors, either by an institutional investor in a private sale or via bonds in a public offering ( securitization ). The original holder of the debt thus obtains new funds, while the investor receives the future income at set dates or rates. Securitization, also known as structured finance, is an important part of any secondary credit market. Securitization developed originally in the U.S. mortgage market and over the past decade has become an important financial tool in use around the world. In addition to the funds or income made available to sellers or investors, securitization brings new players to the capital markets and thus serves to increase liquidity and efficiency. It also enables the funding of infrastructure and public projects, while reducing the interference of governments in the economy 16

17 and increasing the role of the private sector. These features of securitization have caused it to become a major part of financial markets around the world. In 2003, over 3 trillion dollars of asset-backed securities were issued. 3 In Israel, the potential embodied in securitization has not been realized. How It Works Structured finance is based on the separation between the overall credit risk of the original firm (which holds but now sells the debt) and the risk involved in the particular stream of income. The separation of the firm from the specific risk enables an analysis and rating of this income stream and a portfolio based on it. After the risk is determined, the original holder of the debt (known as the originator ) sells the income stream to a newly formed corporation known as a Special Purpose Vehicle (SPV), which can be a company, trust or partnership, and which is usually a separate legal entity. This SPV then sells the package by issuing bonds in a public offering to private or institutional investors. The purpose of selling the assets to an SPV is to separate the sale and its results from the original company, legally and financially, and thus to protect investors from the risks involved in the originator s other business, guaranteeing the stability of the stream of income in the SPV. The originator usually continues to provide the services it always has, such as the actual collection of income, and for this activity it now receives a management fee. Should the originator go out of business, or be unable to provide the collection service, it can be replaced with another service provider that will receive the management fee. In short, securitization is when the original company sells assets (a future income stream) to an SPV, which issues bonds based on this income stream, to be purchased by new investors. The Advantages of Structured Financing Structured financing allows corporations to raise new capital in ways that suit their current needs, while removing assets from their balance sheets for sale to investors in exchange for immediate income. Through securitization, corporations may seek to solve credit problems or spread their debts or payments due over a long, fixed term. 4 Securitization can also be used to reduce a company s dependence on banks, since it is an alternative source of borrowing. Alternative financing creates greater flexibility for entrepreneurs in managing their capital structure and aligning that structure with the timing and levels of capital necessary for executing business growth strategies. In addition, securitization will put more credit at the disposal of small business, if, for instance, small business loan portfolios are securitized. Today, banks offer credit from the funds at their disposal, and they are also forced by banking regulations to maintain a minimum amount of capital in reserve. These conditions limit their 17

18 ability to grant more loans and limit the amount of credit available in an economy, thereby slowing the economy s ability to develop and grow. Creating an opportunity for securitization in Israel would allow local banks to package a portfolio comprised of a large number of existing loans, which they could then resell to investors. This would allow the banks to remove these loans from their balance sheets, freeing the minimum capital they are holding in reserve, and in addition give them immediate income from the sale, all of which can be used to offer more credit. This almost infinite ability to offer loans and resell them to investors would lower credit costs and increase the supply of credit to many sectors and individuals who have until now encountered difficulties in receiving a fair share of the bank s credit. The development of a securitization market will have major impact across the whole structure of the economy. Structured financing holds advantages for investors, creditors and the whole economy. Some of these advantages are: For the Originator (Seller): Reducing financial reliance on the banking system Creating new sources of funding and expanding the base of current and future investors Evaluating the feasibility and effectiveness of raising capital Reducing credit costs in the long term With favorable credit ratings, further lowering the cost of capital Relatively fast access to capital Maximizing the suitability of income dates, credit payments and realization terms, Improvement of balance sheets by realization of assets and by removal of debt from the originator s books Solvency improvement Spreading credit risks For the Investor (Credit Package Purchaser): Increasing the diversity of investments with relative safety and spreading risks Enhancing the information available about investments; securitization can be a tool to compare alternative investments Enhancing market liquidity and the negotiability of securities in the secondary market Obtaining a professional objective evaluation of financial and economic risks Maximizing the suitability of income dates, credit payments and realization terms Enhancing the value of the investments Proven performance For the Government and the Economy: Accelerating development of the capital market Modernizing the local capital market (structure, portfolio management, services and financial systems) 18

19 Assisting banks to maintain minimum capital levels Attracting investors Reducing the interference of the government in the market Promoting specific objectives and removing obstacles to specific sectors (i.e., small businesses, students loans, urban revitalization) Securitization can increase funding for public projects by involving the private sector. Sometimes the government, philanthropic institutions or the private sector itself can offer guarantees and safety nets for projects to be funded and managed by the private sector. State funding and managing of major projects can be reduced, as these projects become efficient and profitable business. Philanthropic organizations can use securitization to leverage their investments and contributions to the community. For instance, by offering guarantees for specific projects or loan pools, they can draw private investment to goals and projects they wish to promote. Despite the numerous advantages of securitization, Israel remains far behind other Western countries in realizing its potential. Securitization in Israel is negligible, and most of the securitization here is not classic securitization: banks, for instance, have made a limited number of sales of portfolios to institutional investors, but without an SPV or a public offering. This deprives companies, investors and the whole economy of the advantages of securitization. The gap in the extent of securitization in Israel s and other countries can be seen in Table 1. Table no. 1 Extent of Securitization in 2003 Country Extent (millions of dollars) USA 3,250 England 67 Spain 33 Italy 30 Sweden 19 Israel 2* Sources: Maalot, Rating Securitization Deals: Structured Finance Theory and Fact (Tel Aviv, December 2004) [Hebrew]; The Interministerial Committee to Examine the Issuance of Property Backed Bonds, Draft Report, p. 16; European Securitization Forum (ESF), European Securitization Data Report (Securitization Issuance Surges to a New Record in 2003), Winter 2004, p. 1, (June 28, 2005). All figures are based on average annual rate of exchange (1 euro = shekels, 1 dollar = shekels). * This reflects the extent of all securitization since The ratio of securitized assets and GDP in the different countries shows that the negligible amount of securitization in Israel cannot be blamed on the size of Israel s economy. Figure 1 shows that Israel s GDP is relatively low, compared to some 19

20 countries, but this is not the reason for the lack of securitization. Among the European countries, Portugal has the highest securitization-gdp ratio. But Portugal has a relatively low GDP, only 1.45 times higher than Israel s. Nevertheless, the rate of securitization is 60 percent of GDP, which is more than 4 times the ratio in Israel. And we must keep in mind that the figure we are using for Israel is the sum of all the securitization accomplished over 4 years! So, Israel is certainly far behind other countries. In the U.S., for instance, securitization is so well developed that it is 2.3 times the GDP. Figure no. 1 The Ratio between the Extent of Securitized Assets and GDP Sources: Maalot, Rating Securitization Deals: Structured Finance Theory and Fact (Tel Aviv, December 2004) [Hebrew]; The Interministerial Committee to Examine the Issuance of Property Backed Bonds, Draft Report p. 16; European Securitization Forum (ESF), European Securitization Data Report (Securitization Issuance Surges to a New Record in 2003), Winter 2004, p.1, (June 28, 2005); Universal Bank, GDP Table 2003, (June 28, 2005). It seems that the main reasons for lack of securitization in Israel are the high costs and the legal complexity involved in conducting the first sales. These costs result from the lack of local legislation authorizing such sales and from the unclear legal and regulatory status of such sales. As a result, the risk involved rises, potential investors refrain from investing, and every securitization sale has to write the rules ab initio. In addition, specific problems with Israel s banking system have stymied the creation of a secondary capital market and securitized debt. The loans and credit process is not standardized, and there is no uniform credit database; these problems make rating loans more difficult, time consuming and expensive. 5 The government has taken some positive steps to promote securitization in Israel, such as offering economic incentives for the first instances of securitization, reducing the amount of government bonds, bringing more players to the capital market and founding a committee to examine obstacles. International experience has shown that decisive legislation will remove the uncertainty about securitization and ease the complex procedure involved in such sales. 20

21 From Theory to Practice: Practical Models There are two feasible models: classic securitization and a straightforward sale. As examples, we will apply these models to securitization in the small business sector. We choose small business because of the ability of small businesses to accelerate the growth of the economy and the funding difficulties they currently encounter, and because of the existence of loan portfolios for small businesses, which have philanthropic or state guarantees. Such external guarantees can facilitate their securitization or sale. A similar model is in advanced planning stages in San Francisco. The Isabella Project is designed to promote the development of the Latino population in the San Francisco Bay area, by increasing the availability of capital to small businesses via securitization. 6 Loans issued to small businesses, backed by philanthropic or governmental guarantees, will be packaged into a loan pool. This will be sold to groups that will securitize and resell them, after dividing them into different layers of debt, in a public offering to private and institutional investors. It is expected that securitization will improve the funding opportunities for Latino small businesses and thus improve the condition of the entire Latino population in the area. 7 Like the Isabella Project, the two models we present are based on the guarantees of a philanthropic institution and/or the government for a sale or an offering of a small business loan portfolio. From meetings held with the Managing Director of Koret Israel Economic Development Funds (KIEDF), we know philanthropy can be involved by giving guarantees within the framework of small business loan securitization. 8 KIEDF currently guarantees loans offered through Bank Otzar Hachayal to facilitate lending to small businesses lacking suf ficient securities. KIEDF guarantees an average 35 percent of each loan. According to Doron Kalif, Vice President and Manager of the Financial Division of Otzar Hachayal, the bank is interested in facilitating the sale/securitization of KIEDF loans. The bank is already conducting an analysis of the portfolio in order to examine the possibility. 9 The government is also ready to cooperate by adding to the necessary guarantees. 10 The first possible model is classic securitization: Classic Securitization The bank would sell KIEDF s loan portfolio in a verified sale to an SPV, which will be formed for this securitization. The bank would transfer the debtors securities to the authority of the SPV. The current philanthropic guarantees in the portfolio would become guarantees for future payments in case of default, or for purchase of the inferior bonds in order to guarantee investors their income stream. The necessary rate of guarantees would be determined by a rating company. The SPV would issue the bonds in a public offering. 21

22 Figure no. 2 Securitization of Small Business Loans Selling the portfolio and its future cash flow to an SPV would enable the bank to remove the loans from its balance sheets, thereby improving its minimum capital ratio. With the securitization of the KIEDF loans, the bank would be required to allocate the income from the sale of the loan portfolio to new small business loans. The second model is a loan portfolio sale. This is simpler legally and involves lower costs and less time to execute. Considering the relatively short life span of small business loans in the portfolio, reducing the costs and time necessary for the sale would make it much more attractive. 11 The Sale Model The bank would sell the KIEDF loan portfolio to an institutional investor. The philanthropic guarantees would ensure payments of the income stream and interest to the institutional investor, if borrowers payments are not made. The bank would allocate the income from this sale to new loans to small businesses. 22

23 Figure no. 3 Sale Model In contrast to the classic securitization model, such a loan sale is not an innovative tool for the Israeli economy and will not directly assist in developing a securitization market. The Importance of Implementing the Models The cost of conducting classic securitization sales is derived from the number and scope of the sales. The more sales, the lower their marginal cost. However, these sales will not simply happen. International experience shows that external intervention to reduce risks and costs can jump-start the securitization market. The involvement of philanthropy in guaranteeing loans to small businesses would ease their securitization and offer opportunities for developing the capital market. The initial contribution of classic securitization, with government and philanthropic guarantees, would be in opening an investment route for new investors. Bonds backed by loans to small businesses would assist in diversifying investor portfolios in a manner only currently available to local banks. The participation of private investors would add new funding sources for small business loans. The more 23

24 such sales are made, the more the rating skills and databases and the legal and procedural practices in conducting them will be developed. Thus the private sector would use securitization, with all its advantages for the creditors, debtors, investors and the whole economy. With securitization, the state and philanthropic institutions could achieve far greater leverage with their guarantees and contributions by generating a continuous stream of new small business financing while, simultaneously, helping to develop a more sophisticated capital market to fuel expanded credit and investment. Recommendations In addition to our primary recommendation to securitize small business loan portfolios, the following steps are necessary in order to develop a securitization market and improve the capital market in Israel: Legislation of a comprehensive securitization law (as exists in many countries). The law should describe the specific characteristics of securitization sales, such as the status of an SPV, and the transfer of rights, 12 define a verified sale, and so forth. Such a law can be based on the U.S. model. It will reduce uncertainty and regulate the legal and accounting procedures for securitization. Promote synthetic securitization. Synthetic securitization is a form of classic securitization that raises capital and reduces risks for the originator, but does not entail transferring securities. It can avoid some of the current legal obstacles to classic securitization and reduce costs and can be implemented more swiftly while the legislative and regulatory frameworks are improved. Standardization of business and individual credit ratings is needed. A credit rating system based on uniform standards will enhance the data that businesses and individuals maintain and improve decision making in bank credit allocation. Standardization will facilitate securitization as it will allow an easier assessment of risk. As a side benefit, competition in the banking system will also be enhanced. Establish a database of small business loans. The data in the loan portfolios backed by government and philanthropic guarantees should be turned into a database suitable for the needs of securitization. This data would then be available for analysis or pooling, taking into consideration geographic and professional parameters, as well as the type of securities involved. Consideration should be given as to how to provide an incentive for the banks to use existing data to create such a database. A database of small business loans would ease the securitization of such loans. Financial innovation is a necessity not a luxury. Israel cannot remain so far behind the rest of the world in exploiting such a proven financial instrument and meet its growth objectives. A secondary capital market and securitization would create new 24

25 funding sources other than local banks while facilitating bank access to huge amounts of new capital that can be offered as credit. The local capital markets would be enervated; investors, creditors, borrowers and the entire country would benefit. 1. Secured debt. 2. Structured finance. 3. In 1990 it was less than $50 billion. 4. This often has important ramifications in accounting. 5. Baruch Govi, accountant, interview with authors, Tel Aviv, March 27, 2005; Asher Rabinovich, attorney, interview with authors; Tel Aviv, May 22, 2005; Ronen Baumes, accountant, Adanim Bank, phone interview with authors, June 15, Marcela Davison Aviles, Richard Ventura, Glenn Yago, Betsy Zeidman, The Isabella Project - Closing the Latino Capital Parity and Procurement Gap (San Francisco: The Latino Community Foundation, Milken Institute, San Francisco Hispanic Chamber of Commerce, 2004) 7. Ibid., pp Carl H. Kaplan, KIEDF Managing Director, interview with authors, Jerusalem, March 10, Doron Kalif, CFO, Otzar Hachayal Bank, interview with authors, Tel Aviv, March 10, Ran Alon, Ilanit Verner, Finance Ministry, interviews with authors, Jerusalem, March 15, Professor Amir Barnea, Interdisciplinary Center, interview with authors, Herzliya, March 10, This is especially important regarding real estate. 25

26 Urban Revitalization in Israel: Emergency Care for the Inner Cities Shelly Hassan and Diana Zaks The study recommends: A National Urban Revitalization Law should be enacted, that will amend the State Economy Law and Municipal Directives to permit cities to issue bonds, create Tax Increment Financing (TIF) and Business Investment Districts (BID), and approve and manage urban revitalization projects. The law should encourage and facilitate philanthropic and private sector investments to revitalize depressed urban neighborhoods through direct investment, guarantees, and other forms of credit enhancement to encourage broader private investment in urban revitalization. Clause 45a of The State Economy Law should be amended to grant more authority to municipalities and authorize contracts with the private sector, and clauses 46a and 47 should be amended to enable municipalities to raise capital by issuing bonds for municipal development projects, based on future property tax revenue from specified assets or from other high-yield projects. Successful projects in the United States such as Genesis LA and Bryant Park in New York should serve as examples for urban revitalization in Israel. Introduction Israel s inner cities need revitalization. Many are overrun with criminal activity and drugs, or devoid of cultural institutions or tourist facilities, and nearby neighborhoods have fallen into disrepair as a result. For instance, Jerusalem, the capital, is the poorest of the large cities 1 ; the Jaffa port was once a popular tourist site and workplace in Tel-Aviv but is now dilapidated. This phenomenon is also found in smaller towns in the country s periphery where many city centers appear abandoned. History of Urban Revitalization These problems are the result of failed urban policy in Israel. Since 1948 the central government has controlled settlement and settlement policy. New immigrants were settled in peripheral areas with no means of employment; facilities of the state and other institutions were encouraged to leave inner cities; and municipal authorities were denied administrative and financial control over their own communities. Eventually social unrest erupted, first in Haifa, later in Jerusalem s Musrara 26

27 neighborhood where residents were displaced in the name of urban rehabilitation, without taking into account their own needs and social concerns. 2 In 1977, Prime Minister Menahem Begin initiated Project Renewal through the Ministry of Construction and Housing. The project is still functioning. 3 It differs from earlier projects in that this urban renewal was social as well as physical. Despite some improvements, the state monopoly on urban development remained as strong as ever. This situation has disenfranchised local authorities and municipalities from both the planning authority and fiscal resources necessary for urban and community revitalization. Five Obstacles to Urban Revitalization This state monopoly on urban development and revitalization has created five major obstacles to urban revitalization: 1. No Clear Definition of a Neglected Area : In order for a community to participate in one of the state programs for urban revitalization, it must meet the government s criteria for being neglected. Yet these criteria are based on Israel s Socio-Economic Index, prepared by the Central Bureau of Statistics (CBS); today s Index is based on census data from The demographic, economic and social changes that have taken place in Israel since 1995 render many classifications based on the outdated census irrelevant. 2. Lack of Budgets: The budget of the Ministry of Construction and Housing for neighborhood restoration is an abysmal 53 million shekels ($11.8 million), a reduction of 75 percent from the 2001 budget of 193 million shekels ($45.8 million). 4 Clearly, urban revitalization is not a high priority of the government of Israel. In 1998, the government adopted a new urban renewal program that granted municipalities some responsibility for initiating, operating, managing and even financing renewal projects. However, local administrative and financial authority is still limited, thereby emasculating the effectiveness of the program. In addition, the 2001 budget for this program was 48 million shekels ($10 million); the 2005 budget has been reduced by 68 percent to only 15 million shekels - guaranteeing a policy of urban neglect Bureaucracy: Urban revitalization has also been stymied by the bureaucracy fostered by centralized state control. The following state institutions all have a hand in urban revitalization: The Israel Lands Administration (ILA): While only 53 percent of urban land was under state ownership when the ILA was founded, it today owns 90.3 percent! 6 The ILA has the responsibility for approving Pinui Binui (Clear and Build), urban renewal projects, yet has no unit focusing on urban development. 7 The Interior Ministry: The Ministry supervises municipal authorities. The Ministry of Industry, Trade and Labor: The Ministry grants tax benefits per the Law for the Encouragement of Capital Investment. 8 It also runs the Israel Small and Medium Enterprise Authority, assisting new businesses. 9 Yet, there is no unit for coordinating urban development in this ministry

28 The Budget Division and Accountant General in the Finance Ministry, as well as the Ministry of Justice, supervise and control the approval of financial instruments or legal changes necessary for urban development. 11 Mayors, residents, and entrepreneurs find it difficult if not impossible to attain the bureaucratic approvals necessary to realize urban revitalization projects. 4. Centralized Control: By law, local authorities are not allowed to contract with the private sector, issue municipal bonds or delegate municipal authorities to private or philanthropic institutions without cabinet-level state approval. Table 1 shows the different approach of the U.S. and Israel regarding municipal responsibility and authority. Table no. 1 Freedom of Municipalities Israel U.S. Property Tax Central government Municipalities decide decides tax rates tax rates Borrowing - Credit Permission of Interior Ministry required Municipality decides Contracting with Permission of Interior and Private Sector Finance Ministries required Municipality decides 5. Lack of Modern Financial Tools: In the U.S. and other countries, much successful urban development is facilitated by means of Tax Increment Finance (TIF), Business Improvement Districts (BID), and Capital Investment Management (CIM). Projects such as Genesis LA in Los Angeles and Bryant Park in New York have succeeded thanks to financial structures in use in the U.S. that are desperately needed in Israel. Tax Increment Finance (TIF) is a financial tool that allows use of tax revenues for public development projects. A TIF district is created by a local municipality, not by a central government. There are two ways to raise funds for this model - entrepreneurial investments for profit or bond issues. 12 Business Improvement Districts (BID) were first implemented in Canada in 1965 and became popular in the U.S. in the 1990s. Today there are more than 1,200 BIDs in the U.S. and Canada; the method is also in use in New Zealand and South Africa. A BID is actually a sub-category of a TIF, based on cooperation between the private and public sectors. A BID is formed in a defined geographic area with the property and business owners agreement. The municipality delegates its authority and also leases public areas to entrepreneurs in order to develop the area. The entrepreneur, in turn, administers the BID and develops it together with property and business owners. Fees within the BID collected by the municipality, on behalf of the entrepreneurs, are used for the finance and maintenance of the BID itself. Additional financing for BIDs may come from government grants, municipal funding, non-profit organizations, bonds issued by entrepreneurs based on future BID income, the leasing of parks and so forth. 28

29 Capital Investment Management (CIM) accomplishes urban revitalization by means of business investors seeking profits. International Experience Israeli urban revitalization is at least 20 years behind other developed countries. Before making recommendations for Israel, an examination of how such tools as those described above are used to facilitate urban revitalization in the U.S. is worthwhile. Such examples of non-government revitalization can provide creative solutions to revitalizing neglected neighborhoods in Israel. Three successful programs are Genesis LA, Bryant Park in New York, and CIM in Santa Monica. Genesis LA - Los Angeles Genesis LA is a cooperative effort between local government and the private sector. The project was originally created by a business team in the Los Angeles municipality to ease bureaucratic impediments for entrepreneurs interested in investing money in blighted districts. Later, two for-profit funds managed by concessionaires - a real estate fund and a growth fund - became part of the project. In July 2001 the real-estate fund raised $85 million from investors and $17 million in grants from sponsors. The fund has 15 partner organizations and is not limited to acting only within the project. 13 The purpose of the growth fund is to invest between $ million in the project. The private investor capital is deployed through mezzanine loans and secondary obligations to technology and industrial firms investing in low and medium income districts. Emphasis is on minority groups and women. Figure 1 shows the structure of Genesis LA: Figure no. 1 Structure of Genesis LA 29

30 The close relationship between the financing organizations (the private sector) and the Mayor s office has encouraged achieving public purpose objectives through private sector capability and financing. The for-profit funds are also large donors to various Genesis projects. 14 Bryant Park - New York City While the Genesis LA model is intended to address district-wide problems, the revitalization of Bryant Park in New York is an example of a subdistrict revitalization project. Such a model demonstrates how to involve the private sector and philanthropic interests in the rehabilitation process along with local residents and businesses, and would seem to be suitable for Jerusalem s central business district, as well as subdistricts in Jaffa, Tel-Aviv, Haifa and other Israeli cities. The Rockefeller Brothers Corporation founded the non-profit Bryant Park Restoration Corporation (BPRC) administrated by a private company for the purpose of rehabilitating Bryant Park. When work was completed in 1988, crime rates were cut by 92 percent and visitors thronged to this once dangerous area. The city signed a lease agreement with BPRC for 15 years whereby BPRC agreed to maintain the park and supply security services in return for the exclusive right to revenue from concessions in the park and the rental of park restaurants. The lease has since been extended for another five years. 15 BPRC illuminates the park, and its security officials - dressed like New York police - are posted around the clock to deter crime and enforce order. 16 The city limits itself to bill and tax collection without involvement in the park administration. The cooperation of local property owners was essential for the success of the project. 17 Local real estate value and rents near Bryant Park have soared. 18 Today the park is alive with cultural activities ranging from festivals to chess and checker tables. Total investment in the park s renovation was $18 million. The money was collected from donations, asset revenue in the park, government and city investment and risk funds. BPRC manages the park as a Business Improvement District (BID). The method involves improving a district based on the common interest of property owners. Capital Investment Management (CIM) draws investments from investors seeking profits. CIM administers the CIM Urban Real Estate Fund LP, with the California Clerks and Teachers Pension Fund as the lead investor. The $676 million fund has facilitated investments of more than $1.6 billion. The fund s investments are diverse: apartments and offices, trade centers, parks and culture centers. 19 Recommendations In order to overcome the obstacles to urban revitalization in Israel, we recommend the enactment of a National Urban Revitalization Law. Such a law should create the possibility of using modern financial tools in Israel, and involving the 30

31 philanthropic and private sectors in urban revitalization. Specifically, the law should: 1. Outsource the Socio-Economic Index: Lack of information and an out-ofdate Socio-Economic Index make defining Israel s distressed urban areas impossible. The solution is to outsource the rating of distressed areas based on National Insurance Institute, CBS and current municipal data. 2. Delegate Authority to Municipalities: This will eliminate centralized government control that fails to finance urban revitalization. Delegating authority to municipalities will eliminate bureaucracy and encourage the private and philanthropic sectors to finance urban revitalization projects. In particular, clause 45a of The State Economy Law should be amended to grant more authority to municipalities and authorize contracts with the private sector, and clauses 46a and 47 should be amended to enable municipalities to raise capital by issuing bonds for municipal development projects, based on future property tax revenue from specified assets or from other highyield projects. Dedicated municipal bond proceeds will result in improved planning, transparency and fiscal responsibility. 3. Authorize the Establishment of Special Municipal Corporations, as the Jerusalem Development Law authorizes the establishment of a Jerusalem Development Authority, that may execute contracts, issue bonds and assume financial obligations. 4. Authorize TIF Financing: The TIF structure is useful for projects requiring public involvement. TIF is not possible in Israel today because municipalities cannot legally allocate property tax income to a specific neighborhood. 5. Authorize BIDs: Chapter 3 of the Municipal Directives governing urban neighborhoods should be amended to allow municipalities and local residents to initiate BIDs, to be administrated by non-profit organizations. The law should authorize municipalities to delegate authorities (such as security) to the private sector (as the central government has already done, for instance in the Road 6 Toll Law), and should also authorize the leasing of public assets to the private sector. 6. Authorize Municipal Bonds: The conditions under which a municipal corporation may issue bonds based on specific streams of revenue from profitable projects should be standardized. With such a National Urban Revitalization Law in place, non-profit and for-profit capital can be combined as it is abroad to effect urban revitalization. This exploits private-sector effectiveness in the public interest. In the Genesis LA model, a realestate fund invests in neglected areas (i.e., meeting the public interest) by means of private money. Figure 2 illustrates how a real estate development fund may operate in Israel. 31

32 Figure no. 2 Fund for Real Estate Investment Also, such a National Urban Revitalization Law will allow for the leveraging of philanthropic funds: While philanthropic involvement has facilitated substantial entrepreneurial investment abroad by providing guarantees for specific development projects, private investments in distressed urban areas in Israel are essentially nonexistent because of the high cost and risk of such projects. A law authorizing structures such as TIF and BID will encourage philanthropic organizations to leverage contributions to neglected areas. For example, a philanthropic organization may choose to guarantee financing for small business development projects in a poor inner city neighborhood. In addition, a philanthropic fund can lend to small business that will rent commercial space in the project. The fund can deploy similar guarantees for area-wide urban real estate development projects, thereby either directly absorbing risk or providing credit enhancement in the financial package supporting such projects. This will signal builders and investors that their efforts will bear fruit. 20 In New York, BPRC issued two bonds secured by a pledge of assessments of the property owners adjacent to the park. The bonds raised $60 million. Fees from property owners covered payments. 21 In 2003, the ministers of finance and interior, Benjamin Netanyahu and Abraham Poraz, allowed municipalities to raise funds by issuing bonds, provided the bonds were rated at least AA- by a reputable rating firm. Here is another role for philanthropy: to guarantee the riskier bonds and enable urban revitalization in Israel. Urban revitalization and development in Israel is hampered by the absence of a national urban policy. Concentrated authority in the central gover nment and the dependence of local municipalities on government ministries smothers all nongovernmental incentives. For the benefit of the residents of inner cities throughout the country, the government should follow the successful lead of cities abroad and facilitate urban revitalization by means of philanthropic and entrepreneurial participation. 32