Bank Otsar Hahayal Ltd Annual Report

Transcription

1 Bank Otsar Hahayal Ltd Annual Report This is a translation from the Hebrew version of the 2005 Annual Report and has been prepared for convenience only. In the case of any discrepancy, the Hebrew version will prevail.

2 BOARD OF DIRECTORS REPORT FOR 2005 At the Board of Directors meeting held on February 27, 2006, it was resolved to approve and publish the consolidated financial statements of Bank Otsar Hahayal Ltd. for the year ended December 31, Detailed below are the principal developments and changes that occurred during Economic Review General In 2005 there was an increase in economic activity in most sectors, principally tourism, trade and services. Market growth was affected by expanded global growth, improvement in the security situation and a moderate increase in export and industrial production. Gross Domestic Product (GDP) increased by 5.2%, compared with an increase of 4.4% in The product of the business sector increased by 6.7%, compared with an increase of 6.3% in In 2005 the domestic deficit in the Government s budget amounted to NIS 10.7 billion, which accounts for 1.9% of GDP, compared with a deficit of NIS 20.4 billion in % of GDP. The target deficit set by the government was NIS 18.9 billion, which is 3.4% of GDP. The narrowing of the deficit was enabled by a sharp rise in Government revenues from taxes and the low expenditure rate of the social and economic ministries. Government revenue from taxes in 2005 increased by 8.0% and amounted to approximately NIS billion. The trade deficit increased sharply in 2005 by 21.4%, to $7.9 billion, reflecting an increase of 9.9% in the import of goods and services to $44.3 billion, and a 7.7% increase in export to $36.4 billion. The trade deficit reflects mainly the sharp rise in oil prices. Unemployment fell to 8.9%, an indication of recovery in economic activity along with stricter criteria for receipt of unemployment pay. The Consumer Price Index (CPI) and Rate of Exchange The CPI rose in 2005 by 2.4%, compared with a rise of 1.2% in In the second half of 2005, the CPI rose by 1.9% and was affected mainly by the strengthening of the dollar against the shekel and a global rise in oil prices. The CPI was within the target range of 1% 3% set by the Government and the Bank of Israel. The foreign currency market in 2005 was characterized by high volatility, against a background of a strengthening dollar against other currencies and by a flow of capital into the local market by foreign investors. Over the year, the shekel lost against the dollar by 6.8%, most of that depreciation 6.2% occurring in the first half of the year. Against the basket of currencies the shekel lost 1.65%, while gaining 7.3% against the euro. Monetary Policy Monetary policy in 2005 reflects stability in the financial markets. To maintain price stability and implement the economic policy, the Bank of Israel raised the monetary tender interest rate in the fourth quarter by a cumulative 1%, to 4.5%, reflecting a real interest rate of 2.5%, which is 0.25% higher than the dollar interest rate. During 2005, the means of payment in the economy increased by 23.5%, reaching approximately NIS 48 billion. This rate of increase was higher than the rate required by the economy s inflation target and economic growth. The sharp increase in means of payment resulted from the low rates of interest and inflation. Total credit in the market rose in 2005 by 1.9%, reaching NIS billion. The moderate change in the volume of credit reflects a slight slowdown in activity in the business sector and a cautious credit policy within the banking system. 1

3 The Capital Market The trend in the capital market in 2005 was positive, with high trading volumes, and was affected by positive economic developments in Israel and the world, by a low interest rate, a stable inflationary environment and the improved security situation in the region. During the year, the general share index rose by a nominal rate of 32.8%, the Tel Aviv 25 Index rose by 33.3%, and the Tel-Tech Share index rose by 4.8%, reflecting slower growth in the sector this year. Government bonds traded slightly higher over the year. The index of CPI-linked Government debentures rose 6.6%, the index of foreign currency-linked debentures rose by 6.1%, and the index of unlinked debentures rose by 5.4%. The positive trend in the capital market in 2005 was influenced by a notable increase in foreign investments in the Israeli economy, which amounted to approximately $9.7 billion for the year, compared with $5.8 billion in Of this total, $4 billion are foreign investments in Israeli securities on Israeli and foreign stock exchanges, and $5.7 billion were invested directly in the various sectors of the economy. The capital market was also influenced by the implementation of Government reforms, such as the removal of limitations on investments by overseas institutional bodies, implementation of the Bachar Commission Law, which requires sale of the banks' holdings in provident funds and mutual funds, and the entry of the banks into the pension market. Activities and business development of the Bank Group Otsar Hahayal Ltd. was established in 1946 by funds for mutual aid set up by soldiers serving in the British Army during the Second World War. In 1970 the company received a license to operate as a bank, and changed its name to Bank Otsar Hahayal Ltd. The Bank is a licensed banking corporation, in accordance with the provisions of the Banking Law (Licensing), In its 60 years, the Bank has developed a network of branches and activities in all areas of banking, and provides its customers with a wide range of banking and financial services. According to its financial statements published as at September 30, 2005, the Bank's share in the banking sector based on the criterion of volume of credit is 1.2%, and according to the criterion of deposits from the public as at the same date is 1.3%. Subordinated notes issued by the Bank are rated Aa3 by Midroog. The Bank operates through two divisions: Retail, which serves customers in the household, private banking and small business segments, and Business, which serves business customers. Non-banking activities are undertaken through subsidiaries and other companies that provide the Bank with various services, among them a. Credit card activities provided by Isracard Ltd. and American Express Ltd., companies that issue, market and operate credit cards for use in Israel and abroad. b. Mutual fund management provided by Otsarit Mutual Fund Management Co. Ltd., a company wholly owned by the Bank. In January 2006, Otsarit reached an agreement whereby it will sell its mutual fund management operation to Gaon Mutual Fund Management Co. Ltd. For further details about the sale, see the section "Capital Market Activity". c. Investment portfolio management provided by Otsarot Investment Management Ltd., a company wholly owned by the Bank. d. Provident fund management In 2005 the Bank managed 10 provident and further study funds, five of which were owned by the Bank. In January 2006 the Bank reached an agreement whereby most of the provident and further study fund management operation would be sold to Ayalon Holdings Ltd. For further details about the sale, see the section "Capital Market Activity". 2

4 Principal holdings Bank Otasr Hahayal Ltd. 95% Trust Company of Bank Otsar Hahayal Ltd.* (A) 86.2% (44.6%) 90.9% 100% 100% 2.0% (8.0%) 9.1% 0% 0% Investment company of Bank Otsar Hahayal Ltd. Asset company of Otsar Hahayal Ltd. (A) Otsarot Investment Management Ltd. Otsarit Mutual Fund Management Ltd. 0% 100% (0%) Shiryon Provident Fund for the Self- Employed 0% 100% (0%) Bitzaron Provident Fund at Bank Otsar Hahayal Smadar Further Study Fund of (A) Bank Otsar Hahayal Ltd. Provident Fund Habitachon at Bank Otsar Hahayal Ltd. 25% (0%) Annuity Fund for (A) Employees of Bank Otsar Hahayal Ltd. Note: Where the right to share in profits differs from the right to appoint directors, the right to share in profits appears in parentheses. * 0% control denotes control of less than one tenth of one percent. (A) The companies above have no formal English name. The name noted is therein Hebrew name translation. Forward-looking information Some of the information in the Directors' Report, which does not relate to historical facts, is forward-looking information as defined in the Securities Law, Differences between the actual results of the Bank and those appearing in the forward-looking information can be attributed to a number of causes, such as macroeconomic, regulatory and intra-organizational factors. Forward-looking information will typically use words such as "we believe", "expected", "projected", "it is estimated", "intend", "plan", and similar expressions, as well as words such as "wish", "should", "can", "will be", etc. These forward-looking expressions involve risks and uncertainty since they are based on assessments made by Management about future events, such as forecasts and assumptions about macroeconomic developments in Israel and worldwide, working assumptions about internal organization developments, estimates of the effects of changes in legislation on the organization, and so on. The information relies, among other things, on the forecasts of economic advisers, forecasts made within the organization, public information concerning estimates of influential parameters, etc. 3

5 Control of the Bank The controlling shareholder in the Bank as at the date of publication of the financial statements is Bank Hapoalim Ltd., which holds approximately 67.99% of the right to share in profit and 66.00% of the voting rights and the right to appoint directors. According to the reports submitted to the Tel Aviv Stock Exchange on January 24, 2006, an agreement has been signed between Bank Hapoalim Ltd. ("Bank Hapoalim") and the First International Bank of Israel Ltd. ("First International "), whereby Bank Hapoalim undertakes to sell all its holdings in the Bank (67.99% of the right to share in profit and 66.00% of the voting rights) to First International for approximately NIS 703 million, subject to certain adjustments and receipt of all the requisite permits within a defined period. According to those reports, the agreement sets out arrangements for a period of six years, during which Bank Hapoalim will continue to provide the Bank with services in accordance with an agreement from 1997, which remains in force until The purpose of this is to ensure that the Bank will be able to provide all banking services for its customers in the way in which it does today and for a consideration which was agreed between the Bank and Bank Hapoalim. However, after three years the Bank has an option to decide that it no longer wishes to receive these services from Bank Hapoalim. In any case, the Bank will pay Bank Hapoalim NIS 20 million per year even if it ceases to receive the operating services. Should circumstances arise in which the Bank is unable to pay that sum to Bank Hapoalim, First International will be liable towards Bank Hapoalim for its payment. The agreement also includes arrangements for the Bank to continue its commitment with Isracard, and states that the Bank will bear the costs of arrangements with its employees following sale of the controlling interest. The Bank was informed by Bank Hapoalim that according to the agreement signed between Bank Hapoalim and First International concerning the transfer of control of the Bank, it is intended to propose to the Board of Directors of the Bank to pay the employees a special bonus at about the time when the transfer of control is actually effected, in the following manner: - For permanent employees, a bonus in the amount of five monthly salaries. - For temporary employees who have been working at the Bank for at least one year a bonus in the amount of one month's salary. The bonus will be calculated according to the salary of December The Bank estimates that the total amount of these bonuses, if paid as described above, will be approximately NIS 49 million. Other shareholders in the Bank are Hever, The Association of IDF Servicemen and Veterans Ltd., with 24.00% of the right to share in profit and 24.00% of the voting rights, The Workers' Compensation Fund of Israel Aircraft Industries Cooperative Association Ltd., with approximately 8.00% of the right to share in profit and 10.00% of the voting rights, and the public, which holds approximately 0.01% of the right to share in profit. 4

6 Investments in the Bank's capital, transactions in its shares and distribution of a dividend In July 2003 a claim was filed in the Tel Aviv-Yafo District Court, together with an application for its certification as a class action lawsuit, against the Bank and against Bank Hapoalim (the parent company), by a shareholder of the Bank. On April 25, 2004 the District Court approved an arrangement, which was validated as a decision, whereby all the shares of the group of shareholders from among the public (according to proof of ownership to be submitted by the members of the group under the terms of the arrangement) would be transferred to the ownership of Bank Hapoalim, against payment of the sum of NIS 10 million. Implementation of the arrangement was placed in the hands of Poalim Trust Services Ltd. The number of shares which were transferred in this arrangement was 2,381,807 ordinary shares of a par value of NIS each. In 2005 there were no transactions in the Bank's shares. The distribution of a dividend by the Bank is subject to the provisions of the law, including limitations deriving from the directives of the Supervisor of Banks and a permit to hold means of control in the Bank dated December 28, 1999 ("the Permit") in connection with acquisition of control in the Bank by Bank Hapoalim (see Note 27 to the financial statements). The Permit clarified that no dividend will be distributed which would involve the Bank's non-compliance with the limitations imposed by the Supervisor of Banks in the matter of the distribution of dividends, minimum capital ratio to risk components, or would result in a situation in which the Bank would not have positive financial capital or would not meet the requirements of Section 23A of the Banking Law (Licensing), 1981, which sets a limit on the percentage of capital which a banking corporation may invest in non-financial corporations. The Permit also states that profits accumulated up to the date of grant of the Permit cannot be distributed as a dividend unless it is assured that not less than 90% of the amount to be distributed as a dividend will be reinvested in the Bank's capital. In December 2004 the Board of Directors of the Bank and the General Meeting of the shareholders resolved to adopt a dividend distribution policy whereby a dividend of 35% of the net profit of the Bank would be distributed every year. Distribution of a dividend On December 25, 2004 the Bank distributed a dividend of NIS 17 million. In January 2006 the Board of Directors of the Bank and the General Meeting resolved to distribute a one-time payment of a dividend of NIS 430 million. In addition, the Board of Directors and General Meeting resolved, in January 2006, to invest the sum of NIS million in the Bank's capital by way of an issuance of 3.0 million ordinary shares of NIS each to the existing shareholders. The shares were issued at NIS each. The distribution of the dividend and the investments in the Bank's capital were approved by the Supervisor of Banks and implemented on January 26,

7 Profit and Profitability Net profit for 2005 amounted to NIS 64.5 million compared with a profit of NIS 58.7 million in 2004, an increase of 9.9%. Net return on equity reached 11.12% in 2005, compared with 10.86% in We present below details of the net return on equity for the past 5 years: % 10.86% 11.07% 5.44% 2.67% The increase in the net profit was mainly affected by: - the decrease in the provision for doubtful debts; - the increase in operating income and mainly in the income from capital market activity; - the increase in operating expenses, mainly salaries. Profit from financing operations before provision for doubtful debts Profit from financing operations before provision for doubtful debts in 2005 totaled NIS million, compared with NIS million in 2004, a decrease of 1.1%. Most of the decrease derived from a decrease in the gain on the sale of available-for-sale securities. The gain on the sale of such securities and from marketable securities amounted to NIS 2.6 million in 2005, compared with NIS 14.8 million in 2004, a decrease of 82.4%. Profit from financing activity (excluding the profit on the sale of available-for-sale securities and marketable securities) increased in 2005 by 2.9%, from NIS million in 2004 to NIS million in The increase, which derived mainly from an increase in income from activity in non-alm derivatives, an increase in income from early repayment commissions, a change in the capital investment and a change in the volume of operations, was partially offset by the effects of a decrease in operating margins. The contribution of the linkage segments to the profit from financing operations before provision for doubtful debts: Average Average Average Average financial volume of Contribution Operating financial volume of Contribution Operating capital( 1 )( 2 ) activity ( 3 ) to profit Margins capital( 1 )( 2 ) activity ( 3 ) to profit Margins NIS millions NIS millions Unlinked shekel segment , % , % CPI-linked shekel segment , % , % Foreign currency and foreign currencylinked segment , % , % (1) In the unlinked shekel segment and the foreign currency and foreign currency-linked segment based on average daily balances, in the CPI-linked segment based on monthly opening balances. (2) Including the effect of ALM derivatives. (3) Total assets of the segment. - The increase in the contribution of activity of the unlinked shekel segment derives mainly from the increase in the excess of assets over liabilities, which was partially offset by the effects of the lower prime interest rate on that excess. - The decrease in the contribution of activity in the CPI-linked segment despite the increase in the rise in the CPI, is mainly a result of the decrease in the excess of segmental assets. - The increase in the contribution of foreign currency activity derives from the increase in the shekel-dollar depreciation rate in 2005, compared with

8 Other financing income and activity in other derivative financial instruments In 2005, other financing income amounted to NIS 39.6 million, compared with NIS 44.0 million in 2004, a decrease of 10.0%. Most of the decrease is due to a decrease in income from the sale of available-for-sale securities. The income from the sale of available-for-sale securities and the gains from marketable securities in 2005 amounted to NIS 2.6 million, compared with NIS 14.8 million in The decrease deriving from the sale of available-for-sale securities was partially offset by an increase recorded in income from early repayment commissions, which amounted to NIS 4.8 million, compared with NIS 2.7 million in 2004, an increase of 77.8%. Income from activities in derivative financial instruments include activities in Maof options, foreign currency options and other instruments not defined as ALM instruments, amounted to NIS 9.0 million in 2005, compared with NIS 3.1 million in 2004, an increase of 190.3%. Provision for doubtful debts The provision for doubtful debts totaled NIS 22.6 million in 2005, compared with NIS 35.3 million in 2004, a decrease of 36.0%. The specific provision for doubtful debts in 2005 totaled NIS 24.6 million, compared with NIS 34.8 million in 2004, a decrease of 29.3%. The current provisions for doubtful debts in 2005 amounted to NIS 59.7 million, compared with NIS 67.4 million in 2004, a decrease of 11.4%. The total decrease in the provision and collection of debts written off was NIS 35.1 million, compared with NIS 32.6 million in 2004, an increase of 7.7%. The following table presents the ratio of the specific provision to the credit portfolio under the Bank s responsibility: % % Expense Ratio to balance sheet credit Ratio to total credit risk* Cumulative Provision Ratio to balance sheet credit Ratio to total credit risk* * Balance sheet credit risk and the credit risk on off-balance-sheet financial instruments as calculated for the borrower debt restriction. The supplementary provision on risk components according to the rates defined in the directives of the Supervisor of Banks, decreased in 2005 by NIS 2.0 million, compared with an increase of NIS 0.5 million in The main reason for the decrease is the NIS 0.9 million decrease in debts in temporary arrears. The balance of the decrease in the supplementary provision, NIS 1.1million, is from the decrease in the provision required in respect of other problem borrowers and a credit liability of customers who do not write financial statements, as stated in Directive 317 of the Supervisor of Banks. Total problem debts amounted to NIS million as at December 31, 2005, compared with NIS million on December 31, 2004, a decrease of 32.6% (see the item entitled Problem Borrowers, below). Profit from financing activities after provision for doubtful debts in 2005 amounted to NIS million, compared with NIS million in 2004, an increase on 3.2%. Operating and other income Total operating and other income amounted to NIS million in 2005, compared with NIS million in 2004, an increase of 7.8%. Income from operating commissions increased by 8.0%, from NIS million in 2004 to NIS million in

9 Most of the increase was recorded in income from capital market activity, as follows: Change NIS million % Income from securities Income from mutual trust fund management fees (1.3) Income from provident fund management fees Total capital market activity income Income from credit cards amounted to NIS 32.5 million in 2005, compared with NIS 30.6 million in 2004, an increase of 6.2%. As at December 31, 2005, the volume of customer credit earmarked for financing purchases with credit cards was NIS million, compared with NIS million on December 31, 2004, an increase of 1.9%. Total income from financing activity in 2005 amounted to NIS 7.0 million, compared with NIS 8.1 million in 2004, a decrease of 13.6% deriving mainly from the lower prime interest rate. Other operating income not deriving from credit card activity or capital market activity amounted to NIS 99.4 million in 2005, compared with NIS 96.4 million in 2004, an increase of 3.1%. This income includes one-time income recorded in the third quarter of 2005 from margin differences from credit and deposits which their repayment to the depositor is dependent on the collection of the credit (loans and deposits for which the depositor is responsible), deriving from accounting in respect of prior periods and which amounted to approximately NIS 3.0 million. Operating expenses In 2005, operating expenses amounted to NIS million compared with NIS million in 2004, an increase of 5.9%. Operating and other income covered 52.0% of operating expenses in 2005, compared with 51.1% in 2004 Payroll expenses Payroll expenses in 2005 amounted to NIS million in 2005, compared with NIS million in 2004, an increase of 4.9%. The increase in payroll expenses derives from: a. An increase due to a change in the definition of salary in the Value Added Tax Law, which led to charging VAT on payments and reserves for retirement compensation and on sick pay for the first time. The effect of the change in the VAT law on the compensation reserve balance and retirement grants as at January 1, 2005 amounted to an additional one-time expense of NIS 2.9 million, and its effect on the salaries paid in 2005 was an additional expense of NIS 3.6 million. b. An increase of NIS 7.2 million in respect of the increase in the number of employees, the effects of salary agreements and employee ranking agreements. c. A decrease of NIS 3.8 million deriving from a one-time expense recorded in 2004 following the grossing of the value of salary benefits in respect of prior years, as a result of tax assessments received and an agreement with the tax authorities. 8

10 Other operating expenses Building and equipment maintenance expenses and depreciation amounted to NIS 64.7 million in 2005, compared with NIS 59.3 million in 2004, an increase of 9.1%. Most of the increase in maintenance expenses comes from an increase of approximately NIS 2.2 million in local authority taxes, and increase of NIS 2.0 million in the costs of building maintenance and an increase of NIS 1.6 million in car maintenance costs. Other operating expenses amounted to NIS 93.2 million in 2005, compared with NIS 87.8 million in 2004, an increase of 6.1%. The major increase in this item was in data processing, which increased by 7.3% from NIS 48.0 million in 2004 to NIS 51.5 million in Other operating expenses which are not data processing recorded an increase of 4.3%, from NIS 39.9 million in 2004 to NIS 41.6 million in Most of this increase was in commissions paid and in communications costs. Operating income before taxes Ordinary operating income before taxes in 2005 amounted to NIS million, compared with NIS million in 2004, an increase of 2.1%. Net operating yield before taxes was 19.69%, compared with 20.71% in Provision for taxes on income The provision for taxes on ordinary operating income in 2005 amounted to NIS 50.4 million, compared with NIS 52.3 million in In July 2005, the Knesset passed the Amendment to the Income Tax Ordinance Law (Amendment No. 147 and temporary order), The Amendment stipulates a gradual reduction in the corporate tax rate, from 34% to 25% as follows: - In 2006, the tax rate will be 31%. - In 2007, the tax rate will be 29%. - In 2008, the tax rate will be 27%. - In 2009, the tax rate will be 26%. - From 2010 onwards the tax rate will be 25%. The provision for taxes contains profit tax in accordance with the VAT Law and the Income Tax Law, as above. The actual tax rate in 2005 was 43.59%, and in 2006 will be 41.03%, in 2007 it will be 39.32%, in 2008 it will be 37.61%, in 2009 it will be 36.75% and commencing 2010 the tax rate will be 35.90%. Current taxes and deferred taxes as at December 31, 2005 are computed in accordance with the tax rates as stipulated in the amendment to the Law. The effect of the change in the tax rate on the balance of deferred taxes as at December 31, 2005 is an increase of NIS 0.8 million in the income tax expense. The rate of the provision for taxes in 2005 was 44.1%, compared with 46.7% in The difference between the statutory tax rate and the actual tax rate reflects mainly non-deductible expenses, discrepancies deriving from the effect of the inflationary adjustment law, as well as the effect of the changes in tax rates. See Note 24 to the financial statements. Ordinary operating income after taxes amounted to NIS 63.9 million, compared with NIS 59.6 million in 2004, an increase of 7.2%. Yield from ordinary operations after taxes to shareholders' equity reached 11.0%, compared with 11.03% in Net profit from extraordinary operations after taxes amounted to NIS 0.7 million, deriving mainly from realization of investments in fixed assets, mainly buildings. Consolidated net profit of the Bank amounted to NIS 64.5 million, compared with NIS 58.7 million in 2004, an increase of 9.9%. Net return on equity reached 11.12%, compared with 10.86% in

11 Developments in Principal Balance Sheet Items were as follows: December Rate of change NIS millions NIS millions % Total assets 10, , Credit to the public 6, , Cash and deposits in banks 2, , Investment in securities Investments in buildings and equipment Deposits from the public 8,937.0 * 8, Shareholders equity Ratio of shareholders equity to total assets 6.3% 6.2% Ratio of credit to total assets 67.2% 70.4% * Reclassified Cash and deposits with Bank of Israel and deposits in banks As at December 31, 2005, the balance of cash and deposits at the Bank of Israel totaled NIS million, compared with NIS million on December 31, 2004, an increase of 10.3%. The balance of the deposits in banks increased from NIS 1,943.0 million on December 31, 2004 to NIS 2,249.5 million as at December 31, 2005, an increase of 15.8%. Credit to the public As at December 31, 2005, credit to the public amounted to NIS 6,937.2 million, compared with NIS 6,569.0 million on December 31, 2004, an increase of 5.6%. Part of the increase in credit is due to the influence of the Gahelet transaction (see the section on deposits from the public). Most of the Bank s credit is to households, as described in the credit risk analysis (see section on credit risks, below). Composition of credit to the public according to linkage basis is as follows: Ratio of segment credit to total December 31 credit as at December Change NIS millions NIS millions % % % Unlinked shekel segment 4, , CPI-linked shekel segment 1, , Foreign currency and foreign currency-linked segment (1.5) Total 6, , Securities In 2005, the Bank expanded its investment activity in securities on behalf of itself. The Bank s own investments in securities are subject to limitations which were laid down by the Board of Directors, which set the maximum size of these portfolios and their daily Var. 10

12 We present below a breakdown of the marketable securities and available-for-sale portfolio, based on issuer and linkage segment in market values (in millions of NIS): December 31, 2005 December 31, 2004 Government Other Government Other Unlinked shekel segment Linked shekel segment Foreign currency and foreign currencylinked segment Total Fixed assets Fixed assets include buildings and equipment used by the Bank in its operations. Fixed assets are stated in reported amounts: equipment purchased up to and including December 31, 2003 were stated on the basis of depreciated cost adjusted to the CPI of December 2003; equipment purchased after that date was recorded on the basis of depreciated cost in nominal amounts. In accordance with Israeli Accounting Standard No. 15, the Bank assessed the need to state the assets at their recoverable value, and no write-down was recorded. In 2004 a write-down of NIS 0.7 million was recorded in respect of buildings available for sale. Deposits of the Public A. We present below details of deposits of the public according to linkage base: As at December 31, 2005 Change from Demand Term Designated December 31 deposits deposits deposits Total 2004 NIS millions NIS millions NIS millions NIS millions % Unlinked , , CPI-linked - 1, , Foreign currency or linked thereto , Total 1, , , As at December 31, 2004 Demand Term Designated Total deposits deposits deposits NIS millions NIS millions NIS millions NIS millions Unlinked , ,081.9 CPI-linked - 1, ,693.6 In foreign currency or linked thereto ,277.6 Total 1, , ,

13 B. In February 2005 an agreement was signed between the Bank and Gahelet Savings Ltd. and Tel Aviv Municipality. Gahelet is a financial institution under the Banking Law (Licensing), and is licensed to manage savings accounts for higher education. The money of the savers in Gahelet was invested by way of credit facilities to the Tel Aviv Municipality. Under the agreement, Gahelet assigned to the Bank all its liabilities towards the savers, as well as its rights to receive money it loaned to the Municipality. The Bank's undertaking towards the savers in those savings plans as at December 31, 2005 amounted to NIS million. Repayment of the loan extended to the Municipality will be concurrent with and at the same pace as repayment of the savings plans up to Subordinated notes The subordinated notes are linked to the CPI and are not convertible into shares. The holders of the notes are institutional entities such as provident funds and further study funds. The total amount of the subordinated notes as at December 31, 2005 was NIS million, compared with NIS million on December 31, 2004, an increase of 6.2%. The Bank's subordinated notes were rated for the first time by Midroog in 2005, at Aa3. In 2005, capital notes in an amount of NIS 10 million were issued, bearing average interest of 4.5% and for a period of ten years. These capital notes were approved as capital for purposes of calculating the minimum capital required. The amount of the capital notes included in the minimum capital calculation, taking into consideration the period to maturity, in accordance with directives of Bank of Israel, is NIS million (December 31, 2004 NIS million). Shareholders equity As at December 31, 2005, shareholders equity amounted to NIS million compared with NIS million on December 31, 2004, an increase of 11.3% (7.5% in 2004). The increase is attributed to the net profit and to increased adjustment amounts for available-for-sale securities at fair value. In 2004 a dividend of NIS 17.0 million was distributed for further details, see "Investments in the Bank's capital, transactions in its shares and distribution of a dividend". For more complete details of developments in capital, see the Statement of Changes in Shareholders Equity in the financial statements.. As at December 31, 2005, the ratio of capital to risk assets was 11.03%, compared with 11.52% on December 31, See Note 12A to the financial statements for details regarding capital and risk components. Accounting Policy with respect to Critical Matters The accounting principles that are applied in the financial statements are described in Note 1A to the financial statements. The implementation of some of these principles requires the Bank's Management to apply criteria and use estimates that have an effect on the asset and liability values presented in the financial statements, including contingent liabilities. Some of the assessments involve uncertainty, and could be affected by changes in the future. As they relate to its accounting policy, the Bank considers these to be estimates and assessments with respect to critical matters. Management uses the best information available to it in order to prepare these estimates and assessments, but a change in the parameters used to prepare them could have a material effect on the business results. 12

14 Provision for doubtful debts The provision for doubtful debts is calculated specifically, and a general provision and a supplementary provision are also included, in accordance with the directives of the Supervisor of Banks. The specific provision for doubtful debts is intended to reflect in the financial statements the Bank s evaluation regarding the loss inherent in the credit portfolio, including in off-balance-sheet items. Determination of the amount of the provision constitutes an estimate, at which Management arrives by relying on a large number of hypotheses and assumptions which are based on the information available proximate to the date of publishing the financial statements. After the Bank has determined the collectible amount of each such debt, a provision is recorded in the financial statements in the amount of the difference between the amount of the debt and the collectible amount as at balance sheet date. The process of determining the collectible amount is based on various parameters, such as the realizable value of the borrower s assets, guarantees and deposits to secure the loan, anticipated business cash flows, etc. In some of cases, the Bank is assisted by external experts, who estimate the collectible amount or part of it. This data is based on estimates and evaluations which rely, inter alia, on economic variables which are beyond the Bank's control, such as the condition of the Israeli economy, the operating markets of companies and their products, interest rates and the condition of the capital market, real estate prices, demand in the local industry, etc. In determining the collectible amount, safety coefficients are calculated in order to resolve situations of uncertainty regarding credit repayment ability, but the dependency on those economic parameters cannot guarantee that the collectible amount will not be less than estimated if the economic parameters change for the worse. As at December 31, 2005, the amount determined to be the collectible amount of the debts defined as doubtful and which is based on the estimates described above, totaled NIS 90.1 million compared with NIS 97.2 million on December 31, The supplementary provision for doubtful debts is based on the quality of the customer debt portfolio, according to the risk characteristics defined in the directives of the Supervisor of Banks. Various rates of provision have been determined in respect of each of the risk characteristics, and include debts classified as problematic according to the classification categories defined by the Supervisor of Banks, the absence of financial information on the borrower, credit to related parties of the Bank, concentration of industry credit and credit to a borrower or group of borrowers which deviates from the single borrower debt limits. Since some of the components of the supplementary provision mainly the provision for problem debts rely on the debt actually being classified as problematic and on the timing of the classification, the Bank, in calculating the supplementary provision, relies on those estimates that relate to the financial stability of the borrower and to his repayment ability when it determines whether and when the debt should be classified as problematic. As at December 31, 2005, the aggregate ratio of the general and supplementary provisions to the total credit risk is 0.20% (December 31, %). 13

15 Fair value of financial instruments Certain of the financial instruments which the Bank uses, including most of the securities in the available-forsale portfolio and in the trading portfolio, as well as derivative financial instruments, are measured in the balance sheet according to their fair value. The fair value of a financial instrument is defined as the value at which it can be sold to a willing buyer who is not a related party or as the value which can close a position in a derivative financial instrument within a reasonable period of time under existing market conditions. In most cases, fair value is determined on the basis of price quotations from stock markets or brokers in the absence of an organized market for the instrument, and on the basis of internal models that were developed and which are based on various parameters such as interest curves, currency rates and standard deviations of options. The methods of arriving at a fair value in these models take into account, inter alia, factors such as liquidity, concentration of transactions with various parties and the credit risk of the other party to the transaction. Changes in fair value of available-for-sale securities are included in shareholders equity net of the tax effect, except when there is an impairment in value that is not of a temporary nature. In such a case the impairment value is included in the profit and loss. The Bank regularly examines whether there has been a decrease in value that is not of a temporary nature on the basis of the financial condition of the issuer, according to the same criteria used to examine the repayment ability of a borrower as described in the previous paragraph. As at December 31, 2005, the amount of financial instruments that are measured according to their fair value is NIS million, of which the fair value of NIS million is determined according to their price on the stock markets and NIS 53.6 million is determined using fair value calculation models. The Bank uses estimates and assumptions in respect of most of the parameters in the fair value models and these may change following possible changes mainly in interest rates and standard deviations in the various markets, as well as where only limited information is available regarding certain market variables, such as regarding variables in long-term interest or currency swap transactions. With respect to securities whose fair value is determined according to stock market prices, the realizable value in the sale of a large amount of such securities might not necessarily reflect the market price. Furthermore, for securities whose price is determined by a broker quotation because of the absence of an organized market and low marketability of the securities, it is possible that the realizable value will be different. Contingent liabilities The Bank is a party to legal proceedings instituted by its customers or former customers who consider themselves to have been harmed or to have incurred damages in the ordinary course of the Bank s business. The Bank's Management, relying on legal opinions, has included in the financial statements appropriate provisions to cover any possible damages in respect of such legal proceedings. With respect to most of the legal proceedings, opinions are received from external legal consultants, which are then examined by the legal counsel employed by the Bank. The evaluations of the legal consultants are based on their best judgment and legal experience accumulated in Israel on the various issues. It is possible that the results of any of the proceedings may differ from the evaluations upon which Management based its provisions. 14

16 Description of the Bank's business by operating segment The Bank provides a range of banking and financial services for its customers through its branches and offices and through subsidiaries operating in the capital market. Since 2004, the Bank's activities have been divided into five main operations, based on the types of customers in each segment. Information on income by segment of operations, as presented to the Bank's Management, serves as an aid to its decision-making. The segments of operation of the Bank: The household segment banking services and financial products for households. Private banking segment banking services and financial products for private customers having medium to large financial resources, including investment advice services. The Small businesses segment banking services and financial products for small businesses with a credit facility of up to $500,000. Commercial segment banking services and financial products for businesses with a credit facility of more than $500,000. Financial management segment coordinates the Bank's exposure management and supports the development and pricing of financial products. This segment also coordinates the liquidity and nostro activities of the Bank. Others and adjustments mainly the activities of units which are not a segment and whose activities are not allocated to a specific segment. The division into segments and products in 2005 and 2004 was dictated by the directives of the Supervisor of Banks. Since this division did not exist in 2003, the data presented here are for 2005 and 2004 only. The results of the segments' operations are described in Note 28 to the financial statements, in accordance with the directives of the Supervisor of Banks for "Principal Segments of Operations". The accounting rules applied in presenting the results of the segments' operations are described in Note 26 to the financial statements. Below are the main rules applied in dividing the results of operations among the segments: - Income from financing operations is measured against the price of capital; income from assets and income from liabilities are measured on the basis of the difference between the interest actually paid and the capital price on the date of making the transaction. - The provision for doubtful debts is charged to the segment to which the borrower in respect of whom the provision is made, belongs. - Operating income is charged to the segment to which the customer belongs. - Operating expenses are measured as follows: - Direct costs identified with and attributed to the segment. - Indirect costs attributed according to rules that reflect the relevant volumes of activity or standard prices set for various activities. - Charge for internal services the segment that includes the customer who receives services from another segment is charged at a computed tariff by way of transfer of income to the segment providing the service. - Retirement costs and salary costs deriving from grossing of one-time expenses are not charged and are stated in others segment. - Income tax the provision for tax is computed at the effective tax rate for the Bank. - Return on capital the ratio of net profit of each of the segments to equity is allocated. The allocated equity is computed according to the balance of risk components in each segment, multiplied by the minimum capital ratio set by the Board of Directors. 15

17 Condensed presentation of net profit and total assets, by segment: A. Net profit For the year ended December Change NIS million % Household banking segment Private banking segment Small businesses segment Commercial segment Financial management segment (23.8) Other (0.4) (0.8) (50.0) Total B. Total assets (average balance) For the year ended December Change NIS million % Household banking segment 3, , Private banking segment Small businesses segment Commercial segment 1, , Financial management segment 3, , Other Total 9, , Retail operations General The Retail division encompasses the activities of the branches and offices and telecommunications banking. Its income accounts for about 80% of the Bank's total income. The Retail division, through the branches for which it is responsible, provides banking services for Business segment customers. The products it provides are banking services such as credit and deposits, capital market activity including securities, provident funds, mutual funds and credit cards. The Retail division's activities are concentrated in three main segments of operation, based on types of customer and the products and services suited to their needs. The segments of operation of the Retail division: Household segment a range of banking services and financial products for households. Private banking segment a range of banking services and financial products for private customers having medium to large financial resources, including investment advice services. Small businesses segment banking services and financial products for small businesses with a credit facility of up to $500,

18 The household segment The structure of the segment and the changes occurring in it The Personal Banking segment provides a range of banking services and financial products for households, and operates by means of the Bank's branches 36 branches and 8 area offices located around the country, from Rosh Pina in the north to Eilat in the south, as well as by direct means the internet and Otsar Yashir. The segment also provides services for customers belonging to other segments, and for occasional customers. The principal banking products provided by the segment are checking account management, credit, deposits, savings plans, credit card activities and capital market products, which include savings in provident funds, investments in mutual funds and in securities. The households are mainly customers with medium to small financial resources, and are divided according to parameters of financial wealth and income level. The segment's customers are divided into three main groups: Defense establishment employees and retirees including standing army servicemen, civilian IDF employees, Ministry of Defense employees and retirees, employees of support units of the Ministry of Defense and other Defense establishment employees. Groups of employees. Other retail customers. Legislative limitations, standards and special constraints applicable to the segment The Bank operates within laws and regulations and according to regulatory guidelines applicable to the banking system in Israel as issued by the Supervisor of Banks, the Commissioner for the Capital Market, Insurance and Savings, the Antitrust Commissioner, the Securities Authority and others. For details about the regulatory involvement in banking commissions, see "Other Matters". For details about Good Banking Practice Directive No. 325 concerning deviation from credit facilities in checking accounts, see "Other Matters". For additional details about changes in legislation following the recommendations of the Bachar Commission and the uncertainty as to their effect on business results, see "Capital Market Reform". Changes in the volume of activity of the segment and in its net profit The net profit of the households segment amounted to NIS 24.3 million, compared with NIS 19.1 million n 2004, an increase of 27.2%. Net return on equity computed on the basis of the risk components in the segment, was 6.6%, compared with 5.3% in The income of the segment was NIS million, compared with NIS million in 2004, an increase of 1.8%. Provision for doubtful debts in the segment amounted to NIS 6.1 million, compared with NIS 18.0 million in Expenses in the segment were NIS million, compared with NIS million in 2004, an increase of 5.2%. Public assets under management amounted to NIS 1.6 billion, similar to