Beyond Bachar. Next Steps for Financial Reform. Koret Milken Institute Fellows Program

Transcription

1 July 25, 2007 Policy Brief Beyond Bachar Next Steps for Financial Reform Koret Milken Institute Fellows Program

2 Koret Milken Institute Fellows Program Beyond Bachar: Next Steps for Financial Reform By Amit Goldwasser, Diana Zaks, and Shahar Shlush, Koret Fellows Editor in Chief: Glenn Yago, Senior Koret Milken Institute Fellow Director of Capital Studies, Milken Institute Deputy Editor: Ronit Purian-Lukatch, Deputy Director, Koret Milken Institute Fellows Program July 25, 2007

3 Acknowledgments Policy briefs by the Koret-Milken Institute Fellows are based on independent research and by graduate student researchers, directed by Glenn Yago, Zev Golan, and Ronit Purian, with input from the program s Senior Fellow, Prof. Yair Orgler. The program, established by the Koret Foundation, provides annual fellowships to exemplary students to complete independent economic research on issues impeding small-business development, employment expansion and private-sector economic growth in Israel. The program is financed mainly by a grant from the Koret Foundation, with additional assistance from the Milken Family Foundation, the Rosalinde and Arthur Gilbert Foundation, and the Jewish Community Foundation of Los Angeles. The Milken Institute is an independent economic think tank whose mission is to improve the lives and economic conditions of diverse populations in the United States and around the world by helping business and public policy leaders identify and implement innovative ideas for creating broad-based prosperity. We put research to work with the goal of revitalizing regions and finding new ways to generate capital for people with original ideas. We do this by focusing on human capital the talent, knowledge, and experience of people and their value to organizations, economies, and society; financial capital innovations that allocate financial resources efficiently, especially to those who ordinarily would not have access to such resources, but who can best use them to build companies, create jobs, and solve long-standing social and economic problems; and social capital the bonds of society, including schools, health care, cultural institutions, and government services that underlie economic advancement. By creating ways to spread the benefits of human, financial, and social capital to as many people as possible the democratization of capital we hope to contribute to prosperity and freedom in all corners of the globe. We are nonprofit, nonpartisan, and publicly supported Milken Institute

4 Beyond Bachar: Next Steps for Financial Reform Milken Institute Executive Summary This paper evaluates the progress made since the Bachar reforms part of a series of policy interventions to ensure that Israel s financial markets help fuel economic growth were approved by the Knesset in July As shown in figure 1, reforms that have been implemented are creating alternative capital flows. But work remains if Israel is to become competitive with the global financial systems of developed economies. Figure 1: Capital market reforms in Israel GDP per capita (in U.S. $) : End of Designated Bonds to Provident Funds and Life Insurance 1995: Ceiling on Designated Bonds to New Pension Funds 2003: Old Pension Fund Reform 2005: Bachar Committee Reform 2004: SEC rulings on disclosure and enforcement adopting U.S. standards 1985: Lift of Exchange Controls Year Source: IMF, Milken Institute Substantial progress has occurred in the following areas: Overall market capitalization of the private sector as a portion of GDP has risen from 83 percent in 2005 to 101 percent in The corporate bond market has grown from 12 percent of GDP in 2005 to 21 percent in 2006 (still small, of course, compared to the United States, where it is 201 percent of GDP). The non-bank credit market has grown nearly 7 percent from 2005 to Momentum has stalled, however, in other areas of financial reform, in part because the Bachar Committee recommendations have been only partially implemented. For example: Five of the ten reforms called for in Knesset legislation, as well as other recommendations, have not yet been implemented. [ 1 ]

5 Beyond Bachar: Next Steps for Financial Reform Milken Institute Banking concentration, as measured by market share of the two largest banks, Bank Hapoalim and Bank Leumi, has increased by 4.23 percent since the Bachar reforms were enacted. Yet a key objective identified by the Bachar Committee was to increase competition for financial services by reducing the high concentration of the banking industry, which has led to conflicts of interest and fewer choices for investors and businesses. Bank market share also increased for deposits and new provident funds (retirement savings that were formerly the recipients of dedicated government bonds); bank market share has only slightly decreased in insurance assets. Recommendations still in need of implementation include: facilitation of new distribution channels for financial services, including online fund purchasing and Internet banking creation of national securitization legislation to reduce bank risks and create new markets implementation of differentiated distribution pricing to facilitate new distribution channels (e.g., retail within and outside banks, and institutional investors) caution in granting foreign investment managers direct access to Israeli markets; entry granted only with regulatory oversight consistent with that of domestic fund managers in order to prevent banks from circumventing reforms regulatory change to allow the creation of money market funds regulatory guidelines for money market funds, deposit insurance, and mutual fund distribution by nonmembers of the stock market national standards for the sale and repurchase of repo (repurchase) securities. This report urges continued monitoring of Israel s financial infrastructure to ensure that the means of financing Israel s future including the distribution of financial products are available to the broadest numbers of entrepreneurs and projects. Further reforms are necessary if local capital markets are to enable economic pricing of risk, and optimal sharing of risk and resources that lower the cost of financial intermediation and cost of capital. They must continue if Israel is to ensure a larger, viable secondary market to support economic growth through lower fees, more financial innovation, and broader and cheaper access to credit and investment. [ 2 ]

6 Beyond Bachar: Next Steps for Financial Reform Milken Institute Introduction The Bachar Committee reforms were intended to increase competition and reduce conflicts of interest in the Israeli economy. As the most comprehensive financial reform effort undertaken in years, the committee s objective was to promote structural change in an arena that had been resistant to previous attempts to increase competition. Two years after the legislation was enacted on July 25, 2005, this paper reviews the effects of the reforms and offers recommendations for further action. No comprehensive assessment of the Bachar reforms or their impacts has taken place since they were launched. This paper is part of an effort to measure those financial reforms, and to sustain interest in the critical role of the financial services industry in maintaining economic competitiveness and growth. According to conventional indexes, the concentration of the banking industry in the financial services arena has increased since the reforms. Conflict-of-interest levels may have dropped since the divestiture of provident and mutual funds, but banks retain control of the distribution system, and thus, their dominant position in the nation s financial system. Background Before the mid-1990s Israeli capital markets were remarkable for their lack of competition, heavy governmental involvement, and the almost unlimited power wielded by the country s main banks. Government involvement in the capital markets: The government administered both the cost of capital and licensed access to financial customers by allocating illiquid and subsidized special bonds for savings accounts and savings funds, insurance companies, and banks. Most of the public s savings were channeled to the government through the purchase of these bonds. Government involvement in the debt market: The government directed investments by subsidizing targeted credit, distributed by the banking system. It also allocated mortgages according to priorities set by politicians and civil servants. Companies were not allowed to issues bonds without express permission from the Treasury and Knesset; as a result, they issued few, if any, corporate bonds. The banking system: Commercial banks were extremely dominant in the national economy. Operating as universal banks, they managed mutual funds and provident funds while controlling subsidiaries that underwrote risk and mortgages. The banking market was highly concentrated, with a few banks controlling all banking credit (the two largest banks, Bank Hapoalim and Bank Leumi, controlled more than 66 percent). Previous reforms, such as the 1995 pension reform or the 2003 reform equalizing capital gains taxes on investment in Israel and abroad, did not directly address bank control of the financial markets but focused mainly on reducing government involvement in the economy. The capital market reform process started in the mid-1990s, when the government stopped selling subsidized special bonds to provident funds (which were owned mainly by the banks), and the provident funds were allowed to allocate a larger percentage of [ 3 ]

7 Beyond Bachar: Next Steps for Financial Reform Milken Institute their assets into non-government bonds. Similarly, banks were allowed to offer credit to the business sector without much involvement by the government. 1 In addition, the government lifted limitations on holding foreign currency. Israelis now had access to capital markets abroad, and companies found new opportunities in international trade, including access to capital from foreign banks. These early reforms did not temper the banks power but may have actually increased their influence: without the government as a financial intermediary, the banks had greater command over credit allocation. In addition, they still controlled a large part of the public s financial assets through provident and mutual funds. It was this pervasive economic concentration in the banking industry, with its attendant concern about conflicts of interest, that framed the main problem of the Israeli capital market as defined by the Bachar Committee. Over the years, the banks expanded their influence beyond the provident and mutual funds into such areas as credit card issuance and mortgage banking. With the advantage of concentrated power and no competition, they created conflicts of interest as they directed their customers to use financial institutions or financial tools that they themselves controlled. This level of concentration of course had the potential to increase systemic risk through the lack of risk mitigation and dispersion. These ingredients, as can be seen in the figures 2 and 3, formed a vicious circle that allowed the banks to maintain their dominant position. Figure 2: The Israeli capital market Savings Non-bank intermediaries Banks Investments Source: The Ministry of Finance, the Bachar Committee Figure 3: Concentration and conflicts of interest Conflicts of interest increase concentration. Concentration increases conflicts of interest. [ 4 ] Source: The Ministry of Finance, Bachar Committee

8 Beyond Bachar: Next Steps for Financial Reform Milken Institute The result of the banks predominant position was a high cost of capital and other economic distortions, including increases in non-performing loans. According to one prevalent argument, the local equities market failed to develop as an independent alternative to bank finance because of the banks dominant position in this market as well. 2 Research on the effects of these first rounds of reform verifies that the bank credit market stayed noncompetitive. 3 The banks dominant position in managing provident funds and mutual funds, as well as their role in the insurance market, continued to cause economic distortions and raise further questions about conflict of interest. For example, bank subsidiaries managed mutual funds that often invested in companies whose debt (and sometimes their shareholders equity) was owned by the parent bank company even when such an investment was not in the best interests of the investors. Indeed, it was found that Israeli IPO share prices were clearly excessive in cases where the bank underwrote the shareholder equity; but those shares were then bought by mutual funds owned by the same bank that held the majority of the company s debt. 4 These bank transactions shifted the risk of poor loans in their portfolios to investors in their mutual funds. An analysis of the performance of the forty-one largest provident funds, most of which were owned by the five largest banks in the country between 1987 and 1994, shows similar findings. Those funds exhibited average annual yields lower than market performance. 5 Moreover, banks advised their customers on the purchase of provident and mutual funds. Bank corporate strategy included duplicating independent mutual fund offerings by bank-owned funds, thereby enabling banks to offer their proprietary mutual fund products to customers without contravening the law. Proof of this can be found in of the subsequent divestment of the banks own funds. 6 The combination of high concentration, poor performance, and potential conflicts of interest led critics and researchers to conclusion that reform was needed to curtail the connections between the commercial banks and the provident and mutual funds. 7 A similar situation existed in the Israeli credit market: most of the capital was allocated to politically directed projects, large firms, and government-owned firms or projects. Other enterprises found it increasingly difficult to raise capital in such a concentrated market, and the lack of alternative financing increased entrepreneur costs and hindered growth. The Bachar Reforms were intended to address the integrated problems of concentration and conflicts of interest with the understanding that while conflicts of interest can be viewed as localized, their presence in highly influential government entities or projects can become a macroeconomic problem due to concentration of credit risk. 8 An examination of the committee s main recommendations and the degree to which they have been implemented follows. [ 5 ]

9 Beyond Bachar: Next Steps for Financial Reform Milken Institute Two Years After the Bachar Reforms: The Status of Implementation Table 1 examines the recommendations of the Bachar Committee and status of their implementation. Table 1: Implementation of the Bachar Committee Recommendations Recommendation 1 Banking corporations shall not control provident or mutual funds. Current Status Most provident funds are being sold. Banks still own a small percentage of mutual funds. 2 Companies with licenses to manage investment portfolios controlled by a bank or by a company that controls a bank shall not manage assets for provident funds, mutual funds or pension funds (except for the bodies nostro accounts). Legislation enacted (the Law for Encouragement of Competition and Reduction of Conflicts of Interest in the Israeli Capital Markets, 2005) 3 Bank Hapoalim must sell its holding in Bank Otzar Hahayal by March Sale completed August 17, An underwriter shall not serve in a price-setting capacity in any public offering of securities if the issuing company has debt of more than NIS 5 million or liabilities of 10 percent to the underwriting firm. Regulations issued in 2006, with certain modifications, including lifting the level of liabilities to the underwriter from 10 percent to 15 percent 5 Underwriters should be forbidden to sell more than 5 percent of an issue to bodies under their control. 6 Purchase of mutual or provident funds shall be allowed if their assets exceed more than 15 percent of the assets in the market. Regulations implemented in 2006 with certain modifications Sales of 5 percent to 10 percent to bodies under control allowed Recommendation was enforced by Yadin Antebi, the Treasury s Administrator of Capital Markets, when he blocked the sale of the Yahav and Gadish provident funds to IDB 7 A team shall be formed to recommend structural and essential changes to capital market regulation. The recommendations shall be presented by August 31, Not yet implemented 8 Formal training and licensing will be required of persons selling or offering advice on capital markets and pension products. Legislation completed and regulation issued under the terms of The Law for Encouragement of Competition and Reduction of Conflicts of Interest in the Israeli Capital Markets, 2005 [ 6 ]

10 Beyond Bachar: Next Steps for Financial Reform Milken Institute 9 Gradual entry of banks into pension consulting and marketing pension products Small banks with shareholder capital of less than NIS10 million shall sell their provident funds; larger banks shall sell their mutual funds. Bank Igud has received a permit to deal with pension products. First International Bank is awaiting a similar permit. Once the large banks sell their mutual funds, they may enter the field, but the law allows the Treasury s Administrator of Capital Markets leeway in granting the permits based on the economic concentration in the market. Yadin Antebi is working to give the larger banks such a permit. 10 The Bachar Committee will continue to monitor the reform s implementation. No formal monitoring committee exists. Several bodies are monitoring the changes, including extra-governmental bodies, such as BDI CODE, which is following the insurance market, and Maalot, which is monitoring the mutual fund market. The Bachar Committee issued several recommendations for the creation of alternative sources of capital and more economic activity. Among these are: issuing commercial paper: The Knesset Finance Committee approved regulations encouraging these issues on October 10, 2005; creating money market funds: This recommendation was not implemented; introducing repo (sale and repurchase of securities): The recommendation to institute this procedure was not implemented. The U.S. standard is now in force, and in 2008 Israel is due to adopt the international standard. Starting in January 2007 the Bank of Israel will stop Makam transactions; 9 distributing mutual funds by bodies that are not members of the stock exchange: This recommendation has not been implemented; introducing measures that make it easier to change banks: A recommendation that has not been implemented, introducing deposit insurance; 10 nostro investments and market making by banks: The regulations are in the process of being approved. They address the role of banks operating trading operations, involving both buy and sell orders into a market to establish further liquidity to establish further market depth. securitization: Creating the legal and regulatory framework to enable the packaging of designated pools of loans, receivable, asset with appropriate levels of credit enhancement to enable the redistribution of such packages to investors in the form of securities that are collateralized or secured by the underlying pool and its associated income stream in order to convert illiquid assets into liquid ones defines the process of modern risk mitigation in linking capital markets and financial institutions. Not implemented. [ 7 ]

11 Beyond Bachar: Next Steps for Financial Reform Milken Institute In its recommendations the Bachar Committee did not deal with bank distribution commissions, which has since be raised in other legislation. The Bachar Committee was supposed to issue its recommendations on all of the above-stated issues to the Finance Ministry by June 30, 2005, but this was not done. We will now look at the influence of the reforms in three fields: banking concentration, access to credit, and control of consulting and distribution. Banking Concentration Throughout the 1990s until 1997, banking concentration decreased due to capital market reforms, foreign currency reforms, exposure to foreign capital, and the gradual withdrawal of the government from its role as a financial intermediary in the market. The trend started to reverse itself, apparently because additional competition-enhancing reforms and privatization did not follow. The use of asset sales for bank privatizations did little to increase competitiveness and efficiency in the financial system. Banks also started allocating a greater proportion of their credit to their largest customers, which increased concentration in credit allocation. Figure 4 illustrates the changes in banking concentration between 1993 and 2006, according to two indexes: the Herfindahl (H) index and the CR2 index, which represents the shares of the two largest banks in percentages. Figure 4: Banking Concentration according to the H and CR2 indices H / / / / / / / / / /1997 CR 2 ( ) H ( ) 02/ / / / / / / / / / / / / / / / / / / /2006 Source: Ami Zadik and Yonatan Erlich, First Commission of Inquiry on Bank Commissions, Banking Concentration and Banking Competition, Knesset Research Office, February 18, CR [ 8 ]

12 Beyond Bachar: Next Steps for Financial Reform Milken Institute Compared with various industrialized countries, Israeli banking concentration is relatively high. In 2003, as shown in figure 5, Israel ranked as 0.228, according to the H index, compared to an average of in the other countries. Figure 5: Banking concentration according to the H index, 2003 As of the end of 2005, according to data from the Ministry of Finance, the two largest banks, Hapoalim and Discount, each accounted for about 30 percent of all assets, including public credit and deposits. Data from 2006 shows that banking concentration remains high and that most of the improvement was in mutual and provident funds. Table 2 shows market share of the banks by sector before and after the reform. Table 2: Changes in market shares among the three largest banks New Provident Funds November 2006 Insurance November 2006 Provident Funds April 2007 Mutual Funds April 2007 Banking April 2007 Total assets Total assets Assets under management Assets under management Deposits from the public Mivtahim 45.4 percent Migdal 24.0 percent Hapoalim 15.0 percent Hapoalim 0.0 percent Hapoalim 29.0 percent Makefet 24.2 percent Clal 21.0 percent Leumi 9.0 percent Leumi 0.0 percent Leumi 34.0 percent Meytavit 14.8 percent Phoenix 14.0 percent Discount 3.0 percent Discount 0.4 percent Discount 18.0 percent 85.0 percent 59.0 percent 25.0 percent 0.4 percent 81.0 percent After the Reform 74.0 percent 63.0 percent 73.0 percent 80.0 percent 78.0 percent Before the Reform [ 9 ]

13 Beyond Bachar: Next Steps for Financial Reform Milken Institute Table 3 presents market shares of the investment banks in Table 3: Investment banks Investment bank Number of issues Market Share (in number of issues) Capital raised (shekels, millions) Market shares (by capital raised) Poalim IBI 39 39% 3,679 40%** Clal Finance 17 17% %** Leader 13 13% 1,292 14% Apex 10 10% 1,121 12% International 6 6% 1,260* 14% Source: Bank of Israel * The issue of Paz under control of the First International group accounted for 70 percent of the capital raised. ** The market shares of Poalim and Clal grew after Poalim and Bank Leumi were not allowed to participate. Analysis of the public s assets entrusted to institutional bodies before and after the reform indicates that despite the entrance of new players, major banks have retained a large part of the market. Figures 6 and 7 demonstrate the stability of Hapoalim, Leumi, and other banks. Figure 6: Distribution of the public s assets before the reform Private Parties 3% Pension funds 4% Insurance companies 10% Others 16% Other banks 16% The Hapoalim Group 27% The Leumi Group 24% Source: Bachar, 2007 Changes in the Capital Market, presentation [ 10 ]

14 Beyond Bachar: Next Steps for Financial Reform Milken Institute Figure 7: Distribution of the public s assets after the reform Markestone 3% Other pension firms and funds 5% Harel 4% York 2% Phoenix 2% Menora 1% Private Parties 3% Others 16% Migdal 4% Clal 4% Other Banks 12% Hapoalim 25% Leumi 19% Source: Bachar, Changes in the Capital Market, presentation It is far too early to celebrate victory on the issue of banking concentration. Even after a reduction from 77 percent to 70 percent, further reforms are required to create a more competitive banking industry. Banking concentration and control of capital markets remains the central economic policy issue. Capital Access Following are the main trends in the credit market as of the first half of Consistent with the past four years, the increase in credit for the business sector came from nonbanking sources. Banking credit for business continued to decline, standing at 57 percent in June 2006, compared to 77 percent toward the end of This trend may make it more difficult for small and medium enterprises to raise capital, especially if they have not yet been able to access non-bank credit sources due to their smaller size. The change in business-sector credit sources was accompanied by an increase in the issuance of tradable and non-tradable bonds and a reduction in loans. The business sector floated NIS 39 billion worth of bonds in 2005 and NIS 13.6 billion in During the past 18 months, the bonds issued on the Tel Aviv Stock Exchange raised capital three times greater than that raised by bonds in the previous two years combined. Liquid and illiquid bonds constituted 28 percent of all the credit extended to the business sector, compared to 11 percent in This is a positive development, which now has to be extended to medium-sized firms. [ 11 ]

15 Beyond Bachar: Next Steps for Financial Reform Milken Institute Changes in the credit market, according to Bank of Israel data, show that liberalization and reform have facilitated an improved and more competitive market in recent years. During the past few years, local authorities have raised $112 million in municipal bonds and another $117 million of these bonds are ready for flotation. Table 4 shows the changes in the business-sector credit market between 2001 and Table 4: Trends in the business sector credit market, (in millions of shekels) In millions of shekels Total credit Bank credit Other Bank credit Institutional investors Foreign residents Mutual funds In percentages Banks Institutional investors Foreign residents Mutual funds June Source: Bank of Israel [ 12 ]

16 Beyond Bachar: Next Steps for Financial Reform Milken Institute Control of Distribution and Consulting The Bachar reforms stripped banks of their mutual and provident funds but left them with the business of distribution and consulting. On the eve of the reform toward the end of 2005, the provident funds were worth NIS 125 billion. With the implementation of the reform that forced the banks to sell the funds, their value fell by NIS13.2 billion. 12 The reasons for the decline can be attributed to the investment consultants in the banks, since the greatest decline was in bank-supported funds. For example, one of Bank Hapoalim s largest provident funds, PKN, declined in value by NIS 10 billion. 13 It is possible that conflicts of interest have been reduced as a result of the funds sale, but the distribution issue has not yet been resolved. Most distribution is still through bank branches, and various developments in the field are raising questions about the nature of investment consulting in banks, the distribution commissions, the arrangements between banks and foreign funds, the banks entry into the pension market, development and marketing of new products, and other issues that we will present here. Portfolio Management: Investment consulting, available in nearly every bank branch, reinforces bank control. After shedding their provident and mutual funds, bank portfolio management businesses are growing rapidly. For example, the assets under management at Pe ilim, Hapoalim s portfolio management company, have increased by 68 percent to NIS 7.4 billion since the beginning of Hapoalim says that assets under management grew from NIS 5.4 billion in June 2005 to NIS 6.9 billion on December 31, 2005, and NIS 7.4 billion in September This represents growth of 37 percent in fifteen months. Similarly, the number of portfolios under management at Tachlit Discount, Bank Discount s portfolio management company jumped in eighteen months by 25 percent, to 1,722 portfolios, and the assets under management doubled to NIS 2.25 billion. 14 Distribution Commissions: The Bachar Committee chose a flat distribution commission model for investment consulting and provident funds. In this regard, it acceded to the requests of the bank representatives; the commission is paid from the funds and not by the customers, who then pay for it indirectly. In November 2006, Discount Bank announced it would charge its customers a commission for buying and selling provident funds. This statement, according to the chairman of the Israel Securities Authority, contradicts the banks statements to the Bachar Committee, and therefore he will consider canceling the distribution commission if the bank goes ahead with its plan. Foreign Funds: If banks were allowed to distribute foreign funds not subject to Israeli regulation, this would enhance their powers. This development would go against the thrust of the intended reforms. According to this scenario, one could expect the banks to sign either exclusive or semi-exclusive agreements with selected managers of foreign funds and then favor these funds over other banks products or provident funds. Even if the banks did not formally sign such agreements, they could still advance beneficial preferential distribution agreements that would have the same negative effects as exclusive distribution agreements. [ 13 ]

17 Beyond Bachar: Next Steps for Financial Reform Milken Institute The managers of independent provident funds effectively act as sub-consultants to a selection of foreign funds. This is another means to increase competition in the provident funds markets without endangering progress up to now. However, there is still a need for several precautionary measures that create an appropriate regulatory framework: Foreign funds must supply material about themselves in Hebrew. The lack of such material does not provide local investor protection. Exclusive distribution agreements must not be allowed. The manager of a foreign fund interested in direct distribution must sign agreements with two or more banks. Distribution of foreign funds must take place under limitations stipulated by the Bachar Committee, with no side deals or soft-dollar folding-in of commissions. Limitations now imposed on local funds managers must be lifted. If, for example, foreign funds that can invest in high-yield bonds, repo, swap, or derivatives are allowed to operate in Israeli capital markets, then Israeli funds must be given equal opportunity. The legislation regarding the distribution of foreign mutual funds was proposed before the Bachar Committee reforms in order to increase competition in the market. However, not only did this effort not increase competition, it also increased the banks dominant position as the sole distributors of the funds and also increases concentration. A risk persists for local investors and fund managers because of the lack of protection in bond investments. The law stipulates that foreign funds will be distributed in Israel under the following conditions: The law does not require registration of the fund with the Israel Securities Authority, and funds will not be obliged to issue a prospectus in Hebrew as are Israeli funds; the law does not require accountability reporting as it does for Israeli funds; the law does not prevent foreign funds from investing in the derivatives markets, in contrast to the ban imposed on Israeli funds; and the distribution commissions limitations applied to Israeli funds will not be applied to foreign funds. Pensions: The Treasury has delayed the entry of the larger banks into the pension market because it fears this would work against the smaller banks and limit competition. As such, smaller banks were given an advantage that should substantially increase competition. The Bachar Committee had anticipated a gradual process in which the banks would dispose of their funds and enter the pension market, and had promised the banks albeit not formally that they would be allowed to enter the pension market once they disposed of their funds. The concern about competitiveness is why this commitment is not being honored. New-Product Development: Upon disinvestment from mutual funds, banks started to offer new investment alternatives, such as structured products and exchange-traded funds. There are two developments that require attention: the bank s investments consultants might give priority to the bank s own products, and the new products might have risk factors that will not be thoroughly understood by or disclosed to customer. If the banks do circumvent the Bachar recommendations by aggressively marketing their own products, this will be a negative influence on decisions by foreign and institutional investors to consider entry into the Israeli financial market. [ 14 ]

18 Beyond Bachar: Next Steps for Financial Reform Milken Institute The Bank of Israel defines structured products as deposits whose yields are defined by formulas based on the cost-of-living index, interest rates, currency rates, or the price of securities or commodities. As such, these products fall under the purview of the investments consulting law. There has not yet been any real data on the amount of these products in the market, but one can assume that banks raised about NIS 13 billion through structured products if one were to take into account the difference between provident funds before and after their sale. 15 The Israel Securities Authority is considering a proposal to differentiate between classic structured products based on the cost-of-living index and currency rates to other products, such as those based on various stock market indexes. If the structured products are becoming a replacement for mutual funds, they will have to conform to the limitations imposed on these products. The financial systems dependence on investment consulting is also evident through the tremendous growth of the exchange traded funds that reached approximately NIS 87 billion in The Bachar Committee considered the possibility that banks would offer portfolio management, structured products, and exchange-traded funds, and even anticipated that this would be one of the results of the reform. In this sense, the good news is that the incentives to block financial innovation have been removed. However, if these new products do serve as replicas of the mutual funds that allow continuation of bank control over the investment market because of their consulting and distribution networks, then the intention of the Bachar Reforms will have been undermined. At a time when the banks advertising budgets have remained stable, the independent investment company competitors have waged aggressive marketing campaigns. In this sense, the advertising industry and media were big winners from the Bachar reforms. As far as the public is concerned, however, that there is too much talk of yields and not enough of risk. There is excessive marketing emphasis on matching customers to products rather than finding appropriate products that best serve the interests of customers. The new products will entail expansion of both the consulting capacities of the banks and their competitors. We now examine issues that remain unresolved by the reforms. Open Issues Distribution remains the major unaddressed issue of the Bachar reforms. Bank control of much of the public s investments through countrywide distribution systems was not addressed. The committee anticipated that other entities would create alternative competitive online systems. This has not happened, and the committee did not intend to involve itself in this issue. 16 In this section, we will deal with these issues and others that stem from the gaps in the implementation of the reforms. [ 15 ]

19 Beyond Bachar: Next Steps for Financial Reform Milken Institute Alternative Distribution Channels Fixing distribution commissions as part of the reform is not a solution that encourages competition. Rather it underscores the need for alternative distribution channels. Therefore, the distribution system should be decentralized to increase competition through the following means: granting regulatory approval for an Internet bank. granting regulatory approval to financial bodies to set up systems that could compete with banks, such as money market funds. 17 One of the recommendations of the Bachar Committee was to develop products that create an alternative to mutual funds or short-term cash deposits that allow investors more flexibility in access to their capital through checks. creating an alternative mutual fund distribution system through bodies that are not members of the stock exchange. The Union of Mutual Funds is promoting such a system that would allow direct marketing of funds without the distribution commission. In addition to increasing the numbers of players in the banking industry and the encouragement of alternative distribution channels, fund managers need regulatory approval to differentiate the pricing of their funds according to distribution channels. This is true for retail distribution through the banks, retail distribution not through the banks, and distribution to the institutional market. The main impediment against efficient use of the Internet as a distribution channel is the demand that each investor open a new personal account in a bank branch. Since nearly all Israelis have bank accounts, what is needed is a means to use existing accounts as identification for Internet investment activities. Such a measure would give the managers of independent provident funds yet another tool to establish independent distribution channels that would compete with the banks. Worldwide experience shows that both postal and Internet applications contributed to capital market competitiveness in countries where such means where approved. The budget needed to open an Internet or alternative postal bank will apparently require foreign investment with the means to undertake long-term investment, requiring substantial additional investment. Up to now, foreign bank involvement in Israel has been limited and confined to the private-equity and business sectors. Without serious incentive, such an investment does not seem very likely. New-Product Development With the lack of alternative distribution channels, it makes sense to allow new products, especially money market funds. These can serve as an alternative to cash deposits and stimulate competition in the CD market. Money market funds offer a double advantage: they compete with investment instruments and offer alternatives to bank financing through various credit instruments. Allowing people to write checks based on these funds will increase their attractiveness. Legislation allowing such activity is now being drafted. [ 16 ]

20 Beyond Bachar: Next Steps for Financial Reform Milken Institute Capital Access The Bachar Committee allowed Israeli businesses to create business leverage from sources external to the banking system. There remains a need to remove the limitations on bond purchases imposed on local provident funds, thus diversifying their portfolios in line with the portfolios of foreign funds. In addition, reform has not yet reached the retail credit market, and the regulatory authorities do not tend to permit entry into bank holdings in credit card companies. Investor Protection Access to capital requires suitable protection. As such, the following strategies should be considered: Credit and Securities Rating: With the expansion of the corporate bond market, there is a need to expedite the development of a risk market. To do this, a committee must be formed with representatives of the Treasury, Bank of Israel, the Tax Authority, and other bodies similar to the committee that considered the repo market. Corporate bonds are not tradable, and there are no indexes that compare ratings with actual risk. As a result, Israeli savings serve directly or indirectly to finance business activity without the means of confidently assessing whether this credit is backed by sufficient security. The two rating companies, the fifteen-year-old Maalot and three-year-old Midroog, are aware of the lack of risk management in credit allocation. Company activities are based on known methodologies, but there is not enough statistical data for the Treasury to make its own assessments. Establishing a credit rating market would create databases that could reduce margins of error and hence the price of these errors in the credit rating. Transparency and Regulation: Another risk-management issue arises with the entry of new players into the Israeli capital market. The identity of the buyers is not well-known, and the quality of transparency and auditing in bodies that manage the public s investments are also unclear. The law does stipulate clear criteria for buying a bank or managing the public s funds, but embezzlements in well-known companies, such as Harel, raise the concern that the existing system is not secure enough. In order to maintain competitiveness, it would be advisable to re-examine the regulatory requirements for these companies. Public Knowledge and Financial Literacy: Another area that requires scrutiny is the level of transparency of various products in the capital market, from traditional products, such as provident funds, to the newer investment alternatives. Management companies should be required to report investment statistics, such as beta risk (which measures volatility compared to the market), alpha (which measure the relationship between risks and yield), and other risk ratios. The public needs more information in marketing brochures and tutorials on web sites of the management companies. The task of educating investors and giving them the basic tools to assess risk and yield should be shared between public and private bodies. Commissions: In light of the many draft bills relating to bank commissions, the Bank of Israel has initiated its own bill, which would give the bank supervisor the authority to set prices for certain specific services in non-competitive areas. The bill is now being examined by government. [ 17 ]

21 Beyond Bachar: Next Steps for Financial Reform Milken Institute Conclusion Competition is neither stable nor well-established at this stage of Israeli capital market history. Concentration is high, and conflicts of interest still exist, though in less obvious ways. The central issue remains the banks distribution system, which requires further regulatory attention to create a competitive market-based system. Legislation promoting competition in areas under bank control must be advanced, for example, in Internet banking and in creating alternatives to traditional bank services. Foreign banks could be candidates for creating alternative distribution channels. The capital and credit markets, with its underwriters and other intermediaries, must develop new financial products and services. Investors need more protection, better pricing of credit, and better information to make investment decisions. The Bachar reform started work in the following fields and can be expanded by: 18 Increased supply of non-bank credit. Competition in asset management with improvements in service and lower prices. A refocusing of the banking system on the retail market. Pension consultancy in banks (consultant training has started in anticipation that this option will be realized) Entry of foreign financial institutions into the market and cooperation with local institutions. Financial innovation in areas like securitization, commercial paper, non-bank retail credit and others. Regulatory action to address the introduction of compulsory pensions, ease of pension portability, personal provident funds, double billing of bank commission for foreign investments and fees all need to be addressed. There is need for continued monitoring as well as ongoing examination of the following issues which have not yet been resolved: Has financial competition increased both among local players and with foreign organizations? Has there been in increase in the variety and quality of pension products? Have financial markets deepened, allowing more access both to institutions and to the capital market itself? Is there a stable market for non-bank credit? Do small and medium firms have access to enough capital to finance growth? How concentrated is the distribution system? What are the relative costs of capital? Has there been an improvement in financial services both for households and institutions? Do foreign funds publish prospectuses in Hebrew to increase transparency for local investors? Is the prohibition against exclusive distribution agreements with banks enforced? Is the cap on distribution commissions as approved by the Bachar reforms also enforced? [ 18 ]

22 Beyond Bachar: Next Steps for Financial Reform Milken Institute The Bachar Committee is committed to monitoring the implementation of its reform recommendations. Regulation should be enhanced in one of two ways: turning the regulator in the Finance Ministry s capital markets division into an independent authority like the Israel Securities Authority, or creating a joint committee with the Bank of Israel, the Treasury the Tax Authority, and other relevant bodies. [ 19 ]

23 Beyond Bachar: Next Steps for Financial Reform Milken Institute End Notes 1. In addition, corporations were allowed to issue to own bonds without express permission from the Treasury. 2. Yafeh, Y., Yosha, O., Financial Markets Reform, Patterns of Corporate Finance, and the Continued Dominance of Large Banks: Israel Economic Systems 22, Ribbon, S. and Yosha, O., Financial Liberalization and Competition in Banking: An Empirical Investigation, Discussion Paper No Bank of Israel. 4. Ber, Hedva, Yeshay Yafeh, and Oved Yosha, 2001, Conflict of Interest in Universal Banking: Bank Lending, Stock Underwriting, and Fund Management, Journal of Monetary Economics 47, Blass, A, The Performance of Provident Funds and Market Structure: : A Series of Papers for Discussion, January, Bachar, Yossi. July 3, 2007, Beyond Bachar: Next Steps for Financial Reform, Milken Institute Israel Center. 7. This argument was first raised in 1986 in the report of the Beiski Committee, which was charged with investigation of the bank shares collapse of Bachar, Makam (the Hebrew acronym for short-term loans) are short-term securities (up to one year) issued by the Bank of Israel to affect the monetary base and the rate of interest in the money market. The sale of makam to the public reduces the monetary base and serves to restrain activity and inflation. The purchase of makam by the Bank of Israel or their redemption by the public injects money into the market and encourages economic activity. This instrument is similar to the deposit auctions, but as the yield is determined by trade on the stock market, it reflects the public s expectations regarding inflation and changes in monetary policy, information that helps the Bank of Israel plan future steps. 10. Nostro accounts are usually in the currency of the foreign country. This allows for easy cash management because currency doesn t need to be converted. 11. Bank of Israel press release. August 27, Bank of Israel press release, Information on Financial Markets. June 13, Ram Dagan, Prisma continues to suffer from Hapoalim s merchandise: Withdrawals of 860 Million NIS in Lahak and P.K.N, Haaretz November 26, See: 1&itemNo= &contrassID=1&subContrassID=0&sbSubContrassID=0 (June 11, 2007). 14. Ram Dagan, New competition for the mutual funds: The banks are transferring clients to portfolio management, The Marker December 6, See: ElementId=skira _ (June 11, 2007). 15. Hagai Amit, The Bachar effect: Banks sold structured products worth 13 billion NIS this year. The Marker, 3 January 2007, (11 June 2007). 16. Bachar, An open-end mutual fund which invests only in money markets. These funds invest in short term (one day to one year) debt obligations such as Treasury bills, certificates of deposit, and commercial paper. The main goal is the preservation of principal, accompanied by modest dividends. [ 20 ] 18 Bachar, 2007.

24 Beyond Bachar: Next Steps for Financial Reform Milken Institute Appendix 1 A workshop, Beyond Bachar: Next Steps for Financial Reform, was held on July 3, 2007, at the Jerusalem Center for Public Affairs, Beit Milken. The workshops are intended to bring together researchers, senior executives from the financial world, and business and political leaders to review the fellows work. The fellows were joined by the following senior policy and business leaders, who reviewed the draft paper. We are grateful for their input and criticism, which enable publication of this policy brief. Name Tal Beiber Dr. Yosef Bachar Dr. Asher Blass Ruthie Dahan Dr. June Dilvesky Avi Temkin Prof. Glenn Yago Aharon Cohen Mohliver Dr. Eyal Solegalnik Sivan Anevi Ronit Purian Lukatch Sherwin Pomerantz Boaz Raday Company/Title Bank of Israel Former Director General, Treasury; former director, Tax Authority IRG Maalot (S&P Ratings Agency Israel Securities Authority Globes Research Senior Koret Fellow; Director of Capital Studies, Milken Institute Koret-Milken Institute Fellow Chief Financial Officer, IDB Koret-Milken Institute Fellow Deputy Director, Fellows Program and Ph.D. Candidate, Tel Aviv University Merage Foundation Bank Hapoalim [ 21 ]

25

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