196 Material Agreements 199 Disclosure Regarding the Internal Auditor at the. 13 General Background - Economic Developments

Transcription

1 Contents Report Of the Board of Directors 13 General Background Economic Developments in Earnings and Profitability 18 Principal Data 19 Developments in income and expenses 26 Chart of Orgranizational Structure 27 Chart of Major Investee Subsidiaries 28 The History of the Banking Group 30 Description of the First International Group's Activity 35 The Bank Group's Segments of Activity 73 Developments in Balance Sheet Items 88 The Bank's Capital Resources 96 Accounting Principles and Estimations in Respect of Critical Matters 103 Liquidity Position and Capital Sourcing Policy 104 The Bank's Risk Exposure and Risk Management 160 Discussion of Risk Factors 165 Basel II 171 Activity of Investee Companies 181 Legislation and Supervision Affecting the Banking System 196 Material Agreements 199 Disclosure Regarding the Internal Auditor at the Corporation 202 Report on Directors with Accounting and Financing Proficiency 204 Human Resources 208 Details of the Owners of Control in the Bank 213 Transactions with Interested Parties 222 Disclosure of the process of approval of the financial statements 224 Other matters Management Review of the Bank's Financial Position and Operating Results 247 Appendices to Management Review AH 272 Certifications of the Chief Excecutive Officer and Head of Comptroller 275 Report of the Board of Directors and Management on the Internal Control of Financial Reporting 277 Financial Statements 5

2 BOARD OF DIRECTORS Jack Elaad, Chairman Zadik Bino Dan Arbel Pnina BitermanCohen Gil Bino Zeev Ben Asher (From ) Dr. Amnon Goldschmidt Meir Dayan Gideon Lahav Giora S. Meyuhas Jacob Sitt (From ) Daniel Furman (Until ) 7

3 MEMBERS OF SENIOR MANAGEMENT AND THEIR FUNCTIONS Smadar BarberTsadik Chief Executive Officer Zeev Gutman Deputy Chief Executive Officer, Chief Risk Officer & Head of Risk Management Division Ilan Batzri Deputy Chief Executive Officer, Head of Corporate Division Yossi Levy Executive Vice President, Head of Resources Division Yoram Sirkis Executive Vice President, Head of Client Assets Management Division Michal AbadiBoiangiu Executive Vice President, Head of Chief Accountant Division Aviel Sternschuss Executive Vice President, Head of Financial Division Irit Shlomi Executive Vice President, Head of Banking Division Aviad Biller, Adv. Corporate Secretary Somekh Chaikin, C.P.A. Auditors of the Bank Nir Abel, C.P.A. Chief Internal Auditor (Until ) 11

4 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 BOARD OF DIRECTORS' REPORT ON THE FINANCIAL STATEMENTS AS AT DECEMBER 31, 2010 We are pleased to inform you that at the Board of Directors' meeting held on March 30, 2011, it was resolved to approve and publish the consolidated audited financial statements of the First International Bank of Israel Ltd. (hereinafter the Bank) and its consolidated subsidiaries (hereinafter "the First International Group") for the year The financial statements were compiled in accordance with the format prescribed by the Supervisor of Banks. Data therein are expressed in reported amounts. GENERAL BACKGROUND ECONOMIC DEVELOPMENTS IN 2010 In 2010, the Israeli economy grew at a rapid pace (4.6%), after growing at 0.8% in 2009, compared to a 3%4% decline in GDP among developed nations. The rapid growth in 2010 was due to the rapid recovery in exports of goods and services, which expanded by 13.6%, against the backdrop of rapid growth (12.2%) in global trade this year. Global growth in 2010 was at 4.9%, compared to negative 0.8% growth in The main cause for this global recovery was the continued growth of developing nations, despite weakness in demand coming from Western nations. China grew at a 10.3% pace, and all developing nations (which grew at a 7.1% pace on average) contributed 70% to global growth in In 2010, local demand also grew rapidly: private consumption and investment. Private consumption grew by 4.9% (or 3.1% on percapita basis), due to improved employment, moderate pay increase and higher general wealth of the public ("wealth effect") due to sharply higher real estate and financial asset valuations (in 2010, the public asset portfolio increased by 5.7% through the third quarter). Lower interest rates also promoted higher consumption, at the expense of savings. Net private savings declined from 14.2% in 2009 to 11.8% in Real wages increased by 0.9% after declining by 2.8% in Unemployment declined from 7.7% on average in 2009 to 6.7% in Note that the decline in unemployment was concurrent with higher participation in the workforce, from 56.6% in 2008 to 57.7% in late In 2010, some 130 thousand newly employed were added. Late this year, the pay agreement for the public sector was signed, granting a 6.25% gross pay increase over three years. A further agreement was reached by the Manufacturers Association and the Labor Union, to raise the minimum wage by 11% by October In 2010, capital expenditure also increased rapidly at 12.4%, after a 5.8% decline in Residential construction investment increased by 10.8%, and housing starts increased from an annual pace of 32,500 in 2008 to 37,000 in 2010 (Estimated). The increase in construction sector activity was due to higher demand for housing and a sharp 52% increase in apartment prices since Investment in machinery and equipment also increased at a fairly rapid pace of 9.0%, while investment in vehicles increased by 28%. Despite Government efforts to increase investment in infrastructure, these actually declined by 11.2% in 2010, on top of a cumulative 13.5% decline in The current account surplus remained relatively high in 2010, at 3.2% in GDP terms (Estimate), compared to 3.9% in Israel has a services account surplus due to rapid growth in service exports (transportation services, software, R&D and tourism), and stable transfer payments (such as aid from the USA), compared to a 13

5 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 small deficit in the trade account and capital account (interest payments to overseas etc.) The current account surplus supports the stronger NIS. Evolution of Government Activity In 2010, fiscal policy was successful. Despite a relatively high budgeted deficit, of 5.5% in GDP terms (NIS 42.9 billion), 2010 actually ended with a deficit equal to 3.7% of GDP (NIS 30.2 billion). The main reason is the sharp increase in state revenues due to rapid growth of the local economy. In addition, Government expenses were NIS 2 billion lower than budgeted. Financing of the 2010 deficit was at highly favorable terms, and the Ministry of Finance utilized NIS 8.6 billion out of carryforward financing surplus to finance about one third of the total deficit. In , the Ministry of Finance raised some NIS 16 billion over and above the financing needed for the current deficit, and the excess was kept in the Ministry of Finance's deposit account with the Bank of Israel. A further contribution resulted from spinoff sales, which amounted to a significant NIS 4.5 billion, compared to the original target of NIS 0.5 billion. Privatization in 2010 included the remainder of State holdings in Discount Bank, and a further NIS 2.5 billion was received from sale of land. In 2010, the Minisitry of Finance raised NIS 70.6 billion on the local markets, and redeemed NIS 80.9 billion (principal and interest) of government bonds (negotiable and nonnegotiable), resulting in excess redemption of NIS 10.3 billion (compared to excess NIS 16.4 billion raised in 2009), supported lower returns in Significant excess redemption in the bond market also resulted in a decrease in government debt, in GDP terms, from 78% in 2009 to 75% in The decline in government debt supports financial stability and reduces the risk premium associated with the State. In 2010, financial markets grew more sensitive to excessive budget deficit and government debt and capital markets around Southern European countries (the PIIGS countries: Portugal, Italy, Ireland, Greece, Spain) suffered from extreme volatility. Monetary policy In 2010, the Bank of Israel maintained its expansive monetary policy, although to a lesser extent than in The Bank of Israel continued to purchase foreign currency on the open market, amounting to $12 billion, to support the NIS, after purchasing $35 billion in World countries (including Brazil, South Korea, Russia, Turkey, Switzerland) have taken action to avoid a stronger local currency, due to significant increase in shortterm capital movement. In early 2011, the Bank of Israel set the background for imposing restrictions on shortterm capital movement, by requiring reporting of foreign activity in the MAKAM market and liquidity requirements in derivative transactions. The monetary impact of foreign currency purchase by the Bank of Israel was offset by an increase in MAKAM issuance, aimed at avoiding the volume of money in the economy and higher inflation. The total MAKAM balance in 2010 increased by NIS 46.5 billion. Foreign banks took advantage of interest rate differentials and a certain shortage in foreign currency at Israeli banks, to increase their holding stake from 2% last year to 28% in late In 2010, the Bank of Israel also acted in the housing market, in order to curb excess demand. This was achieved by limiting total credit to 60% of asset value (or at least making credit above this ratio more costly), and limiting NISdenominated nonlinked credit to 25% of total mortgage. The concern involves implications of significantly higher interest payments on loans linked to the Prime lending rate, as interest rates go higher. 14

6 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 Bank of Israel interest rate In 2010, the Bank of Israel raised its base interest rate four times (by 0.25% each time), to reach 2.0% at year end. In the first quarter of 2011, interest rates continued to rise, up to 2.5% in March. The pace of raising interest rates depends on factors such as the inflationary environment, the macroeconomic environment, global developments and the state of NIS exchange rates. Review of these four factors at any time has definitely resulted in a slow rise in interest rates, which are still far from equilibrium at year end, and are not in line with the robuse state of Israel's economy. Apparently, concern about greater pressure for revaluation of the NIS was a dominant consideration in the very gradual increase in interet rates, despite the concern about a bubble forming in the real estate market. Foreign currency market In 2010, the NIS exchange rate was revalued by 4.9% vs. the USD and by 13.9% vs. the EUR. Vs. the effective currency basket (of the NIS vs. 24 currencies, weighted by their trade volume), the NIS was revalued by 6.6% in The NIS exchange rate was affected by the globally stronger USD, From USD 1.46 per EUR 1 in December 2009, to USD 1.32 per EUR 1 in December The NIS exchange rate was also affected by positive basics. The current account surplus increased from 0.9% of GDP in 2008 to 3.9% in 2009, and decreased to 3.2% (estimated) in 2010; higher interest rates in Israel vs. stable interest rates in Western countries (primarily in the USA), created an interest rate differential which increased capital flow into Israel over the short term. Conversely, in 2010 real investments tended towards overseas, i.e. Israelis invested overseas more than foreign residents invested in Israel, by 0.5% of GDP. Foreign residents reduced their holdings in financial investments in Israel, mainly after late May, when Israel was reclassified on the MSCI index from a developing nation to a developed one. As stated, foreign currency purchase by the Bank of Israel continued in 2010, and apparently prevented a sharper revaluation of the NIS. Inflationary environment In 2010, inflation reached 2.7% below the top of the target range (3%), for the first time since Two major items caused the increase in the Consumer Price Index: Housing and fruits and vegetables. The CPI rose by 1.9% excluding housing (which was up by 4.9%), and only rose by 1.3% excluding fruits and vegetables (which were up by 16%). The increase in fruits and vegetables was due to natural calamities which resulted in lower supply. The housing item is impacted by the purchasing power of the public, increased demand from households, and lower supply of available apartments in recent years. Of more concern was the sharp increase in prices of owned apartments (actual purchase price, as measured by real estate tax data). These increased by 17.3% in 2010, and by 52% since early This trend started, indeed, after several years of stable real housing prices, but the pace of price increases had the appearance of a bubble phenomenon, hence the action taken by the Bank of Israel to curb demand in this market by making credit more costly. The upward trend in housing prices is probably due in part to many years of relatively low housing starts compared to natural demand. However, timing of the sharply higher prices coinciding with declinining Bank of Israel interest rate, down to 0.5% in March 2009, and the low interest rates still prevailing today all indicate there is a link between monetary policy and evolution of housing prices. 15

7 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 EARNINGS AND PROFITABILITY Net earnings of the First International Group in 2010 amounted to NIS 484 million compared with NIS 568 million in 2009, a decrease of 14.8%. In the fourth quarter of this year, net earnings amounted to NIS 140 million compared with NIS 129 million in the third quarter of this year, an increase of 8.5%. Earnings in the fourth quarter of this year decreased by 7.9% compared to earnings in the fourth quarter last year (NIS 152 million). The following were the key factors which affected the lower net earnings in 2010 compared to the previous year: 1. Last year, gain from investment in shares included net aftertax gain of NIS 145 million from realized shares of Bezeq and Hot as well as a dividend received from Bezeq. 2. Decrease in gain from sale of bonds (last year primarily government bonds) was partially offset by an increase in reversal of provision for impairment of bonds NIS 60 million. 3. Loss from accounting treatment of financial derivatives at fair value, as described in the chapter on evolution of income and expenses NIS 58 million. 4. Decrease in gain on severance pay reserve NIS 51 million. 5. Increase in payroll expenses (excluding gain from severance pay reserve included under payroll expenses) NIS 59 million. The following factors partially offset the decrease in net earnings: 1. Increase in earnings from financing operations after adjustments, as set forth in chapter "Evolution of income and expenses" below NIS 117 million. 2. Decrease in provision for doubtful debts NIS 98 million. 3. Decrease in other operating expenses NIS 28 million. 4. Increase in operating commission income NIS 10 million. In 2010 the Bank Group saw two major events: At the end of the second quarter, integration of IT systems of Massad and Otsar Hahayal was completed, and in the third quarter of this year the Group used, for the first time, a unified IT infrastructure. Preparations for system conversion lasted three years, requiring the Bank, Massad and Otsar Hahayal to allocate professional staffing resources and significant managerial resources to ensure success of this process. The integration of IT systems and backoffice systems at headquarters resulted in savings on operating expenses for the Group. Note, in this regard, that after the conversion, integration of other operational functions continues. In the third quarter, employees of the Bank, Otsar Hahayal and Poalei Agudat Israel announced a labor dispute and went on strike for 13 days in a row (for further details, see chapter "Labor Relations" below). Net earnings in the fourth quarter of this year totaled NIS 140 million compared with NIS 152 million in the corresponding period last year, a decrease of 7.9%. Below is the impact of key items on the decrease in Group net earnings, compared to the corresponding period last year: 1. Last year, gain from investment in shares included net aftertax gain of NIS 82 million from realized shares of Bezeq and Hot as well as a dividend received from Bezeq. 16

8 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/ Loss from accounting treatment of financial derivatives at fair value, as described in the chapter on evolution of income and expenses NIS 19 million. Conversely, the following items partially offset the aforementioned negative impact: 1. Increase in earnings from financing operations after adjustments, as set forth in chapter "Evolution of income and expenses" below NIS 41 million. 2. Decrease in payroll expenses (excluding gain from severance pay reserve included under payroll expenses) NIS 18 million. 3. Decrease in expenses for maintenance and depreciation of premises and equipment NIS 10 million. 4. Decrease in other expenses NIS 9 million. 5. Increase in income with respect to interest collected on problem loans NIS 6 million. Net return on equity was 8.0%, compared to 9.7% in Net return on equity in the fourth quarter of this year was 9.7%, compared to 8.6% in the previous quarter and 10.3% in the corresponding period last year (which included income from sale of Bezeq and Hot shares, as set forth above). During the last five years annual net return on equity averaged 9.3%, as follows: %, %, %, %, %. Set out below are the changes in income statement items, gross before the tax effect, in 2010 compared with 2009: 1. Increase in earnings from financing operations amounting to NIS 41 million (1.9%). 2. Decrease in provision for doubtful debts by NIS 153 million (57.1%). 3. NIS 18 million (1.3%) increase in operating commission income. 4. Decrease in gain from investment in shares, by NIS 210 million (94.2%). 5. Decrease in other income by NIS 84 million (70.0%). 6. NIS 33 million (1.2%) increase in operating and other expenses. Operating earnings before taxes amounted to NIS 802 million compared with NIS 917 million in 2009, a decrease of 12.5%. Return on equity of operating earnings before taxes reached 13.0% compared with 15.2% in Operating earnings after taxes amounted to NIS 466 million compared with NIS 546 million in 2009, a decrease of 14.7%. The return on equity of aftertax operating earnings reached 7.5% compared with 9.1% in Basic earnings per NIS 0.05 par value share amounted to NIS 4.82 compared with NIS 5.66 in On September 19, 2010, the Bank unified its share capital by reverse split of 5 Bank ordinary shares of NIS 0.01 par value each into 1 ordinary share of NIS 0.05 par value for details see Note 12a to the financial statements. 17

9 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 PRINCIPAL DATA Profit and profitability For the year ended December Change NIS millions in % Earnings from financing operations before provision for doubtful debts 2,205 2, Provision for doubtful debts (57.1) Operating and other income 1,486 1,762 (15.7) Of which: Operating commissions 1,437 1, Operating and other expenses 2,774 2, Of which: Salaries and related expenses 1,552 1, Operating earnings before taxes (12.5) Net earnings (14.8) Return on equity of pretax operating earnings 13.0% 15.2% Return on equity of aftertax operating earnings 7.5% 9.1% Net return on equity 8.0% 9.7% As of December 31 Balance Sheet Highlights Change NIS millions in % Total assets 100, ,568 (3.7) Deposits from the public 80,155 82,830 (3.2) Debentures and subordinated notes 4,837 4,920 (1.7) Credit to the public 63,447 60, Securities 15,802 14, Premises and equipment 1,288 1,315 (2.1) Shareholders equity 5,787 6,165 (6.1) Active capital 3,050 4,251 (28.3) Principal financial ratios Shareholders equity to total assets 5.7% 5.9% 5.6% Active capital to shareholder s equity 52.7% 69.0% 55.9% Provision for doubtful debts to credit to the public 0.18% 0.44% 0.39% Ratio of core capital to risk assets 8.08% 9.16%* Ratio of Tier 1 capital to risk assets (Basel II) 8.08% 9.16%* Ratio of total capital to risk assets (Basel II) 12.50% 13.81%* Credit to the public to total assets 63.0% 57.7% 61.9% Deposits from the public to total assets 79.6% 79.2% 80.8% Deposits from the public to credit to the public 126.3% 137.4% 130.5% Credit to the public to deposits from the public 79.2% 72.8% 76.6% Operating income to operating expenses 53.6% 64.3% 51.5% Operating expenses to total income 75.2% 69.8% 82.0% Total income to operating expenses 133.1% 143.2% 122.0% * Reclassified. 18

10 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 DEVELOPMENTS IN INCOME AND EXPENSES Earnings from financing operations before provision for doubtful debts totaled NIS 2,205 million compared with NIS 2,164 million in 2009, an increase of NIS 41 million or 1.9%. Set out below are the effects of certain components on earnings from financing operations: For the year ended December Increase NIS millions in % Reported earnings from financing operations 2,205 2,164 Interest income charged on problem loans (80) (78) Effect of reconciliations to fair value of ALM derivatives 78 *(12) Hedging of volatility in provision for taxes (14) 26 Decrease in provision for impairment of bonds (66) (5) Earnings from financing operations after reconciliation 2,123 2, Earnings from sale of bonds Set out below are the effects of certain components on earnings from financing operations by quarter: Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 NIS millions NIS millions Reported earnings from financing operations Interest income charged on problem loans (22) (19) (17) (22) (13) (23) (18) (24) Effect of reconciliations to fair value of ALM derivatives 3 *(1) *45 *31 *(26) *(2) *(33) *49 Hedging of volatility in provision for taxes (8) 4 10 (20) 5 (13) Provision (decrease in provision) for impairment of bonds (9) (13) (37) (7) (2) (12) (5) 14 Earnings from financing operations after reconciliation Earnings from sale of bonds * Restated. Set out below are the effects of the principal factors that led to the change in earnings from financing operations in 2010 compared to the corresponding period last year: A. Business volume an increase of 10.6% over the corresponding period last year in financing operations, due to increase in volume of derivative transactions. B. Earnings for the sale of bonds available for sale and earnings realized and not yet realized from reconciliations to fair value of portfolio of bonds for trading totaled NIS 161 million compared with NIS 316 million in C. In 2010, net provision for impairment decreased by NIS 66 million, compared to NIS 5 million in 2009 due to realization and redemption of securities previously provided for. D. Accounting and other aspects The accounting method employed in order to measure derivative financial instruments, the majority of which are classified as ALM derivatives, other derivative instruments and financial instruments that contain embedded derivative instruments is based on their fair value rather than 19

11 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 on the accrual principle, which is the accounting method used to measure most balance sheet items. This measurement method resulted in 2010 in a "loss" amounting to NIS 78 million under financing income, compared to "earnings" of NIS 12 million in Note, in this regard, that most of the activity in financial derivatives is conducted in conjunction with asset and liability management at the Bank (ALM), and is unrelated to trading operations in which the Bank is a market maker. The hedging activity which the Bank conducted in order to neutralize the volatility in the provision for taxes arising from changes in the value of investments in subsidiaries abroad resulting from a depreciation or appreciation in exchange rates, led to an increase of NIS 14 million in earnings from financing operations compared with a decrease of NIS 26 million in The effect of this hedging transaction was largely offset against the taxes on income item. Overall interest spread in 2010 was 1.10%, compared to 1.07% in the corresponding period last year. Interest spread exclusive of the effect of reconciliations to fair value of derivative financial instruments and the effect of tax hedging in respect of subsidiaries abroad as stated in paragraph D. above, was 1.13% in 2010 compared with 1.11% in In the fourth quarter of this year, earnings from financing operations totaled NIS 569 million compared with NIS 525 million in the corresponding period last year, an increase of 8.4%. In the table below, the volumes of activity in the different linkage segments and the earnings from financing operations from them include activity in derivative financial instruments that were used to hedge positions between the linkage segments (hereinafter ALM activity). Set out below are details of the contribution of activity in the different linkage segments to earnings from financing operations: Business volume Contribution to earnings from financing operations, including hedging and ALM Year 2010 Year 2009 Business volume Contribution to earnings from financing operations, including hedging and ALM % NIS millions % % NIS millions % Nonlinked NIS segment 45 1, , CPIlinked segment *30 1 Foreign currency and fc linked (including activity abroad) * Other derivative financial instruments, net, (not ALM) 5 *8 1 Commissions from financing transactions Other financing income, net Total 100 2, , * Reclassified. The nonlinked NIS segment Earnings from financing operations in the nonlinked NIS segment increased by NIS 222 million or 17.8% compared with 2009, amounting to NIS 1,472 million. The interest spread in this segment was 1.93% compared with 1.76% in The larger interest spread was primarily due to increase in financial margins and higher interest rates. 20

12 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 Business volume including financial derivatives increased by 7.6%, due to increase in loans to the public and in transactions in financial derivatives. The CPIlinked NIS segment Earnings from financing operations in the CPIlinked NIS segment decreased by NIS 27 million or 90.0% compared with 2009, amounting to NIS 3 million. The decrease is due to lower spreads in this segment. The interest spread in this segment was 0.15% compared with 0.33% in Business volume in this segment remained unchanged compared with The foreigncurrency denominated and foreigncurrency linked segment Earnings from financing operations in this segment decreased by NIS 69 million or 18.4% compared with 2009, amounting to NIS 305 million. The interest spread in this segment was 0.39% compared with 0.61% in Excluding impact of fair value adjustment of financial instruments and derivatives attributed to this segment, the interest spread in this segment was 0.51%, compared with 0.60% in The decrease in interest spread is due to higher cost of foreign currency sources, not reflected in higher prices for use and in change of use mix. Commission income from financing transactions mainly includes commission income from guarantees, L/C's and similar activities. This income in 2010 amounted to NIS 63 million, compared with NIS 58 million in Other financing income, net In 2010, other financing income, net amounted to NIS 357 million, compared with NIS 444 million in The decrease is primarily due to a NIS 155 million decrease in realized gain from sale of bonds available for sale. This decrease was partially offset by a decrease in provision for impairment of bonds, which amounted to NIS 66 million in 2010, compared to NIS 5 million in The provision for doubtful debts was calculated, as in the past, on a conservative basis and amounted to NIS 115 million in 2010, compared with NIS 268 million in 2009, a decrease of 57.1%. The specific provision for doubtful debts, net less reversal of provisions due to debt collection amounted to NIS 125 million, compared with NIS 277 million in Specific provision amounted to NIS 298 million, compared with NIS 462 million in This decrease is due to the Israeli economy emerging from the crisis, starting in the second quarter of Reversal of specific provision due to debt collection amounted to NIS 173 million, compared with NIS 185 million in The supplementary provision for doubtful debts, which is recorded in respect of unidentified risks in customer indebtedness portfolios, decreased by NIS 10 million due to the reduction in the amount of problem loans. This provision decreased by NIS 9 million in For details of the distribution of the provision for doubtful debts by segments of activity, see the section on segments of activity below. The annual expense for provision for doubtful debts in 2010 was equivalent to 0.18% of the Group s total credit portfolio at the end of the year, compared with 0.44% in

13 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 Below are details of the annual provision for doubtful debts: For the year ended December Change NIS millions in % Specific provision (35.5) Decrease in specific provision and collection of debts writtenoff in the past (173) (185) (6.5) Change in specific provision (54.9) Supplementary provision (10) (9) 11.1 Total (57.1) Ratio of the provision to credit to the public Provision during the period 0.45% 0.75% Decrease in provision and collection of debts writtenoff in the past (0.27%) (0.31%) Total 0.18% 0.44% Set out below are quarterly developments in the provision for doubtful debts: Year 2010 Year 2009 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 NIS millions NIS millions Specific provision Decrease in specific provision and collection of debts writtenoff in the past (58) (35) (42) (38) (76) (51) (27) (31) Change in specific provision Supplementary provision (5) (3) 8 (10) (2) (10) 1 2 Total Ratio of the provision to credit to the public * Provision during the period 0.66% 0.43% 0.43% 0.39% 0.83% 0.78% 0.62% 0.82% Decrease in provision and collection of debts writtenoff in the past (0.40%) (0.23%) (0.28%) (0.26%) (0.51%) (0.40%) (0.17%) (0.19%) Total 0.26% 0.20% 0.15% 0.13% 0.32% 0.38% 0.45% 0.63% * Annualized. Most of the expense on doubtful debts by economic sector was attributed in the year reviewed to the private sector including housing loans sector (NIS 60 million, or 48% of the specific provision), to the real estate sector (NIS 45 million, or 36% of the specific provision), the industrial sector (NIS 41 million, or 33% of the specific provision), and to the commercial sector (NIS 17 million, or 14% of the specific provision). The balance of the general provision that was determined in accordance with the Supervisor of Banks' directives at 1% of the Bank's total credit at risk as at the end of 1991 (in real values up to the end of 2004), and the supplementary provision and the special provision for doubtful debts in respect of unidentified risks inherent in the credit portfolio, amounted to NIS 177 million on December 31, Earnings from financing operations after provision for doubtful debts amounted to NIS 2,090 million compared with NIS 1,896 million in 2009, an increase of 10.2%. Operating and other income amounted to NIS 1,486 million, compared with NIS 1,762 million in 2009, a decrease of 15.7%. 22

14 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 Below are details of operating and other income: For the year ended December Change NIS millions in % Operating commissions: Account management (3.3) Credit cards Transactions in securities and certain derivatives Financial product distribution commission Management, operation and trusteeship to institutional investors Credit processing Conversion differences (11.5) Foreign trade transactions Net income from credit portfolio service 1 1 Other commissions Total operating commissions 1,437 1, Gain from investment in shares, net (94.2) Other income (70.0) Total operating and other commissions 1,486 1,762 (15.7) The decrease in operating and other income is primarily due to decrease in gain from investment in shares, net amounting to NIS 210 million which is due to gain of NIS 190 million from sale of Bezeq and Hot shares, included in this item last year, and to a NIS 89 million decrease in gain on severance pay funding, included in this item. Total gain on severance pay funding included in this item amounted to NIS 21 million, compared with NIS 110 million in In addition to gain on severance pay funding included under Other Income, the gain on such funding equal to the pay increase was offset against payroll expenses. This year, payroll expenses decreased by NIS 25 million, compared with NIS 15 million in Total gain on severance pay funding amounted to NIS 46 million, compared with NIS 125 million in This decrease was partially offset by increase in operating commission income, amounting to NIS 18 million. Operating and other expenses amounted to NIS 2,774 million in 2010 compared with NIS 2,741 million, an increase of 1.2%. Below are details of operating and other expenses: For the year ended December Change NIS millions in % Payroll expenses: Payroll 1,534 1,449 Voluntary retirement Total payroll 1,552 1, Maintenance and depreciation of premises and equipment (1.8) Other expenses (5.7) Total operating and other expenses 2,774 2, Payroll expenses amounted to NIS 1,552 million compared with NIS 1,468 million in 2009, an increase of 5.7%. This increase is mostly due to updates of pay and pay funding due to linkage to the pay agreement at Bank Leumi. 23

15 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 Expenses on depreciation and maintenance of premises and equipment amounted to NIS 547 million compared with NIS 557 million in 2009, a decrease of 1.8%. Other expenses totaled NIS 675 million compared with NIS 716 million in the corresponding period last year, a decrease of 5.7%. The decrease is due to cost savings on IT and other operating expenses, due to completion of the Group's IT and backoffice system integration project. Below are details of other expenses: For the year ended December Change NIS millions in % Marketing and advertising Communications (postage, telephone, shipping etc.) (1.0) Computer (28.2) Office Insurance Legal, audit and professional consulting (18.5) Remuneration of Board members and attendance fees for Board meetings Training and professional development 6 6 Commissions Goodwill amortization Other Total other expenses (5.7) Operating expenses are composed as follows: Payroll and related expenses 55.9%, maintenance and depreciation of buildings and equipment 19.7%, communications and computer 9.7%, marketing and advertising 2.2%, other 12.5%. The mix of operating and other expenses was not significantly changed in 2010 compared with the previous year. The coverage ratio of operating and other expenses by operating and other income (the operational coverage ratio) reached 53.6%, compared with 64.3% in The decrease in coverage ratio compared with the corresponding period last year is due to the following: 1. Decrease in gain from investment in shares, due to inclusion last year of gain from realized Bezeq and Hot shares, as described above (amounting to NIS 238 million). 2. Decrease in gain from severance pay funding, compared with the corresponding period last year. Excluding these items, and excluding goodwill amortization expenses, the coverage ratio is 53.7%, compared to 52.4% in In the fourth quarter, the coverage ratio excluding the aforementioned items, was 55.7%. The provision for taxes on operating earnings amounted to NIS 336 million compared with NIS 371 million in The effective tax rate as a ratio of operating earnings before taxes amounted to 41.9% in 2010 compared with the statutory tax rate of 35.3%. 24

16 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 The high rate of tax compared with the statutory rate of tax is attributed to three main factors: A. Negative exchange rate differentials that are attributed to income from subsidaries abroad, as a result of the appreciation of the shekel against the pound sterling and the Swiss franc, which are not recognized as an expense for tax purposes. This impact was offset by earnings from financing operations, as described above. B. Unrecognized expenses, principally amortization of goodwill. C. Tax and interest differentials in respect of the collection of doubtful debts. In 2009, the effective rate of tax as a ratio of operating profit before taxes amounted to 40.5% compared with a statutory rate of tax of 36.2%. The high rate of tax compared with the statutory rate of tax derived mainly from decrease in tax rate on deferred tax expenses, as described below, tax and interest differentials in respect of the collection of doubtful debts and unrecognized expenses (principally amortization of goodwill). On July 25, 2005, the Knesset passed a law for the amendment of Income Tax Ordinance (No. 147) 2005, which stipulated inter alia a gradual reduction of the rate of corporate tax to 25% in the 2010 tax year and thereafter. On July 14, 2009, the Knesset passed the Increased Economic Efficiency Law (Legislative amendments for application of the economic program for the years 2009 and 2010), 2009, which stipulated inter alia an additional gradual reduction of the rate of corporate tax to 18% in 2016 and thereafter. In accordance with ordinances issued in 2009 and 2010, the profit tax imposed on financial institutions was 16%. This rate also applies for , as confirmed by the Knesset on December 29, As a result of the said amendments, the statutory rates of tax applying to banking corporations (companies that are defined as a financial institution under the Value Added Tax Law) are as follows: in the 2009 tax year 36.21%, in the 2010 tax year 35.34%, in the 2011 tax year 34.48%, in the 2012 tax year 33.62%, in the 2013 tax year 32.47%, in the 2014 tax year 31.60%, in the 2015 tax year 30.74% and in the 2016 tax year onwards, a rate of tax of 29.00% will apply. The impact of changes for 2009 was a NIS 19 million increase in deferred tax expenses. The Bank s share in the operating earnings of investee companies after the tax effect amounted to NIS 45 million, compared woth NIS 64 million in The decrease is due to decrease in earnings of Israel Credit Cards Ltd. (ICC) and to change in holding stake in Underwriting (an investee in 2009 and subsidiary in 2010). CONTRIBUTION TO THE COMMUNITY In late 2006, the Bank established the Turning Point social project, in cooperation with Ashalim a nonprofit organization founded by the Joint and by Matan. The project is designed to promote and foster business entrpreneurship among youth at risk, in order to help them return to normative society. Recently, the Bank decided to continue expanding its contribution to the community via Benleumi Bank House on Rothschild Street in Tel Aviv, which would be open to the public for art and culture events, such as: Music, dance, theater, videoart and film performances. Special assistance would be provided to young artists, who would gain exposure to a varied audience in the city that never stops. In addition to these projects, the Bank and its subsidiaries make charitable donations to various nonprofit organizations. Total charitable donations by the Bank Group in 2010 amounted to NIS 3.0 million. 25

17 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 THE HISTORY OF THE BANKING GROUP The Bank is a publiclytraded company that was incorporated under the provisions of the Companies Ordinance (New Version) 1983 (hereinafter: "Companies Ordinance"). The Bank is a banking corporation and holds a bank license under the provisions of the Banking Law (Licensing) 1981 (hereinafter: "Licensing Law"). The Bank was incorporated in 1972 and started doing business on October 1, Concurrent with the incorporation of the Bank, its parent company FIBI Holdings Ltd. (hereinafter: "FIBI") was established. Among the founders of FIBI were the Israel Government and foreign investors, including First Pennsylvania Corporation and Israel Investors Corporation. The business basis for the Bank's operations was a merger of the activity of two banks the Foreign Trade Bank Ltd., which owned the Mortgage and Savings Bank Ltd, whose name was changed to First International Mortgage Bank Ltd.) and the Export Bank Ltd. In 1976 the Bank acquired control of the Israel Industrial Bank Ltd., the activity of which including its branches was merged within the activity of the Bank, and its employees were absorbed by the Bank. The Israel Industrial Bank Ltd. changed its status from a commercial bank to an investment finance bank. In 1985 the Israel Industrial Bank Ltd. changed its name to the First International Bank for Financing Industry Ltd. This bank was later merged with the First International Bank and the merger order was issued in May 1995, effective from December 31, Bank Poalei Agudat Israel Ltd. was established in 1977 under the joint ownership of the Bank (65%) and the Histadrut Poalei Agudat Israel in Eretz Israel (35%). On April 7, 2010, the Bank completed acquisition of all outstanding shares of Poalei Agudat Israel from the other shareholders. Upon conclusion of this acquisition, the Bank owns 100% of capital and voting rights in Poalei Agudat Israel (for further details, see chapter on activity of held companies. In 1978 the Bank acquired control of Bank Lemelacha Ltd., the activity of which including its branches was merged with the activity of the Bank, and its employees were absorbed by the Bank. The purchased company changed its name to FIBI Lemelacha Ltd. and ceased to operate as a bank. In 2009, FIBI Lemelacha was merged with one of the Bank's assetholding companies. In 1982 the Bank issued shares of NIS 0.05 par value each to the public that are listed for trading on the Tel Aviv Stock Exchange. In 1982 FIBI Financial Trust Ltd. was established (now called: FIBI Bank (UK) plc) as a wholly owned subsidiary. The company began operations as a financial company and has held a bank license in the UK since In 1984 FIBI Bank Switzerland Ltd. was established as a wholly owned subsidiary that holds a bank license in Switzerland. In 1987 the Bank purchased the activity of the Bank of North America within the framework of the liquidation of that bank. 28

18 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 On December 11, 1992 the Bank floated a public offering by means of a prospectus of 353,500 ordinary shares, registered, of NIS 0.01 par value each. On December 31, 2002 the Bank purchased from FIBI 25% of the equity and 75% of the voting rights in InternationalSelective Investment Management and Consulting Ltd. Shortly after the sale, International Selective was merged with the Modus company. The name of the merged company is ModusSelective Investment Management and Consulting Ltd. On May 18, 2009, the Bank purchased the holdings of Mr. Ariel Neiger and of IBI Investment House Ltd, in ModusSelective. As a result of the acquistion, the Bank increased its holdings in ModusSelective to 100% of equity and control. At the beginning of 1983, the First International Mortgage Bank purchased 50.5% of the control and ownership of Atzmaut Mortgage and Development Bank Ltd. (hereinafter: Atzmaut Bank), and acquired an additional 26% in October From the time of this acquisition and until the end of 2004, the First International Mortgage Bank purchased additional shares that brought its holding to 88% of Atzmaut Bank's equity. At the end of 2005, the First International Mortgage Bank purchased the remaining holding in Atzmaut Bank from the public under an offering circular. At the beginning of 2006, the Bank purchased the outstanding holdings in the First International Mortgage Bank from the public under an offering circular. The First International Mortgage Bank and Atzmaut Bank were merged within the Bank with effect from March On December 22, 2004 the Bank purchased the entire holdings in Ubank Ltd. (hereinafter: Ubank ). On August , the purchase of 68% of equity and 66% of voting rights in Bank Otsar Hahayal (hereinafter: Otsar Hahayal) from Bank Hapoalim B.M. was completed. On March 2, 2010, the Bank purchased 5.79% of the capital rights and 7.33% of the voting rights in Bank Otsar Hahayal. Following this acquisition, the Bank holds 73.79% of the capital rights and 73.33% of the voting rights in Otsar Hahayal. (For further details, see the section on activity of held companies). On September 29, 2000, the Bank purchased 20% of the equity and 15% of the voting rights in Israel Credit Cards Ltd. (hereinafter "ICC ) Following additional purchases of ICC shares in 2006 and 2007, the Bank s rate of holding in ICC rose to 28.2% of equity and 21.0% of voting rights. On May , the Bank purchased a 51% holding in the issued and paidup share capital of Bank Massad Ltd, from Bank Hapoalim B.M. 29

19 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 DESCRIPTION OF THE FIRST INTERNATIONAL GROUP'S ACTIVITY The First International Group is one of the five largest banking groups in Israel. The business activities of the Group are centered in five main areas: Financial intermediation between depositors and borrowers, which forms the basis for commercial banking. Income from this activity is reflected in the Bank's earnings from financing operations, and constitutes the Group s main source of profit. Commission generating financial and banking services in a wide range of activities in the areas of foreign currency, foreign trade, securities, information services, credit cards, financial and banking consulting and management, derivative financial instruments etc. Investment consultancy and pension consultancy. The Bank's nostro investment and management of market and liquidity risks. Banking operational services in the area of provident, mutual pension fund activity. The Bank s management is directed and guided by the Board of Directors and its committees regarding the Bank s business strategy and policy. Within this framework, the Board of Directors approves the Bank s objectives, targets, areas of activity and the allocation of resources between them. The Bank s strategic plans, annual work plans and budgets are submitted to the Board of Directors, with quantitative and qualitative details of the composition of income, expenses and investments which the Bank s Management have determined as longterm targets and detailed targets for the coming year. The Board of Directors and its committees supervise and control the work of Management in all matters relating to the implementation of the business policy as approved by them, and the determination of various limitations on exposure with respect to credit, market and liquidity risks. The Bank's branch and head office units operate in accordance with written procedures and circulars that guide them in their ongoing activity. These procedures and circulars define inter alia the powers of the bank s various units and the manner in which they are to operate. In addition to the International Bank, the group also includes four commercial banks in Israel specializing in unique client bases: PAGI, Bank Poaley Agudat Israel which is the only bank in Israel specializing mainly in retail and private banking in the ultraorthodox sector; Ubank, purchased in 2004, is a bank specializing in private banking and sophisticated services in the capital market; Bank Otsar Hahayal, purchased in 2006, which specializes in providing services to private and commercial customers, with emphasis on employees and pensioners of the defense forces; and Bank Massad, purchased in 2009, which specializes in providing services to the members of the teaching profession in Israel. The Group has two overseas subsidiaries: FIBI Bank (Switzerland), located in Zurich, which specializes in private banking; and FIBI Bank (UK), located in London, which specializes in Israeli and local business customers. During recent years, in order to maximize the Group s operational efficiency, a shared services model has been applied at the Group. This was done while preserving the independent identity of each bank in the Group in its activity with customers. The Group has completed the process of integrating the computer systems of the banks that were acquired into the Bank s computer systems. The integration of Ubank was completed at the beginning of 2009, the integration of Massad was completed in February 2010, and the integration of Otsar Hahayal was 30

20 קובץ,eng01.doc0609 תאריך 15:20:34 09/06/2011 completed in May Concurrently, the bank is amalgamating the backoffice and headoffice units the activity of which requires a high level of specialization and/or a substantial investment in computer systems. In recent years, the procurement, construction and security departments, units involved in applying regulatory directives, part of the bank s dealing rooms, part of the training departments, the Group s trust services and the operational services for provident and mutual funds, were incorporated within this framework. This process has speeded up considerably with the completion of the integration project. In addition, the banks in the Group cooperate in the provision of banking services. In this respect, the bank s call center, Benleumi Call, provides services to all of the group s customers, with the subsidiary companies operating the Bank s mortgage counters and selling structured products based on those created by the Bank. Concurrently, the Bank refers customer wishing to obtain factoring services to Otsar Hahayal, which specializes in this area of activity. These expectations and intentions include forward looking information. This form of information in uncertain information about the future that is based on information existing at the Bank as of the report date, and includes the Bank's assessments or its intentions as of the report date. The Bank adopted during 2005 corporate strtegy, leading to the acquisition of the retail banks, while increasing the weight of income from private customers in the Group's total income. Following the acquisition a decision was made to implement a shared services model to all the banks in the Group, which allows synergy and size advantages. With the completion of the conversion process and the putting of a corner stone of eficient banking Group, the Bank formulated a new multiannual strategic plan, which is a continuance of the strategy of the previous years. The plan is based on sizable conduct in all areas of operations, while aspairing to proper profitablility, without fluctuation over long period of time. Efforts for increasing the retail and private area in the Group will be continued, while preserving the leadership of the subsidiaries in their hishes, increasing the volume of operation in the Bank, taking steps of efficiency and increasing use of the direct banking. In the corporate commercial banking emphasis will be on increasing credit with proper diversification. In the capital market, the Bank will do its best to reserve the leading position, among other things, by developing unique advance product and services. The following is a description of the areas of activity and responsibility of the Bank's divisions and departments: The Business Division The Division s Business Department coordinates the entire range of activities of large and international corporate clients with an obligo of NIS 30 million and above, as well as the activities of borrowers with complex credit requirements, such as telecommunications, diamonds and project finance and such like. The Commercial Banking Department handles debtors with credit of between NIS 13 million and NIS 30 million. A Business Sector operates within the Division, coordinating the activity of the Bank s main business branches. The Business Division also includes an International Banking and Foreign Trade Department and the International Trade Center, which provides services to all the banks in the Group. The Head of the Division is a member of the Bank s Management and is professionally responsible for FIBI Bank (UK). The Banking Division is responsible for the Bank's branch network (except for the seven largest business branches, which are subordinate to the Business Division, and the Rothschild Branch and the International Private Banking IPB Center, which are subordinate to the Customer Assets Division). The Division coordinates the activities of private banking customers, personal banking customers (households and small businesses) and small to mediumsized commercial customers. The Division is responsible for the Bank s Marketing and 31