Can the banks be reformed?

The Jerusalem Post
26 Feb ’04

The public arena is abuzz with anti-bank sentiment.

An imperious decision by Bank Ha’poalim to raise its controversial “line commission” (this on top of charging customers for the privilege of letting the bank make profits on their deposits) – seems to have broken the camel’s back.

Not that bank commissions are “a straw”.

In other countries commissions represent on the average 36% of banks profits (more often only 15-20% percent).

In Israel they are above 60%, a neat sum of 8 billion shekels, that the banks levy from defenseless customers through over 200 different kinds of Byzantine commissions.

Filed under:

financial markets • public policy • reform

The banks are extremely powerful. They have managed to fend off for two decades the Beisky commission recommendation for the restructuring of financial markets, as well as the recommendations of subsequent commissions. When the Bank of Israel’s Comptroller of the Banks objected to the hike, they ignored him. But maybe this time the banks have misjudged the political atmosphere. Political parties were afraid to act against bank interests for fear the banks would not roll over their debt. Bank lobbyists intimidated Knesset members by explaining that the high cost of primaries required that they better have a good friend in the banks.

Still, 51 Knesset members, mostly from the opposition have signed a proposed law that will force the banks to sell off their provident and mutual funds, holdings that create very borderline criminal conflict of interest situations. In addition, three Knesset committees are dealing critically with various monopolistic bank practices. The media too is full of reports and comments critical of bank practices.

A report recently completed by a group economists, high tech leaders, investment bankers and jurists under the aegis of The Israel Center for Social and Economic Progress (which I direct) has described the enormous negative consequences caused by our overly concentrated financial markets, especially in the banking sector.

Distortions in financial markets are tied to the fact that land and labor, as well as capital, are not utilized productively in Israel. 93% of the land is owned by government or by quasi-governmental bodies, so the thin market in tradable land is easily manipulated. Land’s inflated prices absorb an excess of investment capital. It distorts other factors such as bank guarantees.

The Labor marker is also badly distorted. Only 2.3 out of 6.5 million Israelis work, 800,000 of them in the public sector. Government is much too big its budget is 55% of GNP, its debt 110%.

Financial markets suffer from over-regulation, but the big banks mostly ignore it. Regulation creates therefore not only great inefficiencies, but erects entry barriers against new and foreign entities.

Our Capital markets – including credit, stocks, negotiable debt and private equity – are highly concentrated and non competitive. The banks control 1 trillion out of the 1.4 trillion shekels of the public’s financial assets.

The report insists that over concentration and inefficiency in financial markets is probably the chief inhibitor of economic growth. The banks have lent over 70% of credit to 1% of lenders, many of them cronies who used the banks cheap credit for highly leveraged and risky deals. By the end of 2002 the banks had accumulated bad debts amounting to 120% of their equity. The banks could sustain these enormous losses by making excessive profits from their monopolistic hold on commissions and on interest rates. The banks forced household to subsidize their great lending losses. Worse still, by giving almost all credit to their cronies the banks put the rest of the economy into a devastating credit crunch, stifling potentially productive smaller and medium sized enterprises, many of them in the “periphery”. Unavailability of credit may be the chief reason the Galilee and the Negev stopped developing.

The banks effectively control most of the public’s financial assets deposited in pension funds, provident funds etc. They are engaged in severe conflict of interest practices by serving also as loan providers, underwriters, investors and financial advisors. Regulation and discriminatory taxation have favored savings in the banks and dried up the corporate bond market. They also curb investments abroad.

There is almost no private equity market in Israel, except for venture capital. As a result, it was impossible to sell government and private companies. Where purchases were made, they were with bank credit, and highly leveraged. Foreign buyers were outbid by well-connected local buyers who enjoy reduced “cross subsidized” bank rates.

Malfunctioning financial markets cause the yield on the 1.4 trillion NIS in public assets to be very low. Israeli companies are forced to raise credit abroad and “migrate”.

The inordinate centralization of economic power in the hands of the few (three families and one banks own 44% of all assets in Israel!) creates a dangerous nexus between economic and political power, since politicians become dependent on support from our oligarchs who dominate the economy.

Most importantly, the economic allocation of resources through the price mechanism – the only kind that promotes growth – is replaced by an anti-productive mechanism of favoritism and political pull. The results are obviously bad.

What has to be done is simple: Regulation must be drastically cut so that competition can take its place in preventing abuses more effectively. Competition can also be enhanced by separating the provident and trust funds from the banks. Only then must the government privatize the two banks it still owns.

After such reforms the markets relations between the banking sector and the insurance sector must also be defined in a manner that will encourage competition. Competition will facilitate the emergence of private equity firms, Israeli and foreign, and make the Israeli economy flourish.

Our powerful banks must realize that such steps are going to also benefit them in the long run. Their reliance on monopoly power was not only ruinous to the economy but resulted in the banks periodic insolvency, so that they had to be bailed out almost every decade.

Finally Israel has a Finance Minister who understands economics and is willing to take great political risks to mend the Israeli economy. He deserves help from those who realize how crucial a well functioning economy is not only for our welfare, but for our very survival.

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