To Presentation (Hebrew)Prof. Nathan Sussman, the Director of the Bank of Israel Research Department, spoke today at the Globes newspaper’s conference, “Podium—Israel’s Institutional Investor Forum”. Following are the main points of his address.
In my remarks, I will present the Bank of Israel’s approach to the financial market, in terms of the challenges it faces and reforms that are planned, while addressing the conditions necessary for increasing competition, and presenting an analysis of the features of the banking and institutional system, and an international comparison of the features of the domestic and global banking system.
The financial market has features that prevent—at least as a starting point and given existing technologies and participants—its reaching perfect competition. In order for there to be perfect competition, there need to be several basic conditions: full information, no externalities influences, no “agency problems”, and a large number of participants. I will analyze the financial market’s features with regard to each of these conditions:
Full information
Customers that take credit have more information about their repayment capacity than does the entity that lends to them. Therefore, lenders demand a risk premium due to the information problem. There are, in effect, two types of data about borrowers that can be received. There is “hard data”—which is made up of measurable parameters, such as the borrower’s salary—the acquisition of which is not contingent on an extended relationship with the borrower and which can be attained through, for example, various statistics sources. In contrast, “soft data”—which is based on familiarity with non-measurable characteristics of the borrower, such as honesty, trustworthiness, etc.—is generally attained based on an extended relationship with the borrower. Banks have a structural advantage in attaining information on borrowers, particularly “soft data”, as they have an extended relationship with the borrower.
In the area of information, there are several reforms being considered, such as a banking ID card (which bank customers will receive for the first time this coming February), and a credit database to be established at the Bank of Israel. These reforms will provide a solution for the “hard data” issue, but not for “soft data”. An additional solution for the information problem can be provided by diversifying risk very broadly. When there are many borrowers and lenders, it is easier to disperse the risks and thus provide a partial solution to the information problem. We are seeing the entry of additional platforms into the credit market, such as P2P, that will lead to diversification of the credit portfolio. With that, even after the very important reforms in the sector, there will still be some advantage to entities that have access to “soft data”, and to large institutions that benefit from economies of scale, and thus these reforms and changes are not expected to lead to perfect competition that exists in other industries.
Externalities influences
Credit and liquidity are the economy’s lifeblood, and a negative impact to them affects the entire economy. Likewise, a herd mentality can result in a failure of a financial entity leading to a broad failure, which would have extensive effects on the economy—as is known, the world has been attempting for 8 years to recover from a financial crisis with very deep and long term effects. This crisis would not have developed as it did if the company that went bankrupt would have been a nonfinancial company, as opposed to the Lehman Brothers investment bank, a financial company whose collapse had an immediate effect on the global financial system.
Agency problems
Financial entities invest money on behalf of others, and the portfolio manager’s interest is not necessarily identical to that of the asset owner. This problem is known in economics as the “agency problem”. In particular, we know that there is a problem in managers’ incentive structure, which encourages them to take on more risks compared with the level of risk that their customers would want; this is particularly so in a market with intense competitive pressure.
The classic solution to the agency problem is supervision. However, all regulation and supervision has a cost, not only in terms of the supervising entity but also from the perspective of the supervised entity. This cost serves as a barrier to entry for additional participants, especially small ones. A good example of this cost is capital requirements. The solution that the Bank of Israel is promoting in this regard is risk-adjusted supervision, meaning, regulation that will allow new and small players to benefit from reduced supervisory demands, which are in line with the risk level and the scope of their activity. Nonetheless, there will still be supervision, and it will have a cost, that will serve as a necessary barrier to perfect competition.
The number of participants
A feature of financial activity is economies of scale. For example, the larger a portfolio is, the easier it is to diversify risk, which gives an advantage to large institutions. We noted this regarding the cost of regulation, as well. These make the entry of new participants difficult, and therefore, the number of participants in the market will not be as large as it is in other markets. There are several solutions for this—for example, I noted risk-adjusted supervision, which will reduce the cost of regulation for small entities. An additional element is creating access to public data—for example, a credit database that will be established at the Bank of Israel will make it easier for small institutions to accumulate data that today only large institutions have. The securitization reform that the Bank of Israel is leading will help in this regard, because it will allow small institutions as well to diversify the risk of their credit portfolio. Another example is providing some of the services to financial institutions publicly. For example, the Bank of Israel provides and supervises clearing services, and thus will be able to allow small entities to make use of these services. And also on the agenda, as is known, is the separation of credit card companies from banks—that is, taking some activities away from large institutions and increasing the number of players.
As such, there are many reforms under consideration, and they will positively affect the level of competition in the industry. However, it must be remembered that due to the limitations that I described, the financial system will not be able to reach a state of perfect competition. Likewise, we must be wary of a situation in which the reforms lead to what we would call unintended consequences, or to our attempts to increase competition ultimately actually leading to a negative impact on competition.
When we come to deal with the banking system, we need to remember that our starting point is that Israel’s banking system is small relative to the world. Banking system assets in Israel are about 125 percent of GDP, markedly lower than most other OECD countries, and its share is similar to those of banking systems in less developed countries in Europe. Since, as noted, the banking system has advantages in extending credit and in other activities, reducing it even further is likely to have effects on productivity in the economy.
An international comparison indicates as well that Israel’s banking system is not very leveraged, and its profitability is not high, compared with OECD countries, although it is notably high mainly in the small business sector. The contribution of the financial system in Israel to GDP is similar to the OECD average, and as is known, the banking system is relatively concentrated—this derives to some extent from the economies of scale, and thus, as I noted, the industry overall is not very large, so that there is room for a relatively small number of players.
In contrast to the banking system, where even before the proposed reforms its assets relative to GDP did not grow in recent years, the assets of institutional investors are on a trend of consistent increase, as a result of significant reforms in previous years in pension savings. The institutional system is also marked by concentration, especially among the new pension funds, where concentration is not very different than in banking, and competition is not high, and for the reasons I previously noted, we also would not expect to reach perfect competition.
Some of the proposed reforms come from the assumption that there is a shortage of credit in the Israeli economy, and that those that are initiating the reforms want to increase credit volumes. However, over time, it can be seen that the total debt of households and the business sector is slightly greater than 100 percent of GDP, and a lot of research carried out worldwide indicates that this is approximately the optimal leverage level, as higher leverage levels are liable to pose a risk to stability, and there is relatively little advantage to economic growth. It is possible, and it is important, to increase competition and reduce costs, but overall, there is no reason to strive to increase the extent of leverage in the Israeli economy.
In conclusion, the financial market is a complex market, and it requires supervision and regulation. Cautious and thought-out reforms, and at the Bank of Israel we emphasize the need to carry out reforms cautiously, will be able to increase financial market efficiency, by helping solve the information problem, bringing supervision in line with risk, and leading to the entry of new instruments, such as securitization and P2P players. It is possible to increase competition, but apparently, the features of the financial system prevent reaching perfect competition, which exists in other industries. Since the market is characterized by a small number of players, a competitive balance between banks and the institutional system should be maintained, by encouraging competition between banks, and not just by transferring activities to the institutional market.