The Bank of Israel is publishing today its semiannual report on the stability of the domestic financial system. The analyses in the publication cover events that occurred through the end of June 2015. The legislative basis for the publication of the report is the definition in the Bank of Israel Law, 5770-2010, of one of the Bank of Israel’s objectives as supporting “the stability of the financial system and its regular operation”, a widely accepted role at central banks in advanced economies.
The current Financial Stability Report contains a survey of the risks in the financial system’s various components—banks, insurance companies, institutional investors, and financial markets—and also covers the institutional structure of the public’s savings. According to the report, the domestic financial system continued to maintain its stability in recent months, against the background of accommodative monetary policy in Israel and abroad. Nonetheless, the domestic financial system is exposed to three material risks:
1. One risk is from the effects of low interest rates over an extended period of time, as a result of the accommodative monetary policy in Israel and abroad that was adopted against the background of the global crisis and the slow recovery from it, and recently in light of, as well, the decline in inflation in Israel and abroad. In Israel, similar to markets worldwide, the low interest rate and the flattening of the yield curve led to a sharp increase in asset prices, which created risks. These risks are liable to materialize in an environment of low interest rates over an extended period of time, because for some of the financial institutions, such as insurance companies, the increase in the discounted value of liabilities is liable to negatively impact their profits. Alternatively, the risks may also materialize if interest rates increase and lead to a shock in the markets and to an overreaction by asset prices, with ramifications on the asset portfolio of the public and of institutional investors.
2. The financial system’s exposure to the housing market remains a major risk. This is because the banks continue to be exposed to the construction and real estate industry, as well as to mortgages at notable volumes. The risk in exposure to the construction and real estate industry and to mortgages, as well as to nonhousing consumer credit, increases in light of the strong correlation in those types of credit. A shock that leads to an increase in the interest rate or to a negative impact on borrowers’ incomes, is liable to lead to a negative impact on banks that are exposed to those borrowers. With that, the measures adopted by the Supervisor of Banks in recent years, such as limiting the loan to value (LTV) and payment to income (PTI) ratios for new mortgages, led to a decline in the risks of new mortgages that are taken out. At the same time, the decline in long term yields also led to a decline in the interest rate on fixed rate mortgages, and thus a considerably greater share of new borrowers are choosing that track, which does not incorporate the risk to borrowers of a future interest rate increase. Nonetheless, about 71 percent of outstanding mortgage loan balances still carry a variable interest rate, of which 36 percent are indexed to the Prime interest rate.
3. The financial system is also exposed to underpricing of risks in the corporate bond market, against the background of the low interest rate environment in Israel and abroad—a factor that impacts on pricing in this market in particular and in asset markets in general. Beginning from the end of 2014, corporate bond market spreads began to decline again. Apparently, the decline in spreads derives partly from the improved financial situation of these companies, though it cannot be ruled out that part of it reflects continued underpricing in this market. Evidence of such underpricing can be seen in the very low yield gaps in corporate bonds between Israel and the US, and in the unusual volumes of foreign companies, primarily real estate firms, that choose to issue bonds in Israel. The underpricing of risks in this market also reflects the sharp decline in yields on government bonds during these months, and, in part of the period, the negative yield gaps between Israeli and US government bonds.
The Report (Hebrew)