The full Survey in PDF format
The global economy, including the financial systems, is dealing with a number of challenges that emerged following the COVID-19 crisis and that have intensified as a result of the Russia-Ukraine war. The disruptions in the supply chain, and in particular in the export of oil and wheat, have led to an increase in global commodity prices, and inflation has risen to levels not seen during the past decade. In response to the inflationary pressure, central banks worldwide, including the Bank of Israel, have initiated a process of raising the monetary interest rate and gradually tightening monetary policy. Thus, after a long period of near-zero interest rates, the global economy must now adjust to a rising interest-rate environment.
From the perspective of the banking systems, the increase in interest rates and inflation is beneficial in the short term, given the resulting increase in interest income, but it is liable to have a negative impact at a later stage. This is due to the possible decline in the quality of credit if borrowers’ ability to service their debt is impaired. What is unique about Israel compared to many other countries is the existence of an indexation mechanism for some of the credit segments, which leads to a surplus of indexed assets, thus further contributing to the profitability of the Israeli banking system. The contribution of the interest rate and inflation can be seen in the high return on equity (15.8 percent) recorded by the banking system at the end of the first half of 2022, the highest level in more than a decade. The high rate of return was also due to one-off revenues, some of which are part of the efficiency processes that Israeli banks are undergoing (for further details, see the chapter on business results and efficiency).
The marked growth in the banking system’s capital, which is the result of, among other things, high profitability and capital raising in the market (see the chapter on capital adequacy), has allowed the banks to continue providing credit at an accelerated pace in response to the high levels of demand following the exit from the pandemic (primarily housing credit and credit to the construction and real estate industry; see the chapter on credit). Nonetheless, as a result of the rapid growth in credit (alongside the distribution of dividends in respect of 2021 profits and the losses reported in the portfolio of available-for-sale assets), the banks’ capital ratios eroded during this period. Note that in this period it is important, from a forward-looking perspective, to build up capital, since a period of high uncertainty is being experienced as a result of inflation and the interest rate increases worldwide, which are manifested in lower equity prices, a rise in yields, and even a decline in real estate prices in some countries. Furthermore, since the rise in interest rates and inflation increases the debt burden on households and the business sector—which may be
a threat to GDP and consumption1—we may see an increase in credit defaults, which calls for an addition to capital buffers. Note in this context that during the period being surveyed the total credit loss allowance rose relative to December 2021. Although the increase is primarily due to the transition to the CECL rules (which went into effect at the beginning of the year2), there was also a deterioration in the macroeconomic environment during the second quarter of the year, which also partly explained the increase in credit losses.3 Nonetheless, there is no visible increase in defaults in the credit portfolio at this stage.
Against this background, we note that all of the banks in the system have capital ratios that exceed the minimum levels set by the Banking Supervision Department; nonetheless, there are a number of banks that are working in other ways to further strengthen their capital, in view of recent developments, and first and foremost the accelerated pace of growth in credit to the public. Thus, two banks in the system have issued shares while others reduced or suspended the distribution of dividends in the first quarter of this year (for further details, see the chapter on capital adequacy).
The fears of the effect of an increase in households’ debt burden is clear since the lion’s share of household debt bears a variable interest rate and/or is indexed. During the period of a negligible interest rate and prior to the interest rate increases, taking a loan with a variable interest rate (in which the price is lower than that of a fixed-rate loan, but the borrower is taking on interest rate risk) provided borrowers with particularly inexpensive debt. However, the interest rate risk is currently being realized, which is raising monthly payments. In particular, there has been an accelerated increase in housing credit during the past two years, which was also characterized by an increase in loan to value ratios due to rising home prices. Furthermore, with the recent sharp rise in housing credit, we are seeing an increase in consumer credit, both inside and outside the banking system. This increase is in parallel to the provision of housing loans, an indicator that households are taking on additional leverage.
We note that based on the understanding that many borrowers are focused on minimizing their initial monthly mortgage payments, rather than taking into account the risk implicit in the possibility of interest rate increases and higher inflation, the Bank of Israel instituted a consumer-related reform at the end of August 2022 that will increase transparency of information for bank customers and improve the competitive environment in the mortgage market. As part of the reform, a number of measures related to mortgages went into effect that will help customers to, among other things, more easily understand the terms of the mortgages being offered and their implicit risk, given the expected developments in market conditions, including the rates of interest and inflation.
1 Both directly, due the variable interest rate mechanisms and CPI indexation, and indirectly, due to the decline in disposable income of borrowers as a result of the increase in other expenses which may not be fully compensated for in their income.
2 The initial implementation of the CECL rules (in January 2022) required the adjustment of the total credit loss allowance (thus increasing it) which was not by way of the provision for credit losses. Following the initial implementation, changes in the macroeconomic environment are manifested in the credit loss allowance rates.
3 As mentioned, under the CECL rules for credit loss allowance, changes in the macroeconomic environment are manifested in an increase in the total allowance already in the present.
On the saving side, the increase in the Bank of Israel interest rate led to some increase in the interest rate on the public’s deposits (for further details, see Box 1) and therefore households are choosing to transfer a growing portion of their funds from demand deposits (which do not earn interest) to interest-earning deposits (for further details, see the chapter on the balance sheet). In this context, the Supervisor of Banks sent a letter to the banks’ CEOs in September of this year in which he expressed the expectation of the Banking Supervision Department that the banks would adjust their investment products in order to keep pace with the changing interest rate environment with the goal of satisfying the needs of their customers.4 We note that correct financial behavior on the part of households can increase their bargaining power and therefore improve the interest earned on their deposits. As such, and following the various reforms recently promoted by the Bank of Israel in order to increase transparency and strengthen the customer’s power, the Bank of Israel has begun to publish the interest rate on NIS deposits actually paid by each of the banks. The goal is to provide customers with a simple tool that will help them evaluate the terms offered by the various banks. This comparison tool is available to the public on the Bank of Israel website.5
In sum, the banks’ results for the first half of 2022 may be misleading. Their financial statements present a positive picture – high returns on equity, an improvement in efficiency ratios, capital ratios, and liquidity ratios, growth in activity and good credit quality. However, from a forward-looking perspective, there is uncertainty regarding future economic developments and their implications for the banking system. Initial indications that may point to changes in the trends are already visible. Thus, during this half of the year there was, as mentioned, an erosion in capital as the result of a drop in bond values in the available-for-sale portfolio. This was the result of a sharp increase in yields, which also led to a number of banks transferring part of their available-for-sale bonds to the bonds-held-to-maturity portfolio,6 with the goal of moderating the effect of the increase in bonds yields on the volatility in capital. Furthermore, households have started to further exploit their credit lines (although as of today, the rate of usage is still similar to pre-pandemic levels). Meanwhile, we are starting to see a slowdown in housing credit, which is occurring after a slowdown also in the level of home purchases and a more moderate rate of growth in credit to the construction and real estate industry. The Banking Supervision Department is continuing to monitor the developments in the markets and the growing risks, from both a macroprudential viewpoint and a consumer viewpoint.