• Well-developed tradable debt securities are important for three main reasons: a) Increasing the competitiveness and efficiency of the financial system, which in Israel is dominated by a few large banks; b) Enhancing the stability of the financial system by creating alternatives to banks thus reducing their relative power and the potential moral hazard problems, which are related to this power. c) Serving as means of two-way communication between policy markers and financial markets, and through them to the public at large.
  • In this paper I will discuss this three topics they relate to the current state of the Israeli financial system - its problems and what can be done to improve it’s functioning.

A) Competitiveness and Efficiency

Financial intermediation in Israel is at present dominated by a large few banks. This is evident for example in the high proportion of bank loans out of total finance resources available to businesses and households (table 1).

Raising funds outside the banking system, by the private sector, through issuing shares is rather limited and the corporate bonds market is miliscule. The main competition to banks for the public’s savings comes from government bonds. Despite the large outstanding government debt (about 95 percent of GDP in 2001) the government bond market suffers, for various reasons, from liquidity problems. Contrary to the interest of foreign investors in Israeli shares, particularly those that are traded on NASDAQ, there is almost no interest in domestically issued Israel bonds.

Developing viable alternatives to bank finance in Israel will help in promoting balanced growth. The structural change which the Israeli economy has been undergoing, (in the direction of increasing the weight of the high-tech advanced sector, with its relative access to sources of finance such as venture capital and international capital markets) underscores the need to develop non bank finance sources for the other sectors of the economy so that they too can grow.

B) Enhancing the stability of the Financial System

  • Developing a viable bond market in Israel will also enhance the stability of the financial system. When firms can raise funds buy issuing bonds they are less dependent on banks, less exposed to difficulties of the banking system and less vulnerable to the adjustments that banks need to make including those required by bank supervisors. When banks know that they do not have a captive audience because firms have alternatives, they may improve their internal supervision. The result of alternatives to banks may result in a more sound banking and financial system.
  • Another way in which a well-developed bond market contributes to the stability of the financial system is through its positive effects on the development of securitization. Scrutinizing mortgages, receivables credit card payments act means a more efficient diversification of risks. This in turn enhances the stability of the banking and the financial system as risk becomes more transferable to those ready to bear it.
  • In addition, in well develop capital markets; in which bonds of various types are an important element, it is easier to mark to market. This in turn means that troubled spots in the financial system can be detected earlier. At present Israel is still very underdeveloped in the above respects. There is no market for mortgage banks securities neither is their any securitization of other types loan. At times mortgage banks sell some mortgages to providence funds but on a limited and erratic basis.
  • An important infrastructure for the of a private bond market is a well functioning government bonds market. The outstanding stock of government bonds in Israel is 178 billion shekel, about 38 percent of G.D.P. Net issuance of government bonds in 2001 amounted to 16 billion shekel. The rest are non-tradable market bond issued to pension funds thus creating a situation where a potentially important player in effectively circumventing the capital market.
  • Despite this deficiency, and others, the liquidity of the government bond market has been improving in recent years. Daily turnover of government bonds traded on the Tel-Aviv stock exchange increased markedly in 2001 (figure 1) and so have been short positions (figure 2).
  • Recent improvements the functioning of the Israeli bonds market also include: a) reducing the number of series and concentrating on benchmark maturities of 5 and 10 years for the fixed rate nominal bonds, and 10 and 20 years for the CPI linked bonds. In addition the treasury issues nominal variable bonds for 10 years, b) the size and composition of the government bond auctions are now announced a month in advance.
  • A cornerstone for a well-developed capital market is the ability to conduct REPO operations (secured lending). In Israel at present such operations do not exist. Recently however, an obstacle, which prevented the Bank of Israel (BOI) from conducting monetary policy through REPO operations, has been removed. This was done by removing the ceiling on short term government notes (with a maturity up to one year) which by law are designed to serve monetary policy only. That is the proceeds from their sale cannot be used to finance the government deficit. Prior to the change the maximum amount of treasury notes that the BOI could issue was limited by a ceiling which was updated twice a year by the rate of increase in M1 during the last half year. The removal of the ceiling is a welcome development as central bank REPO operations serve as an important benchmark for such operations in the private sector, thus creating an alternative finance source to banks.

C) Signal to Policy Makers

1) A request to relax the monetary stance in light of planned reductions of the government deficit

In 1996 the government deficit in Israel grew much faster than originally planned at a time when inflation expectations were above the inflation target. The government decided to cut expenditures and, based on this decision, it asked the Bank of Israel (BOI) to ease its monetary stance. The response of BOI was that the decision to take the corrective fiscal steps was certainly an important step in the right direction, but it is also important to see how credible this decision is from the point of the view of financial markets. In particular it was important to see how the market derived inflation expectations responded to the government decisions. These expectations are derived from the difference between regular nominal bonds and CPI indexed bonds with the same maturity. Both types of bonds are traded regularly in a relatively well-developed market. These inflation expectations are an important element in the monthly monetary policy decisions of BOI.

2) The response of long term yields on to the economic slump and policy implications

The current slump in economic activity resulted in much smaller tax receipts than expected, a much larger deficit than planned and hence much larger government financing needs. The government originally planned to raise (net) about NIS* 3 billion in 2001 but will end up rising more than NIS 16 billion. This obviously affected the long-term rate, which also serves as a benchmark for the mortgage market. Those yields rose from around 4.3 percent at the beginning of 2001 to around 4.9 percent in the third quarter of last year. The existence of developed government bond and mortgage markets were very important in raising the point that the government decision to accept the larger deficit (the automatic stabilizer argument) had immediate consequences in the mortgage market. In an important sense the “bill” to the government was “served” immediately.

These two examples show that developed debt instruments can serve as important “warning lights” to problematic macro policies.


* New Israeli Shekel.