People stand beside a branch of Bank Hapoalim, Israel's second largest bank which is controlled by Shari Arison's Arison group, in the southern city of Ashkelon July 27, 2011. (photo by REUTERS/Amir Cohen)

Leading Economist Says Israeli Banks Not That Secure

Author: calcalist Posted July 30, 2012

"It's absurd that the same banks that were operating here when I was lecturing at the Hebrew University of Jerusalem 35 years ago and that were nationalized in the 1980s by the government, are still operating in Israel," said Sam Peltzman, Professor Emeritus at the University of Chicago [Booth] School of Business, in an interview with the Israeli daily business newspaper Calcalist. Peltzman, who is following from afar the goings-on in the Israeli capital market, does not hesitate to voice his criticism over the local capital market, which he characterizes as "underdeveloped." He also expressed concern regarding the stability of the local banking system. "At present, the Israeli banking system is doing well," he stressed and, at the same time, noted: "However, it is susceptible to negative shocks."

SummaryPrint Professor Sam Peltzman, the intellectual godfather of deregulation markets, blasted the Israeli capital market, calling it "very immature," writes Uri Pasovsky. He also expressed concern about the stability of the Israeli banking system.
Author Uri Pasovsky Posted July 30, 2012
TranslatorHanni Manor

Peltzman, who is one of the prominent conservative economists in the United States, is, according to the New York Times, "widely considered the intellectual godfather of deregulation." He is a renowned international expert in the sphere of regulation or, more precisely, deregulation. Nevertheless, when it comes to the regulation of the banking system, he defines himself as a "hawk." He believes that tougher capital and liquidity standards should be enforced on the banks and argues that the financial reforms enacted so far have not addressed the most important issue of all, i.e. the bankers' incentives.

Ineffective regulation

At 72, Sam Peltzman can boast membership in the exclusive group of economists who have an effect named after them. In an article he published in the 1970s on car safety regulations, he conceived what has come to be known as the “Peltzman effect.” His idea is provocative: Safety regulations, for instance, the seatbelt law, actually prompt us to react by adopting other risky behavior, counteracting the intended effect of the regulation. His original argument was radical: The unruly, wild driving of drivers [in reaction to the seatbelt law] is bound to offset the benefits of putting on a seatbelt. Today, Peltzman admits that his assessments were apparently somewhat exaggerated. Yet, he mentions one hundred researches showing that "the actual benefit of regulations is not as great as expected." He further notes that the “Peltzman effect” has widespread application in a variety of areas, including finances.

The research work made by Peltzman has led him to question the justification for governmental regulation. In most cases, he says, he would rather "let the competition work out problems." His is the stance characteristic of the Chicago School economists, who advocate minimal governmental intervention in the market and free market to the maximal extent possible. Peltzman says that the research he did in the 1970s served as the intellectual basis for the deregulation movement of the 1980s and 1990s in quite a number of markets. At the same time, Peltzman points out that he is trying to be flexible and focus on facts rather than on theory. He is therefore all for governmental control of the financial system, "for the simple reason that the government provides guarantees for the banking system's liabilities, and once this happens [i.e. once such backing is provided], there is justification for regulation."

So what should the regulation achieve?

"The regulation is not intended to guarantee that we will never face a financial crisis. Crises may happen. The goal is to limit their frequency and, when crises do occur, to limit their adverse impact — in particular as far as the taxpayers are concerned. In the real world, financial crises negatively affect the economy, and it is the taxpayer who is paying the price. We seek to minimize the damage to both [the economy on the whole and the private taxpayer] as far as possible. Generally, I believe that for the regulation to be effective, you should take care of the incentives." In this respect, Peltzman maintains, the prevailing attitude in the West, which seeks to dictate to the bankers rules that establish what's right and what's wrong, is ineffective. "Financial regulation has no bearing on the incentives that push the bankers to adopt risky behavior, and they thus find ways to bypass the regulation."

Leveraging is the root of all evil

What then are the incentives that lead bankers to take risks? And how can you cope with them?

Like many others, Peltzman believes that the huge leveraging in the banking system is the root of all evil, as it leads to a situation where the balance sheets of banks are based on low levels of equity capital and a high ratio of loans. In other words, the banks are drawing on money that is not theirs, while the safety net that would enable them to handle losses on their own without having to ask for [governmental] financial bailout at the expense of the taxpayer is too small. According to Peltzman, the key to resolving the problem is tougher capital and liquidity standards enforced on the banks, so that they would themselves feel the brunt of their own losses.

"If you invest more of your own capital, it means that a larger part of your capital is on the line and in this case, you are less inclined to take excessive risks. In fact, I believe that the capital adequacy requirements presently in force are not tough enough. The approach adopted by the Swiss, requiring [the banks to have at least] 20% equity capital is the right one. The higher the percentage of equity capital the banks are required to have, the less regulation is required to control the way they use the money." Therefore, Peltzman suggests the use of financial instruments that would be to the detriment of the major creditors of the banks in case they are in need of financial bailout. This suggestion, too, is based on the same rationale. "At present," Peltzman says, "it [generally] does not occur to people who extend credit to the banks that they are liable to ever lose their money. However, once they realize that the money they are lending to the banks is at a risk, the investors will ask for higher interest rates and the banks' leverage levels will subsequently fall off."

Wouldn't it entail the risk of credit crunch?

"If the banks choose to decrease the volume of their assets to meet the capital adequacy requirements, it may indeed have such an effect in the short run. As a matter of fact, we are already witnessing this effect in action. However, this is the price we have to pay to maintain economic stability. The [banking] system is built on subsidized leveraging. The only way to mitigate the severity of potential crises and lessen the cost involved for the taxpayer is by cutting the leverage subsidies. It would be painful. I am not denying it."

Let's return to the present reality. In recent weeks, losses of billions of dollars have been exposed in the derivatives portfolio of J.P. Morgan and they are growing by the minute. Are you surprised that they are still taking such risks in Wall Street?

"No. Absolutely not! I am not surprised by anything that I see, since they [the bankers] enjoy the same incentives [they were given in the past]. They are out to do precisely the same things that they did before the [2008] financial crisis, as they receive cheap money. As a matter of fact, they have been granted even larger government guarantees than before  they are considered of importance for the system! In this kind of system, the bankers have the same incentives they used to have. They receive cheap money from the capital market, perhaps not as cheap as before, but they are still not paying on their bonds the interest rates charged on junk bonds."

Close acquaintance with Israel

Having discussed the distorted incentives enjoyed in the global banking system, we are taking the time to discuss the local problems we are facing here in Israel. Peltzman has longstanding relations with Israel and he has been following the Israeli financial system since his days as a visiting scholar at the Hebrew University of Jerusalem's Institute of Advanced Studies, in 1978. He also maintains close ties with the top echelon of Israel's economy. He knows Jacob Frenkel [former Governor of the Bank of Israel and currently Chairman of J.P. Morgan Chase International] and Stanley Fischer [the current Governor of the Bank of Israel] from way back in the 1970's, when they first met on the snowy lanes of the University of Chicago, and he meets with Fischer, as well as with other senior policy makers on his visits to Israel. During his last visit to Israel, he discussed with [Prof.] Eugene Kandel, Head of the National Economic Council, the centralization reform, so he tells us.

His close acquaintance with the Israeli economy and its senior officials puts him in a position that enables him to see the big picture, even though not necessarily every minute detail in the picture. "I don't consider myself a great expert on the Israeli banking system," Peltzman said. "I am watching it from the outside and I try to evaluate the message that people inside the system are sending outward. And I have a skeptical ear."

It is the skepticism of Peltzman that leads him to voice certain concern over the stability of the system. "At present, the Israeli banking system is doing well," he stressed and, at the same time, noted: "However, it is susceptible to negative shocks." The safety net of the banks includes various elements, some of which, like the banks' capital notes, Peltzman dismissed as worthless. Ultimately, these too are loans that have to be rolled over, and at a time of crisis, the banks will find it difficult to do it. The relevant figure is thus the core capital of the banks, and the banks in Israel are in fact in the midst of a process of increasing the core capital ratio, which stands at present at about 8%. Peltzman considers it a positive development, although there is still much to be desired.

Is this level of capital adequacy sufficient?

"I am of the opinion that the banks should have much higher capital rates and only once they achieve those rates, they may be given freedom of action. I don't think that regulation of the banks' activity that goes down to details can be effectively carried out. The alternative is thus to let them play with their own money as they deem fit on condition that if they lose, they will not come running to the government asking to bail them out."

Of course, the banks' liabilities and [equity] capital account for only one side of the banks' balance sheets. On the other side there are the banks' assets, that is, the credit they have extended [to various parties]. And on this point too Peltzman finds reason for concern.

"The banks have lent a lot of money to the pyramid companies," Peltzman said. "It is the second issue that you should worry about. In case of a negative economic shock, you should ask yourselves where the losses are likely to originate [and how they are going to be covered]. Well, there is good news and bad news here. First, the bad news — the banks have given numerous loans to highly leveraged companies and these companies are extremely susceptible to negative economic shocks. The good news is that the banks have an order of priorities of their creditors. Is it of any value at a time of economic recession? I cannot tell.

"Hence, there are reasons for concern on both sides of the balance sheet. The banks here [in Israel] still have rather low levels of equity capital on the liabilities side, and they are too concentrated on the assets side, involving primarily the traditional sectors of the Israeli economy. They don't have enough exposure to the hi-tech industry, as the capital there is derived from foreign sources. However, they are exposed to a very large extent to real estate companies and conglomerates and any shock in the real estate sector is liable to have far-reaching negative repercussions."

In conclusion, Peltzman mentioned another cause for concern, the exposure of the Israeli banks to foreign currencies, a problem that is characteristic of countries whose currency is not a reserve currency [currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves] (like the dollar or the euro). "If you are not completely hedged, you are liable to get into trouble for no other reason than exchange rate changes," Peltzman noted, adding: "and we don't know to what extent the banks are hedged — what the CPAs tell you does not necessarily reflect the situation as it really is. The banks would naturally tell you that, at the end of the day, they are totally hedged. However, I am rather skeptic about it."

Not enough shares in the system

Peltzman goes on to say that "In certain respects, Israel is better off than, say, the French banks, which are real junk. The banking system there is a disaster in the making. There are banks in Europe which are in a much worse situation than the Israeli banks.

"My point is this," Peltzman said, summing up the interview, "The Israeli banking system is often over-evaluated; it is presented as far more stable than it really is. I may not be the right person to tell you this, although it is common knowledge. I can simply say it more freely than people who live here."

The situation where banks are giving loans to a relatively small group of leveraged elements "is symptomatic of the underdeveloped Israeli capital market," Peltzman notes. According to Peltzman, the [excessive] reliance on credit and leveraging testifies to the fact that the local stock market is devoid of "depth", as he puts it. There are not enough shares in the system, he adds. I have no idea why you have this practice here, why no one can enter the supermarket business [for instance,] without over- leveraging. Given a more sophisticated financial market, there would have been no problem accomplishing it. In that case, your pension funds would have been invested in shares as well and they would have been of the right asset mix.

"And it isn't only the pension funds," Peltzman says. "It's also the common man on the street that wants to save for his retirement, beyond the pension fund. He invests in real estate, he puts money in the bank, but he has hardly anything in shares."

How would a more developed capital market look like? What does such a market mean?

"It means that you would be able to start a business with credit and develop it up to the point where you can go IPO [go public and offer stocks for sale for the first time]; it means that you would have a fluid stock market, with a large number of growing companies, and that you would not have to go to New York to raise share capital. It means that you would be able to raise share capital locally. Compared with the period I stayed in Israel, 35 years ago, Israel is moving in this direction. But it has been taking too long.

"And another thing," Peltzman adds, "You would let foreign parties in. It's absurd that the same banks that were operating in Israel when I was lecturing here 35 years ago, the same banks with the same market share, more or less, are still operating here. And they all crashed in the 1980's and were [subsequently] nationalized by the government, and then you went on to establish the very same system. So where is the logic here? There is no foreign party active here, with the exception of venture capital funds. You have two separate economic systems here — economy A and economy B, hi-tech economy and traditional economy. Economy A is a system onto itself that works fine, but that's the way it should be with the other economic systems as well."

On the other hand, it seems that no foreign bank is eager to seriously enter the Israeli market.

"You should ask why it is that way. Are the Israeli banks so super-efficient that no one can challenge them? I rather doubt it. And I am not necessarily saying that such entry has to be made on the retail level. It can be accomplished on a higher level."

And if it transpires that entry to the Israeli market is not that lucrative for foreign banks; is there another possible mode of operation?

"It does not have to be banks. The question is, what is the level of financial development in Israel? Traditional economy relies primarily on bank credit. Could it be more varied? And in case the answer is negative, why is it so? These are the questions. The solution could be provided by investment banks too or by venture capital funds. Another possible solution could be business development funds that have public shareholders but that, nonetheless, are buying privately held shares."

By the way, there were private investment companies that entered the Israeli market, like Apax, whose experience here has not been all that successful.

"My suggestions are naturally only part of a [comprehensive] public policy. You are not going to get the change I am taking about if under your judicial system a single individual who owns 5% of the shares can knock out all the minority shareholders. You need to have defenses for the minority shareholders if you want them to enter the market. But the truth is that I would rather not tell you what to do and in what direction to go," Peltzman says smiling. "It's your problem to solve."

Sam Peltzman, 72

Marital status: Married + 2

Residence: Chicago, USA

Education: PH.D. in economics from the University of Chicago

Previous roles:

- Economic adviser at the White House under the Nixon administration.

- Visiting scholar at the Hebrew University of Jerusalem's Institute of Advanced Studies.

Read More: http://www.al-monitor.com/pulse/business/2012/07/sam-peltzman-the-banks-in-israel.html

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