The financial results of the banking corporations continued to deteriorate in 2002, as they had in 2001. The total income of the five major banking corporations was half the 2001 amount, standing at NIS 1.1 billion-reflecting a return on equity of only 2.8 percent. This low level is explained mainly by the realization of credit risks, which required a significant increase in loan-loss provision. While the exacerbation of credit risks in 2002 derived from the continued recession, it was also the product of deficiencies in the management of bank credit in previous years-placing credit at relatively high risk, at prices that did not reflect that risk, undue reliance on collateral (sometimes even without the right of recourse to the borrower), and tardy acknowledgement of the aggravation and realization of risks.

The deterioration in the quality of the credit portfolio encompassed most of the principal industries, especially the technology sector, and the communications, computer services. construction, real-estate, hotels, and food services and catering industries. The repayment ability of the household sector was also adversely affected, but this has not yet been reflected in the banks' financial statements.

Banks' managements and boards of directors must monitor the process of identifying and classifying problem loans more closely, as well as making adequate loan-loss provision against them.

Another problematic aspect of credit management in Israel is the large share of overdrawn credit in excess of the limits set for customers-a share which has even increased in recent years. Overdrawn credit is problematic from the customer's point of view, as he cannot be sure what his credit limit is, to what extent his overdraft withdrawals will be honored, and till when. The customer also pays a heavy toll for overdrawn credit. Overdrawn credit is problematic from the bank's point of view, too, and in order to cope with the credit risk associated with it, special monitoring processes are required on a daily basis. It is our intention to act to improve the banks' management of this area, and to significantly reduce the phenomenon of overdrafts beyond the limits.

The marked increase in risks led to greater stringency in the criteria for extending credit in 2002, and this, together with the banks' desire to improve their capital adequacy, put a stop to the expansion of credit extended to the public, after its double-digit growth rates in the last few years. It also led-for the first time-to a decline in total bank assets. Within the framework of the implementation of the new Basle Committee recommendations after 2006, the banks are expected to allocate capital against credit risks on the basis of sophisticated statistical models. These will help facilitate the calculation of expected losses in the credit portfolio and support the decision-making process regarding credit, including prudent risk pricing.

In the last ten years there has been a constant decline in the banking groups' risk-weighted capital ratio, and in 2001 this was very near the minimum requirement (9 percent). This ratio improved in 2002, but was still about 2.1 percentage points below the level in the OECD countries. Within the framework of the implementation of the Basle recommendations, the banks will also have to allocate capital against operating risks (including fraud and embezzlement), assess their capital adequacy in relation to their profile of risks-which have risen-and build a strategy for maintaining an appropriate level of capital adequacy, beyond both the required minimum and even the current level.

The extraordinary events that have occurred in Israeli banking in the last two years serve to emphasize the need to tighten the banking corporations' internal and external control mechanisms. The banks' internal control systems are the vanguard of defense in preserving the stability of each bank. This was illustrated once again by the collapse of Trade Bank and the lessons to be learned from it. The chapter of the State Comptroller's Report which deals with the functioning of the Banking Supervision Department contains the following: "The Department's basic view of the allocation of duties and responsibilities between it and the bank's management and internal controls as regards embezzlement risks appears reasonable to the State Comptroller. The office of the Comptroller did not find any deficiencies in the actions of the Banking Supervision Department with respect to the embezzlement at the bank that indicate a direct causal connection between them and the failure to prevent or detect the embezzlement at an earlier date." Nevertheless, the State Comptroller recommended that the compliance mechanism for regulating enforcement in the Banking Supervision Department, be reinforced, and in particular that the Supervisor of Banks be empowered to levy administrative fines on banks that breach this regulation. The State Comptroller's comments and recommendations are being carefully considered by the Banking Supervision Department, some have already been implemented and others will be at a later date.

Liquidity risk materialized in Industrial Development Bank in 2002. This was expressed in a run on the bank, in the wake of heavy credit losses, damage to the bank's reputation, and depositors' sensitivity after the collapse of Trade Bank. Consequently, the government and the Bank of Israel decided to take action to immediately stabilize the bank, and subsequently to stop its banking activity once the process of liquidating its assets and repaying its liabilities to depositors and the Bank of Israel was concluded. Against the backdrop of this event, in view of developments in the banking world which had brought liquidity risk into the limelight in recent years, as well as in light of the relevant recommendations of the Basle Committee, the Banking Supervision Department issued a special regulation requiring the banks to manage their liquidity with the aid of sophisticated models.

Another lesson to be learned from these events is expressed in the Bank of Israel's recommendation that a formal deposit-insurance scheme be introduced in Israel. By 2002 72 countries had systems of this kind, 30 of them introduced in the last ten years, in the context of the financial crises of the 1980s and 1990s. In order to guarantee the success of Israel's deposit-insurance scheme it is important to learn from the experience of other such systems elsewhere, choose the appropriate time for establishing it, and designing it so that its existence does not impair the conservatism and caution required in risk management.

The Banking Supervision Department attributes utmost importance to fairness in customer-bank relations, as well as to full transparency and disclosure to customers. In 2002 the Department acted to increase the transparency of the banking system by expanding and improving the rules of disclosure regarding fees and interest rates, regulating the procedure regarding the appointment of compliance officers designated for consumer-related issues, etc. Much still remains to be achieved in this respect, and the Department will continue to work to improve these matters.

Chapter 1 - Israel’s Banking System: A Long-Term View
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Israel's banking system underwent a very difficult year in 2002, even more difficult than 2001. Taking a long-term view, these two years were exceptional in many aspects: return on equity (ROE) in the five major banking groups fell to a low single-digit average of 4.4 percent-comparable only to the level at the end of the 1980s and the beginning of the 1990s (Figure 1.2)-with a marked rise in the variance between the different groups. The decline of ROE in 2002 was the outcome of the combination of a halt in the increase in bank credit (which rose by 1.6 percent after increasing at a two-digit annual rate throughout most of the 1990s), a stable total net interest margin (NIM) (2.3 percent in 2002) and a significant rise in credit risks in 2001 and 2002. The increased risks were reflected by annual loan-loss provisions at unprecedented levels of about NIS 4.6 billion in 2001 and NIS 7.3 billion in 2002 (compared to about NIS 2 billion in 1999 and 2000). The ratio of annual loan-loss provision to outstanding credit more than doubled in the last two years, and reached 1.32 percent in 2002. The ratio of problem loans to equity in the banking groups has also risen sharply, from an average of 0.8 in second half of the 1990s to 1.3 in 2002, and so too has the share of problem loans in total bank credit, from 7 percent in 2000 to about 10 percent in 2002 (Table 1.3).

In April 2002 an operational risk was realized that resulted in the collapse of a commercial bank, the first since the bankruptcy of the North American Bank in 1987: a case of embezzlement was discovered in the Trade Bank amounting to more than the bank's equity. In the course of 2002 the situation of the Industrial Development Bank of Israel deteriorated due to the realization of liquidity risk, against the background of problems in its management of credit risk, the realization of its reputation risk, and the sensitivity of its depositors following the collapse of the Trade Bank. In the light of these developments, the government (the bank's owner) decided to introduce steps that would lead to the ending of the bank's activity.

The combination of the fall in ROE and the rise in risks led to a significant reduction in risk-adjusted return on capital (RAROC) in the banking system, and this was reflected by the erosion of more than half of this return in the last two years in most of the banking groups. The leading credit rating companies Moody's, Fitch, and S&P also assessed that the performance of the large banks had greatly deteriorated in this period and was not expected to improve in the near future, and they therefore reduced their ratings. Operators in the capital market were also of the opinion that performance had declined in the banking system and that no improvement was expected in the near future. These assessments found expression in sharp falls in the prices of shares of most banks, so that the market value of banks at the end of 2002 was only 70 percent of their book value. This decline in market value to book value (MV/ BV) of banks was an extension of the trend that had started at the beginning of 2000.

The dismal picture that emerges regarding competition and risks, and the indices that combine them, also encompasses the two other tests normally applied in analyses of the robustness and market functioning of a banking system, i.e., competition and operating efficiency.

With regard to competition, particularly in the area of credit to the public, the situation has been deteriorating for some years, as can be seen from the rise in several concentration indices since the mid-1990s. This is mainly due to the fact that in the last few years the large banks in Israel gave large amounts of credit to large borrowers who in some cases proved to be problematic. In the industrialized countries there has been a general increase in concentration, but this was due to a rise in mergers and acquisitions (M&A), that has at least till now passed over Israel's banking system (except for a few mergers of small banks with large ones). Regarding competition it is important to emphasize the “market power” exercised by the banks over households is generally greater than that which they yield over businesses.

As far as operating efficiency is concerned, although some of the banks did introduce measures in the last two years intended to reduce operating costs- wage cuts, encouraging early retirement, laying off staff, closure of redundant branches-but due to the high expenses involved in early retirements, there is no evidence yet of significant improvement in the indices of operating efficiency normally used in banking, such as the efficiency ratio or the coverage ratio, which have not changed significantly in the last few years.

Many of the negative developments described above were affected very strongly by the deep economic recession that has persisted for some years (with negative GDP growth rates and a marked rise in unemployment), by the escalation of security incidents, and the prevailing political and economic uncertainty. It appears that the capital market crises in Israel and throughout the world (for example the collapse of the Nasdaq in the US and its failure to recover) had a negative effect on the banks' performance in 2001 and 2002.

Macroeconomic developments also affected the activity and performance of principal industries, headed by construction and real estate, tourism and hotel services, high-tech and communications, and recently also the household sector, and this also had a significant adverse effect on the banks' performance. This is reflected in the sharp rise in the credit/output ratio in these industries and in the rates of loan-loss provision for credit extended to them.

Against the background of higher credit risk and lower profitability, the banks improved their capital adequacy slightly in 2002: the risk-weighted capital ratio of the five major banking groups rose by half a percentage point from 9.4 percent to 9.9 percent. Nevertheless, the capital ratios in Israel remain about 1–2 percentage points lower than those in most other banking systems throughout the world. Against the background of the persistent recession and the continued deterioration expected in businesses' and households' repayment ability, it would be advisable for banks to continue to improve their capital ratios, to be better able to deal with the possible future realization of risks.

Chapter 2 - The Financial Activity of the Commercial Banks
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The year 2002 was a difficult one for the Israeli economy, and the worst experienced by the banking system in the last decade. A combination of domestic and external factors had an adverse effect on the activity, risk exposure, and financial results of the banking system. The banking system was influenced by macroeconomic conditions, chief among them the recession, but it also influenced them, and its moderating effect could increase in the future.

The year was notable for the cessation of the expansion of bank credit to the public, and this remained at its 2001 level after having risen continuously and markedly for the last decade, in years of both boom and recession. The deterioration in 2002 stemmed primarily from the contraction of the supply of credit by the banks, but also from the fall in demand for it by firms and households, because of the recession.

The quality of credit from Israel's banking system has also deteriorated in the last two years, making increased loan-loss provision necessary. This eroded banks' capital and led to greater caution in extending credit. Credit substitutes offered by extra-bank intermediaries continued to contract in 2002, because of the slump in the capital markets in Israel and abroad and the rise in the risk premium ascribed to Israel's economy and firms in it, in view of the ongoing deterioration in economic activity and the geopolitical situation.

Another change that characterized 2002 was the real decline in the supply of the public's deposits in banks and the general contraction of the public's asset portfolio, after positive growth rates for the past ten years. The contraction stemmed from the fall in disposable income and the private saving rate, as well as the erosion of the value of the shares in the public's portfolio. An examination of the public's asset portfolio shows a marked shift away from unindexed deposits to those indexed to the CPI and foreign currency—due to the marked rise in the inflation rate as well as to local-currency depreciation. There was also an appreciable decline in the proportion of shares in the portfolio due to the erosion of their value, and a rise in residents' investments in banks abroad.

Interest rates in local-currency activity channels rose during 2002 as a result of the hike in the Bank of Israel's key interest rate, which was part of monetary policy, and the increase in net borrowing by the government, restriction of credit by the banks, and greater interbank competition for sources. The effects of all these left the total net interest margin close to its 2001 level (1.9 percent, compared with 2.0 percent in 2001), and the net interest margins in other intermediation segments also remained at similar levels to the past, with the exception of the foreign activity segment, where it rose.

Chapter 3 - Financial Results
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The banking system experienced an even more difficult year in 2002 than in 2001; total profit of the five major banking groups declined from NIS 2.3 billion in 2001 to NIS 1.1 billion in 2002. This reflects a fall in return on equity from 5.8 percent to 2.8 percent-the lowest level of profitability recorded in the last decade. However, profitability varied widely among the five major banks-from a positive return of 8.6 percent at United Mizrahi Bank to a negative return of –1.4 percent at the First International Bank. The low levels of profitability of the five major banking groups in 2002 and their wide variance are explained primarily by the loan-loss provision, which reached an unprecedented level of NIS 7.3 billion in 2002 compared to NIS 4.6 billion in 2001-in itself a high level. The exceptional size of the loan-loss provision was due to the worsening recession in Israel that followed the escalation of security incidents, and the continued worldwide economic slowdown, particularly in the high-tech industries, which eroded the solvency of many businesses. It may also have revealed deficiencies in credit management by the banks in previous years.

The differential effect of the loan-loss provision on the profitability of the five major banking groups stemmed mainly from differences between them in the amount of credit extended to business enterprises, in particular to those operating in industries worst affected by recent economic developments (e.g., communications and computer services, manufacturing, construction and real estate, financial services, and hotels and catering). On the other hand, the loan-loss provision for retail customers was low, enabling the banks to achieve profitability, albeit at a low level, even in this difficult year.

The recession also left its on the banks’ interest and non-interest income, both of which remained relatively stable. The banks also succeeded in halting the rise in operating expenses and even reduced them, thus improving operating efficiency. This meager improvement, however, did not offset the adverse effect of the steep rise in the loan-loss provision.

Chapter 4 - The Main Companies in which the Five Major Banks’ Have a Holding
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The five major banks’ investments in consolidated and non-consolidated companies, mainly in areas that constitute significant profit centers for the banks-the mortgage banks and banking companies abroad-increased to a considerable extent in 2002. However, investments in non-financial companies continued to decrease. The investments in the principal consolidated and non-consolidated companies yielded income similar to that recorded in 2001. <

The main companies in which the banks have holdings (Table 4.1) engage in banking activity abroad (27 percent), mortgage loan activity (20 percent), commercial banking (9 percent), other financing activities complementing the banks’ business activities (22 percent), non-financial activity and insurance (5 percent), capital market activity (3 percent), credit card activity (2 percent) and investment in other companies.

During 2002, investments in consolidated and non-consolidated companies yielded income of NIS 1.4 billion and a return of 5.2 percent (Table 4.1). This was below the average rate of 6.5 percent recorded during recent years, and less than in 2001 (5.7 percent). 

Local companies engaged in non-financial activities (insurance, income-earning real estate, housing construction and hotels) as well as companies operating in the capital market recorded substantial losses in 2002. However, overseas companies contributed NIS 976 million to the banks’ income. This contribution resulted from the increased profitability recorded by certain of these companies, and from exchange rate differentials on the banks’ investments in the companies that derived from the real depreciation of the shekel against the companies’ host countries. These results highlight the importance of investment dispersal, and especially dispersal between the local market and foreign markets.

The mortgage banks presented high profitability in 2002 as in recent years (9.3 percent), although this profitability was lower than the average for the past decade. Their income stability, as well as the decline expected in various income items, are encouraging the mortgage banks to increase their efficiency by reducing operating expenses and by closing branches, as well as by examining the possibility of mergers with the parent commercial banks.

Investments in non-financial companies, which are mainly held by the two largest banks, fell to NIS 1.5 billion. Once again, the return on these investments was negative, to the amount of NIS 61 million, due inter alia to the adverse impact of the recession on companies specializing in real estate and tourism activity, and the continued crisis in the high-tech industries.

Chapter 5 - Risks and Capital Adequacy
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The continued recession in the Israeli economy during 2002, which resulted from the global economic recession and the security situation in Israel, increased the banks’ exposure to credit risks and market risks in the course of the year. Exposure to credit risks increased considerably due to the decline in borrowers’ repayment ability and the serious deterioration in the quality of the credit portfolio. The ratio between non-performing loans and shareholders equity rose at all of the banking groups. The ratio of problem loans to outstanding credit, and the ratio between the annual expense on loan losses and outstanding credit increased at most of the banking groups. The ratio of risk assets to total assets (before risk weighting), which reflects the extent of risk in the asset mix, and the ratio between credit and business sector product, which reflects borrowers’ repayment ability, did not change to any major extent compared with 2001, although they were higher than in previous years. The deterioration in the quality of the credit portfolio encompassed most sectors of the economy and particularly the high-tech industries, and the communications and computer services, construction and real estate and hotels, and food and accommodation services industries.

The rapid expansion of the credit portfolio typical of previous years ceased in 2002, mainly due to the materialization of credit risks and the decrease in capital ratios towards the minimum required level in 2001.

As in previous years, the credit portfolio by borrower size was notable for relatively high concentration and for variability between the banking groups.

The banks’ exposure to interest-rate risks (as estimated by Value at Risk) increased in the three indexation segments at all five banking groups in 2002, and all the groups were exposed to an unexpected rise in the interest rate. However, exposure to indexation-basis risk (inflation and exchange rate risks) fell slightly at most of the banking groups, and most of the groups were exposed to an unexpected rise in the consumer price index and to an unexpected decrease in the real shekel-dollar exchange rate.

In April 2002, the embezzlement by an employee of the Trade Bank to the amount of NIS 254 million - five times the shareholders equity of the bank- was revealed. As a result, the Bank of Israel had to seize the bank immediately, and sent it for liquidation. This event served to highlight the significance of operational risk, and the damage that can be caused when this risk materializes.

At the end of the first half of 2002, liquidity risk materialized at the Industrial Development Bank. This was reflected by massive withdrawals of deposits from the public that resulted from the incompetent management of credit risks, the materialization of the bank's image risk, and depositors’ sensitivity following the collapse of the Trade Bank.

Capital adequacy, the principal function of which is to enable the banks to absorb losses that could be caused due to risk materialization, increased in 2002, due mainly to the halt in the growth of credit to the public, but is still lower than in most Western countries. The increase in Tier 2 capital, whose characteristics are less stable than those of Tier 1 capital, continued in 2002. The ratio of deferred notes to Tier 1 capital rose, and at most of the group's came very close to the restriction imposed by the Supervisor of Banks.

Chapter 6 - Structure of the Banking System and Activities of the Banking Supervision Department
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The main goals of banking supervision are to maintain the stability of the banking system in a changing economic environment, protect depositors’ money, and encourage fairness in bank-customer relations without compromising the competitive nature of the system. The Banking Supervision Department acts at various levels to attain these goals, including supervising the banks’ business activities, the soundness of their management, monitoring their ability to manage risks and adjust to economic developments, regulating the system by means of regulations and guidelines; performing inspections; monitoring relations between banks and their customers; ensuring that the banks provide capital against unforeseen risks; and credit restrictions at the single-borrower and single-industry levels, to name but a few.

In 2002, in addition to its ongoing activities, the Department engaged in regulation in various fields: the appointment of compliance officers, procedures related to bank fees, banking corporations’ repurchase of their own shares, prevention of money laundering, customer identification and record-keeping, information retrieval, financing of corporate takeovers, accounting rules for derivatives and hedging activities, etc. The Department also examined banking corporations’ exposure to various credit risks after the transitional provisions of the Prohibition of Money Laundering Order went into effect, preparations for emergencies, and other matters. In view of the persistence of the economic and security problems that were evident in 2001, the Department performed special credit inspections with emphasis on evaluating the adequacy of the categorization of problematic and dubious debts and inspected on-line banking services.

The number of bank branches continue to decline in 2002, in line with the trend of the three previous years, and the banks’ use of temporary branches leveled off. Greater use was made of the Internet and other technological media that give consumers direct-and almost immediate-access to banking information and allow customers to perform banking transactions without visiting the bank branch. The number of registered users of on-line services climbed to 700,000, and the number of requests for information on-line came to 16,000,000 on monthly average.