The financial results of the banking corporations and their capital adequacy continued to improve in 2004. This is an indication of the greater strength of the banking system - the outcome of only a minimal increase in the credit portfolio and a sharp rise in profit. Most of the components of income and expenditure contributed to the high profits recorded by the banking system in 2004, in particular the steep rise in net interest income and the decline in loan-loss provision. The economic recovery together with lively activity in the capital market also boosted banks' income from fees and commissions. The rise in banks' profit was slightly reduced by the increase in labor costs, especially direct salary expenses.

Despite the economic recovery, credit risk remains high, as can be seen from the high proportion of problem debts in total credit (11 percent), from the loan-loss provisions, and the high proportion of these provisions in total credit. The construction and real estate industry-which has long suffered from a recession-constitutes a special risk. This makes it incumbent on the banks to continue to exercise great caution in their credit-risk management and to pursue a conservative policy with regard to their loan-loss provisions.

There was much improvement in the concentration in the bank credit portfolio, with the main reduction taking place among the large borrowers: the share of credit to borrowers whose balance of indebtedness exceeded 5 percent of the banking groups' equity fell in all the five largest groups by between 10 percent and 48 percent. This was due to stricter definitions of large groups of borrowers in the Banking Supervision directives and also to the increase in the banks' capital. The concern expressed prior to the introduction of the directive, that the contraction of credit to the banks' large borrower groups would result in a credit drought in those groups, proved to be unfounded as they switched their demand for credit to the capital market, thus contributing to the development and deepening of the nonbank credit market.

Recently (in July 2005), the legislation required to implement the recommendations of the Bachar Committee was completed. The Banking Supervision Department, which was a full partner in the formulation of the recommendations, does not view this reform as a threat to the banks stability, but as an important opportunity to enhance Israel's money and capital markets, increase competition and minimize conflicts of interest. Separating the ownership of capital-market activity (insurance, provident funds, pension funds and mutual funds) from the banks will allow them to constitute a competitive threat to the banks. Research carried out recently by the Banking Supervision Department showed that in banking systems that are more exposed to competitive threat, even in very concentrated banking systems, the level of competition is higher. Separating the ownership and management of the funds from the banks will greatly help the development of a deep and active capital market that will enable the banks to manage credit risks, market risks and liquidity risks more effectively, and to share these risks with market factors. The separation of ownership will also tackle head-on the problem of irregularities that came to light with regard to banks' advice to their customers about the worthwhileness of investing in their various funds (together with the operational/legal risk inherent in this unacceptable practice). Moreover, separating the funds from the banks will enable the banks' distribution network and skill in economic analysis to be utilized for their customers' benefit by offering objective advice about the purchase of the instruments most appropriate to each customer.

As part of the reform, the authority of several supervisory bodies was extended and combined. This included giving a legal basis to the authority of the Supervisor of Banks to issue directives on the proper conduct of banking business. The Supervisor was also given authority to impose an administrative fine on banks that breach the rules set out in laws or directives. These changes complete the previous legislation, passed in 2004, that among other things authorized the Supervisor of Banks to intervene to prevent the appointment of, or remove from office, any official deemed unfit to hold office in a bank. The above measures all improve the effectiveness of the Banking Supervision in the areas of stability and bank-customer relations.

The Basel II principles are intended to improve risk management, including the management of capital adequacy, in banking systems throughout the world. The Banking Supervision Department considers the implementation of these principles to be a major strategic target in the next few years, part of the process of improving banks' credit-risk management. It is important that the large banking groups adopt the advanced-internalmodels approach to calculate capital adequacy, in order to create a closer link than existed previously between capital adequacy and the risks that banks are exposed to. With regard to credit, the banks will have to upgrade their borrowers' rating systems so that they are consistent with the Basel II framework, according to the guidelines published by the Banking Supervision Department. Substantial upgrading is also required in the area of internal auditing and management of banks' operational risks, as required by the Basel II guidelines and the new standards introduced in the advanced economies.

The process of merging the very small banks in Israel into larger banks, or ending their operation as banks, gained momentum in the last few years and has almost been completed. Six very small banks were bought and merged into large banks, two others ceased their activity as banks and relinquished their licenses, and the license of one bank was revoked. This was also due to the deliberate policy of the Banking Supervision Department, as the very small banks encountered difficulties in surviving at the level of expenses currently required to operate management and control systems appropriate to modern banking. These banks had a high risk profile while they made hardly any contribution to competition in the banking industry. The Banking Supervision Department closely accompanied this sensitive process to ensure that it succeeded, while protecting customers' deposits and general interests.

The Banking Supervision Department pays close attention to and invests considerable resources in the subject of bank-customer relations:
The Supervision policy on bank charges was reviewed, and criteria were formulated governing its intervention regarding the level of certain charges, mainly those that adversely affect competition or reflect the absence of competition. The Banking Supervision Department proposed that legislation be passed on this matter, authorizing supervision over this area too. In the context of measures taken to increase competition, the Supervisor of Banks recently issued a directive on Transferring Activity and Closing a Customer's Account, intended to simplify the technical procedures incurred in transferring from one bank to another, and to minimize the inconvenience to customers undertaking this step. In order to deal with the problem of deviations from credit frameworks, a directive was formulated requiring banks to draw up an agreement for each customer wishing to have a credit line that matches his requirements, repayment ability and collateral, and that does not allow any deviation from it whatsoever. The system of account management that took root in Israel, typified by significant long-term credit in excess of the credit limit, harms customers by dint of the uncertainty regarding its terms and the considerations that guide the bank in its decisions as to which debits to decline. This makes it difficult to enforce the Checks Without Cover Law, and thus harms people holding such checks and undermines the public's confidence in this means of payment. From the point of the view of the banking corporation, its control over the credit risk of those specific borrowers and its ability to assess in advance the overall risks of its portfolio are likely to suffer too.

In 2004 the Banking Supervision Department also updated the arrangement concerning debit cards: the rules of issuing them, handing them over (and the cautionary steps to be taken in these processes), their renewal and cancellation, and the system for dealing with transactions extending beyond the cancellation of a card. Also, the information provided on the monthly statement about the conversion of foreign currency in purchases made abroad, and the disclosure of the method of accumulating points or stars and their redemption has been broadened.

To summarize: the improved strength of banks provides a good springboard for the achievement of the targets of the next few years--reorganization of management, operating and control systems and corporate governance in line with the advanced standards underlying Basel II; implementation of the reforms proposed by the Bachar Committee; and increasing the level of competition in banking and in other spheres of financial activity, at the same time streamlining and innovating, and improving the price and level of service to the customer. The Banking Supervision Department will closely accompany and lead these processes, while continuing to improve the level of disclosure to the customer and the propriety of the latter's contacts and activity with the bank.

Table of contents
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Chapter 1 - Israel’s Banking System - Activity, Financial Results and Risks in 2004
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Chapter 2 - The Structure of the Banking System
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Chapter 3 - Activities of the Banking Supervision Department in 2004
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