The Past, Present, and Future of Israeli Finance

How Ongoing Reform Is Transforming Israel’s Capital Markets, Business Landscape, and Private Wealth

By Brian J. Friedman, CFA, CBE

President, Co-Founder, and Portfolio Manager of Israel Investment Advisors, LLC,

https://israelinvestmentadvisors.com/

April 2021

Prologue: From Start-Up Nation to Scale-Up Nation

While technology start-ups punch well above their weight in Israel, they hit significant barriers as they grow. Technology pundits in Israel often lament the “early exit” problem. They usually blame founders, investors, or managers for selling out to larger companies too soon, but they often miss the true culprit: small, illiquid, and therefore inadequate capital markets.

Well-functioning stock and bond markets gather and reallocate large amounts of capital from thousands or even millions of investors, enabling companies to achieve significant scale. In the U.S., for instance, new stock issues between 2010 and 2019 allowed companies to raise $2.2 trillion from public equity, 3.4 times the amount that venture capitalists invested into American technology start-ups over the same period. The ratio was even higher before the 2008-09 Financial Crisis. By contrast, Israeli technology start-ups are more dependent on private equity. During the same decade, they raised 1.8 times as much from venture capital as from the Tel-Aviv Stock Exchange (TASE). (See Chart 1).

Israel’s innovative tech companies have given it a reputation as the “Start-Up Nation,” yet the technology sector employs just 9% of the Israeli workforce and accounts for a similar percentage of Gross Domestic Product (GDP). To become a “Scale-Up Nation,” Israel must develop more robust capital markets. Fortunately, a financial revolution is already underway in Israel, but global investors seem unaware because it emanates from outside the technology sector.

As Dan Senor and Saul Singer so eloquently describe in the book Start-Up Nation, technological innovation rests upon many of Israel’s strengths as a country and Israelis as a people, including a culture of frank communication, critical thinking, creativity, immigration, military necessity, and pro-innovation government policies. But Senor and Singer underemphasize that the technology sector also flourishes because it is unencumbered by Israel’s formerly socialist economic system. Israel’s financial institutions

and financial markets, however, were the beating heart of its socialist past.

This report sketches the transformation of the Israeli financial system from its socialist beginnings to its capitalist present and its free-market future. After several decades of reform and restructuring, the Israeli financial system is now on a path of convergence with the dynamic competition and innovation on display in the technology sector.

From Financial Basket Case to Economic Success

The backdrop of Israeli finance is rapid economic and population growth. From the 1920s through the 1960s Israel’s highly monopolized socialist economic structure was remarkably efficient. The population was very small but growing rapidly. These two characteristics – small scale and rapid growth – kept the inefficiencies of socialist monopolies in check, since Israel could not support large scale competition during its formative years.

By the early 1970s a larger Israeli population exposed the inefficiencies of the mature socialist system. Economic growth stagnated, exacerbated by global economic stagflation and mounting military expenditures in the aftermath of the 1973 Yom Kippur War. By the early 1980s, the Israeli economy was in crisis.

In October 1983, the Israeli government nationalized the banks amidst financial collapse and hyperinflation. By 1984 the inflation rate was approaching 500% per year ➀, and Israeli government debt exceeded 280% of GDP ➁. Money-losing businesses owned by the state or the quasi-state Histadrut labor union comprised 2/3 of GDP. The small, overregulated private sector was losing competitiveness. The Israeli economy was in dire straits and its financial system bankrupt.

As it turned out, this economic crisis laid the foundation for Israel’s future success. At the core of Israel’s economic transformation over the past three decades was a gradual but fundamental restructuring of its financial system.

Finance in Israel is moving away from its monopolized, bank-dominated, political, and sometimes corrupt past toward more competition, greater reliance on capital markets, fewer conflicts of interest, and a more commercial orientation. While much work remains to elevate Israel’s financial system toward the sophistication of the United States or the United Kingdom, there is good reason to believe Israel is moving in that direction.

The 1983 Bank Stock Crisis

In the late 1970s and early 1980s, the banks perpetrated a national Ponzi scheme using their own publicly traded stock on the TASE. When their stock prices dipped, the banks purchased their shares on the open market to boost prices. When their share prices increased, the banks issued new stock to the public. Bank executives tried to limit losses during downturns while providing reliable capital gains to their shareholders. These financial maneuvers ultimately triggered the collapse of Israel’s financial system.

The Israeli economy struggled in the aftermath of the 1973 Yom Kippur War. Global stagflation (stagnant economic growth in combination with accelerating inflation), escalating defense expenditures, and excessive government involvement stunted the Israeli economy. In this deteriorating environment, the banks continuously required additional capital to shore up their balance sheets. To raise the necessary cash, bank executives issued stock to the public. Israelis believed bank stocks provided a risk-free, high return alternative to bank deposits. By 1983, the banks had raised substantially more cash from share issuance than their entire market value in 1977.

Bank HaPoalim started the “adjustments,” as the stock manipulations came to be known, in the early 1970s. By the end of the decade, seven out of Israel’s eight banks, representing almost all commercial banking activity in the country, were regularly adjusting their share prices. These seven banks comprised 60% of Israel’s $20 billion total stock market value ➂. Although big relative to Israel’s $30 billion economy, Israel’s financial problems were tiny by global standards. For comparison, U.S. stock market capitalization was $1.8 trillion in 1983 and U.S. GDP was $3.6 trillion.

In the fall of 1983, bank share prices plunged amidst heavy selling pressure. As before, the banks intervened to purchase their own stock. This time, however, the banks strained their liquid reserves in a vain attempt to support their share values. To forestall a run by jittery depositors, the Israeli government seized the banks and closed the TASE for 18 days. Bank shareholders received government guaranteed bonds as compensation.

The Crisis Revealed Structural Flaws in the Israeli Financial System

A variety of structural flaws in the Israeli financial system contributed to the Bank Stock Crisis of 1983. The banking system was highly concentrated and political. The three largest banks – Bank HaPoalim, Bank Leumi, and Israel Discount Bank – accounted for 80% of deposits and assets. Israeli banks reflected the tripartite structure of the Israeli economy. Bank HaPoalim emerged from the quasi-state Histadrut sector and was controlled by its economic arm, Hevrat HaOvdim ("Society of Workers"). Bank Leumi came from the World Zionist Organization and later the state sector, and Israel Discount Bank (IDB) from the private sector (see Figure 1).

Bank HaPoalim

Bank HaPoalim was controlled by the Histadrut labor union, financed Histadrut business operations, underwrote and brokered securities for Histadrut companies, managed Histadrut pension assets, and directly owned equity stakes in Histadrut companies. The Histadrut, through its Hevrat HaOvdim holding company, controlled monopoly or oligopoly businesses accounting for approximately 1/3 of Israeli GDP. The Histadrut controlled the national health insurance system called Kupat Holim and large pension plans. Every worker in Israel belonged to the Histadrut to gain access to Kupat Holim, and, for many, the pension system as well.

With its resources and vast reach within Israeli society, the Histadrut was an important source of patronage and power for politicians since the days of the Yishuv (the moniker of the pre-state Jewish community in Palestine). The Histadrut empowered a coalition of socialist political parties that controlled the Yishuv and, after independence in 1948, the Israeli government until 1977. In 1968, three social-democratic parties merged to form the politically dominant Labor Party. Even after losing political power in the elections of 1977, the Labor Party and its social-democratic allies retained control over Histadrut companies until privatization in the 1990s.

Bank Leumi

Bank Leumi was controlled by the Jewish Colonial Trust, founded by Theodore Herzl and the World Zionist Organization in 1902. Originally established to funnel philanthropic donations from Jews in Europe to fund Zionist settlement activities in the Yishuv, Bank Leumi operated as a de-facto central bank in pre-state Palestine. After the State of Israel was established in 1948, Bank Leumi was the financial hub of the growing state sector.

While the Histadrut came to dominate the economy of the Yishuv, state-owned monopolies and oligopolies established by Israel’s early socialist governments eventually controlled an additional 1/3 of GDP. Although technically independent, Bank Leumi was also politically influenced by the dominance of the Labor Party and its predecessors during the early decades of the new state.

Israel Discount Bank

Of the large banks, only Israel Discount Bank (IDB) was established as a profitmaking enterprise. The private sector in Israel, however, was dwarfed by state and Histadrut owned monopolies and hemmed in by extensive government regulation. Success in the private sector often required patronage, contracts, joint ventures, or other politically oriented business dealings with public sector companies or regulators. As such, IDB was deeply entrenched in the political provision of capital in Israel just like Bank HaPoalim and Bank Leumi.

The smaller banks in Israel often served specialized purposes but were nonetheless often connected to the political system. For example, Israel’s fourth largest bank, Bank Mizrachi, was established in 1923 to fund the settlement activities of religious Zionists affiliated with HaPoel Mizrachi (later the National Religious Party). Bank Igud (Union Bank) was established by the Jewish Agency (the primary Jewish governance institution in the Yishuv and an important parastatal organization after independence) in the 1950’s to channel capital to Israel’s war-ravaged diamond industry.

Commercial banks, and most particularly the big three, also controlled securities underwriting, trading, and investment brokerage, as well as pension and asset management. Under Israeli law, banks were exempt from insider trading restrictions. Bankers exploited conflicts of interest. Brokers working for the banks promoted their own company stock to clients. Bank executives used pension and provident fund assets to purchase their own shares. This heavy concentration in the banking system across a variety of important business lines meant that nationalization was not just the government rescue of a few banks but of nearly the entire financial system.

The Economic Stabilization Plan and Privatization

In 1985, a national unity government enacted a sweeping Economic Stabilization Plan to curb hyperinflation. Israel slashed government spending, imposed wage and price controls, and stopped printing money to fund budget deficits. Within two years, the inflation rate dropped to 20% and fell below 10% by 1995. As economic growth resumed and inflation eased, the banks slowly recovered.

Anticipating eventual re-privatization, the Israeli government maintained the independent identity of each bank it owned. The government nursed the economy to health in the years following the Economic Stabilization Plan, thereby restoring the profitability and capital base of the banking system. Although the government managed the banks’ balance sheets prudently and conservatively, it left the concentrated and conflicted structure of the financial system intact. It also left the expensive unionized workforce untouched.

The economic crisis receded in the 1990s, but Israel was still encumbered by significant fiscal constraints. Global investors were reluctant to extend credit to Israel except at high interest rates. To finance deficit spending, the government forced pension plans to buy specially designated bonds at lower interest rates, diverting capital away from corporate bonds, stocks, real estate, or infrastructure. While the U.S. government provided economic assistance and guaranteed a portion of Israeli debt, the Israeli government looked to further boost revenue by selling the banks.

By the early 1990s the banks were recapitalized and ready for sale. The government wanted to plug its yawning budget deficit by selling 100% of all bank holdings, but several obstacles hindered their rapid transfer back into the private hands. Due to Israel’s socialist origins, economic turmoil, high inflation, and high taxes, the private sector was small and domestic private wealth in short supply. The TASE was poorly capitalized and illiquid, impeding large IPOs. Meanwhile, IPOs on foreign exchanges or sales to foreign investors ran up against Israel’s legacy of government ownership, heavy regulation, and political interference in the economy and financial system.

With private capital inadequate to purchase all of the nationalized bank holdings, the government kicked off its privatization drive in 1993 by selling those holdings piecemeal on the TASE, listing 21% of Bank HaPoalim’s shares and 13.5% of Bank Leumi on the exchange. The government also sold 60% of much smaller Bank Igud (Union Bank) to a consortium of domestic institutional investors.

Insufficient investor interest, budgetary pressures, and political opposition from bank managers and employees pushed the government toward gradual and opportunistic privatization of the banks. Between 1993 and 2018, the government sold bank stock in blocks of varying size, sometimes in public offerings on the TASE and at other times through private sales. Control over the banks remained in flux for many years, allowing collusive owners, managers, politicians, regulators, and borrowers to exploit conflicts of interest. After 25 years of gradual privatization, the government sold its final 5% stake in Bank Leumi in 2018. Effective control, however, shifted to the private sector between 1997 and 2005 as government ownership of the banking system dropped below 50%.

Enter the Tycoons

In 1994, the Israeli government removed Kupat Holim from the Histadrut’s control. Israelis quit the union en masse, depriving the Histadrut of its main sources of income: health insurance premiums and union dues. Under financial duress, the Histadrut started unloading companies, many of which were unprofitable but held potential if properly managed. The Histadrut was an economic colossus in Israel, owning a vast portfolio of large industrial, wholesale, retail, insurance, and primary commodity monopolies.

During the socialist era, many Israelis established small private businesses, but large-scale business success was rare. Direct competition with Histadrut or government-owned companies was very difficult, if not impossible. A few private entrepreneurs exploited cracks in the socialist system to amass great wealth, either through entrée into Israel’s politically influenced financial institutions or via successful foreign ventures. Israel’s now-booming technology sector was still in its infancy. Given the encumbered legacy of private business, Israel’s small cadre of wealthy families typically did not possess enough capital to buy majority ownership of privatized companies.

To acquire privatized assets, Israel’s wealthy families needed additional funding. With so few creditworthy borrowers, limited attention from foreign investors, an illiquid stock market, and a highly concentrated financial system, Israel’s small community of tycoons (as they came to be known in the late 1990s and 2000s) were eager to partner with or take over Israel’s financial institutions.

As the Histadrut and the government gradually liquidated their bank and insurance holdings, the tycoons exploited the opportunity. Control over Israel’s financial institutions allowed the tycoons to build sprawling business empires with privileged access to capital. From the mid-1990s until the global financial crisis in 2008 and 2009, business in Israel resembled a Game of Thrones contest for economic power and supremacy, as tycoons jostled to buy privatized companies.

The tycoon phase of Israel’s economic history began in 1997 when the Israeli government sold a controlling stake in Bank HaPoalim to an investor consortium led by Ted Arison, the Israeli-American founder of Carnival Cruise Lines. Arison’s group included the wealthy Israeli Dankner family as well as several prominent Jewish Americans. They paid the Israeli government $1.4 billion for a 43% stake. A year earlier, Ted Arison purchased a controlling interest in Israel’s largest construction company, Shikun v’Binui, in a privatization sale by the Histadrut. He now controlled Israel’s largest lender as well as one of Israel’s largest borrowers.

Nochi Dankner and his cousin Danny Dankner borrowed 1.4 billion shekels from Bank Leumi to fund their 11.6% ownership interest ➃. The Dankner family had owned Israel’s salt monopoly since 1957, and they used their company – Israel Salt Industries – plus their newly acquired shares in Bank HaPoalim as collateral for the loan. Over the next 10 years, Nochi built Israel’s largest business empire, including holdings in insurance, retail, manufacturing, and mobile telephony.

As with most of Israel’s tycoons, Nochi Dankner’s business empire was highly leveraged and overextended. Poorly timed investments in Las Vegas real estate and the Credit Suisse investment bank eventually forced the liquidation of his holdings and ultimately his conviction in court for securities fraud. Danny became Chairman of the Board of Bank HaPoalim, only to be forced out by bank regulators and then sentenced to prison for self-dealing. As outlined below, overextension and improved regulation eventually unraveled many tycoon business empires.

Erecting the Pyramids

Lacking capital to purchase majority stakes, the tycoons instead built business pyramids. In a typical pyramid, a tycoon established a holding company, usually in partnership with other investors. This primary holding company purchased a minority controlling stake in a large company or companies, preferably including a bank or other financial institution. The directly owned companies in turn purchased minority controlling interests in other companies, fostering indirect control by the owner of the primary holding company. Some pyramids extended to multiple indirectly owned layers. Lax oversight often allowed each level of the pyramid to raise a separate capital structure. By ignoring interrelationships among various levels of the pyramid, the tycoon-controlled bank, insurance company, or other financial institution could maintain the charade of prudent lending while enabling tycoons to amass sprawling but highly indebted business empires. (See Chart 2.)

Privatization allowed the new tycoon owners to exploit the monopoly power and regulatory loopholes that remained in the Israeli banking system, structural flaws that nationalization did not fix. The banks exceeded prudent standards regarding collateral and loan concentration when extending credit to the new owners and their partners. The tycoons also tapped bank-managed pension fund assets to finance pyramid acquisitions.

The three major Israeli banks still controlled almost all financial flows, including capital markets activity such as securities underwriting, brokerage, and fund management. The new owners, like the old ones, suppressed direct competition against affiliated companies by manipulating capital allocation. Potential competitors could not easily access bank loans, issue bonds, tap retirement savings, organize investment funds, or list stock on the TASE. Bank owners and their affiliated companies or pyramids easily accessed capital from all these sources.

Among other political reasons, the government failed to act because Israel’s concentrated system served its need for forced loans from pension and provident fund assets. Israelis mostly save through government mandated pension plans and provident funds (see Chart 3), but for many years Israeli law required these plans to buy specially issued government bonds rather than other investments. This system diverted substantial capital away from business investment to pay government debt obligations.

Israeli Tycoons Were Never Oligarchs

In contrast to many Eastern European countries transitioning from state ownership to a capitalist economy, Israel started with many advantages. Economic power in Israel was concentrated but never monolithic. The private sector survived and expanded from the very earliest periods of the Zionist project in Palestine. Private business often formed partnerships or joint ventures with companies owned by the Histadrut, the state, or the Jewish Agency. Most importantly, Israeli tycoons never became an oligarchic ruling class dominating or threatening the political system.

Since the time of the British Mandate, governance in the Yishuv, and later the state of Israel, was characterized by the rule of law. The judiciary is an independent and co-equal branch of government, headed by a powerful supreme court. The courts were not arbitrary; on the contrary, they followed judicial precedent and legislation enacted by the Knesset. Although Israeli finance was political and sometimes corrupt, all parties, including companies owned by the state or Histadrut, operated within a British Common Law framework that enforced well-defined property rights and contracts.

Oligarchs or other powerful people in many developing countries, and most particularly in the former Soviet sphere, often maintain private security forces or control the state security apparatus for their private benefit. This allows them to use corrupted legal institutions or direct violence in their business and political dealings. While Israeli tycoons could exploit financial conflicts of interest for a time, they never controlled, or probably even considered, private violence or public armed force.

With Israel’s strong rule of law, active democracy, and external security challenges, the tycoons could not translate economic power into significant political power. While some tried to bend legal and regulatory institutions toward their interests, they still operated within the letter of the law. Starting in the 2000s, the tycoons’ pyramids suffered a series of economic and regulatory blows. They initially buckled during the Second Intifada recession. They were further weakened by major financial reform legislation in 2005, pummeled by the Global Financial Crisis in 2008 and 2009, politically whipsawed by massive street protests in 2011, and unraveled by economic restructuring laws in 2013, 2017, and 2019.

The Bachar Committee Reforms: Capital Markets Rising

Privatization removed the state and the Histadrut from dominant positions in economic life, but instead of eliminating monopolies, it merely transferred them to private ownership. Further reforms were necessary to promote business competition. The Israeli government understood that financial concentration was the root cause of economic concentration. In 2005, the Knesset passed “The Law for Encouragement of Competition and Reduction of Conflicts of Interest in the Israeli Capital Markets,” acting on the recommendations of the Bachar Committee (named for its chairman, Dr. Yosef Bachar, Director General of the Ministry of Finance.)

The Bachar reforms mandated that the three largest banks limit their securities underwriting and investment banking activities, as well as divest their pension fund and asset management operations. Israel’s five major insurance companies (Migdal, Clal, Harel, Phoenix, and Menorah) acquired the asset management subsidiaries from the banks. The Bachar legislation also empowered a previously enfeebled cottage industry of independent asset management companies and investment banks. Although traditional bank lending remained concentrated, the stock and bond markets gained traction as viable alternative financial channels.

The Cottage Cheese Rebellion

The Histadrut and the government privatized monopolies in almost every major field, including the Israeli oil refinery, dairy and other food products, shipping, banking, insurance, wholesale distribution, and a host of other industries. The purchasers typically bought companies with weak financials and low valuations. To their credit, the new owners strengthened balance sheets while boosting profitability and growth. Along the way, this small group of businesspeople became the tycoons, in some cases even dollar billionaires.

The public was conflicted about the role of the tycoons in Israeli economic life. On the one hand, these business owners invested in their companies, spurring economic growth and employment. On the other hand, they exploited monopoly power to raise prices and stifle competition.

Following its privatization, the dairy monopoly Tnuva boosted prices by as much as 40%. In the summer of 2011, 500,000 outraged consumers (in a country of 7.5 million at the time) poured into the streets to protest the high cost of living in Israel. Fueling some of the outrage was an outright ban on imported dairy products, a holdover from the years prior to privatization. In response to the protest, the government quickly scrapped the import ban.

To his credit, Prime Minister Benjamin Netanyahu had already taken steps to address the problem upon assuming office. In October 2010, he established the “Committee for the Promotion of Competition in the Economy” a.k.a. the Concentration Committee. Netanyahu explained his reasons for setting up the committee as follows: “I saw that Israeli consumers were suffering from the rise in the cost of living, and because they can compare it with prices for goods and services around the world. We have a cost of living problem because of a lack of competition. My goal is to boost competition in the economy in order to lower the cost of living.” Finance Minister Yuval Steinitz added, “Separating holdings between financial and non-financial companies is essential for creating a more competitive market, as well as addressing the issue of complex structures and pyramids.” ➄

Israel Charges Toward a Less Monopolistic, More Competitive Economy

The Cottage Cheese Rebellion bolstered the authority of the Concentration Committee. In December 2013, the Knesset unanimously passed the “Law for the Promotion of Competition and Reduction of Concentration.” This law launched a profound economic restructuring, reminiscent of Teddy Roosevelt’s early 20th century trust-busting in the United States. The law limited large business pyramids, and, more importantly, mandated separate beneficial ownership of financial and nonfinancial companies. With a deadline of December 2019, the tycoons controlling monopolistic business empires engaged in a flurry of deal‐making.

Examples abounded. Shari Arison, the late Ted Arison’s daughter, sold her inherited Shikun v’Binui stock to an Israeli-American real estate investor. She sold a portion of her Bank HaPoalim shares in a 2018 secondary offering on the TASE. Since she could not find a strategic buyer for her remaining shares prior to the December 2019 deadline set by the Concentration Law, she negotiated an extension agreement with the Bank of Israel (Israel’s central bank and primary banking regulator) to reduce her remaining holdings from 15.7% to below 5% by 2023 through additional stock sales on the TASE.

Her father’s former investment partner, Nochi Dankner, built the biggest business pyramid in Israel through his acquisition of the IDB Group holding company (see Chart 2). At one time he controlled Israel’s largest insurance company (Clal Insurance), largest supermarket chain (Super-Sol), second largest cellular phone company (Cellcom), a major chemical company (Makhteshim Agan), and a sprawling variety of other assets.

In the years since the financial crisis, as regulators and lenders dismantled his pyramid, Dankner resorted to fraudulent stock manipulation in a desperate attempt to save his empire. Instead, lenders foreclosed on his business assets, and he was sentenced to three years in prison. He became Israel’s poster child for the excesses of the tycoon era.

Delek Group, a conglomerate controlled by billionaire Yitzhak Tshuvah, owns Israel’s recently discovered offshore natural gas fields, the second largest chain of gas stations, and a large portfolio of properties in Israel, the United States, Canada, and Europe. To comply with the Concentration Law, Delek sold Phoenix Holdings, Israel’s fourth largest insurance company, to U.S. private equity funds. To pay down his large debts, Tshuvah is currently liquidating his real estate assets. Despite his financial woes, Tshuvah will likely retain his natural gas holdings and his billionaire status.

Many tycoons gambled their empires on highly indebted acquisitions or foreign real estate deals during the global boom and were subsequently forced to liquidate assets during the bust to remain solvent. Others discovered that the pieces of their conglomerates were more valuable when sold separately than when held together in their pyramids. Given the paucity of private capital in Israel at the time, perhaps the tycoon phase was a necessary evil in the early years of privatization.

In general, the tycoons transformed Israel’s sclerotic monopolies into dynamic businesses. Even as the pyramids, or at least their worst excesses, were dismantled, the underlying operating companies improved their efficiency and competitiveness. Many of these companies will ultimately benefit from more efficient capital markets, improved liquidity, and potentially higher valuations even as competition slowly erodes their monopoly power.

The Law for Increasing Competition and Reducing Concentration in the Israeli Banking Market

Until spring 2019, Israel’s two largest banks – Bank HaPoalim and Bank Leumi – oversaw the country’s most popular credit cards. Bank HaPoalim’s Isracard is the largest credit card brand in Israel, with 5 million cards issued that account for 50% of Israeli credit card transaction volume. Leumi Card and the ICC‐Cal card (controlled by Israel Discount Bank, Israel’s third‐largest bank) evenly split the remaining 50% of the credit card market. According to the Israeli business newspaper Globes, credit card transactions totaled 300 billion shekels ($84 billion) in 2017 and grew by 7% over the prior year. ➅

In 2017, the Israeli government passed “The Law for Increasing Competition and Reducing Concentration in the Israeli Banking Market.” The law ordered Bank HaPoalim and Bank Leumi to divest their credit card businesses. To meet the requirements, Bank Leumi sold Leumi Card to the U.S. private equity firm Warburg Pincus in March 2019. Bank HaPoalim opted instead for an IPO of its Isracard subsidiary on the TASE. Bank HaPoalim sold 65% of Isracard shares in May 2019 and distributed the remainder through a stock dividend to shareholders in 2020. The newly independent credit card companies will be allowed to develop full-service banks, at which time Bank Leumi and Bank HaPoalim will be allowed to reenter the credit card business de-novo.

Regulators hope intensified competition will expand Israel’s consumer credit market. Most cards in Israel are charge cards, rather than the revolving lines of credit familiar to Americans. Fees can be high and charge limits tight, with banks requiring payment in full each month. Loan options are available, but credit limits are low and typically restricted to customers with better credit histories. Many options resemble installment payment plans, rather than bank credit.

Perhaps more importantly, cards in Israel offer meager fraud or theft protection compared to the benefits offered to American consumers. Stronger protections would reduce transaction risks for many consumers, and expanded credit options could boost personal consumption expenditures above 56% of GDP (in comparison, personal consumption expenditures are 67% of GDP in the United States).

Increased competition should improve credit availability and services for Israeli consumers. For example, following the passage of the credit card competition law, Bank of Jerusalem – one of the smaller banks in Israel – announced it will launch its own credit card business focused on customers previously denied credit.

Wealth and Capital in Israeli Society

Political debate in Israel tends to focus on security, relations with the Palestinians, settlements, and geopolitical threats. Economic issues are often secondary. When debating the economy, however, inequality is usually the hot-button issue. While vociferously arguing about wealth gaps, Israelis sometimes take the wealth creation process for granted.

Despite wealth inequality, most Israeli families experienced substantial increases in wealth and income over the past several decades. Wealth accumulation is reaching a tipping point whereby more of it is spilling into the capital markets, with important implications for asset valuations, business competition, economic growth, and social equality.

Israeli households continue to amass wealth at a rapid clip due to their high savings rate. As you can see in Chart 4, net saving as a percentage of GDP stands as of 2018 at 11.1% in Israel vs. 2.6% in the United States. Most of this capital resides in private pension and provident funds.

The Israeli savings system is based on tax‐advantaged defined contribution plans similar to American 401(k) accounts, but with government mandated contribution requirements by employees and employers. Historically these plans covered government employees or large companies with a unionized workforce, but in 2008 the Knesset expanded this system to virtually all employees in Israel.

To be clear, Israel also has a tax-funded public Social security pension system. Contributions into the private system discussed above are individual saving accounts invested in stocks and bonds by asset management companies. Due to the onerous government debt burden in the 1980s and 1990s, Israel required asset managers to invest large percentages of their pension portfolios in government bonds. As Israel reduced its debt burden (see Chart 5), the government eased the bond requirement, allowing more capital to flow into stocks and corporate bonds.

Israel was one of the very few countries to reduce government debt as a percentage of GDP during and after the global financial crisis. Since Israel’s own financial crisis in the 1980s, the Knesset repeatedly enacted lower debt‐to‐GDP targets into law. Although derailed temporarily by the economic implications of the COVID-19 crisis, the current goal is 60% down from 67% in 2015. A high savings rate combined with less pressure from government debt means money is spilling into capital market opportunities at an accelerating rate.

Inflation and interest rates in Israel have been low for quite some time and economic growth robust. As you can see in Chart 6, Israeli companies issued large volumes of corporate bonds in this environment. Stock offerings lagged in the aftermath of the financial crisis, Eurozone crisis, and other episodes of global stock market volatility, but they also should ultimately benefit from the rising tide of capital available in Israel. Although Israel is unlikely to become a utopia of economic equality, the foundations are now in place for continued wealth accumulation by an expanding percentage of Israeli society.

Disintermediation is Boosting the Importance of Securities Markets

Throughout Israel’s history, banks played a leading role in financing Israeli economic growth. Starting about 20 years ago, however, the banks could not keep up with the growing demand for capital. Economists call the shift away from bank credit toward capital markets and alternative financial institutions “disintermediation.”

The process of disintermediation is new but well underway in Israel. According to data from the Bank of Israel, in 2001, banks financed 45% of corporate investment in Israel, while equity capital financed about 35% and only 6% came from corporate bonds. Companies with publicly traded stock amounted to at most 20% of total corporate equity, a number likely overstated by a large margin since most “public” companies listed a very small percentage of their shares.

Twenty years later, however, the picture is already quite different, despite two major economic and financial market meltdowns along the way (not including the COVID-19 turmoil that began in 2020). Bank loans fell from 75% of total commercial credit in Israel in 2001 to 47% in 2019. During the same period, corporate bond issues grew from $639 million to $19 billion ➆. Stock market capitalization increased from $57 billion to $237 billion, and TASE turnover increased from $64 million to $365 million per day. ➇

40 Years Ago and 40 Years From Now

In the 1980s, Israel was a fiscal basket case with a government debt ratio exceeding 150%, hyperinflation and sluggish economic growth. Very few countries in world history made the leap from an emerging market to a high‐income industrialized economy. Israel managed this feat while fighting wars and terrorism and reducing deficits, debt, and taxes.

In part, Israel enacted structural economic reforms because sustained economic growth is vital to the country’s military defense. A growing economy allows Israel to raise living standards for its people while also investing in security. In turn, strong security provides necessary space for the economy to grow. Because of this virtuous circle, Israeli defense spending remained a constant percentage of GDP. Israel’s GDP per capita now exceeds Japan, Italy, and France (see Chart 7) because these countries did not adopt obvious but politically unpopular reform policies. They do not face existential threats.

Much remains to be done. Israel lags other developed countries in productivity, labor force participation, and affordable cost of living. The country has taken steps to address some of these issues in recent years. There has been a drive to bring work-skills training to populations that are underrepresented in the workforce, particularly Ultra-Orthodox Jews and Arab women. A construction boom, fueled in part by innovative public-private partnerships, is increasing Israel’s housing supply and building new infrastructure and mass transit, all of which should make real estate more affordable for Israeli workers and improve their productivity.

The COVID economic shutdown has thrown a monkey wrench in these efforts. It is also forestalling Israel’s ability to meet its mandated debt-reduction targets, as well as dipping into the savings held by companies and families. Like other countries, Israel faces a long climb returning to its pre-pandemic economic trajectory. But Israel is more fortunate than many other countries. The past 35 years of restructuring laid the cornerstone for its sound economy and fiscal discipline. Israel has a strong foundation upon which to rebuild.

Finance in Israel is moving away from its monopolized, bank-dominated, political, and sometimes corrupt past toward more competition and a greater reliance on capital markets. Israel’s savings rate is robust, financial assets are growing, and the government debt burden is modest. The financial services sector is burgeoning. Intensified competition in the financial sector is improving capital access in Israeli society, thereby fostering improved business competition. Israel firmly implemented the economic fundamentals necessary to attract heightened global investor interest. Our mission at Israel Investment Advisors, LLC, is to help our clients seize the growing opportunities in Israel we believe others are missing.

References

➀ Stanley Fischer and David Orsmond “Israeli Inflation from an International Perspective” (November 2000), p. 5. International Monetary Fund Working Paper No. 00/178. https://www.imf.org/external/pubs/ft/wp/2000/wp00178.pdf

➁ Israel Government Debt to GDP, Trading Economics/Bank of Israel. https://tradingeconomics.com/israel/government-debt-to-gdp

➂ Asher Blass and Richard Grossman, “A Harmful Guarantee? The 1983 Israel Bank Shares Crisis Revisited” (May 1996), p.3. Bank of Israel Discussion Paper No. 96.03. https://www.boi.org.il/en/Research/DiscussionPapers1/dp9603e.pdf

➃ Shlomi Sheffer and Ora Coren, “Bank HaPoalim Magnates Sell Off NIS 670m in Shares” (September 28, 2004), Haaretz. https://www.haaretz.com/1.4687545 (Subscription required)

➄ Koby Yeshayahou, “Netanyahu: We want to boost competition, not hurt business” (September 19, 2011),Globes. https://en.globes.co.il/en/article-1000683859

➅ Irit Avissar, “Bank of Jerusalem enters credit card market” (September 27, 2017), Globes. https://en.globes.co.il/en/article-bank-of-jerusalem-enters-credit-card-market-1001206403

➆ “Capital Raised by Security Types, 1992-2020,” Tel Aviv Stock Exchange. https://info.tase.co.il/Eng/Statistics/StatRes/Annual/Stat_132_AnnualStatisticsTables_Eng_l07.pdf

➇ “Main Indicators of the Equities Market, 1992-2020,” Tel Aviv Stock Exchange. https://info.tase.co.il/Eng/Statistics/StatRes/Annual/Stat_132_AnnualStatisticsTables_Eng_l01.pdf

This material is not intended to be relied upon as a forecast, research, investment, accounting, legal, or tax advice and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes, and financial markets are for illustrative purposes only. Past performance is no guarantee of future results.