Background / Bank of Israel on business groups and systemic risk
Systemic risk has become an important concept in the discourse about the stability and survivability of the economic system at large; in many respects, it is not unique to financial institutions or markets.
The implications of the 2008-09 global financial crisis have precipitated lively discussion about the toughening of regulation concerning financial stability and expanding it into new areas of market activity. The dire results of the crisis were reflected in the uncovering of deep fissures in the foundations of the financial system and in our understanding of the system’s intrinsic risks. Consequently, systemic risk has become an important concept in the discourse about the stability and survivability of the economic system at large.
Although the term “systemic risk” lacks a consensual formal definition, in its essence it refers to the possibility that an idiosyncratic event, e.g., the collapse of a financial corporation, will cascade into material harm to the activity of numerous other firms and quickly escalate into an event that has general economic implications. Thus, a systemic risk is one relating to the collapse of a financial system or market in its entirety, and not to that of individual elements. A financial institution, market, or instrument has systemic importance if, by succumbing to total collapse or malfunction, it spreads financial distress through the system at large and spills into real areas of activity either directly or, by “infecting” other elements, indirectly. Importantly, estimating the level of systemic risk that adheres to any particular entity is usually based on measuring its economic size, i.e., its market share in its industry or in overall economic activity, or the extent of its assets, and also on analysis of the strength and complexity of its connections with additional entities. Accordingly, when they consider the possibility that a given institution carries a risk that entails public intervention, decision-makers have to ask two main questions: is the institution “too big to fail?” and/or is it “too complex to fail?” i.e., if it should not be allowed to collapse in view of the systemic implications of such a collapse.
In many respects, systemic risk is not unique to financial institutions or markets. Historical experience (1), however, shows that the systemic risk of real-sector firms is rather limited and does not exceed specific damage to the welfare of their investors, employees, suppliers, or direct consumers. Such is not the case when assessing the systemic risk of business groups—groups of companies that do business in different markets, are subject to single administrative and financial control, and are tied together by bonds of mutual trust based on a shared personal or business background (Khanna and Yafeh, 2007; Granovetter, 1995); these entail special treatment.
The Israeli economy, as a developed economy that has strong financial and judicial institutions, is a classic but nonetheless unusual example of an economic environment that is exposed to the wide scope of activities of business groups - which are among the characteristics of the business landscape in most countries (with the US and the UK as exceptions). Recent studies (Kosenko, 2008; Kosenko and Yafeh, 2009; Hamdani, 2009) show that these ownership structures have been the most common form of ownership in Israeli firms throughout the country’s history. This has also been so in the past decade, as some twenty business groups, nearly all of family nature and structured in a pronounced pyramid form (Figure 1), continue to control a large proportion of public firms (some 25 percent of firms listed for trading) and about half of market share. In terms of dispersion of control, Israel is one of the most concentrated developed countries and even resembles a developing country in this respect (Figure 2). Israel’s business groups are typified by broad sectoral dispersion (2), a significant tendency to focus on the financial sector, strong maturity of affiliated firms in terms of both age and size, slow growth, and higher levels of financial leverage—and therefore also of risk—among affiliated than among stand-alone companies.
Analysis of ownership structure in the Israeli economy provides a unique point of view for study of the nature of the business groups and elicits several important findings for the assessment of the systemic risk that the groups pose.
• A dense web of interrelations exists between the banking sector and the business groups; thus, the groups’ owners and the groups themselves fit the definitions of the most significant risk group of bank customers - large borrowers. This problem has already been addressed in the banking system via regulatory limits to a banking corporation’s liabilities to single borrowers and borrower groups - limits designed to reduce the concentration of the bank-credit portfolio and thereby help to keep the system stable.
• The group maintains ramified internal group relations, reflected in co-ownership or multiple interlocking directorships (3). This presents the Israeli economy with complex economic issues, e.g., the quality of information accessible to investors and the transparency of the business groups’ activity.
• Apart from the highly concentrated corporate ownership, the nature of control in the business groups is family-related. This may have implications for the stability of the financial system and economic activity at large, because both the control and ownership of firms and their performance and effect on the public’s welfare depend on the quality of intra-family relations; the strategies and tastes (caprices) of a small number of people; and, above all, the quality of the successor generation’s managerial capabilities.
• Lastly and importantly, not only are companies affiliated with the groups less profitable than non-affiliated companies on average; the market also assigns them lower valuations, an outcome reflected in a negative premium for them (4).
On the basis of the totality of findings about their activities, one may include
Israel’s business groups among the entities that have the latent potential of systemic risk. This is because their activity satisfies two main criteria in the test of systemic risk: both their economic size and their complexity - in terms of concentration of control, ownership structure, and sectoral interrelations with financial and real institutions - create the probability of a spillover effect in the event of their failure, make it difficult to analyze information about their activity, and, in turn, make it hard to assess the risks of this activity and its relation with overall system stability. Accordingly, more active regulatory intervention may be needed, in addition to the activity of market forces, to keep sectoral shocks from evolving into systemic shocks. The involvement of business groups in the nonbank credit market illustrates this argument (5). (For examples, consider the settlements concluded by the Africa-Israel and the Ofer groups in 2009.) Failures of this kind did not prejudice the stability of the banking system during the crisis, for reasons including the tough regulatory restrictions that apply to this system (6). However, due to the involvement of Israel’s business groups in the nonbank credit market, the implicit pass-through mechanisms in their modus operandi indirectly exposed the economy to foreign shocks. From the regulator’s standpoint, the existence of complex ownership structures generally, and the activities of business groups particularly, entail the formulation of a comprehensive and consistent policy to diagnose accurately various economic problems and estimate systemic risk (Morck et al., 2005). The very fact that business groups may become “too big to fail” or “too complex to fail,” (7) as in the case of banking institutions, may exacerbate moral hazard and, by so doing, induce excessive taking of risks that are distributed among all savers in the economy. Thus, basing oneself on the principal motive (8) behind international entities’ proposals of ways to cope with systemic risks and following the principles of banking regulation, one may consider several solutions to this matter that are tailored to the structure of the Israeli economy (9).
• For control and supervision purposes, a legal definition of a business group is needed (10). It is important to define the obligations and rights of such groups and give them market and legal incentives to discharge their duties.
• To enhance system transparency, compulsory reporting about business groups’ activity should be expanded at both the micro level (e.g., requiring them to report transfers among affiliated companies) and at the macro (group) level.
• Similar to recommendations abroad, it may be correct to require financial entities to include an assessment of business groups’ activity in their risk management models.
• To contend with the acute concentration and the pyramid structure of ownership in the Israeli economy, one may consider imposing a dividend tax on capital transfers between firms (as was done in the US in the 1930s) or strengthening the direct linkage between ownership and control of affiliated companies (a British solution from the 1960s) by setting a minimum threshold for direct ownership. Also, strengthening the board of directors and increasing institutional investors’ involvement in the holding and management of the companies may reduce concentration and improve corporate governance.
• To mitigate risks and enhance competition in the financial markets, separating the control of financial institutions from the control of real corporations may be considered (11).
It bears emphasis that if the business-group issue is disregarded, various policy measures may fail or their goals and outcomes may be distorted, leading in turn to impaired functioning of the financial and real systems at large. The recent crisis offers a unique platform for the striking of a balance between the roles of market forces and regulation (Morck and Yeung, 2009), in order to reshape the web of ownership relations and, thereby, to reduce systemic risk and improve resource allocation throughout the economy while strengthening and streamlining the mechanisms of supervision.
1 The collapses of Enron and World Com and the bankruptcies of several American aerospace firms in 2000-09.
2 As Khanna and Yafeh (2005) found, the dispersion of business activities does not shield against external shocks.
3 See Suari et al. (2007).
4 Kosenko (2009); Kosenko and Yafeh (2008).
5 Group-affiliated companies hold 40 percent of corporate bonds in the investment and real estate sectors, which traditionally are considered relatively high-risk areas of activity.
6 Thus, among other things, during the current crisis, the Banking Supervision Department examined the efficacy of the various restrictions that apply to banking corporations, e.g., the single-borrower and borrower-group limits, sectoral concentration of credit, credit for acquisition of controlling stake, etc.
7 This phenomenon was evident during the Asian financial crisis in the late 1990s.
8 See “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments (IMF and BIS, October 2009).
9 The local adjustment is needed because the mechanisms used to supervise corporations that have decentralized ownership (such as those proposed in the US) are ill suited to cope with the strength of a corporate principal; some of these mechanisms are irrelevant for corporations that have controlling principals and others may even enhance their power (Hamdani, 2009).
10 Precedents for regulation of this kind may be found in Chile, Portugal, Germany, and
Hungary, among other countries.
11 As recommended by the Brodet Committee (1995).
Hamdani, A. (2009), “The Concentration of Control in Israel: The Legal Aspects,” The Israel Democracy Institute Press.
Kosenko, K. (2008), “Evolution of Business Groups in Israel: Their Impact at the Level of the Firm and the Economy, Israel Economic Review 5, 55–93.
Kosenko, K., and Y. Yafeh, “Business Groups in Israel,” in A. Colpan, T. Hikino, and J. Lincoln (eds.), Oxford Handbook of Business Groups, Oxford University Press, forthcoming.
Morck, R., D. Wolfenzon, and B. Yeung (2005), “Corporate Governance, Economic Entrenchment, and Growth,” Journal of Economic Literature 43, 657–722.
Morck, R., and B. Yeung (2009), “Never Waste a Good Crisis: An Historical Perspective on Comparative Corporate Governance,” NBER Working Papers No. 15042.