How concentration is rotting the capital market
The same people own banks and businesses, lend money to themselves and their cronies, stifling competition and development.
To build a pyramid, to become a business tycoon, you need to borrow money. That's the first and most important step. It takes nerve. And to tap the public for money on the capital market nowadays, it takes having the right phone numbers.
You don't need many. It's enough to have contacts at the three big insurance companies, Clal Insurance, Migdal and Phoenix, and the three big investment houses, Psagot, Excellence and DS-Apex.
The power in the Israeli economy is concentrated in the hands of a few families and business groups. That is a bad thing in that needing to pressure only a few centers of power to get your way creates risk.
"There are six massive financial institutions, each handling more than NIS 100 billion," said a top money manager. "If I were sitting on the government committee examining economic concentration, I would lose no time instituting competition. The amount of money entering the capital market has increased due to the law mandating pension saving, but we've been left with the same six players."
Diversifying the public's assets among a multiple money managers also ensures money is being lent to a range of players.
Truth be told, things used to be even worse. The Bachar Reform, which forced the banks to sell their mutual funds and provident funds six years ago, began a process that ended the banks' monopoly over giving credit.
"The reforms that took power away from the banking sector changed things. Instead of a few banks making all the decisions, hundreds of bodies now offer credit," said a businessman. "One may finance a jewelry store, another a farmer up north, one has some nonsense in Romania and another invests in an ingenious startup. That's the advantage of variety."
But the trend reversed. The capital market seems to be is consolidating: Small money managers are struggling to hold their own, and tough regulation increases their expenses.
"There's a thin line between too much regulation and abandoning responsibility," said an investment manager. "Regulation is so tight that ultimately you're not responsible for anything. The regulator binds the investment managers' hands to the extent that all they do is sit with their lawyers for advice all day. The most dangerous thing is passing the point at which people lose their sense of responsibility. Why should I bother taking a risk in order to get another 2% a year? We've returned to where we were with the banks, except instead of selling credit, these groups are selling insurance."
An insider speaks, with concern
The concerns about concentration in the pension sector got a boost from an unexpected direction in February - from Ronen Tov, CEO of Psagot and a former VP at Migdal.
"The pension fund sector and the managers' insurance sector are highly concentrated. The main distribution network, insurance agents, is controlled by the insurance company and blocks competition. Do we really want three families to be managing all our pension savings?" he said at a conference at the Dead Sea hosted by the Institute of Certified Public Accountants in Israel. "Even though people can now choose their own pension funds and pension management companies, there's a problem and this isn't really happening.
"Currently, the investment houses hold a negligible amount of pension savings. None of their pension funds have really gotten off the ground because the insurance companies bought the main distribution means - the insurance agencies. This doesn't mean that their agents don't sell other products, but this is how the industry looks right now. Some people were saying that the first Bachar legislation would address the banks, and the second would address the insurance companies."
The domination of the market by a few – its concentration – depresses competition on all levels, from the quality of investment management to efforts to obtain the highest returns for customers.
It also causes upward pressure on the fees we pay.
Tycoons lending to themselves
Even if you have all the right phone numbers, some people will have an easier time raising money than you will.
Of the six aforementioned institutions, half - Clal, Phoenix and Excellence - are controlled by the two biggest borrowers on Israel's capital market.
These two borrowers are Yitzhak Tshuva and Nochi Dankner. In other words, two of the people who borrow the most money in Israel also control financial institutions responsible for lending the public's money to those who need it.
While they do face limitations and they can't just lend as much money to themselves as they want, the result of this combination gives the tycoons unprecedented power in the face of hired money managers. They recognize that the tycoon asking to use the public's money may latter offer them jobs at the many companies these tycoons control, and could be drawn into investing in a less than optimal way.
Those who control financial institutions are members of the "lenders' club." Membership in this club is worth a lot.
Investment managers say the tycoons occasionally call the investment houses' executives in order to personally recommend they invest in a share or bond issue by one of their companies. They also send representatives to push their own companies. Sources also say that tycoons occasionally come to the offices of investment houses deciding whether to invest in their fundraising efforts, and hint to employees about job opportunities awaiting if they make the right decision.
"If a tycoon is wandering around my building and offering jobs to investment managers, that's a problem," said a former CEO at a major investment house. "Then it starts to involve the personal interests of people who want to be friends with others who can offer them jobs."
"Everyone knows who his or her next employer is," said a senior investment manager. "The average money manager spends three or four years at a small institution, until he or she gets to one of the big institutionals. And then what? These companies are controlled by parties with clear interests. They invite you to a basketball game and say, 'You're really smart,' 'You're the best investment manager in the world.' They're clearly your next employer, and the employer after that."
If pyramid structures create conflicts of interest, then this mix of controlling financial companies and non-financial companies creates ridiculous situations. One example of this is the story of three sister companies that was revealed in a transaction that Delek Real Estate reported in January 2011, when it announced that its control committee and board approved "a standard transaction in which the controlling shareholder has a personal interest." Delek Real Estate, of the Delek group, announced that it had asked Phoenix Insurance to approve its decision to sell off its portion in the Bayit VeGan development to Elad Israel Residence.
Delek needed Phoenix's approval because Phoenix had given Delek a loan whose securities included the Bayit VeGan project. At that point, all of Elad Israel's shares were also attached to Phoenix. All three companies - Delek Real Estate, Phoenix and Elad Israel - are controlled by Yitzhak Tshuva.
Who did that deal benefit? Sister company Delek Real Estate, who was selling; sister Elad Israel, who was buying, or sister Phoenix, to whom the other two sisters were indebted? Or was it Tshuva, who was pulling all the companies' strings? The one thing certain is that no solution would make the other shareholders feel comfortable in the face of the conflicts of interest inherent in this transaction.
Endless conflicts of interest
An institutional investor that invests the public's money in the shares of a company can take an active role in that company, since the shares give the institutional's representatives voting rights at shareholders' meetings on fateful matters, such as insider transactions, dividends disbursals or executive salaries. This creates endless conflicts of interests when the same individuals can control both financial companies and non-financial companies.
It can start as something small, as in the story told by Meitav Investment House controlling shareholder Zvi Stepak.
One day, as he recalls, a senior official at one of Israel's two largest banks called him to ask him personally to ensure that the official's niece would be appointed a board member of a company that that same official controlled. Stepak had this control due to the public's funds invested in the company.
"He asked that we consider our stance," said Stepak. "My person responsible for this matter decided to vote against. They called the shareholders assembly for 7:30 A.M. on a Friday morning up north, and we couldn't make it. I told him, 'You have to go and vote against.' When that company's workers have their money in your provident fund, you're managing his portfolio. And then you say 'I trust the opinion of an external party.' There were two cases where we lost investment portfolios because we voted against that party."
"Ninety-five percent of the transactions involving controlling shareholders are approved in Israel," said a former senior regulator. "The problem is structural, cultural and legal. People who control non-financial corporations take advantage of their holdings in financial corporations to make things harder for their competitors. They make it harder for the competitors to receive credit. They use their power to influence and to direct the institutionals in order to make the transactions legit. How free are the institutionals in the current situation?"
Even sources at the Israel Securities Authority admit that the combination of financial and non-financial holdings within the same business group limit the ISA's ability to supervise the market.
"Many of them live based on the worldview of scratch my back and I'll scratch yours," said a former senior official at the ISA. "When an investment house decides at the lower ranks how to vote regarding an interested party transaction, everything is set from above, by the tycoon who controls things. The tycoons won't fight among themselves at the lower ranks for no reason.
"Ultimately it won't end in regulation, due to economic interests," said the former regulator. "As long as everyone is caught up in the web of cross holdings, it won't happen. Managing investments with money captive to external interests is problematic. Often they choose to sell off the stocks at a loss. In order to pass the legal test in court you need a good story, and the institutions are the ones who have to tell it. No one wants to be first. Currently, there aren't enough investors' organizations. My dream is to launch a group to protect investors."
The U.S. example
The mix of financial and non-financial holdings within the same group - cross holdings - can damage competition within the economy. For example, until February Clal Insurance and Clal Finance were interested parties in Alon Blue Square, a company controlled by Dudi Wiessman. Blue Square competes with Super-Sol, one of the leading companies in Israel's retail sector. Super-Sol also happens to be a sister company of Clal Insurance.
"If Super-Sol has a holding in Blue Square through Clal Insurance, then it becomes a deciding party in interested party transactions. Even if it's a wise investment, it's best that a competitor not have any control over Blue Square. Blue Square's board is not supposed to think about the large institutional sitting on the control committee," said Dror Strum, Israel's former antitrust commissioner.
Insurance companies that issue credit are exposed to an additional form of pressure.
"It's not tenable that the CEO of a non-financial company could say to the CEO of an institutional, 'If you vote like this at my assembly I'll take my company's business to another insurance company,'" says an investment manager at an institutional, describing the behind-the-scenes pressure surrounding assemblies.
The problem is personal, too - our pension managers are supposed to represent the public before the businesspeople who need credit, and demand that they pay the highest possible interest in exchange for borrowing our pension money. But they're making their income on the capital market, and the result is that their decisions are not always relevant or designed to maximize the public's wellbeing.
As a former senior ISA official put it, "Every buy-side in Israel [the public's money managers at the institutionals] is a prisoner of the sell-side [the tycoons issuing bonds]. There are few people here who don't think about their future."
S., an institutional investment manager who launched a campaign against a major businessman who tried to get away with a transaction that involved a conflict of interest under the public's nose, experienced what this means. "I transcribed all my conversations with the institutionals, and I looked at all their excuses when they didn't want to take part. 'We can't right now,' 'We need time to study the issue.' They get scared and say, 'Why do I need this trouble?' 'Why should I waste the time?' You're subject to these pressures all the time. Why should the institutional give himself a hard time? Particularly when his side has some lawyer who's charging NIS 1,000 an hour. The solution is for the union of mutual funds, which gets paid dues every month, to hire lawyers like Yossi Segev, Jacob Weinroth, Ram Caspi and Yigal Arnon. If someone wants to sue on behalf of the public, he or she needs lawyers of this caliber."
Fifteen years ago, the government attempted to address the issue of concentration in general and financial/non-financial cross holdings in particular. In 1996, the Brodet Committee recommended banning banks from holding more than 20% of a non-financial company or of the bank's own equity, in order to avoid conflicts of interest between asset management and corporate management.
"With the Brodet Committee, we created a system in which banks wouldn't control non-financial businesses for a number of reasons," said Avi Ben-Bassat, a professor at Hebrew University, who was a member of the committee.
"So the banks wouldn't discriminate in giving credit to the bank's companies; so they couldn't take advantage of insider information if they had it on companies competing with their non-financial holdings; because it was easy for banks to block competitors; because it was easy for them to have aggressive policies toward competitors; and because they could lower prices in order to break competitors, because they had broader backs.
"All these things apply not only to banks, but also to institutional investors. If you have a holding in a company that manages pension funds, it's easier to expand your empire. The head of a pyramid is constantly forming partnerships with institutional investors. Almost always, some of the partners in a company are institutional investors, and it's easier when they're part of your conglomerate. We need to implement reforms similar to what we recommended at the time - we didn't forbid them [cross holdings] entirely, but we did forbid a method."
"I don't miss the days when banks were political entities," said a former banks supervisor. "But if someone owns a bank and a company, he can pressure you not to compete with him. Currently, the financial and non-financial leaders are the same people with the same executives and the same lawyers, who interact constantly and closely."
Strum said, "When it comes to internal financing at the conglomerates, they're helping each other. The question is whether we're not continuing to unthinkingly invest in these same marionettes. After all, it's an investment in the same large, veteran groups. When institutionals are used to investing in the same businessmen and the same companies and are stuck in the same swamp, it's not efficient.
"You need to ask the same question when it comes to corporate bonds. It's not for nothing that Bank of Israel Governor Stanley Fischer sounded the alarm, with 30% of the public's money invested in six corporate groups following the global financial crisis. Only the big guys know how to issue bonds nowadays. The institutionals don't bother with bonds from small companies because they need more knowledge about the field, and that's something only the banks have."
There is no other country where things work quite like this, said Strum. "The U.S. has the Banking Act, which states that if you handle money, you can't be involved in other things - you have to decide which horse you're riding. We don't have that here. All the lenders are knowledge aggregators. Who has more information on Osem, a shareholder or a lender? A lender has more information, and has his hand on the pulse."
Strum believes there's only one solution. "I've always said that you don't need regulation or Chinese walls. Instead, we need to make sure the structure is proper. We need to find the most elegant fix, such that the regulator won't spend the entire day overseeing investment boards. I don't know any mechanism aside from competition, and the only thing that will advance competition is separating financial holdings and non-financial holdings. It's a pity that nothing will happen unless there's a crisis involving the loss of public money. That division will likely occur after the next crisis. Things advance here only after a bomb goes off. The army calls it 'responding only to commissions of inquiry.'"
What's the alternative?
Strum: "The United States limits the business interests of people who control investment banks. The committee discussing competition within the economy is supposed to discuss this. The options including limiting the percentage of a financial institution that groups can hold if they also control non-financial companies that need credit."