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Four small banks in the Bank Hapoalim group last week published their financial reports. The most noteworthy was Continental, which had run foul of the Peled-Givony group's credit scheme and finished 2002 with losses of NIS 111 million. Continental's tremendous loss, coupled with the fact that the bank has no relative advantage as an independent enterprise, is likely to lead to its merging into the Hapoalim group in 2003.

The three other banks - Otsar Hahayal, Yahav and Massad - managed to end 2002 in the black, and at this point there are no merger plans for them - although mergers could be very beneficial to Hapoalim, to the merged banks and to any other bank that might acquire them.

Otsar Hahayal, Yahav and Massad are three sector banks, with specialized fields, and with a loyal clientele of salaried employees and households.

After two difficult years in which the banks suffered from their operations in the business sector, it is clear households are the banks' true assets. Otsar Hahayal, Yahav and Massad have an abundance of households among their depositors, and they have helped maintain the banks' profitability, even if it is small, in this difficult period.

The largest of the three banks is Otsar Hahayal, which specializes in providing services to those in the military and security fields. It has close to 150,000 clients in 43 branches and service centers. The bank ended 2002 with net profits of NIS 25.4 million, up from NIS 12.3 million in 2001. The bank's yield on its equity amounted to 5.4 percent.

Otsar Hahayal is currently controlled by Bank Hapoalim, but the latter will have to sell its controlling stake in Otsar Hahayal by the end of 2003, in keeping with a 1993 government decision to separate the small banks from the large ones.

Although 10 years have passed since that decision, Hapoalim has apparently benefited from the postponement of the sale because the consensus at the Bank of Israel these days is to reduce the number of players in the banking industry, rather than enlarging it, in order to create strong groups that will be more competitive.

Yahav, the second largest of the three, has clients in the civil service and bodies that get their budgets from the state, like local authorities, schools, universities and the security forces. Yahav generated a net profit of NIS 31.7 million in 2002, up from NIS 16.9 million in 2001. Yield on equity was 10.1 percent.

Yahav has 110,000 depositors and its license restricts it to providing services to civil servants and state-financed bodies only, and it is not allowed to offer services to the general public. This restriction causes a distortion in the structure of the bank's balance sheet, which is based mainly on deposits and marginally on credit. Yahav's has deposits totaling NIS 6.2 billion, but has extended only NIS 1 billion in credit.

These figures theoretically indicate the bank's financial strength, which is reflected in a capital ratio of 17.5 percent (the Bank of Israel's minimum is 9 percent). In effect, however, the low credit is an under-utilization of the bank's resources.

What is the bank doing about this? It deposits its surplus funds in the central bank or in other banks (including the Industrial Develop Bank) and receives relatively low financing profits (1.8 percent in 2002).

Massad, the smallest of the three banks, serves 60,000 clients, most of whom are teachers. Massad operates 11 branches and service centers and has 249 employees. Massad finished 2002 with net profits of NIS 8 million, down from NIS 18.7 in 2001. The drop in profits was due to losses in the bank's securities portfolio.

These three banks are natural candidates for mergers into the Hapoalim group, due to their small size, the potential inherent in their clientele and the growing difficulties of the small banks in competing with the larger ones. However, the Teachers' Union, which is a partner in Massad, the civil servants, who are partners in Yahav and the security establishment, which is a partner in Otsar Hahayal, are in no hurry to give up the asset that provides them with dividends and easy access to a financial institution.

From Hapoalim's perspective, the small banks it controls are a vehicle for promoting its district managers who have excelled at their jobs or for finding positions for senior personnel whose jobs have been eliminated for various reasons.

Today, with the rising consensus that the small banks have no right to exist, these sectoral banks are proving that they can succeed thanks to the niche in which they operate. Their unique relationship with their clientele, the appropriate geographical distribution of their branches and even the restriction that prevents them from financing large companies, grant them the right to exist.

The relative advantage of these banks is particularly evident in their financial margins. Massad , for example, had a financial margin of 3.12 percent in 2003, compared to an average of 2 percent for the large banks. Massad's margin, like that of the Mercantile Bank (of the Israel Discount Bank group), stems from the high ratio of households in its depositor base and from the bank's limited activity in the business sector.

In addition to Otsar Hahayal, Yahav and Massad, there are three other niche banks in Israel - Poalei Agudat Yisrael Bank (Pagi), whose clients are from the Haredi ultra-Orthodox population (Bank Leumi group); Mercantile (Discount group) and Arab-Israel (Leumi group), which serves the Arab sector. All three recorded net profits in 2002, even though they are small banks that suffered from the side effects of the collapses of the Trade Bank and the Industrial Development Bank.

One of the advantages of the sectoral banks is the low-competition environment in which they operate. Otsar Hahayal, for example, has branches on army bases, where there are no other banks, Mercantile has 30 branches in Arab towns in which the large banks have almost no presence, and Pagi has a near exclusive relationship with the Haredi community.

Another advantage is their low level of risk. The sectoral banks are hardly ever involved in granting loans to the business sector, which hurt the large banks. Small banks also provide mainly basic services and do not invest in the fanciest expensive technologies.

Will these advantages remain strong in the long run? Probably not. The small banks will find it difficult to come up with the massive investments required for technical infrastructure and for developing new marketing and distribution avenues. They will also have great difficulty meeting the new regulatory demands, particularly those involving the tax reforms, with their ongoing collection and reporting requirements.

One solution to the problem of resources for infrastructure and technical investment is the merger of the three Hapoalim group banks into a group of their own. If the supervisor of banks is interested in a third banking group to compete with the other two large groups (Hapoalim and Leumi) nothing could be more promising than the absorption of these three sectoral banks into that group.

Hapoalim, however, has been unsuccessful in acquiring the shares of its partners in these banks and also has no interest in contributing to the formation of a third banking group, so for the time being this solution will have to be shelved.