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The prime minister and finance minister have a problem.

Since Israel adopted an economic policy that preserves fiscal discipline, with the aim of reducing the national debt, Finance Ministry and Bank of Israel officials have been using international comparisons as their main argument.

In the global era, they would explain, Israel cannot keep running up huge budget deficits. It can't keep pumping up the national debt. Local and foreign investors would flee, they'd reason.

This year, as they dish up their budget proposals for this year and 2010, the Finance Ministry and Bank of Israel officials cannot whip out that explanation with the same facility. This year the budget deficit will apparently run at 6% of GDP, and that's tiny compared with the deficits of countries like the U.S., U.K. and Ireland. The risk that investors will bolt from the Holy Land because of big budget deficits looks somewhat smaller.

Naturally, the fundamental economic argument still stands. Israel isn't America. It has a tiny, vulnerable economy. If Israel was spared the worst wrath of the crisis, then the next two years should bring an historic opportunity to start the long journey toward closing the gap with the rest of the world.

Yet we need to understand what lies behind the monster budget deficits and growing debts of nations like the U.S., U.K. and Ireland. Most of the increase in their debts originated in the gigantic cash outlay that de facto nationalized the banks in those countries. Nationalization was effected directly by buying the banks, or by granting guarantees amounting to tens of billions, hundreds of billions or in the case of the U.S., trillions of dollars. The nationalization of the banks will haunt these countries for long years to come. In retrospect, it legitimizes theft by the banks, warps the allocation of resources and will cause towering outrage among the taxpaying population. Now, after the fact, the public has grasped that the gluttonfest on Wall Street was at its expense.

In Israel, on the other hand, the entire deficit expected this year, about 6% of GDP, originates in the routine activity of government. It hasn't had to sink a cent into Israel's banks. The guarantees the government offered the banks amount to less than 2% of GDP, and the banks haven't even touched them anyway.

How did this miracle come about? How was Israel spared the plagues of economic meltdown, how did the banks avoid nationalization? First of all, a word to the wise: The crisis isn't over yet. Nobody can promise that if it gets worse, the Israeli banking system won't get dragged down. But one reason stands out for the strength of the Israeli banking system in the last half-year: the rapid implementation of the Bachar Commission recommendations, which extracted the banks from the capital market.

The Bachar Commission, headed by the director general of the treasury at the time, Joseph Bachar, prevented the Israeli capital market from merrily aping the two main ills of Wall Street, which had spread like wildfire in the last five years. Once upon a time, banks engaged in organizing loans and selling them to financial bodies. What wiped out the American banking system is that the banks leaped into holding loans on their own books. Meaning, the risk stayed at the bank.

America's banks went broke because in the last five years they accumulated towering piles of bad assets on their balance sheets.

Until five years ago, Israeli banks did the same. All kinds of loans, from the shortest to the longest, from loans to finance-leveraged buyouts to loans to establish industrial works, all stayed on the banks' balance sheets. The Bachar Commission redrew the map of the capital market. Where once the banks had been the sole real source of credit, during the past five years, institutional investors came to adopt that role too. Today about a third of the credit to business is provided by institutional investors.

Did the institutional investors tend to take greater risks than the banks? Probably not. The history of Israel's banks is strewn with periods of addiction to intense risk. The banks played an active role in all the financial crises of the past 30 years.

The starkest example is naturally the fact that Bank Hapoalim had to write off NIS 5 billion on its investments in the riskiest type of asset there is: subprime mortgages. If the supervisor of banks at the Bank of Israel hadn't ordered Hapoalim to wind down its position in these securities when the crisis erupted, the loss could have been double, wiping out half the bank's capital.

It is hard to imagine Israel's credit market if not for the Bachar reform. But it would have been enough for a quarter of the loans extended by institutional investors to be sitting on the banks' books, to destabilize the entire Israeli banking system. Before the Bachar reform, Israel's capital market was ruled by the two big banks, Hapoalim and Leumi. If that concentration of risk had been preserved, it would have dramatically increased the probability of a run on the banks, and a vast outflow of money from all investment avenues.

A similar horror scenario arose in 1995, when the general situation was a lot less critical than a planet-wide economic crisis. The provident funds of Hapoalim and Leumi held sway in the government bond market. A giant wave of withdrawals threatened to bring down the market altogether, which forced Jerusalem to soak up government bonds on the market. The decentralization of the financial system that the Bachar reform caused rendered the system more resilient to financial crises.

The second plague that spread through Wall Street during the past decade was conflicts of interest and weakening regulation. The regime under former U.S. president George W. Bush and the former chairman of the U.S. Federal Reserve Board, Alan Greenspan, was addicted to the powerful oligarchy of the Wall Street banks. The banks castrated regulation over Wall Street, allowing the conflicts of interest to flourish anew. The Bachar reform eradicated the worst conflicts of interest in the Israeli capital market: the total control exerted by the banking duopoly of Hapoalim and Leumi over the capital market and financial advice. The advisers at the banks were basically pushing shoddy wares onto customers, until the reform freed them to do their work properly.

The reform saved the economy from the global economic crisis, sparing the Israeli taxpayer from falling into the bottomless pit of nationalization of the banks. But it only did half the job, if that much.

The second half of the job remains to build a strong regulatory system to govern the institutional investors who manage the public's money. Possibly that's a job for the capital markets commissioner at the Finance Ministry and the Israel Securities Authority. What's sure is that nobody's doing it with any sort of seriousness. The difficulty in increasing regulation in Israel is great.

The dark side of the shift to a free market is that tremendous power and resources pass from the public to a clique of a few hundred managers and businessmen, who know well how to manipulate the political echelon, the press and the public to achieve their own ends, to weaken regulation and roll risk onto the public. Just witness the assault through the media on the Supervisor of Banks at the Bank of Israel because of his demand that Bank Hapoalim improves its management. That demonstrates how hard it is to step up regulation in Israel, even at a time of crisis like this.

The chairman of the Securities Authority, Zohar Goshen, and the head of the capital markets department at the Finance Ministry, Yadin Antebi, need to move fast and hard to step up regulation of Israel's institutionals. They need to go out into the field, meet the managers and hear for themselves what seasoned capital market animals already know: that corruption has staged a comeback in recent years to levels last seen in the late 1990s, before the wave of arrests at the banks by the Securities Authority.

Goshen and Antebi need to distance the controlling shareholders from the investment committees at the institutions they control. They should make a number of showcase arrests of investment managers who took kickbacks, and force the institutional investors to adopt transparent processes of investment approval and execution. The supervisors need to show a special interest in the investment committees of the insurance companies, and see how they reach decisions to invest in illiquid assets such as private equity funds and unlisted bonds. In some investment committees, no true checks are carried out. Decisions are handed down from the controlling shareholders or managers, and investments are based on favors for friends, who will naturally return the favor some day.

Time is short and the work is great. The money involved is huge and the window of opportunity is closing. The more the recession recedes, the more remote the chance of truly reforming regulation over the capital market, and the public's money will remain a toy in the hands of a clique of cronies which may be more decentralized than a decade ago, but is just as greedy.