Banks Face Risk From Property Sector, Bond Market

Bank of Israel lays out worst-case scenarios in first-ever financial stability report.

Bloomberg

Israeli banks must be wary of potential risks from the real estate sector and the corporate bond market, the Bank of Israel said in a report issued Monday.

The report — the first issued by the central bank’s financial stability division since it was formed a year ago — warned that Israel’s banks face risk due to their high levels of lending to the construction and real estate sectors as well as their growing exposure to mortgage lending.

Together, the two segments now account for 43% of the banks’ combined loan books, it said.

Although Israel successfully navigated the 2008-2009 global recession set off by the U.S. mortgage crisis, a recession or other domestic or external shock that brings about a sharp increase in interest rates would raise unemployment and cause housing prices to fall, the Bank of Israel said.

“Mortgages are the central component in the banks’ balance sheets, and so create a direct risk to their stability and financial stability generally,” the report warned. “An increase in mortgage risk is likely to reduce the banks’ capital and the value of the collateral they hold.”

That, in turn, would force the banks to cut back real estate lending, including to builders, and cause lending rates to rise. Rising lending rates would hurt mortgage borrowers, forcing them to cut other spending to meet repayments, thus harming other sectors of the economy.

Israel’s financial system is also exposed to risk from the underpricing of risk in Israel’s corporate bond market, the Bank of Israel said.

“The yields in the corporate bond market are at a very low level, which arouses concerns that pricing does not reflect the risks in this market,” the report said.

The bank pointed a finger at the huge influx of capital into mutual funds specializing in bonds, without a commensurate growth in the supply of new corporate debt. On the other hand, the bank said, the situation does not mimic the period leading up the 2008-2009 financial crisis, because companies have not exploited conditions to issue large amounts of new debt or leverage.

“In the case of a sharp turnaround in the markets, it may negatively affect pension savings, banks exposed to companies that have issued bonds, and the supply of credit in the nonbank market,” said the central bank’s financial stability division, which will be issuing similar reports once or twice a year from now on.

In spite of the concerns, the Bank of Israel said the country’s bank, insurance companies and other financial institutions have demonstrated “impressive resilience both during the global financial crisis of 2008 and afterward.”

The authorities supervising the financial system have tightened cooperation and are employing macroprudential tools to identify and handle systemic risks has been increased, the report said. The central bank has reduced Israeli banks’ exposure to the rapidly growing volume of mortgages, while initiating stress tests to assess banking system risks.

Last month, the results of a Bank of Israel stress test showed there is no danger to the stability of Israel’s banking system should there be a severe recession, although the hit to banks’ profits could be significant.