Prophesy, as everyone knows, is given to fools. So we'll risk sounding foolish and say that the Israeli capital market is heading towards a bubble and a subsequent burst. When will this bubble inflate? Safe to say, it will sometime in the coming decade.
In light of the wretched and worsening condition of the Israeli capital market, which suffers from dwindling trading volumes and paltry numbers of new securities offerings, it's hard to believe a bubble is on the way, with the burst to follow later. But the numbers show this is to be so.
These numbers – which forecast the rate at which pension savings are accumulating in Israel or, if you like, the rate at which assets in the hands of the institutional organizations is growing – were presented to the government last week by the National Economic Council, which is chaired by Eugene Kandel.
The assets of institutional investors – the pension funds, insurance companies with the managers' policies and provident funds – are now nearly equal in size to that of the banks. At the end of 2012 the institutional holdings amounted to about NIS 780 billion, compared with about NIS 900 billion at the banks.
However, from the perspective of this relative balance, the picture of the Israeli credit and capital market is expected to change dramatically. The banks, which have always been the leading financial force in Israel, are shrinking. The transition to the Basel III regulatory standards requires the banks to increase their capital considerably at the expense of lending more to the public. In the wake of this, the National Economic Council estimates that growth of bank credit will slow to between only 2% and 4% annually in the next decade, more or less in line with economic growth. Thus, by 2020 the banks’ credit portfolio will grow to only about NIS 1.4 trillion.
However, no regulations are imposed on institutional investors, and they have no need to accumulate capital. Therefore, they are continuing to accumulate assets full steam ahead. In fact, the rate is increasing as compulsory pensions become the rule and fewer people are entitled to so-called budgetary pensions or have their saving in the old-style pension fund, both of which do not invest their assets in the capital market.
Therefore the council estimates that the assets managed by institutional investors will grow 8% to 11% annually in the next decade to NIS 1.6 trillion in 2020 –double the amount they are managing today and 40% more than forecast for the banks. The institutional investors are on their way to becoming Israel’s main providers of credit and capital.
Where will the money flow?
There would of course be nothing wrong with the rapid growth of the institutional investors, were it not for two major problems:
The first is that their rate of growth is far too big for the domestic market to absorb because it is atrophied and meager. In other words, it is not at all clear where the institutions are going to invest the deluge of cash. Currently, they are putting about half their assets into government bonds, another approximately NIS 300 billion into domestic stocks and corporate bonds and about NIS 100 billion into overseas investments. But the Israeli government’s borrowing needs are not going to grow commensurately over the next decade. The council estimates that by the end of the decade the value of government debt securities will grow about 50% to about NIS 600 billion. The government does not need more than that.
Institutional investors will therefore be left holding some NIS 1 trillion looking to be invested, compared with NIS 400 billion today. Where are they going to invest that money? A huge sum of money like that with no place to go spells the kind of situation where asset inflation takes hold.
We have already seen institutional investors err in bad investments, such as when they piled into the bonds issued by pyramid groups, even when it was already clear that they were a financial risk. They did this in part because of the absence of alternatives in the domestic market. And this happened when the institutional investors needed a place to park a mere NIS 3 billion.
In 2020, when they will need to invest more than 300 times that figure, the possibility that they will throw the money at anything that moves – regardless of its price or quality – is a real and very dangerous possibility. Though the institutions do have the option of diversifying their portfolios by investing abroad investing, they haven't done so to date, in part because they lack confidence in their ability to do so. In addition, although biasing the growth of savings in Israel towards investments abroad may be good for pensioners, it does nothing for the growth of the economy here.
This is also the second problem: Israel's institutional investors are inferior as providers of credit compared to the banks. Not only do they invest less well than the banks, they invest in a far narrower range of assets. The institutionals invest almost solely in the large concerns. They do not invest in medium-sized and small companies or provide them with credit, and they certainly do not make retail credit available to the general public. These two groups are too small for the capital market.
This has produced the skewed situation in which the banks, which provide credit to small businesses and consumer, are left almost without capital while the institutional investors, which do not, are rapidly accumulating tremendous capital. This distortion will exacerbate problems that already exist. Concentration of credit will increase; the capital market will become less fair; small and medium-sized businesses will not be able to raise capital to grow and develop; and the economy’s growth potential will diminished.
Jumping the regulatory hurdles
It's no wonder that the National Economic Council took the trouble to present these things to the cabinet. The situation it has depicted is a real strategic risk for Israel. However, there are also three important solutions for this situation.
The first is to prevent the institutional investors from concentrating all their investments in a small number of large companies as when they invested in the big holding companies in recent years. This can be achieved by rules requiring them to diversify their holdingsjust as a bank is allowed to lend only so much of its capital to a single borrower or group of .related companies.
The second solution is to allow capital to move from the institutions to the banks. To this end it is necessary to develop here a set of financial tools that are very much accepted abroad, like securitization, with the help of which the banks to transfer part of their loan portfolio to the market.
The third solution is to bring about a dramatic increase in public traded assets to fit the forecast increase in the institutional investors' demand. That will increases the access of small business and consumers to the capital market. To achieve this, it is necessary to open the Israeli credit world to new, non-bank financial groups that make loans and can be traded on the market – meaning they will raise their capital from the institutions.
These non-bank banks are also very much accepted abroad. They do not in Israel only because of regulatory impediments. Credit histories are not shared nor is there any regulator prepared to take this segment under his wing.
The financial supervisors are engaged in warding off the idea so that – perish the thought – they will not have more work to do. But their refusal means sacrificing future economic growth and risking a gigantic asset bubble.
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