Ignore the Myth, Capital Market Reform Has Its Good Side, Too

Yes, it enabled the Dankners and others to run up huge debt, but it also helped finance economic growth.

Last week was a tough one for Israel’s tycoons. A petition was filed against Yossi Maiman to declare him bankrupt; Motti Zisser was faced with a suit by Bank Hapoalim seeking to appoint a receiver over what remains of his assets; and Nochi Dankner continues his delaying tactics against his inevitable fate. Over the past three years we’ve become accustomed to the idea that the tycoons will impose haircuts, disown their debt or file for bankruptcy − or all three.

Maiman, Zisser and Dankner have something in common with Lev Leviev, Beny Steinmitz and Yitzhak Tshuva: They all became wildly over-leveraged over the last decade, encountered difficulties in their businesses and had to arrange bailouts with the banks and-or the investing public. But that’s not everything.

They have one other thing in common: They were the solution to the problem of bank concentration in the 1980s and 1990s. That’s right, the solution.

The most widely accepted history is that the government formed the Bachar Committee in 2005, which recommended removing the provident and mutual funds from control of the banks and, by so doing, put the money in the hands of the tycoons. That ultimately let the tycoons impose haircuts on our money. The blame falls on Benjamin Netanyahu, who cares only for the rich. It’s a nice story, but it’s very far from the reality.

Back to the 1980s

To really understand what happened in the capital market, you have to go back three decades. With all due respect to Netanyahu, the outlines of today’s capital market were drawn 30 years ago when he was an ambassador to the United Nations.

The idea of separating the institutional investors from the banks doesn’t belong to Yossi Bachar and his committee, but to a panel dating back to 1986. The Beiski Committee wasn’t formed simply to make recommendations for reform but to investigate the manipulations of the bank shares in the 1970s and ‘80s, which led to Israel’s biggest ever stock market crash.

What it found was that the banks controlled nearly all aspects of the economy and capital market. They owned companies as well as the companies that underwrote their securities offerings, and they controlled the institutional investors that bought into the offerings. The banks bought and sold shares, including their own. They also loaned money in companies they owned. In short, it was a deep pile of conflicts of interest.

19 years later

The Beiski Committee recommended separating the banks from their institutional investment arms, but it took another 19 years for the government to get around to it − and only after more damage was done.

Likewise for the issue of bank concentration. Already in 1996, a committee headed by then Finance Ministry Director General David Brodet recommended that the banks be forced to sell their nonbank holdings. The banks protested that the government was interfering too much and that there was no problem with concentration. But in the end they sold − and Tshuva bought the Delek group; Leviev got Africa-Israel; and the IDB group Clal and Koor, to name a few. Thus was born the generation of tycoons.

The tycoons had several common characteristics. They liked leveraging their assets, buying old veteran businesses in monopoly industries, as well as companies that had easy access to bank credit thanks to their long history with the banks. The banks even financed the acquisitions.

Throughout the Israeli economy’s go-go years, the groups waxed fat, but their indebtedness to the banks and the public also swelled. The reason is rooted in another development also totally unconnected with the Bachar Committee.

Israel’s economy was bankrupted in the 1980s by enormous budget deficits and galloping inflation reaching 400% a year. The 1985 stabilization plan was based on a series of economic reforms, including the government’s gradual withdrawal from the capital market. Until 1988 all the public’s pension savings were invested in government bonds. The huge government deficit sucked in every available shekel and was the main consumer of the economy’s financial resources.

Under the reform, monies managed by the provident funds and, later, the insurance companies and pension funds, were diverted from the government into the capital market’s commercial enterprises. The process started out cautiously and subject to restrictive regulations, but the restrictions were gradually removed and the institutions could freely invest in stocks, bonds, and real estate, both in Israel and abroad.

Economic growth meant that the flow of money into the institutions kept growing and needed an outlet. At the same time the leverage-infatuated tycoon generation was trolling for business gambles in Israel and around the world.

This was exactly at the point at which the veteran pension funds began diverting their investments to the capital market and pumping in billions of shekels, while the mutual and provident funds were being removed from bank control in accordance with the Bachar Committee recommendations. Once again, both developments stemmed from decisions taken in the 1980s.

The banks sold these assets at audacious prices and the capital market’s center of gravity switched to the insurance companies that acquired most of them. Since provident funds and insurance companies had already been allowed to invest in the market since the late 1980s, taking them away from the banks doesn’t explain why they invested the public’s money in bonds issued by the tycoons.

As for the pension funds, the reason was macroeconomic. They had reached enormous actuarial deficits amounting to NIS 140 billion at the beginning of the last decade due to the corrupt management of the Histadrut labor federation. The only way to stabilize them was through comprehensive reform. This included having the government stop issuing bonds earmarked for the funds, trimming back the pension rights of fund members and forcing the funds to invest most of their money in the market.

Over the last three decades the economy has grown and developed, becoming more open and efficient, with these reforms playing a large role. Capital market reform also paved the way for thousands of strong, productive businesses that created jobs and investor value.

So after relieving Netanyahu of responsibility for the wave of haircuts, bankruptcies and disavowal of debts by the tycoons, what’s left is to examine the failures and their damage to the economy. Here are a few conclusions:

1. Restrictions on leveraging by the big tycoons are effective enough. Banks have rules for limiting credit to heavy borrowers, but these still didn’t prevent most of them from getting into trouble. The situation is more critical in the capital market since the haircuts there are larger and the restrictions fewer. The collapse of many of the tycoons over the last three years shows the need to prevent borrowers from becoming too large to fail. The concentration committee provided a partial solution.

2. Barring the banks from controlling nonfinancial companies didn’t prevent the opposite from occurring − namely, nonfinancial enterprises controlling banks and financial concerns. The concentration committee tried tackling this problem, but it was too late in the cases of Dankner and Tshuva.

Slack oversight

3. Capital market oversight is too slack and hasn’t kept up over the years with failures that have emerged. An annual flow of new capital reaching institutional investors reaching NIS 50 billion makes more stringent supervision a necessity. The total removal of investment regulations for life insurance was a reasonable idea, but it was implemented before investment management practice at the insurance companies became sufficiently professional. The price was an excessive flow of pension money toward investments with too much risk.

4. Institutional investors are in face-offs right now with companies controlled by tycoons over debt restructurings. Imagine what would have happened if, say, Africa-Israel and the provident funds were still owned by the banks. Their managers would have been wearing so many hats at the same time − a deadly stew of conflicting interests and a surefire recipe for undermining the stability of the banking system.

The time has also come to examine why Israel’s financial market hasn’t attracted more foreign players. The Israeli capital market remains a tiny, localized pond.

Ilan Assayag
Tess Scheflan