Israel's Capital Market: A Swamp of Concentration

Teach the people about finance while changing the rules of the game, urges a panel of experts.

Eran Azran
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Eran Azran

Revolution is in the air. Tens of thousands, even as many as 150,000, marched on Saturday night to protest housing prices, food prices, and a host of other beefs that weigh on their quality of life. Doctors are protesting their employment conditions; parents, the price of baby goods. The protests aren't political or sectorial; they encompass the entire middle class - and now it's time to shed the light of disgust on another area crying out for reform: the capital market.

Reforming the capital market won't be easy and the masses are unlikely to take to the streets over it. A Facebook campaign won't do it. Yet the need is there; and at the end of June, leading figures from the market itself, the business world, government, banking and academia convened for a series of discussions at the Recanati Business School of Tel Aviv University, under the auspices of TheMarker Israel 2021 program for long-term planning.

The basic position of the participants was that Israel's capital market is controlled by a handful of vested parties raking in profit for themselves at the expense of everyone else, and doing all they can to block potential competition. Their conclusion: The local capital market needs systemic change that would impact on every aspect of the economy - from the real estate market, to retail, to the end consumer. This, in turn, would spare society any number of protests. There is no one solution; but their exchange of ideas, presented herein, could be the fodder for future change.

The purpose of Israel 2021 is to direct the public debate toward long-term planning. Eight meetings on the state of the capital market were held, focusing on economic concentration, regulation, competition, competitiveness, how the capital market influences the broad economy, diversification of investment, risks and innovation. Each discussion included 10 people whose names, as part of the agreement with them, shall remain anonymous so as to assure frankness and to relieve them of fear of repercussion. Quotes herein are therefore unattributed.

Concentration: Screwing the minority shareholder

Concentration in the capital market is very high, the participants agreed to a man. "A tiny group of people manage the money and block access to anyone else," said one of the participants. "The real sovereign of the market, the citizen, is crowded out."

The main topic of discussion was the pyramids, consisting of dozens of public and private companies. They are the foundation of the tycoons, whose greatest fear is losing control. They therefore create chains of companies, subsidiaries of subsidiaries of subsidiaries of a holding company at the top, said one panel member.

The company at the top achieves control of a vast conglomerate that castrates minority shareholders in the group companies; they have no influence, said another, adding: "That pyramidal structure allows controlling shareholders to rob companies down the chain by withdrawing money, by way of high wages or insider transactions that benefit themselves."

An accountant added that the pyramid's controlling shareholder gets a control premium: If the pyramid is likened to a pie, some of that pie belongs to the public. "But the bigger the control premium, the more the public is screwed," he said. "The boards of the pyramid companies may approve transactions that benefit the controlling shareholder at the expense of the public, and may approve pay that eats away at the dividends the company might have distributed."

A bigger problem with the pyramids, said another, is that somebody comes along and buys a toy without using his own money: He borrows, not always wisely. "The more concentrated the market, the less people express opinions freely; concentration castrates," he said. "To what degree was Koor's investment in Credit Suisse based on a learned decision by the board?" he demanded. "To what degree was the acquisition of Maariv [by Discount Investment Corporation] the result of such a decision? Maariv has been losing money and its acquisition wasn't the best deal, economically speaking. Yet the board approved the acquisition and Dankner bought himself another toy using somebody else's money."

(Both Koor and Discount Investment are members of Nochi Dankner's IDB group of companies. )

Power hubs and risk warps

A key problem with Israel's pyramids is that the people at the top control both finance companies (banks, investment banks and insurance companies ) that lend, and industry/technology companies that borrow. The finance companies control the public's savings and lend it, through bank loans and investment in bonds and stocks.

In short, concluded the participants, ownership of both finance and non-finance companies warps the allocation of credit to business. Big companies borrow with ease but smaller companies have difficulty. "There is an exclusive club of companies that can issue debt easily," said one participant. "Nochi Dankner can raise money in half an hour, easily."

This is not the case with small companies, he said, noting: "In fact, the biggest companies benefit from the concentration of credit allocation. You can see it in the demand for their bonds when they issue."

Small companies that may be more efficient than the monsters are outside the game, in the market and vis-a-vis the banks too, said another.

The concentration in the market, reflected in the existence of the business pyramids, makes supervision by institutional investors more difficult, the participants said. These institutionals represent the public; they own small pieces of companies through mutual funds, provident funds and pension funds; and if the economic structure was more diversified they could stand stronger against the conglomerates.

"The sheer existence of power hubs that large damages the market," said one. The stronger the power center, the less finance bodies can withstand its clout, knowing perfectly well that struggling over one matter will cause them to lose elsewhere.

The upshot is conflicts of interest. "A director at an investment bank represents savers, but gets paid by the owner of companies in which the investment bank invests," said one. The investment bank may even rent its offices from another company belonging to a company in which it's invested.

The difficulty institutionals have in standing strong before the great power hubs in defense of the general public is just as applicable to the banks, observed another participant.

"There, the concentration warps risk management and allocation of the bank's resources," he said.

A top banker can be challenged to coldly access a loan request by a big tycoon. The result is that if one of the big pyramids starts to quake, and the loans from banks are at risk, the risk at the banks suddenly gets a lot worse, he added.

Forging the perfect external director

"The problem is clear. The chains are dangerous. A way has to be found to stop pyramids from forming," concluded one of the participants during the second discussion, which was devoted to solutions for economic concentration.

First: Ban business pyramids from owning controlling interests in finance companies, insurance companies, or media companies, he suggested. They could be allowed to own 25% at most. That would reduce the pyramid owners from controlling credit allocation, he said.

The answer lies in regulation, agreed another participant - but his angle is for the regulator to abandon the concept that "controlling shareholders" for financial institutions is a good thing. Finance companies should not have a "controlling core" of owners, he urged, and it's up to the regulator to find a model to sever the ties, and enable finance companies to function well without controlling shareholders.

One thing the participants agreed on: Decrease the dependence of "external directors" on the controlling shareholder, so they can faithfully represent the interests of minority shareholders. One suggestion was for the institutional investors to elect external directors out of a select, trained group. These trained external directors should be amply compensated, to neutralize alien influences, said the participant.

Another suggested forming an independent research institute to advise the external on how to vote at shareholder assemblies - something like the Institutional Shareholder Services in the United States.

To assure stability of the Israeli financial system in the shadow of the giant pyramids, the participants also counsel curbing institutional investments in these great business groups - and greater overseas diversification of their investments. For instance, they shouldn't invest more than 5% of their assets in the companies belonging to a single group, suggested one.

'Abroad, the tycoons are nobodies'

Another idea is to pen the market to competition from abroad, while tearing down barriers. "When there's more concentration, more globalization is needed," said one participant. "The tycoons may be big in Israel, but they're nobodies overseas. The answer to Tnuva raising prices is to open the market to the world."

Another idea raised is to strengthen the powers of the general assembly of shareholders at the expense of the board of directors, by allowing remote voting via Internet.

One round of discussions was devoted to regulation in the capital market. The regulator is the long arm of government. Among the ones influencing the market are the supervisor of banks (at the Bank of Israel ), the supervisor of capital markets and insurance (at the Finance Ministry ) and the Israel Securities Authority.

Many of the participants feel better regulation lies in consolidation of forces - and in less rules.

"Now we have regulators with different interests, not a single body with a broad view," said one. "Despite the tremendous implications of each decision by each regulator, they don't talk with one another. They are sector-bound. The forum of supervisors doesn't function."

Forming a single body will enable fast action that takes all the interests into account, he summed up: That single regulator could be innovative, helping to promote the development of the Israeli capital market.

As things are, several complained, the government is a force damaging the market's development. As things are, regulation enables people with narrow interests to lead the market. Development is stifled, they said.

Moreover, if anything, the market is over-regulated at present, they said: The supervisors are too involved and prevent the allocation of adequate time to managing the public's money.

Another claim is that the government "doesn't always think things through," or understand the implications of regulatory changes. One example raised is applying international accounting regulations (IFRS ) and the SOX act (board supervision over accounting ) in Israel, over a period of 16 months. In Europe, these rules were gradually adopted over 10 years, he said.

How can matters on the regulatory front be fixed?

Firstly, the participants urged the creation of think-tanks to formulate new regulations, manned by representatives of government, the market itself and experts. They would have to consider the budgetary implications of their proposals.

Secondly, consolidate the supervisors.

And thirdly, set a grading to distinguish between mild offenses and serious ones, they propose.

Giving the public access to the market

The two main failures in the Israeli capital market are economic concentration and bumbling regulation.

They have two major implications: They block competition in the capital market (which means new players can't join, and influence the existing players ), and innovation is stifled.

"The job of the market is to serve growth through innovation, introducing advanced solutions from the world, handling barriers and, most of all, enabling new players to enter the market and raise money," said one.

But what does Israel have? A market consisting of big players pulling the strings, making the money and blocking development and innovation.

One way they block new players is by denying them credit. Credit allocation is heavily biased toward the big players.

The law prevents bad companies from raising money on the market, observed one. But it's also the case that perfectly good companies can't because of barriers created by law. In other words, it isn't only the "tycoons" and big business blocking competition: The regulator must share the blame through its inflexibility.

The economic concentration committee headed by prime ministerial adviser Eugene Kandel is addressing the role of regulation in suffocating innovation; but the bureaucratic element in the committee is too strong, claimed one.

"Regulation preserves the situation as is," said one, adding that it therefore clashes with innovation. The market must be made more accessible to the general public: that is one form of innovation, he said.

But the public can't be set free on the market without education, they agreed. The public needs to learn more about long-term investment vehicles - pension funds and provident funds. They need to learn about short-term investments as well. While the public learns, more bodies must be allowed into the market.

"The public is crippled. It has no financial knowledge," one of the participants summed up. People need to be taught financial management from a young age; they need to grow up with that knowledge and to be taught correct consumerism.