Israelis to Finally Get State Deposit Insurance

Pressure on the Bank of Israel to let more banks open up to bring more competition has finally forced it to change policy on protecting deposit holders if their bank goes belly up.

Olivier Fitoussi

Bank failures in Israel have been few and far-between and only involved minor banks: The Eretz-Israel Britannia Bank, the North America Bank, the Industrial Development Bank and the Trade Bank. All collapsed due to egregiously bad management, some involved fraud and, in all cases, the damage to households was minor, if any. However, the state consistently compensated the depositors, restoring the full amount of their deposit, or most of it.

The state willingness to compensate was really tested only once, after the collapse of Israel’s biggest banks in 1983, following manipulation of the banks’ shares. Four of the five biggest banks (Hapoalim, Leumi, Discount and Mizrahi) fell. The public did lose money they’d invested in bank shares, but they didn’t lose their deposits, because the state stepped in. It forked over an amount estimated to be tens of billions of shekels, seriously burdening the national budget.

In effect the State of Israel always did have deposit insurance, though it doesn’t say so explicitly. Like its nuclear capacity, the state prefers a policy of opacity, though everybody and his dog knows the the truth. Choosing opacity is supposed to give the state more wiggle room. It doesn’t have to pay out compensation if a bank implodes, though it may choose to do so. It may also improve the management of the banks.

One criticism about deposit insurance is moral hazard. The claim is that knowing their customers won’t suffer allows the banks to behave irresponsibly and to take excessive risks. The moral hazard is especially grand for the biggest banks, whose managers figure there’s actually no risk at all: they’re too big to fail, so the government will save depositors and the bank itself, too.

The damage caused by direct deposit insurance, and the even worse damage caused by indirect insurance (the too-big-to-fail thing), has been hotly debated since the great financial crisis of 2008. There is no question that the crisis was caused by egregious irresponsibility among America’s bank managers, and there is no doubt that none of the bankers paid a price. The American government, and other governments around the world, had to intervene to save the banks, causing terrible damage to taxpayers; in some cases, like in Ireland, the mission to rescue the banks almost brought down the whole country.

Hedva Ber, the Bank of Israel’s banks supervisor.
Ofer Vaknin

That is another reason why the Finance Ministry is opposed to formal deposit insurance in Israel. They worry that Israel’s sovereign credit rating could suffer, whether because deposit insurance could cause trouble later, or because they suspect Israel is providing formal deposit insurance because it thinks its budget isn’t strong enough to handle an event like a bank’s collapse.

How to lure in the people

Considerations of this sort were taken into account by the committee formed to spur competition among the banks (headed by Dror Strum), which did indeed recommend formalizing deposit insurance in Israel. The insurance would be compulsory at all banks, and would be based on premiums depositors would pay to some government fund. The committee recommended that deposits be insured up to a certain ceiling, but rich people would be allowed to split up their money into smaller packages in more banks. That would of course encourage the rich to take the risk of depositing money in small banks too, making them more competitive.

The committee decided to support deposit insurance despite the risks involved, largely at the behest of the Bank of Israel. Over the last couple of years, the central bank has changed its long-term position on the establishment of small banks, and agreed to it, after years of opposition on the grounds that they’d be managed badly and would be relatively risky.

Because of this policy, no small banks have arisen in Israel since the 1970s. All we have now is the two big ones, Hapoalim and Leumi, three medium ones (Discount, Mizrahi and First International) and three small ones (Union Bank, Jerusalem Bank and Dexia). Israel’s banking system is small and stable, but of course, highly uncompetitive.

The pressure on the Bank of Israel to let more banks open doors for the sake of competition forced it to change policy. Now it has changed policy, under Governor Karnit Flug and Supervisor of Banks Hedva Ber. But it demands guarantees: if the government wants more banks it has to promise to rescue them in time of trouble. And to provide deposit insurance.

The Bank of Israel views deposit insurance as a double-pronged tool: it mitigates the fallout from a bank’s collapse (also minimizing criticism of the Bank of Israel’s supervisory department after a bank’s collapse,) and, it would enable the small banks to compete, because deposit insurance would allay the public’s concern about putting money into a small, theoretically unstable institution. Otherwise the people might not come.

One could argue whether a country that has informal deposit insurance (all depositors at small banks that fell received their money) formal insurance is necessary. In any case, the Bank of Israel ruled in favor of it.

But the question of ensuring competition while providing deposit insurance is a tricky one. Deposit insurance is paid by depositors. The premiums they pay accrue in a state-owned fund, for the rainy day of a bank’s collapse.

How high should that premium be? There are three possible answers. The first is that the premium should represent the specific bank’s risk of collapse. So premiums collected from depositors at small banks should be bigger than premiums collected from depositors at big banks. If that is done, deposit insurance will impede competition.

As a result, the second option, some countries have flat deposit insurance, which fails to reflect the bank’s specific risk but helps encourage competition.

That is what the Strum committee favored. The third option: deposit insurance should be linked to each bank’s risk, but not only the risk of the bank failing – also the systemic risk that the collapse will cause to the entire Israeli financial system.

According to Strum, deposit insurance should be linked to total systemic risk, not only to the bank’s risk. With that, the committee hoped to balance the two risk types: small banks are more likely to fall, but their fall hardly matters to the system. Big banks almost never fail but when they do, the damage is tremendous. Now teams at the Finance Ministry and central bank are studying the risk types and the issue of the premiums.