Obama's Path: Central Bank to Expand Powers

Bank of Israel Law gives systemic risk protection.

Israel is following in the footsteps of the financial-supervision reforms declared last week by the administration of U.S. President Barack Obama. As part of the new Bank of Israel Law, the central bank is taking on itself the same authorities proposed last week for the U.S. Federal Reserve: to provide backup for the entire financial system - not just the banks - if the collapse of a financial firm threatens the country's financial stability.

In concrete terms, it means that if the Bank of Israel sees that a financial institution - and this mainly applies to insurance companies or brokerage firms - is on the verge of a failure that could set off a chain reaction destabilizing the entire financial system, the central bank could step in and provide liquidity to the institution.

Up to now only banks, which are themselves supervised directly by the Bank of Israel, have acted as lenders of last resort for other financial institutions. Broadening the central bank's powers to allow it to step in directly to save other financial firms would mark a significant change to the Bank of Israel's purview, and is a direct consequence of the global financial crisis.

Until that crisis, the BoI fiercely opposed the Finance Ministry's request that it assume this authority. In the wake of the crisis, however, and after the Fed set the precedent by stepping in to bail out major U.S. investment banks - and especially after the massive intervention to prevent the collapse of insurance giant AIG - the Bank of Israel changed its attitude.

And so the Bank of Israel Law proposal now contains an LLR clause that would apply to any financial institution whose failure poses a systemic risk.

The financial reforms proposed by Obama would give the Federal Reserve the responsibility and legal authority to provide emergency loans - after obtaining Treasury approval - to companies other than banks that are in danger of failing.

Expanding the Bank of Israel's position as lender of last resort to the entire financial sector, not just banks, focuses attention on the central bank's supervisory authority. It would seem that if the Bank of Israel is responsible for providing backup support to every financial firm, it is reasonable to demand that the bank supervise the stability of all these firms. That means giving it the supervisory authorities of the Finance Ministry's insurance supervisor and the Israel Securities Authority.

That demand would not go down easy with the supervisory bodies who stand to lose part of their job description. And it should be noted that in Obama's plan the Fed would only be given authority over systemic risk and not over the stability of the companies themselves.

The new Bank of Israel Law is set to follow the U.S. model in that aspect, as well: The insurance supervisor would still be responsible for dealing with the collapse of an insurance company, unless the central bank decided that its failure could undermine Israel's financial stability as a whole.