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Dr. Liliana Schumacher, International Monetary Fund

“Is There too Much or too Little Bank Regulation and Supervision in Israel? – An Opinion Based on International Standards”
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Good afternoon. I first would like to thank the organizers for this invitation to come to Israel to discuss these issues that are important for Israel, they are also very important for the International Monetary Fund. I would like to look at this topic by presenting the framework that belongs to the international standards, I don’t agree that the international standards are so vague that they can't be used on the day
day work of the supervisor, and I also believe that even though people may agree that the banks have to be regulated and supervised, they forget what the reasons are when it comes to the daily debate over particular regulations, so I am going to use part of the theory and part of the international standards and I also will try to do, try to address some of the debates on the individual regulations.

Where do these international standards come from, and it's amazing, there's probably no other corporate sector where there is so much convergence in terms of why and how to regulate a corporate sector. It all begun with the work of the Basel Committee and also IOSKO and IAIS that regulates securities and insurance, and this is particularly important for conglomerates that undertake not only banking but also insurance and securities activities. There are documents by the OECD and there are countries' experiences, in particular countries that have a good record of bank performance. And also, the IMF and the World Bank has started a new program which we view as a service to our member countries, is the Financial Sector Assessment Program that was created in the aftermath of the Asian crisis where it was clearly to everybody, and especially to us, that crises do not only depend on fiscal or capital accounting balances but also they can happen because of high corporate leverage, bad banking policies and poor bank supervision. So this program we have started this three years ago and many countries have already had an assessment, that includes, among others, the UK, South Africa, Germany is going through this assessment right now, and Israel.

It was said here that if Bank of Israel or the Supervisor of Banks is too much involved in supervision, he will be seen, in the first place, as directly responsible for any mistakes that banks can commit. I think it's the other way around. I think there are important reasons for which the Supervisor is involved in this work in the first place, and one of the main reasons is the fact that in many countries, including in Israel, there is a depositing chance, explicit or explicitly, with a large coverage. This means that investors, large investors, large depositors, large creators, they don’t have too many reasons why to monitor banks. If that happens they are going to price, not price risk, properly, usually less then it should, and everybody knows that when something is priceless then what it has to be the amount of risk in this case will be more than optimal. So this is something which is really relevant and it's relevant in particular for the supervisor and for the governments because if there is too much risk in the system then when risk materializes there are large costs in terms of depositors' bail out, and that's just the first round, because there are many other consequences, there are many more disruptions to financial instability that will create more undesirable consequences in the country. Is this present in Israel? Is there a lack of market discipline? Is there a need to compensate for the discipline that one would expect that the market participant should impose on the banks? I am not going to give you the answer, I am going to just read what MOODY'S have said recently, in October of this year, about the ratings that are given to the largest banks. For example, about Bank Ha'Poalim, MOODY'S is saying that "the rating that they give takes into account not only the fundamental credit worthiness of the bank but also the assumption that the Israeli authorities, if necessary, will step in to support Bank Ha'Poalim", and the same is in MOODY'S with respect to Leumi, saying that "no matter what banks in Israel are privately or publicly held, the government has always and will always step in to support the banks if necessary", so it's not that the supervisor would be responsible, exposed, but, I mean, the supervisor and the government is involved ex-anti because this is what the market is thinking and the banks do benefit from this because they pay, any corporation that has a lower rating pays a lower interest rate, so that responsibility is there in the first place.

I will like to show very briefly, with a very simple numerical example, how the principles embedded in the standards are very useful to solve daily problems of bank supervision. Let me present a very stylist example of a bank that have deposits and loans and also probably there will be a ten something provision that will reduce the bank equity to zero eventually, but that's also only known to the bank, the bank has the choice to take a deposit that could be invested in two alternative projects, in one case, it's a very risky project with probably to .05, the bank line will lose all the money with probably to .95 it will make a lot of money. The second project is clearly completely risk less, because no matter what is the state of nature it will be the same return. Both projects have the same average return but clearly both projects have a different volatility. Which is the project that the bank would choose? What the supervisor will have to say about it and need to say about this, and what are depositors' preferences? So let me present the matrix of payoff that each participant in this problem will choose. Clearly, in the bank estate the bank will lose what lent in the first place plus the interest that promised to the depositor. In the good stay will make a lot of money that would allow the bank to comply with capital regulations there was not complying in the first place, and in the other project it will make the same amount of return no matter what project the bank decides. But the difference is that when we look at the second table, actually in the bad state, for the risky project, the bank can't do worst than zero, because there is corporate limited liability. What will be depositors preferences clearly, depositor doesn’t care, because no matter what's the state of the world, he will get his deposit and his interest rate and what the supervisor will have to say or what will a deposit insurance fund will have to say, clearly, the matrix of payoff that is facing the government, there is no deposit insurance like is the case of Israel, I mean explicit, there is no deposit insurance fund, clearly will have to take, you know, face the consequences of the decision.

So I think this example is very clear because, and I tend to understand why sometimes bankers say that the regulators don’t understand their businesses, and the regulators say that banks do not understand their concerns, because everybody is looking at the same thing but people are looking at different intervals in the distribution. I mean, clearly, the supervisor and the IMF is interested in the tale of the distribution in episodes that probably have a very low probability of happening, but if they happen, they will imply a very large lose, while, let's say in the case in the example before, I had the tale that was .05, that is still very high, you know, that is, but there may be tales that can be accepted yet the probability is low and the exposure is low, it may not be necessary to require capital, while the banks on the day to day work they are more interested in the inside of the distribution, which is 95% or 99%, depending on how one measures those confidences … what is the limit and what imposes some risk, so it's clearly that the concerns are different and that the potential consequences are different too. This example also illustrates about a number of points that the international standards make that are very useful, actually, not just principles, not just guidelines. The new … will include the possibility that banks and supervisors discuss, in terms of what is the probability of the fault, what is the size of the exposure and the main point that is at the core and the international standards is this risk, this capital risk equation.

This is the whole point, I mean, no one, and certainly not in Israel, the regulators or the supervisors, they do not tell the banks not to undertake a project. What they tell the bank is to have enough capital to face the consequences of the risk, in case the risk materializes, and that is said in different ways, sometimes through some limits that are within the regulations, but also there is enough space to bring into the discussion a quantitative evaluations and issues about correlations and whether there is a possibility that there may be potential losses in the future or not. Let me just say, basically, the principles of what they are saying these days is that provisions have to cover average potential losses and the capital should be enough to cover the un-expected losses, which are the losses that can happen in the tale and that there are some events that may not necessary be covered with capital because they are very unlikely to happen, but there may be big exposures so there is a need to control the size of the exposures too.
I would like to bring, because the issue has been also whether Israel and the Israeli supervisor can be compared with the other supervisors, I just want to bring, I've just been almost all last year going to the UK for the assessment of the FSA, and given that the large exposures is one of the issues that is being debated in Israel, I would like to bring into, as an example, what is the regulation and how supervisors proceed in the UK with respect to large exposures. To being with there is a limit, no more than 25% of bank capital can be allocated to one group of borrowers or one borrower. And then the law allows the banks to go up to 800 of capital, to the maximum amount that they can lend to all the borrowers. But in the middle there are a number of triggers, there are a number of ratios that triggers immediately the FSA intervention. When banks exceed a 100% of their capital allocated to all their large exposures, immediately the supervisor can get into the picture and can ask the bank to increase capital, and the way in which this is happening is that actually the supervisor goes to the bank and the banker has to make a presentation of what is the risk involved, maybe there are collaterals, maybe there are exposures that have a correlation of minus 1, so maybe the capital has to be decreased and not to increase. So there are a number of issues that can be discussed because mechanic limits are sometimes very, they are not very good to capture something which is very difficult to measure because risk, we are always talking about potential losses, it's the forward concept, so, I mean, it's not so easy and this requires a lot of discussions between the supervisors and the bankers. A second trigger is the 300, when in the UK when the banks get to 300 large exposures as a percentage of capital there is a new trigger and there has to be a written approval by the FSA for the bank to be able to undertake that exposure, so there is, supervision is a continuous process where banks and supervisors continuously assess what is the potential that the bank may have a big loss that could endanger financial instability.
Let me also say that I am not surprised about the fact that there are so many discussions in Israel about this topic. I would like to bring the example of what's going on in the international community, I mean, the international banks have been discussing with the Basel Committee for years, exactly for 15 years, trying to have their models accepted. Even though the risk capital equation has been present in the Basel Accord since day 1, since the Basel Accord came out in '88, but it's a very inefficient way to do it, and banks have been really discussing and in the end J. P. Morgan decided to put, it's very well known, a risk management program in the Web to show everybody that they have a clear, transparent and good way to measure risks, and little by little the regulators, which have the same problems that the IMF has and the same problem that the supervisor of banks has, that are always extremely conservative because they are the ones that will have to face the risk and the loss of something that maybe has very little probability of happening but if it happened it is a big mess. The VIS has been continuously questioning the banks about their morals, about their capacity to come up with the reliable measure of potential losses, so I am not surprised, I think it's useful for bankers and supervisors in Israel to hold these kind of discussions. The principles also go more in detail, they look at conditions for licensing, they look at how banks should be supervised, they look at the former powers of the supervisors. In summary, the international standards call for a strong supervisor. A strong supervisor doesn't mean an arbitrary supervisor, a strong supervisor means a supervisor that is very serious about checking if banks are in a position to take the risks they want to take, which means whether banks have enough capital.
Finally, and I would like to give an official answer to the question that has been discussed in this session – is there too much or too little bank regulations and supervision in Israel? We came to Israel in 2000 and 2001, we did an update in 2003, and, I mean, what I mean, we came, it was a team of 15 people, it included people that sit regularly in the Basel Committee, and supervisors from banks, from countries who's banks have very good records of bank performance and what was said was that Israel has the competent and professional supervisory staff and a satisfactory legal and regulatory framework in which to supervise banks. We gave some recommendations, we said that there was a need to better share information with the other regulators in the country in order that you be able to do consolidated supervision. We asked to have explicit regulations for country and transfer risk and we also ask for, we said that it will be convenient to have a fit and proper tests for the bankers. I don’t have more time because if I had maybe it could address another discussion, I could tell also the interesting way in which the UK performs its fit and proper tasks for members of the board, for the senior management and for all the people in key positions in management in the bank, but we can probably do that in a discussion. So clearly I think that, I mean, Israel has successfully passed the formal assessment of compliance with international standards and I think the discussion have to continue and my opinion is that preparations for Basel II should start, we are having discussions at the fund who's countries we'll have to advise to get into Basel II, certainly Israel, I talked many times with the bankers and I know very well the supervisors and I think they are all in a position to get into this risk framework which is much more challenging, more sophisticated, but it will also will make it easier for bankers and supervisors to discuss the amount of risks because it's more precise in a quantitative way. And my final advice would be to try to handle this difference within the consultation process instead of doing this after the regulation is out in the market. Toda Raba.
 

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