In the late 1980s,
Israel's financial system consisted of various financial intermediaries
providing a range of services from short-term overdraft privileges
to the financing of long-term investments in construction, industry,
agriculture, and research and development. This financial system
was concentrated among a limited number of large banking groups
under the supervision and control of the Bank of Israel.
The government-owned Bank of Israel is Israel's central bank.
Its legal powers and functions allow it to determine policies
and regulate activities in all fiscal areas, including interest
rates, money supply, foreign currency, and export financing and
control. As part of its duties, the Bank of Israel seeks to create
institutions specializing in defined sectors of business or customers.
Consequently, banking corporations have been divided into two
main groups: ordinary banking institutions, such as banks, foreign
banks, and merchant banks--all of which are subject to liquidity
regulations on both assets and liabilities--and specialized banking
institutions, such as mortgage banks, investment finance banks,
financial institutions, and joint services companies.
The financial system in 1988 consisted of five major bank groups:
Bank HaPoalim, Bank Leumi Le Israel, Israel Discount Bank, United
Mizrahi Bank, and the First International Bank of Israel. Given
the high degree of concentration (the three largest bank groups
accounted for more than 80 percent of total bank assets), banks
operated in an oligopolistic environment, with little competition
in determining lending and borrowing rates.
The financial system provided three types of credit instruments:
short-term, nondirected credit financing; short-term, directed
credit financing, and long-term and medium-term credit financing.
The granting of directed credit was the responsibility of the
Bank of Israel. This credit, however, actually was provided by
joint funds of the Bank of Israel and the commercial banks, and
it was primarily intended to meet the working capital requirements
of export enterprises. Seventy-five percent of these funds were
in foreign currency, with interest charges calculated on the basis
of United States dollar credits.
Apart from directed credit, the other major form of short-term
capital was nondirected credit, which was composed of overdraft
facilities. This credit facility provided the customer with great
flexibility at a nonindexed fee, which adjusted with inflation
on a periodic basis. The other loans that were denominated in
new Israeli shekels (NIS--see
Glossary) were either indexed to the consumer price index or,
if nonindexed, were fixed-term credits.
Medium-term and long-term loans (exceeding eighteen months) were
primarily directed government loans. These credit flows were supervised
by investment finance banks such as the Industrial Development
Bank of Israel. The government generally determined how medium-term
and long-term investment was encouraged and how it was financed.
In an economy with a need for short-term capital, longterm financing
was also used for financial activities other than investment.
Government intervention in investment financing has taken forms
such as direct budget credits, development loans, and investment
grants (under the Law for the Encouragement of Capital Investment).
Since 1974 development loans--whose interest rates were not adjusted
for changes in the rate of inflation--have contained a subsidy
element that arises from the differential between the low interest
rate paid by the borrower on the one hand and a reasonable market
rate of interest plus the expected rate of inflation on the other.
Beginning in 1979, the government linked development loans, thus
reducing this subsidization. Despite this linkage, the persistent
high rate of inflation had kept the effective real interest on
these linked loans negative.
Although Israel had a well-developed banking system, it did not
have a well-developed stock market in 1988. The Tel Aviv Stock
Exchange (TASE), founded in 1953, had never developed properly
because of the government's domination of activities relating
to the raising and allocation of capital. TASE thus remained a
shallow market, poorly regulated and dominated by the major banks,
who assumed all stock market roles--brokers, underwriters, issuers,
fund managers, counselors, and investors.
Between 1975 and 1983, private corporations increasingly raised
more of their capital on the stock exchange. Most of the shares
sold were highly overvalued and carried little or no voting rights.
By the end of 1982, the total value of the shares registered on
the TASE reached more than US$17 billion; in real terms, the value
had more than doubled in a year and had multiplied five-fold since
1979. This development stood in sharp contrast to Israel's stagnant
GNP growth and the worsening trade and debt position of the economy.
In January 1983, however, the market sharply declined. In a matter
of days, most speculators lost 50 to 70 percent of the value of
their stocks. Mutual funds, which had been responsible for much
of the market manipulation, became nearly valueless.
In October 1983, the shares of the banks (which up to that point
had been unaffected by the market malaise) finally collapsed.
Their crash precipitated a dramatic change in the development
of Israel's banking system.
The banking industry had expanded spectacularly in the 1970s,
both at home and abroad. This process had forced the banks to
increase their capital base rapidly. The gradual advance of inflation
in the economy, and its distorting effect on financial statements
drawn up under historic accounting rules, only added to this thirst
for capital. But in a capital market dominated by the government,
which was able and willing to issue endless quantities of index-linked
bonds, the banks found this capital difficult to raise.
The banks' solution was to transform their shares into indexlinked
paper by creating a system that ensured that the price of their
shares would keep pushing upward, irrespective of the underlying
market forces. Over the years, bank shares were perceived as a
riskless investment. By 1983 the price of bank shares was steadily
becoming more detached from their true value. When it became obvious
in 1983 that the government would have to devalue its currency,
many people began to liquidate their holdings of shekel-denominated
assets in favor of foreign currency. The assets most widely held
and most easily liquidated were bank shares. The selling wave
began in the summer of 1983 and peaked in October, forcing the
government to intervene. In 1988 the government undertook to secure
the US$7 billion obligation (equal to the public's holding of
bank shares) at the United States dollar value before the crash.
The closing of the TASE, on October 6, 1983, became known as the
"economic day of atonement" and represented the end of the speculators'
paradise created and supported by leading Israeli banks.
Data as of December 1988