Karnit Flug: The macroeconomic situation and the stability of the
financial system
Main points of address by Dr Karnit Flug, Governor of the Bank of Israel, at TheMarker
Financial Conference, Tel-Aviv, 4 March 2014.
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Accompanying slides can be found in the Hebrew version of the speech on the Bank of Israel's website.
The macroeconomic situation
The global economy is continuing to grow at a moderate pace. Growth in the US continues to
take root - even though the recent data has been weak, apparently due to the harsh
weather. In Europe, the very moderate and fragile recovery is continuing, with some concern
of deflation. In the emerging markets, there has been some improvement, although in some
of the larger countries, mainly those that have current account deficits, there have been signs
of weakness and fragility in recent months. Together with the moderate recovery, global
trade is also expanding. Growth in Israel moves in line with, and higher than, that of the other
advanced economies, and we expect that both the correlation and the gap will continue this
year as well (slide 2).
However, looking at recent months, we see a further slowdown in growth in Israel, and the
pace of growth declined from about 3 percent in the past year and a half to less than
2.5 percent in the past two quarters, while business output grew in those two quarters by just
1.6 percent (slide 3). Exports were the main factor in the slowdown in the third quarter, and
there were signs of improvement in it in the fourth quarter., but at this stage, they are
concentrated mainly in the pharmaceuticals industry and to a certain extent in the chemicals
and electronics industries as well, and we have not yet seen the improvement expand to the
other export industries.
The labor market continues to show a mixed trend: The unemployment rate declined and is
at a historic low thanks to an increase in employment rates that took place together with
stabilization of the participation rate at a very high level (slide 4). Our assessment is that the
decline in the unemployment rate reflects, among other things, a structural decline in the
unemployment rate due to processes increasing labor market elasticity in recent years that
led to a decline in the frictional and the natural unemployment rates. Furthermore, most of
the growth in employment in the past two years was in the public service industries - mainly
in the non-governmental portion of the public services - while the number of Israeli
employees in the business sector did not grow (slide 5). The number of work hours per
employee in the business sector also declined, and the rate of those who are involuntarily in
part-time employment increased. These reflect a certain weakness in the labor market.
Inflation in the past 12 months was 1.4 percent, and one year forward inflation expectations
are anchored within the target range, below the center of the range (slide 6). Following the
relatively rapid appreciation in the shekel exchange rate during the first half of 2013, there
has been a moderation in the pace of appreciation (slide 7). It is important to note that the
main forces acting for appreciation this year are the start of natural gas production and
expectations of the effect it will have on the balance of payments in the next few years, as
well as the relatively good position of the economy that is reflected in a current account
surplus and in the flow of direct investments in innovative and attractive Israeli companies.
All of these factors formed the basis of monetary policy this year, including the background to
the most recent interest rate reduction. It is important to mention that the monetary policy
goals set in the law are, first of all, maintaining price stability, meaning keeping inflation
within the range of 1-3 percent, and subject to that, support of growth and employment, and
of financial stability. Therefore, the decline in inflation, together with expectations of
moderation in inflation, enabled and even supported the reduction of the interest rate, which
is intended to support activity and growth, both by lowering the cost of credit and by its effect
on the exchange rate which mainly affects the commercial sector - the export industries and
alternatives to imports.
As I have noted in the past, we are not indifferent to developments in the exchange rate, and
we are aware of the effects it has on exports and on employment in the commercial
industries. Therefore, in addition to the interest rate policy, the Bank of Israel also intervenes
directly in the foreign exchange market - and we were active in the past year both in
purchases to offset the effect of natural gas production on the current account of the balance
of payments, and in order to moderate excess volatility in the exchange rate that is not in line
with fundamental economic forces (slide 8). We must remember that the foreign exchange
reserves are an important component of financial stability, and there are studies around the
world that indicate that a high level of foreign exchange reserves reduce the likelihood of a
financial crisis in the economy.
Regarding the housing market, home prices have continued to increase at a rapid pace,
increasing by about 8 percent in 2013, together with a rapid increase in the number of new
mortgages taken out. The Supervisor of Banks adopted measures intended to reduce the
risks inherent in mortgages and in their rapid growth. The recent measures adopted - which
restrict the payment-to-income ratio and set out that at least one-third of the mortgage should
be at a fixed interest rate - are acting to reduce the risk that households that took out a
mortgage will have difficulty in meeting their payments, for instance in a situation where one
of the household members loses his job, or if the burden of repayment increases due to an
increase in the interest rate. The decline in the share of mortgages with an loan-to-value
(LTV) ratio above 60 percent, and the decline in the share of mortgages with a
payment-toincome (PTI) ratio above 40 percent, indicate that the measures adopted have reduced the
risk inherent in mortgages (slide 9). With that, the continued rapid growth in the number of
mortgages and in their weight in the bank's credit portfolio are a risk factor, and if additional
measures are required, we will not hesitate to take them.
The increase in the number of building starts and completions that we witnessed in the past
year, to almost 45,000 starts and more than 40,000 completions - higher than the basic
demand for homes that is derived from growth in the number of households - is a positive
development. If this trend continues - and we see that the government is making efforts
in this direction - and if it includes areas of high demand, it will act to reduce the
pressure and stabilize home prices.
Financial stability
The picture of the stability of the economy can be presented in multi-dimensional form by
way of a radar chart that includes real data, accounting data and survey data, as well as data
that show the risk philosophy of Israeli and global investors (slide 11). The diagram for the
end of January 2014 indicates that the financial system and the economy are stable. The red
diagram reflects the situation at the end of 2008, and shows a picture in which almost all risk
indices, both global and domestic, were at record high levels at the height of the global
financial crisis. The blue diagram, which shows the levels of the current risk indices, indicates
relatively low levels, with most of the measured risks reflecting the global macroeconomic
situation - moderate growth, high unemployment, and low indices reflecting consumer
confidence and business confidence. These, of course, also have an effect on the domestic
macroeconomic risk, which reflects moderate growth. In contrast, the market risk indices,
both in Israel and globally, are at low levels, which creates a gap - both in Israel and abroad
- between the real situation and the investors' risk philosophy. This gap is apparently
affected by the search for yields in a low interest-rate environment, but it is possible that
expectations of an increase in corporate profits that will accompany the recovery also have
an effect.
A view of the business sector's sources of financing indicates that the trend of a decline in
the weight of bank credit and an increase in the weight of domestic nonbank credit - through
corporate bonds and recently through direct loans from institutional investors as well - that
we witnessed since the beginning of the century continues even after the global crisis of
2008-9 (slide 12). This is obviously a positive process, in that it increases and variegates the
sources of financing to the business sector, creates competition for the banks and acts to
reduce the cost of financing, thereby supporting growth. However, the process is also
accompanied by the creation of risks that must be addressed. Among other things, these
reflect the fact that the nonbank credit market has developed rapidly, while its regulation is
developing gradually. During the global crisis, most of the negative impact to the financial
system in Israel was reflected in this market: Yields in the market skyrocketed and issuances
froze. In total, more than 100 companies have entered debt restructuring proceedings thus
far - representing bonds totaling about NIS 40 billion. It is important to emphasize that this
number does not represent the scope of the loss absorbed by investors, which will naturally
be lower (slide 13).
Since the global crisis, as a lesson from global developments as well as developments in
Israel, in order to reduce the risks of a crisis and to reduce the damage of a crisis should one
take place, many measures are being taken in the field of regulation that are intended to
reinforce the durability of the financial institutions and system. Regulations have been
updated in the field of corporate governance and risk management at the banks; the Basel III
guidelines have been adopted in the area of capital requirements, and rules in the area of
liquidity and leverage will be adopted; the use of stress tests to identify risks in institutions
and in the system as a whole has been increased; the Business Concentration Law has been
passed to reduce the risks derived from complex and leveraged business groups and to
separate control of real corporation from financial corporations; the recommendations of the
Hudak committee to strengthen control of investments by financial entities in corporate bonds
have been adopted; the supervision of the payments and settlement systems has been
strengthened; and the Banking Supervision Department has taken a series of measures to
reduce the risks in the mortgage market (slide 14).
Beyond these changes, which have already been implemented or are in the process of
implementation or assessment, there is also a series of committee recommendations or
recommendations that are still being formulated, that are meant to complement the
improvement of regulation: the Goldschmidt committee to arrange the management of direct
loans by institutions; the Andoran committee, which is handling debt restructuring
proceedings in the economy. There is also a bill in advanced stages of legislation to handle a
failing bank, similar to legislation enacted in this area following the crisis in other advanced
countries.
Even though much has been done in the field of financial regulation since the crisis, and
there are steps still being taken, there remains much work to do. One of the important
lessons taken out of the development of the financial crisis in various countries is the fact
that while the institutions themselves were, in most cases, subject to supervision, there were
parts of the system that are not supervised or are less supervised, which expanded rapidly. It
also became clear that the connections between the various institutions, and the interfaces
between them, which led to the rapid transfer of risks between parts of the system and
increased its fragility, were neglected by regulators around the world. Therefore, the issue of
an overall view of the financial system, and the issue of coordination and joint work by the
various regulators is at the center of the recommendations of the various international bodies
on an issue that is at the heart of the required reforms in the field of financial regulation.
In terms of Israel, it is desired, as the International Monetary Fund has recommended in this
regard, to establish a financial stability committee that will entrench the coordination and
cooperation between all of the financial regulatory authorities, with the aim of identifying,
preventing and reducing systemic risks. This committee is supposed to define, monitor and
assess systemic risks; examine risks and exposures in the financial system in order to
identify and assess systemic risks; promote the exchange of information among the
financial regulatory authorities and between them and the stabilizing institutions (the Bank of
Israel and the Ministry of Finance); improve the coordination and cooperation between
the financial regulatory authorities and the stabilizers in analyzing evaluating, developing and
operating tools and methods to prevent and reduce systemic risks; issue warnings when a
systemic risk could become a material risk; make recommendations of measures to
prevent or reduce systemic risks that are identified; and track the actions taken as a result of
the warnings and the implementation of the recommendations (slide 15). It is proposed that
the staff work for the committee be done by the Financial Stability Division that was recently
established in the Bank of Israel Research Department, with the aim of acting to promote
financial stability which, according to the new Bank of Israel Law, is one of the Bank's goals.
A stable financial environment, and a financial system in which the public places its trust, are
essential for sustainable growth and a continued increase in the standard of living. I am
convinced that completing the steps that are currently being taken, including the
establishment of the committee as I have outlined, will contribute to the economy's ability to
withstand shocks which, by nature, will come. We have the privilege of taking these steps
during a period of relative calm and stability, and it is therefore important that we complete
them soon.