Stanley Fischer: Capital market reforms in Israel
Address by Professor Stanley Fischer, Governor of the Bank of Israel, to the Knesset Finance
Committee, Jerusalem, 5 July 2005.
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Mr Chair of the Finance Committee MK Yakov Litzman, Members of Knesset, ladies and gentlemen:
This is my second appearance here before you, and I am pleased that the subject concerning which
you invited me is also one of the most important to have reached the Knesset in the recent past--the
reform of the capital market in line with the proposals of the Bachar Committee.
Let me clearly state at the outset that I support the reform proposed by the Bachar Committee. That is
what I said a month and a half ago here when I first addressed you as Governor, and again last week
to the participants in the Caesarea conference.
When I say that I support the Bachar Committee reforms I mean the following:
1. I agree that the purposes of the reform have great impact on the financial system's ability to
support growth in Israel. These purposes are:
a.To reduce the concentration in the financial system and to increase competition in the
capital market.
b.To reduce the possibility of conflict of interest in the financial system.
c.To create significant alternatives to the banking system as sources of finance.
2.I favor separating the provident funds and the mutual funds from the banks as this is a way of
achieving all three of the above objectives.
3.I favor allowing the banks, after the above separation, to give objective advice about, and to
distribute life insurance, pension schemes, provident funds and mutual funds, provided we find a way
to prevent the banks from abusing the power and dominance they hold owing to their extensive
distribution network to give them an unfair advantage. In this context the proposed restrictions on bank
fees are intended to ensure that this will not happen.
4.I am in favor of banks known as emerging banks selling their mutual funds and provident funds as is
proposed for the big banks and operating within the same framework proposed for the big banks.
Otherwise the present potential for conflicts of interest will remain. We have recently heard from the
emerging banks that they need the various funds to preserve their financial robustness. I believe that
separation will not adversely affect their robustness; on the contrary, after the implementation of the
reform of the capital market, the developments in the financial system, and in particular in the banking
system, will lead to the creation of incentives to the emerging banks to find ways to strengthen their
ability to compete with the big banks, including via mergers.
The following serious questions arise in the course of discussions of the capital market reform:
a. The stability of the banking system. I think that this will not be affected by the separation of
the provident funds and mutual funds from the banks. The stability of the system depends on
the quality of the asset portfolios held by the banks and the manner in which they manage
them. I believe that when the banks focus on classic banking they will manage their
portfolios even more efficiently than they do today. I am not saying that the banks are
inefficient now; I am saying that they will become even more efficient.
b. The stability of the financial system. In this regard too I see a great advantage in
separating the funds from the banks. During the severe global financial crises in the 1990s
we discovered that the broader the range of financial institutions a country had without any
institution being dominant, the more stable was its financial system. This is the case because
a problem experienced in one sector did not roll over into other sectors, and the system
benefited from the flexibility to act efficiently. When our financial system is more diverse, we
can have greater confidence in it.
c.The concentration among banks. It is true that from the customers' point of view, initially
there will not be any great changes. Nevertheless, the reform will reduce the dominance of
the large banks in relation to the others, and this will eventually be reflected in a more
competitive system.
One important aspect of the bill placed before you as part of the reform of the capital market is the
supervisory aspect. It is clear that this subject comprises an important basis for the reform of the
capital market. On the one hand we hope to create a foundation in which the market--when it is
competitive and free from conflicts of interest--will constitute an effective supervisory mechanism, but
on the other hand we must strengthen the supervisory setup in order to ensure that the capital market
really is more competitive and free from potential conflicts of interest. We therefore suggest that within
the framework of the proposed legislation that you are considering, the Banking Ordinance should
incorporate the authority of the Supervisor of Banks to issue directives on the proper conduct of
banking business. This he would do after consultation with the Bank's Advisory Committee and with
the approval of the Governor. With regard to the concentration in the banking system, the Supervisor
of Banks is working to make it easier to move from one bank to another, which should have a direct
beneficial effect on customers.
I would like to add a few remarks from a personal angle: my standpoint on this matter is affected by
my experience in the private sector in the last three years in Citigroup, the largest financial institution
in the world. Five years ago Citigroup was a universal bank that encompassed commercial banking,
investment banking, a large insurance company, pension funds etc. Originally Citigroup thought it to
their economic advantage to own and manage a range of financial products.
However, in 2003 and 2004 Citigroup decided to sell the insurance company, because after three
years' experience they realized that a large bank such as Citigroup derived no financial benefit from
owning and managing an insurance company.
A few months ago Citigroup decided to sell their funds too. Charles Prince, Citigroup CEO, is quoted in
one of the leading financial papers as saying that one of the reasons for selling the funds was the
concern of the supervisory authorities, and not just them but also investors themselves, regarding
potential conflict of interest that exists when a bank, in this case Citigroup, offers funds that it owns to
the public. This concern made it less economically worthwhile to continue to do so. Prince remarked
that other banks that owned funds would eventually reach the same conclusion.
In this context I would also like to tell you what an analyst in an important financial company in Boston
said. He commented, in reference to the sale of funds by Citigroup, that during the 1990s huge
financial companies were anxious to merge financial intermediation activity with that of financial-asset
management, such as funds. With regard to the potential for conflict of interest in the new reality
created, he said that the distribution and management of funds are two distinct occupations that
require different qualifications. Distribution is related to marketing and consultancy, and it is important
for customers--both from the point of view of the supervisory authorities and from that of customers
themselves--that the consultant be objective. That cannot occur, however, when the same bank holds
the funds that it is trying to market and give advice on.
I would say that a bank that owns funds has an economic advantage if it occupies a dominant position
in the capital market and it faces no restrictions with regard to potential conflict of interest. But when a
real mechanism exists that prevents such potential from arising, the bank apparently derives no
economic advantage from such a situation. In Israel we tried to deal with this problem by erecting
firewalls. By the way, that is what was done also in the US. But as we were to discover eventually,
these firewalls in Israel were not effective enough, and all attempts to shore them up and increase
their effectiveness were unsuccessful.
In the US, because the banks--even the big ones, even Citigroup--are small in relation to the
financial system and are not dominant in it, the firewalls worked, and market forces resulted in a bank
like Citigroup deciding to sell its insurance company and its funds, for economic reasons.
In Israel we have tried various methods of solving the problem, including firewalls, but without
success. This is because the banks remained as dominant as they had been. That is why the Bachar
Committee opted, and rightly so, to go in the direction of legislation.
I hope that in time, once the reform has been carried out, when the banks in Israel are less dominant,
market forces and economic considerations will also make the banks realize that it was not worth their
while to hold a range of financial products, but to focus on areas where they have a comparative
advantage.
Then we can claim that the reform was really successful. Thank you very much.