Errors, lack of familiarity with the situation, lack of awareness of the characteristics of the Israeli market, as well as fundamentally mistaken conclusions and recommendations that are wide of the mark, characterize the report by US consultancy Promontory that was recruited by the Association of Banks in Israel to aid it in its battle against the recommendations of the Bachar committee on reform in Israel's banking system and financial market.
This is the view put forward in a document, entitled " The Association of Bank's White Knight", prepared at the Ministry of Finance's behest by economists Professor Marshall Sarnat, of the Faculty of Business Administration, Ono Academic College-Kiryat Ono, and Professor David Levhari, of Mercaz Shalem and Netanya Academic College. Sarnat and Levhari met Prime Minster Ariel Sharon two weeks ago and expressed full support for the Bachar recommendations, which, among other things, call for the banks to be divested of their provident and mutual funds.
The following is the text of Sarnat and Levhari's response to the Promontory report:
"Promontory Financial Group (hereafter "Promontory") was hired by the Association of Banks (the "Association") to evaluate the Bachar committee's proposals, despite the fact that they have yet to be formally published. Hence it should not come as too great a surprise that Promotory's very distinguished panel of economists appears to be in virtually complete agreement with policy proposals already advocated by the Association.
"Although we agree with Promontory that "the laws of economics are not country specific", it should be emphasized that all applications of economic theory in practice, as well as the policy prescriptions derived from such theory, must be evaluated within the context of the specific "industry structure" (in this instance the financial system) and socio-economic environment of the country in question. This is especially crucial when dealing with Israel's financial system, which has suffered relatively violent shocks during the past twenty years.
"The distinguished members of Promontory's panel appear to be innocent of the implications of the manner in which Israel's existing financial system evolved and of the critical importance of basing their policy proposals on the specifics of the existing institutional framework. The basic tenet that underlies their report, i.e., that Israel's financial structure is not sufficiently different from that of other small countries to warrant the Bachar committees "unique" recommendations, is simply incorrect.
"Where else can one find comparable fee structures to that which characterizes Israel's banking systemfees levied on each and every transaction, fixed monthly fees independent of transactions, substantial custodian fees even for the banks own mutual funds (often reaching 0.5% per annum)?
"Israel's relative isolation from "foreign" competition provides yet another example that sets Israel apart from supposedly similar countries. For example, investors in the Netherlands have recourse with little or no difficulty to the financial markets of neighboring countries. Similarly, Promontory's comparison of Israel's "concentration ratio" to those of individual States of the USATennessee, Alabama and Oregonagain misses the essential point. The banking and financial markets of New York, Chicago and California are readily accessible to firms and individuals in Tennessee, Alabama and Oregon. Perhaps Promontory has been led astray by the old joke that Israel is the "51st State" of the union.
"Moreover, many of Promontory's recommendations ignore the absence, in Israel, of major non-banking financial institutions (such as GE Finance, GMAC) and of a well-developed investment banking sector. It is these non-banking financial institutions that play such a significant role in fostering competition in the financial sectors of the United States, Western Europe and other developed economies. As a result, the panel underestimates the negative impact on competition of the Israeli banks' virtual dominance of the capital market.
"It is this dominance that has served as an effective barrier, discouraging and often precluding, the entry of additional competitive institutions. Promontory's contention that, "Competition is fostered by the entry of new firms, not by the exit of old ones", while generally correct, does not hold for Israel. In the specific case of Israel, the complete separation of the commercial banks from the control and management of provident funds, mutual funds and underwriting is a sine qua non for the creation of an economically viable investment banking industry.
"Israel is confronted by a dilemma. The creation of an efficient competitive capital market requires new entrants but this requires the complete removal of the banks from the markets for provident and mutual funds and not just a reduction of their market share. Hence, in Israel meaningful capital market reform is contingent on the prior disengagement of the banks, but this cannot be accomplished without first promulgating the reform.
"Promontory also addresses the problem of mitigating conflicts of interest. However, once again the panel is in error when addressing specific problems in Israel. Promontory's dictum, that in Israel, "the usual potential conflicts of interest exist,…as they do all over the world, but there is no substantial record of abuse" is simply wrong.
"Promontory ignores much of the past twenty years of Israel's economic history the 1983 collapse of the banking and financial system; the abuses of the banks' management of their provident and mutual funds and the numerous conflicts of interest, documented in great detail, in the Bejski Report; the evidence presented at the trial of Israel's leading banks before the Jerusalem District court and the Supreme court; as well as the financial scandals that rocked the mutual fund industry in the 1990's. A more careful examination and evaluation of the empirical record and documents might have permitted a more even-handed approach.
"An even more misleading error can be discerned in Promontory's conclusion: "if banks are replaced by insurance companies, the potential conflicts of interest will remain. So we do not see a valid conflict-of interest rationale for the proposed divestiture." This implies that the potential conflicts of interest of insurance companies or other non-banking financial institutions, who replace the commercial banks in the management of the funds, are of the same order of magnitude as those of the banks.
"Nothing could be further from the truth. Just consider the fact that the banks in Israel are in virtual control, or at very least constitute the dominant factor, in the short- medium- and long-term lending markets, in underwriting, in the corporate bond market and in stock brokerage. Moreover, as the Bachar committee has emphasized the banks, by virtue of their comprehensive national network of branches, enjoy and will continue to enjoy, a virtual monopoly on the provision of investment advice to the public.
"Having failed in their diagnosis, by underestimating the depth of the conflict-of interest problems in Israel's financial system, it is altogether surprising that the panel finds the divestiture proposed by the Bachar committee "a drastic remedy". Once again, the panel chooses to ignore the specifics of Israel and opts for a long list of alternative palliatives, for example, disclosure, so-called "Chinese walls", and enhanced regulation and supervision, that "international experience demonstrates…are better ways to deal with conflicts of interest".
"In this instance we find it impossible even to accept Promontory's (unsupported) interpretation of international experience, let alone its application in Israel. Many, if not most, serious researchers abroad agree that it is "market discipline" imposed by competition that constitutes the key to preventing the abuse and exploitation of conflicts of interest. Moreover, even the most cursory examination of the evidence would show that it is Israel's experience with Chinese walls and regulation that helped spawn the demand for complete divestiture.
"To paraphrase Dr. David Klein, the Governor of the Bank of Israel, Chinese walls made out of steel distort the capital market; and if made out of bamboo, they are too porous to effectively carry out their designated tasks. Or as one researcher has succinctly put it, "In Israel, Chinese walls are made out of Swiss cheese".
"The Bachar committee's recommendations with respect to divestiture of commercial and investment banking, by themselves, do not constitute the comprehensive reform required by Israel's financial system. Much remains to be done especially in the area of commercial banking. But the Bachar committee's recommendations do constitute a necessary first step on the road to a comprehensive restructuring and reform of Israel's financial system. With apologies to Sir Winston Churchill -- This not the end; it is not even the beginning of the end; but it is, perhaps, the end of the beginning."
Published by Globes [online] - www.globes.co.il - on October 27, 2004