Worker assembling electronic equipment
Courtesy Embassy of Israel, Washington

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 Develop 13cb pment 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