Has the Bank Leumi (TASE: LUMI) affair become the Bank of Israel affair? Supervisor of Banks David Zaken's resignation announcement this week threatened to focus concern about Bank Leumi's conduct in the US on the central bank. More and more regulators in recent weeks have begun to examine the affair, following the grave findings about the bank's conduct that emerged in the investigation by the US federal authorities. The Attorney General, the State Comptroller, and even the Ministry of Finance Accountant General, are conducting investigations into a matter at least formally under the authority of the Supervisor of Banks, who is himself conducting his own independent inquiry.
In a "Globes" interview, Governor of the Bank of Israel Karnit Flug comments on various subjects, including the Bank of Israel's version of events at Bank Leumi. She says she knew nothing of the severe findings before the end of the investigation in the US. The Bank of Israel regards the criticism coming from all directions as hindsight, while promising to draw conclusions and learn the lessons.
In the "Globes" interview, Flug comes to the defense of Zaken, who she says took "unprecedented steps" to put households in a strong position vis-a-vis the banks and bolster competition in the industry. In the real estate market, Flug expects prices to begin falling in 2015, and finds it hard to conceal her sharp criticism of former Minister of Finance Yair Lapid's VAT exemption initiative for. She believes that inflation will reappear in the second half of 2015, but is unwilling to even consider raising the interest rate. Prices in Israel are relatively high, but not exceptionally so, nor is the stagnation in wages at all alarming. The banking system is more resilient than it was on the eve of the global credit crisis, but the banks are still too big to fall.
The Bank Leumi investigation: Banks should not assist tax evasion
"Globes": Is there a connection between David Zaken's resignation and the Bank Leumi investigation?
Flug: "The Supervisor is leaving in June, and I'm sure that the investigation, or audit that he's carrying out on Bank Leumi will be completed long before then."
But is there a connection?
"No. He intends to complete his probe in the Bank Leumi affair, and in general, he is continuing all his work on expansion of competition in his remaining five months here."
It could be that in view of this investigation, you should draw conclusions about your level of supervision here at the Bank of Israel. Maybe you fell asleep at the wheel?
"The Bank Leumi affair is certainly alarming. The Banking Supervision Department is in the midst of a thorough probe of the event, including the responsibility of officeholders, and we'll also draw conclusions at the level of the bank, the system, and the Bank of Israel. The State Comptroller is also checking the matter, and if there are lessons we have to learn, we'll certainly do so."
That's obvious, but what do you think in this context?
"First of all, conclusions are premature."
But why did you actually have to wait years until the US investigation was finished? Do you think that this was the most appropriate thing to do?
"You're talking with hindsight. We don't manage the bank, and there are things that we know in retrospect. Some of the criticism of the Banking Supervision Department's activity on the matter of Bank Leumi is also due to a lack of familiarity with all of the facts. The fact that the Supervision Department's activity is not conducted in public or in the headlines doesn't mean nothing is being done.
"It's true that the Supervision Department does not have the powers and means for an investigation available to the US enforcement authorities, and it was therefore correct to wait for the results of their examination, so that the Supervision Department would have the full picture in front of them when it did its checking - and it was correct to start its check only then, as is now being done. The probe will of course be thorough and painstaking, and incidentally will be concluded within a few weeks."
Are you liaising with the Attorney General?
"We are. Beyond that, this is a type of behavior that often leads to criticism of us. In my opinion, however, when you look at the long term, it's the right thing to do. It's right to wait until you have the facts, and to act on the basis of a full picture."
But the argument is that during this process, which the US authorities began in 2008, you had internal discussions, and discussions with the banks here, but you gave no instruction to the banks themselves during this period.
"Although we were briefed in general, we were definitely not briefed about the details of the investigation and the accusations - it's important to emphasize that. In addition to that, we were available to the other banks, but I won't say anything more than that."
When something seemed wrong in what the banks were doing, your predecessor said so. Here is where the question of the bonuses taken by the banks managers at that time comes in - whether to demand that they give them back. What will your position be?
"As I said, the Supervisor is in the midst of his probe, and when it is completed, it will be possible to draw conclusions. I don't want to make suppositions before we know what the investigation findings are."
In principle, though, what do you think about this entire affair?
"There's no doubt that when we look at it today, the affair is alarming, and it's very important to adopt a policy along the lines of the emerging norm around the world, what is called a white money policy. The banks should act in a way that does not help people trying to evade taxes in the way that happened in this case. Incidentally, I also think that it's about time to make tax evasion a predicate offence, so that the law can step up enforcement and impose more severe punishment in all matters pertaining to tax evasion in general."
Of Lapid and 0% VAT: A year of uncertainty
What mark do you give Lapid for his term as Minister of Finance?
"You won't get an answer to that."
You said that had it not been for the VAT exemption initiative, housing prices might have stabilized. Do you expect that to happen in 2015?
"What I said at the time was conditional, because it depends to a large extent on the supply of housing. If construction continues at the pace set in 2013 and 2014, in other words 44,000 building starts, and if it includes high-demand areas, then there is a reasonable chance that we'll see stability and even the beginning of a drop in prices."
So why don't we see a drop in prices>
"It's not immediate, although there was some backlog of demand that has still not been met, so it's reasonable for these processes to take a little time. In one sense, 2014 was a lost year because of uncertainty about the measures that were not taken, so many on the demand side, but also on the supply side, sat on the fence. I very much hope that we'll see some relief on this."
According to the Ministry of Finance, December was a peak month for purchases of new housing. There haven't been so many housing units sold in a single month since early 2000.
"Here we're really still at the height of the noise over clarification of government policy."
All in all, this 0% VAT affair caused a lot of damage in the market, did it not?
Flug's silence speaks louder than words.
Whichever way you look at it, the Bank of Israel's interest rate policy pushed up real estate prices substantially, primarily in the context of money seeking for an alternative to investment at a nearly 0% interest rate.
"The main target of interest rate policy is above all price stability and support for economic activity. Had the interest rate been higher, you would have asked me, 'Why is the overseas interest rate negligible or negative, while here it is high?' I think the exchange rate would have been in a completely different place, and we wouldn't be at the same level of growth and unemployment rate that we are right now. Our unemployment rate is low, our growth is reasonable, and we are seeing its rewards in improvement at companies. We see it in traditional industry companies in the figures from the corporate survey. We have seen a turnaround there, and interest rate policy is above all designed to affect the entire economy. That means taking care of employment, growth, and companies. As far as the effect on housing is concerned, there is some effect, but had there been a significant response on the supply side, I don't think that we wouldn't have seen the same price rise that we did, and it took a long time before the supply began to grow. In addition, in looking after borrowers, we embarked on a series of measures to prevent borrowers from assuming mortgages in amounts or on terms that they would not be able to repay."
But in the end the housing market paid the price of an expansionist monetary policy.
"I don't exactly agree with the way you describe things. The Bank of Israel has certain policy tools - the interest rate and the foreign currency market - but control over the supply and sale of land lies elsewhere. Unfortunately, there was no synchronization of housing supply policy with the demand, which was also affected by the interest rate."
Consider three scenarios for the real estate market. The first: real estate prices continue rising. The second: some stabilization takes place, and prices even start falling in a moderate and controlled way. The third: deflation of the bubble and collapse. Which of these scenarios lies around the corner?
"Assuming that the volume of construction continues at current levels, we're in the area of the second option."
Has the banks' risk in the real estate market receded? What are the other risks?
"The risk in the real estate market, and definitely its rise, has been halted. If I look at the mortgage parameters, they are safer today. The risk is lower. It still exists in an extreme scenario that is very unlikely, but if it occurs, it will be a combination of a steep fall in housing prices during a recession and a rise in unemployment that will make it hard for people to repay their mortgages. The second risk we mentioned, at a lower level, was underpricing of the risk in corporate bonds, and we have also seen some increase in margins. It's still a risk, but a less powerful one."
When a 10-year government bond is traded at 1.6%, is it possible that even the risk to the Israeli government's repayment ability is underpriced?
"The entire interest rate environment is very low, and inflation is very low."
With the Consumer Price Index falling 0.1% this year, you missed the target by a wide margin.
"Keep in mind that the inflation target regime enables us to deviate for a certain period from the inflation target (1%-3%), and according to the law, we should put inflation back into the target range within two years. In this sense, we have some room to maneuver. We're now seeing a steep decline because of lower prices for water and electricity, and also the effect of plunging fuel prices. Discounting these factors, we should return to 1.5% within a year. When I look at inflation expectations for a longer horizon, I see they are well within the target range. In the coming months, we'll see some kind of turnabout, and a rise in inflation."
Towards the middle of the second half of 2015?
"Yes."
In other words, there is no deflation caused by a drop in demand.
"What we have seen here is very light demand for investments and for exports. Potential production is greater than actual GDP, and that in itself is working to keep prices low. If we look at total demand, private consumption was relatively strong, especially for cars and durable goods. General consumption was definitely reasonable. It may be that to some extent, we have some degree of output gap, meaning that we're below potential GDP, but not by a wide margin."
Is it easier for the Bank of Israel to live with the current exchange rate?
"When I look at the current level, compared with where it was before the interest rate cuts and before the changes and at the dollar exchange rate in comparison with other exchange rates, it's definitely more comfortable than it was."
Is another interest rate cut an option for you?
"As I said at on a previous occasion, we're seeing that even when the interest rate reaches the vicinity of 0, there are still many tools that central banks have used in other places, including the European Central Bank. If we think that this is relevant, we'll consider it. At present, we're not there."
Does Israel have a problem with product prices?
"When we look at the level of prices in Israel, given the per capita GDP here, and of course there's a connection between per capita GDP and price levels, we see that Israel is not exceptional in this regard. The level of prices here is a little above what you'd expect to find in a country with the per capita GDP we have. That doesn't mean that there aren't any elements in the basket with relatively high prices, and food, for example, is one of the examples in which prices have gone up more."
Do you think that wages should rise?
"We need to increase productivity, which will eventually also increase wages. In the long run, wages are derived from productivity."
Productivity has not risen in recent years.
"It did rise, but moderately."
According to figures presented by Prof. Yossi Zeira, productivity in the private sector has risen 23% since 2000, while wages have gone up less than 1%.
"Zeira's point of departure is a peak in wages. During the first decade of the 21st century, wages rose much more quickly than productivity, and in the second decade, they rose more slowly than productivity. If you look at the entire period, there is some gap, but not a large one. Wages did indeed rise by slightly less than GDP per hour."
What are your expectations from the next government?
"I expect a stable government that will be able to go ahead with plans having a long enough horizon, because too frequent changes of government cut reform initiatives short. If we have a temporary budget every two years, there is a real problem. Beyond that, we need a very active policy in the labor market on doing business, and on infrastructure. There are long-term plans that can be put forward only with a government that has a longer horizon. In addition, I hope that there will be a government with an open professional dialogue, and that it will be possible to discuss all policy matters."
Published by Globes [online], Israel business news - www.globes-online.com - on February 5, 2015
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