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Israel's Silent Struggle

After decades of monopoly, Israel's banks are finally facing reform.

9:00 AM, Jul 20, 2005 • By DANIEL DORON
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ISRAEL'S UPCOMING WITHDRAWAL FROM GAZA is drawing so much attention that few have noticed the dramatic vote this week in Israel's Knesset Finance Committee ratifying a government resolution to finally reform Israel's regressive financial markets. This reform will break up a bank duopoly which has inflicted more harm on the Israeli economy than Japanese banks have inflicted on Japan. Despite continued resistance from the banks, once this reform is enacted and bureaucratically implemented, Israel's economy will take off, realizing its potential to become one of the 10 richest countries in the world

Israel--which has excellent human capital--is economically hampered because after 60 years of socialism and statism it is dominated by highly concentrated, inefficient monopolies. Israel's labor and real estate markets are poorly utilized due in large part to punishing government regulation and ownership of land, utilities, and communication.

But the worst monopoly is Israel's banking system which is totally dominated by two banks, Ha'opalim and Le'umi, run by former Bank of Israel and Treasury officials working for an oligarchic cabal. Over 44 percent of tradable assets are controlled by three families and one bank. Credit is only offered by banks in Israel. There is hardly any commercial paper market. The banks are also underwriters dominating the stock market.

The Israeli economy has remained stagnant for two decades with per capita productivity barely growing because the banks made no productive investments. This resulted in over 10 percent unemployment and low labor participation. Most Israeli workers earn a salary of merely $1,200 a month and hundreds of thousands of families barely make ends meet. Economic stagnation has badly aggravated the many social problems that an immigrant absorbing Israel has had to face.

FOR TWO DECADES the banks managed to resist all proposed reforms despite the fact that the bankers have inflicted a series of economic calamities on Israel--starting with the notorious 1980s bank share manipulation and collapse, which cost the Israeli taxpayer at least $10 billion directly, and hundreds of billions of dollars more in lack of growth.

The banks continuously squandered the hard earned savings of Israelis, while making huge profits on exorbitant commissions and interest rates for consumers. With all interest earned on bank savings tax exempt until recently, 80 percent of all savings went to the banks. The banks paid savers below-market interest rates (their financial spread is over 5 percent), causing an annual transfer of wealth in the hundreds of billions of shekels from savers to the dozen or so families controlling them. Out of 1.5 trillion shekels in savings, the banks effectively control 1.15 trillion. Returns on investments by the banks are abysmally low, about 3 percent to 4 percent on average, costing the Israeli economy many billions annually.

On the lending side, 70 percent of loans went to 1 percent of borrowers, mostly bankers' cronies, on "favorable terms." Loans were invested in very speculative, highly-leveraged deals in real estate and entertainment, at the peak of a stock market bubble. Many went sour. The banks now admit to 61.4 billion shekels in questionable debts (their own capital is only 47 billion).

Medium- and small-sized businesses have limited access to credit; 70,000 of them have gone out of business. Discriminatory credit allocation has also badly inhibited the growth of the "peripheral" Negev and the Galilee regions, where mostly small- or medium-sized businesses operate.

The banks were able to maintain their stranglehold because the two major parties, Labor and Likud, owed them large sums and Knesset members needed bank loans for primaries. So the banks were confident that they could block any reform, even when Finance Minister Benjamin Netanyahu--the first high level Israeli politician to understand economics--pledged to break the banks' monopoly and introduce competition into the market.

When they realized that the Netanyahu was serious, and that there was considerable support for reform, the banks launched a costly campaign of disinformation and exerted enormous political pressure against it.

NETANYAHU, with only the support of Israel's economic media and from independent pro-market think tanks was fighting very high odds. He enjoyed, however, the support of Prime Minister Ariel Sharon, who was convinced by some of his knowledgeable aides that the government had no choice but to go ahead with the reform, because the alternative was not just a return to economic stagnation, which is bad enough, but the risk of an Argentina-like financial collapse. Netanyahu also enjoys the backing of Professor Stanley Fischer, the new governor of the Bank of Israel. But even more encouraging, for the first time in Israel's history, university students' organizations, representing 80,000 students, publicly struggled for the reform in coalition with free-market advocates. Israeli universities, like their American counterparts, are usually left-leaning. That their students, who have been for so long under the influence of professors who are strident advocates of an extreme welfare state would join the fight for free markets in Israel represents a sea change. This change in mindset, and the structural changes that the economic reform will generate, could transform Israel profoundly.

In a country justly preoccupied by security concerns, economic developments, even if they have a great impact on the country's well-being and security, usually don't get top billing. Still, if banking reform is enacted, the Israeli economy will finally perform to its full potential, and the year 2005 will be remembered as an historical turning point not only for Israel's economy, but for its social and military strength as well.

Daniel Doron is Director of The Israel Center for Social and Economic Progress, an independent pro-market policy center in Mevasseret- Zion, Israel.