Of banks and bankers (2)

Last week’s column posed the question – increasingly frequently asked – of whether one or more Israeli banks are likely to “collapse.” The official line, almost needless to say, is that Israeli banks are sound, well-capitalized and in no danger. But, equally needless to say, the more often this mantra is chanted – whether by the top echelon of the Bank of Israel or by the prime minister or finance minister – the less credible it sounds and the more concern develops among the general public.

Let us therefore start from the other premise: that, yes, the problems of the global and domestic banking industry are such that one or more Israeli banks will suffer such serious losses that they will be seen to be in danger of collapse. What then?

The answer is obvious, especially given the numerous examples provided around the world in recent months: The government will have to step in and prevent the bank’s collapse.

This is true irrespective of which bank is involved, because the Israel system is so interconnected that the collapse of any one of the five main banking groups – Hapoalim, Leumi, Discount, Mizrahi-Tefahot and First International – would inflict sufficient direct damage to bring the others down. Furthermore, if the direct damage did not suffice, for whatever reason, the ensuing panic would encompass all the banks, with inevitably dire consequences.

To prevent any such cataclysm, the government would “step in.” But what does that mean? The answer derives from the nature of the crisis, and requires a clear distinction between a liquidity crisis and a solvency crisis.

In a liquidity crisis, the assets of the bank are sound – the borrowers have not gone bust and are capable of servicing their debts – but the demand for cash on the part of depositors exceeds the bank’s reserves. In this situation, the central bank “steps in” and provides additional liquidity by acting as “lender of last resort” to the stricken bank. Once the liquidity crisis subsides, the bank can, in the best case, resume normal function, or, more likely, take steps to repair itself by raising new capital and/or merging or selling itself to a stronger entity.

But a solvency crisis is a quite different and more dangerous beast. It means that the bank’s underlying assets – the loans it has made to customers and/or the bonds it has bought – are so impaired that its own equity will be insufficient to cover the losses that have been incurred, or will be shortly. In this case, the bank needs to be saved in one of two ways: by an injection of new capital, which more than compensates for the capital destroyed by the losses incurred on loans; or by the sale of the bad loans and their removal from the bank’s books, so that the remaining capital is sufficient to support the remaining healthy loans.

That is the essence of all the sound and fury that has surrounded the global banking system for the last 18-20 months. In Israel, the banks were not significantly exposed to many of the proximate causes of the mess in the US, such as “subprime” mortgages, and were therefore spared the losses these generated. Even then, those who were tempted into this investment channel paid heavily, as Hapoalim’s write-down of over $1 billion last year illustrated.

But these foreign-generated losses aside, Israeli banks’ losses have not been on a life-threatening scale – so far. The concern, the questions and the attempted reassurance all relate to potential losses.

Where might these come from? One obvious source is exposure to the real-estate sector, primarily in Eastern Europe, where Israeli companies have been active, the economies are crumbling and losses are mounting rapidly. But these losses are unlikely to be large enough to destroy any of the banks, although they will certainly force them to raise more capital – as, indeed, they are engaged in doing. If it transpires that the private sector is unwilling to provide the amounts needed, there will be little choice but for the government to take on that challenge and make loans or directly buy equity in the banks.

The other potential killer is the slowdown in the domestic economy. The longer this goes on and the broader it gets, in terms of sectors hit, the more the banks lose. As soon as you accept that this is no normal recession, the countdown to disaster begins. Granted, Israeli banks are in better shape than most of their foreign peers, because of the lessons learned (the hard way) in the severe recession of 2001-2003. But that is a relative advantage, which may ultimately prove insufficient.

In short, therefore, the banking system is as good as the economy as a whole. That’s good news, because in many countries, such as the US, the UK and Switzerland, the banking system is a problem in and of itself, with the economy as a whole representing a second level of problem.

We have largely skipped the first level, but that doesn’t mean we are safe. As things stand, the banks are at the mercy of the domestic economy, and the domestic economy is being dragged down by the rest of the world. So there is a serious and potentially existential issue here. Over to you, government, prime minister, finance minister, etc. Government? Are you there? Prime minister? Hello-oo?