Israeli bank crisis of 1983

In the Israeli bank crisis of 1983, bank shares collapsed, leading to a takeover by the government. For several years, the banks had actively intervened to promote their share prices, contributing to a 300% rise in real terms. The nationalized banks were not sold back to the public until 1993.

The crisis
On October 6, 1983, the Tel Aviv Stock Exchange (TASE) was shut down for 18 days following several weeks of heavy selling by shareholders of seven banks representing nearly all commercial banking in Israel. As during previous episodes of excess supply, the banks reacted by making large-scale purchases of their own shares. The unusually large autumn sell-off, however, strained bank liquidity and raised concerns about overall banking stability. These concerns threatened to cause a run on deposits and a drain of foreign exchange reserves that, together with other political considerations, led the government to close the Exchange. During the closure the government devalued the shekel and and assumed control of the banks, converting their shares into government guaranteed bonds. These newly issued bonds declined in value by 40% after the TASE reopened.

In a later verdict the banks were found to have caused the crisis by manipulating share prices for several years preceding the collapse. The government-appointed Bejsky Commission concluded in its 1986 report that the banks had manipulated stock prices "through a series of actions . . . designed to affect share prices and returns," and that these actions, the object of which was to convince investors that bank shares were riskless, caused the subsequent collapse.

A study estimates that investors and taxpayers incurred losses totaling $10 billion (in 1983 present value) - equal to about a third of Israel's 1983 GDP - during the crash and the subsequent period of government ownership.

Background
The crisis occured after a period of several years during which the banks intervened in the market for their shares, smoothing price fluctuations and providing support for upward movement in price and for frequent and substantial new issued. Share prices quadrupled in real terms, while stock offering proceeds from 1977 through 1983 were larger than 1977 market values for every defendant bank. Share appreciation and offerings contributed to a real 700% increase in banks' market value during the period. The banks' intervention prevented bank shares, representing more than half of overall market value, from falling even when industrial shares declined in real terms by 70% in 1978 and 1979 and by 50% in early 1983.

Normally, it might be difficult to sustain price levels not in accordance with fundamental values for long periods of time. Capital markets in Israel, however, were then characterized by features that allowed the intervention to succeed for many years:


 * Commercial banking was highly concentrated - as of 1996, the top three banks accounted for 80% of commercial banking activity. Moreover, it has been alleged that substantial barriers to entry into Israeli commercial banking have further dampened competition. Such barriers have probably been fortified by the political nature of ownership structure at several of the banks.
 * Commercial banks in Israel have traditionally dominated investment banking, mutual and provident fund industries, and the brokerage business, which may lead to conflicts of interest within banks among their different fiduciary roles. Indeed, such conflicts were key factors behind the passage of laws in various countries limiting the securities' activities of commercial banks.
 * Commercial banks in Israel are also merchant banks holding large equity stakes in many nonfinancial corporations, which may have allowed them to exert market power in those sectors.
 * Despite some relaxation, Israeli capital markets were relatively closed and constrained - Israeli investors are generally not allowed to own foreign securities, and the presence of foreign financial interests has been limited.

Why did the banks manipulate stock prices? The Bejsky Comission described two motives. First, if market prices were above economic values, the offering of additional shares at prevailing market prices benefited existing shareholders. Second, the high inflation that prevailed in the late 1970s and early 1980s, combined with poorly designed regulations, forced banks to repeatedly raise equity to maintain required capital ratios. Until the mid-1980s, equity was generally stated at historical values, whereas other balance sheet items were stated at current values, which, beginning in 1979, more than doubled every year. Unless new shares were issued frequently, equity-to-asset ratios would have fallen below regulatory requirements.

The banks were not hindered by government regulators. The Supervisor of Banks was reportedly concerned that banks would find it difficult to raise capital and meet reserve requirements unless they manipulated share prices. Other officials were pleased with the manipulation-aided new equity issues, since the proceeds of these offerings were, as required by law, invested in government bonds that funded annual budget deficits totaling 6% to 8% of GDP.

Not only did regulators and legislators fail to stop the banks, they actively facilitated manipulation in at least three ways. First, they granted the banks an exemption from insider trader legislation so that they could buy and sell their own shares without breaking the law. Second, they exempted the banks from a turnover tax imposed after the 1982 Lebanon War so that the banks could manipulate their shares without being hindered by transactions costs. Third, monetary restrictions that normally prevented the banks from converting foreign currency to local currency did not apply to conversions for manipulating bank stocks.

The banks employed a variety of techniques to support share prices. First, each bank maintained inventories of its own shares for the stated purpose of causing share prices to rise smoothly and consistently over time. The rise in total inventories to more than $1 billion (U.S.) by September 1983 and resulting liquidity problems ultimately led to the government guarantee.

Bank-employed stockbrokers, who accounted for almost 90% of trading in securities of all types, bolstered demand by recommending that clients purchase bank shares. Banks extended credit to purchasers of bank shares. Because credit was tight and regulated in Israel during the 1970s and 1980s, it was difficult for many customers to obtain credit at any interest rate. Tying credit to bank share holdings pumped up demand.

Hyperinflation
Inflation accelerated in the 1970s, rising steadily from 13% in 1971 to 111% in 1979. Some of this higher inflation was "imported" from the world economy, instigated by extreme oil price rises in 1973 and 1979. This introduced a new phenomenon in world economy, which came to be known as "stagflation" - an unprecedented combination of rising unemployment and economic stagnation (always accompanied in the past by deflation) now coupled with inflation. In Israel, a post-1973 full-employment government policy postponed this depressing development until the 1980s.

But inflation kept gathering pace. From 133% in 1980, it leaped to 191% in 1983 and then to 445% in 1984, threatening to become a four-digit figure within a year or two. It became obvious that the linkage system (the indexing of wages and prices to the CPI) was fueling the fire of inflation at an increasing pace. As inflation evolved into hyperinflation, the price spiral was taking a toll on economic output. Dealing with daily linkage adjustments and their repercussions was draining the time and resources of households and businesses.

In July 1985, the government adopted the Economic Stabilization Policy, which called for interference in the economy to an extent that would be considered "reactionary" among economic theorists. A total freeze of prices of all goods and services was imposed and the linkage mechanism was suspended. Everything from price tags in shops and stores, charges for services, prices specified in contracts, wages and public budgets to foreign exchange rates, remained fixed at the exact nominal quotation on the day the policy was declared.

In 1985, inflation fell to 185% (less than half the rate in 1984). Within a few months, the authorities began to lift the price freeze on some items; in other cases it took almost a year. In 1986, inflation was down to just 19%.