Bank of Israel report shows Israeli financial system might be at risk

Reductions in credit quality ratings coupled with risk realization could lead to an overall tightening of the global financial environment

July 6, 2019 19:24
2 minute read.
An Israel Shekel note

An Israel Shekel note. (photo credit: REUTERS/THOMAS WHITE)

Israel’s financial system is prone to significant risks due to falling bond yields in the United States and increased levels of global debt, according to a financial stability report published earlier this month by the Bank of Israel.

The report predicts an overall tightening of the global financial environment due to reductions in credit quality ratings coupled with risk realization. Global financial asset prices are also expected to decline.

Israel is expected to be affected by these downturns due to “high correlation between the capital markets in Israel and abroad,” with significant ramifications on financial asset prices in Israel, as well as on the desire to take financial risks, according to the report.

Liquidity risks in Israel rose due to high levels of corporate bonds held by mutual funds, passive investments and robotic algorithmic trading on the stock exchange. These factors may contribute to a decline in asset prices should a global recession hit.

In the United States, the 10-year Treasury Yield Curve – which measures the relationship between interest rate levels and the time to bond maturity – inverted earlier this year and was also cited by the bank as a major player in the likelihood of bringing turbulence to Israel’s financial environment.

“The yield to maturity on US government bonds, particularly long-term bonds, declined during the first half of 2019, and the slope of the curve, which the economic literature considers to be a leading indicator of the business cycle, became negative during the period,” the report said.

An inverted curve, where long-term yields drop below short-term yields due to investors thinking the economy will soon enter a recession, has historically been a reliable indicator of downturns. A curve inversion successfully predicted worsening economic conditions seven times between 1970 and 1998, according to an article in the Review of Economics and Statistics published by the Massachusetts Institute of Technology Press Journal.

The Bank of Israel also warned of a higher government credit risk due to a budget deficit currently at 3.8% of gross domestic product.

While real estate market risks decreased in recent months, along with a slight drop in housing prices, the bank advised the government to boost investment in housing construction to prevent future difficulties that could harm the economy.

“In order for the low likelihood of a shock in this market to persist in the long term, it is important to maintain an investment level that will respond to the volume of demand and avoid the resumption of upward pressure on home prices,” the report said.

Since 2007, real housing prices in Israel have trended upward, decreasing prospective homeowners’ ability to purchase a house, according to the Taub Center for Social Policy Studies in Israel.

“Following the most recent financial crisis, the link between the real cycle and the financial cycle has become much clearer,” the report said, “and shows that a slowdown in real economic activity is more serious when it is paired with a slowdown in financial activity.”

The Financial Stability Report is issued twice a year. The report analyzes and assesses risk exposure in Israeli financial institutions, households and businesses. It also evaluates a number of sectors, including portfolio assets, commercial real estate and nonprofit organizations.

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