The decisions taken by a small group of key individuals at the Bank of Israel can have profound implications for the welfare of the country
By ZIV HELLMAN15-ziv(photo credit: )
The computer screens look as comp-
licated and busy as the cockpit display of a fighter jet. The men and women in this air-conditioned room in Jerusalem coolly keep their eyes glued to a bank of monitors presenting up-to-the-second reports on multiple currency exchange rates, bid-ask spreads for government-backed securities from dozens of countries and graphs detailing the performance of international financial markets, all the while executing complicated deals by phone and e-mail with colleagues in foreign locales. Their calmness belies the fact that they are managing the single largest financial fund in Israel, valued at $29 billion.
But this money does not belong to a private bank or a hedge fund - it is the sum total of the foreign currency reserves of the State of Israel. It is, in a sense, owned by every citizen, and the traders in the room on the third floor of the Bank of Israel are charged with preserving its value, while at the same time managing it at a high level of liquidity and achieving a reasonable yield.
In their daily business, few people give much thought to the large Bank of Israel building that looks like an immense ship, or an upside-down pyramid, located across the street from the Prime Minister's Office in Jerusalem. Nor do many pay attention to the activities that take place inside it, apart perhaps from a momentary thought when there is a news report on the latest change in the interest rate. The central bank, however, is a crucial pillar in the functioning of the economy, which like every modern economy is so complex that few have a grasp of how it operates, so intangible that most take its workings for granted and, at the same time, so delicate that the decisions taken by a small group of key individuals, such as the bank's governor, can have profound implications for the welfare of the country.
The senior managers of the Bank of Israel have their offices on the upper floors, where they enjoy a sweeping view of the government's executive branch - in the form of the Prime Minister's Office and the Finance Ministry - and the legislative branch - the Knesset building - from both of which the bank has broad independence. Ever since the 1970s, inflation has come to be viewed as the single largest threat to financial stability. Israelis, who experienced inflation that reached nearly 450 percent in the mid-80s, have particularly bad memories of its negative effects. A functional division of labor has developed, in which the government sets the inflation ceiling, but the tools to achieve the target rate are in the hands of the governor of the Bank of Israel, who, like his counterparts in the United States and the Britain, is independent of government oversight in this matter.
In recent years, Israel has succeeded in keeping inflation down, to low single digit figures. Forecasts for this year show inflation falling to the lower end of the government's annual target of 1% to 3%.
This independence has the potential to lead to friction, although both Yaakov Danon, director-general of the bank, and Yossi Saadon, the bank's spokesperson, insist that, at least recently, the government and the Bank of Israel have worked very closely without disagreements. "There is a single financial policy assembly line that includes the treasury and the Bank of Israel," says Danon. The independence of the central bank from the government is considered a nearly sacred principle in most developed nations, designed to maintain a separation fence between the professional financial considerations of the bank and the political goals of government ministers.
When pressed, Danon admits that it is nearly impossible to disentangle economic matters from political value judgements - even the definition of poverty, for example, can reflect differences of emphasis with important implications - but he says firmly that the bank does its utmost to stick to professional matters alone. "At the end of the pipeline, obviously, the Knesset and government make decisions that are political in nature," says Danon, "but we are at the end that feeds in the professional facts, and without the correct professional facts no government of any political leaning can make correct decisions."
The bank controls inflation through the levers of money supply and demand. Although it may be strange to think of money itself as a commodity subject to supply and demand, it can be controlled in this way. The bank can reduce the supply of money in the economy, for example, by selling short-term securities that 'soak' up money from the public and thus make less of it available. The demand for money is reflected in the interest rate, and the governor sets the prime interest rate mainly by making changes in the interest rates charged to commercial banks, which take loans from the bank. This then affects the interest rates the commercial banks charge those taking loans from them.
With power comes public scrutiny and criticism. A high interest rate dampens economic growth, because it discourages people from taking loans to finance new purchases or new investments - and that is precisely the effect desired by the bank. "Controlling economic growth is the way inflation is dampened," says Saadon.
But not everyone agrees that reining in inflation is more important than growth. Saadon notes that, in the past, there has been talk by some in government about raising the inflation target as a way of influencing the central bank's decisions involving the question of growth versus inflation. But, he adds, this has never been undertaken seriously, especially given the role of the governor as economic adviser to the government. The bank is also heavily influenced by a current near-consensus in international financial circles - a delegation from the International Monetary Fund visits the bank every year, for example - that puts fighting inflation very high on any central bank's agenda.
Adam Reuter, who was a high-ranking dealer in the Bank of Israel's monetary department in the early 90s and is today CEO of Financial Immunities Consulting, however, accuses the bank of insufficiently implementing the provisions of the law that created it in 1954. "The Bank of Israel Law requires the bank to work toward both financial stability and economic growth," Reuter told The Report. "By concentrating solely on financial stability, it is harming economic growth. One of the main sources of inflation in Israel now is the dollar-shekel exchange rate. The Bank of Israel refuses to intervene in the exchange rate, even though it could attain both the targets of holding down inflation and encouraging economic growth, as is done in other countries with economies of the size and type of Israel's, by weakening the shekel instead of relying solely on interest rate manipulation." Setting the interest rate correctly can sometimes be as much of an art as science and, in the end, the decision is in the hands of one person, the governor, who sets it as he or she sees fit for the goal of financial stability.
The current governor of the Bank of Israel is Stanley Fischer, formerly a professor at MIT, vice-president of the World Bank and vice-chairman of Citigroup in the U.S. Fisher's name is extremely well respected among economists. The international journal Global Finance last month included him in its list of the seven leading central bankers, saying that he had successfully handled the economic effects of the Second Lebanon War and strengthened the central bank's position, while also earning praise for his interest rate policy.
Fischer, who was born in Northern Rhodesia, today Zambia, and came to Israel only upon his appointment in 2005, has also managed to overcome initial local skepticism that he was "insufficiently Israeli" for the position, even insisting that meetings be conducted in Hebrew and not in English for his benefit. Under Fischer's direction, Israel's interest rate is now below that of the United States, a situation that a decade ago would have been considered incredible because much foreign investment in Israeli markets was based on the higher interest returns then available in the country.
Despite Fischer's undeniable credentials, there are those who feel that the setting of the interest rate should not depend on one individual alone. Danon says that under the reorganization of the bank that is scheduled to take place in the near future, and may be accompanied by a new Bank of Israel Law, decisions on monetary policy would be determined by a majority vote of a committee that would include both Bank of Israel employees and financial experts, making the Israeli system more similar to the American one.
Danon himself was brought in to the bank to implement a reorganization in the wake of a series of image-harming revelations of immense salaries being paid to bank employees and work disputes that followed efforts to reduce salaries and benefits.
Reports in newspapers two years ago stated that top employees were receiving salaries of between 87,000 shekels ($21,500) and 97,000 shekels ($24,000) per month. "Those figures do not reflect reality," says Danon. "They were manipulated, by conflating one-off payments and benefits with monthly salaries." Danon has spent nearly two years negotiating with the treasury and the worker's union at the bank, in an attempt to work out a restructuring at the bank that would reduce costs. "We are in the last 100 meters of the marathon in this respect," he says. The proposed reorganization includes the consolidation of departments and reducing the staff of 750 by 80-100 employees.
Danon hopes the disputes over salaries will be resolved by a multi-tiered salary system, in which veteran workers will continue to receive salaries and benefits as promised them in the past, and newer employees will have salary caps more in line with civil service rules. There will also be a differentiation between salaries paid to financial professionals and other workers - a differentiation that did not exist in the past. "I can pay administrative workers with one scale, but need a different scale for the finance people," says Danon. "We work with tens of billions of dollars and need top-notch talent, which can easily be lured away by large salaries in commercial establishments."
The word 'stability' is often stressed in the offices and hallways of the Bank of Israel, just as it would be in any bank. And the Bank of Israel is, among its many roles, also an actual functioning bank. "We are the banker of the banks," points out Saadon, meaning that banks turn to the Bank of Israel for their banking needs, just as individuals go to their local bank branch.
The banks deposit money with the Bank of Israel in interest-bearing deposits and also borrow money from it, but just as importantly, the current accounts the banks maintain with the Bank of Israel serve for inter-bank transfers. The Control Room, on the second floor, is where local currency clearing operations, in which the different banks exchange checks and other items, are monitored. "We execute immense transactions in microseconds," says Talat Abu-Lil, who oversees the ultra-computerized real-time gross settlements system in the bank.
The Bank of Israel is also the banker to the government, handling government financial accounts - mainly from tax receipts - domestic loans and some foreign-related activities. The shekels jingling in our pockets are also a product of the bank. The currency department is charged with ensuring a regular supply of banknotes and coins, in just the right amount - currently over NIS 26 billion in physical cash, with 96 percent in banknotes, although surprisingly more than 50 percent of the coins are in the small 10 agorot (about 2.5 cents) denomination. The cash physically flows from the Bank of Israel to the public via the commercial banks.
The bank's website dryly states that "banknotes are printed and coins minted abroad, since the requirements of Israel's economy do not justify establishing a printing press or mint in Israel." But Saadon steadfastly refuses to disclose where precisely abroad the money is printed. There is a reason this is such a closely held secret. The increasing sophistication of readily available printing systems makes counterfeiting banknotes ever easier - and in a kind of 'arms race,' mints and banknote printers are always racing to remain a step ahead of the counterfeiters in technological sophistication, and striving to keep their techniques a secret.
Israel is not unique in having a central bank, a system that has existed in various countries since the 17th century, and virtually every central bank today operates in these spheres - a visit to the Bank of England or the U.S. Federal Reserve, for example, would yield a similar picture. Countries actively seek to learn from each other about what works or does not work when it comes to keeping the financial ship stable, under the assumption that there are laws of economics that apply nearly universally.
"We meet with our counterparts in other central banks and travel to visit them, in order to study what is best for us," says Danon. "This has been especially true recently, as the Bank of Israel is planning a reorganization, and we have mostly focused on the operational models of European central banks, including some of the newer ones in postcommunist Eastern Europe." There is one feature that distinguishes Israel from nearly every other country, according to Danon - the governor of the Bank of Israel is by law considered the chief economic adviser to the government. "This requires us to maintain a top-notch research department," says Danon, "and in fact we have one of the best and largest research departments amongst central banks in the world."
Not everyone agrees that the European model is the best one for Israel to adopt. Reuter believes Israel would be better served copying central banks of countries closer to Israel's economic profile, such as Taiwan or South Korea. "The Western European countries used to have independent currencies, but the introduction of the euro changed that," notes Reuter. "The euro-zone is immense, and the tools of the European Central Bank might not necessarily be the right ones for a country the size of Israel."
The fourth floor of the Bank of Israel houses the bank supervision department. Although current economic orthodoxy holds that, in most cases, the business decisions of private companies are best made by themselves rather than external supervisors, this thinking does not extend to the banks at the heart of the world's financial system.
Banks everywhere are a potentially disastrous source of instability, because the bank statement each of us receives displaying the current balance in our account is in a sense fictitious - the money is certainly registered in our name, but most of it is not physically located in the bank. Instead of simply storing customers' money, the bank uses deposited money to issue loans. If defaults on the loans start piling up, or too many customers queue up at once to withdraw their deposits, a bank can quickly find itself going out of business - and its customers can lose all their savings. Even worse, this is a situation that can snowball out of control - the mere rumor that a bank is experiencing difficulties can prompt customers to withdraw funds, which puts pressure on the bank to call in loans, some of which typically cannot be repaid, thus weakening the bank's financial stability and inducing even more withdrawals.
Central banks act as a bulwark against such bank runs by promising to bail out commercial banks caught in such a situation - the fact that this is not a theoretical possibility was underscored in September when the Bank of England announced it would guarantee all deposited savings at the Northern Rock bank in order to stop a run that had already removed £2 billion from that bank's vaults. But, in exchange for this largesse, central banks are given wide-ranging supervisory powers over the commercial banks. These powers include enforcing minimal reserve requirements for liquid bank assets, limiting risky business decisions, capping the maximum amount lent to individual borrowers, and careful inspection of bank records.
Saadon presents the bank's supervisory authority as a public service. "We are the public's watchdog in this respect," he says. "We maintain a daily review of bank reserves, because the public has placed its trust - and money - in the banks and we have a responsibility to safeguard that." The Bank of Israel's authority over commercial banks was recently extended, with a new law set to take effect in 2008 that will enable the supervisor of banks to cancel or reduce excessive fees charged by banks for their services. Perhaps this measure will go some way toward helping to mend the damage done to the bank's image by the salaries scandal.
