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Financial Innovations for Israeli Financial Innovations for Israeli Capital Markets: A PrimerCapital Markets: A Primer
Glenn Yago, Ph.DDirector of Capital Studies
Milken [email protected]
Milken Institute Global ConferenceApril 20, 2005
7:45am
2
• The Milken Institute is actively engaged in work on open markets, democratization of capital, financial innovations and market based solutions to social problems
• The Institute has identified four areas in Israel and the Middle East ripe for reform– capital markets– municipal and local reform– regional economic development– decentralizing and privatizing the economic
peace process
3
4
5
Financial Technology TransferFinancial Technology Transfer
First Municipal Bond in Israel
6
Revitalizing TelRevitalizing Tel--Aviv and JaffaAviv and Jaffa
7
Tel Aviv Jaffa Area : Socioeconomic Index
JAFFA
• Economic levels are lowest in city- 28% are registered with social agencies- Average per capita income one half
of levels in the rest of the city- Crime and social fragmentation are on the
rise- Lack of educational, cultural, and social
institutions- Absence of stable middle class with
young couples to purchase homes
• Jaffa is characterized by a high degree ofheterogeneity between Arab and Jews- Severe housing shortage in Arabneighborhoods
• Jaffa has remained an underdeveloped island in the middle of the populous and economically successful Tel Aviv Metropolitan area
JaffaJaffa Today Today -- ChallengesChallenges
8
JaffaJaffa InIn TransitionTransitionTheThe GenesisGenesis JaffaJaffa OpportunityOpportunity
12 3
4
5
76
8
1. Jaffa Port – Tourist Potential2. Old City – Already Developed3. Clock Quarter – Development Focus4. Seaside District – Private Seaside Homes5. Jaffa Entrance – ‘Tayelet” Promenade6. Central Jaffa – Residential Focus7. Neve Zedek – ‘Hot’ Neighborhood 8. Ajami – Depressed Neighborhood
The Genesis Jaffa Fund will be part of a development process that has already begun,neighborhood by neighborhood
“Jaffa and also Acre are not flourishing just because no one has taken them as a single project.If we connect between all their attractions, purchasing power will not be long in arriving, and they will become like all the port cities to which we flock to in Europe.”
-- Tamir Ben ShacharChemanski Ben Shachar InvestmentsMa’ariv, June 2003
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Genesis Jaffa ProjectGenesis Jaffa ProjectA Preliminary Analysis A Preliminary Analysis -- Our ParametersOur Parameters
Financial Test12% Return Threshold
The first question for our team:
Could each project offered by the Tel Aviv Municipality hold its own as a financially viable stand-alone nvestment?
‘Genesis’ Toolbox
Could projects benefit from the application of financial innovations used by Genesis LA?
Can public and private finance bridge the “financial gap” required for undervalued areas in southern Tel Aviv?
Purpose
Will the creation of a Genesis Fund for Jaffa serve the purpose of reinvigorating this historic area while also meeting the needs of its current residents?
Fund Structure
Which management/capital structure and what size of fund would be most suitable for the launch of a Genesis Fund for Jaffa?
10
Cleaning IsraelCleaning Israel’’s Yarqon Rivers Yarqon River
11
View from the Sea View from the Mountains
“Layer” Scheme
Example of the Master Plan for Example of the Master Plan for the Yarqon River in the Telthe Yarqon River in the Tel--Aviv Aviv
Metropolitan AreaMetropolitan Area
12
???? ???? ???? ?????????? ???? ???? ??????
13
Developer
Construction Fund
Enterprise Fee
Yarqon River Authority
Investors
$
$
$
$$
Case Study Case Study
14
Israeli Capital Markets IssuesIsraeli Capital Markets Issues
• 70% of assets in government fixed-income securities.
• Most private savings in government bonds.• Bank concentration of ownership is high.• Pension funds invested almost entirely in
inflation-linked government bonds.• Inability for small- and medium-sized
companies to access capital.
15
Macroeconomic OverviewMacroeconomic Overview
16
GDP Per CapitaGDP Per Capita
Actual
At 50% of pre 1973 growth rate
0095908580757065605550
30000
25000
20000
15000
10000
5000
0
Chained at year 2000 US$
17
2004200320022001200019991998199719961995
15
10
5
0
-5
-10
Percent Change, Year Ago
Sources: Global Insight/IFS
Real GDP GrowthReal GDP GrowthConstant Prices
18
General Government ExpenditureGeneral Government ExpenditureAs Percent of GDPAs Percent of GDP
50.7%
53.4%54.7%
53.3%
51.0%50.2%
40%
42%
44%
46%
48%
50%
52%
54%
56%
58%
2000 2001 2002 2003 2004F 2005F
19
DeficitDeficitAs Percent of GDPAs Percent of GDP
0.7%
4.5%
3.8%
5.6%
4.0%
3.0%
0%
1%
2%
3%
4%
5%
6%
2000 2001 2002 2003 2004T 2005T
20
Total DebtTotal DebtAs Percent of GDPAs Percent of GDP
105.2%105.4%106.1%
90.9%
95.6%
104.4%
90%
100%
110%
2000 2001 2002 2003 2004F 2005F
21
Interest RatesInterest RatesLong Term and Short TermLong Term and Short Term
2004200320022001200019991998199719961995
18
16
14
12
10
8
6
4
2
Percent
Source: Global Insight/IFS; Datastream
Treasury Bill5-Year Bond Yield
22
2004200320022001200019991998199719961995
15
10
5
0
-5
Percent Change, Year Ago
Source: Global Insight/IFS
Inflation RateInflation RateConsumer Price IndexConsumer Price Index
23
Current Account BalanceCurrent Account BalanceAs Percent of GDPAs Percent of GDP
2004200320022001200019991998199719961995
1
0
-1
-2
-3
-4
-5
-6
Percent
Sources: Datastream
Note: Close to 0 in 2004.
24
Exchange RateExchange RateNew Shekels per US DollarNew Shekels per US Dollar
20042003200220012000199919981997199619955.0
4.5
4.0
3.5
3.0
2.5ILS/US$
Source: Global Insight/IFS
25
Israeli Workforce vs. Unemployment RateIsraeli Workforce vs. Unemployment Rate
26
Government Policy:Government Policy:From Welfare to WorkFrom Welfare to Work
27
Welfare SupportWelfare SupportNumber of welfare support recipients (monthly average)Number of welfare support recipients (monthly average)
28
3.2%
4.9%
6.5% 6.5%5.9%
4.5% 4.3%
0%
2%
4%
6%
1984 1994 2001 2002 2003 2004F 2005F
Welfare Payments to Recipients of Working AgeWelfare Payments to Recipients of Working AgeAs Percent of GDPAs Percent of GDP
Percent
29
Unemployment and Participation RatesUnemployment and Participation Rates
6.9%6.7%
7.7%
8.6%8.9% 8.8%
9.4%
10.3% 10.6%10.7%9.9%
4%
6%
8%
10%
12%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004F 2005F52%
53%
54%
55%
56%
57%
58%Unemployment Participation
30
Capital MarketsCapital Markets
31
Percentage of Total Assets for Three Largest Percentage of Total Assets for Three Largest Commercial Banks for Selected CountriesCommercial Banks for Selected Countries
Pana
maG
erm
any
Uni
ted
Kin
gdom
Luxe
mbo
urg
Uni
ted
Stat
esSi
ngap
ore
Cos
ta R
ica
Ukr
aine
Tai
wan
, Chi
naL
eban
onC
olom
bia
Nig
eria
Hon
g K
ong,
Chi
naSe
rbia
& M
onte
negr
oR
ussi
aPh
ilipp
ines
Indi
aAus
tria
Japa
nArg
entin
aU
nite
d A
rab
Em
irat
esU
rugu
ayIt
aly
Kyr
gyzs
tan
Suda
nSp
ain
Bra
zil
Gue
rnse
yJe
rsey
Arm
enia
Gua
tem
ala
Tur
key
Mal
aysi
aB
osni
a an
d H
erze
govi
naB
ulga
ria
Para
guay
Ven
ezue
laPo
land
Cam
bodi
aFr
ance
Isle
of M
anK
enya
Chi
leH
ondu
ras
Egy
ptJo
rdan
Swed
enH
unga
ryPa
kist
anTh
aila
ndTu
nisi
aR
oman
iaLa
tvia
Mor
occo
Cro
atia
Slov
akia
Zim
babw
eC
zech
Rep
ublic
Slov
enia
Ecu
ador
Kor
eaK
azak
hsta
nM
oldo
va, R
epub
lic o
f B
oliv
iaA
zerb
aija
nSw
itzer
land
Mac
edon
ia, R
epub
lic o
f G
ibra
ltar
Saud
i Ara
bia
Puer
to R
ico
Gre
ece
Mac
au,
Chi
naSo
uth
Afr
ica
Aus
tralia
Sene
gal
Gha
naPo
rtug
alC
ôte
d'Iv
oire
Can
ada
Mex
ico
Bah
rain
Bel
arus
Qat
arA
ntig
ua a
nd B
arbu
daPe
ruNor
way
Bur
kina
Fas
oM
alta
New
Zea
land
Sain
t Luc
iaM
ali
Om
anA
lban
iaEl
Sal
vado
rTa
jikis
tan
Lith
uani
aB
elgi
umN
ethe
rland
sK
uwai
tC
ypru
sD
enm
ark
Guy
ana
Sri L
anka
Bur
undi
Mau
ritiu
sN
icar
agua
Togo
Isra
elG
uine
aSe
yche
lles
Lie
chte
nste
inA
lger
iaSu
rina
me
Rw
anda
Turk
men
ista
nM
adag
asca
rSa
int K
itts
and
Nev
isN
iger
Fi
jiG
ambi
aEs
toni
aB
enin
Tri
nida
d an
d T
obag
oFi
nlan
dA
ruba
Bhu
tan
Bot
swan
aB
ritis
h V
irgi
n Is
land
sIc
elan
dL
esot
hoPa
pua
New
Gui
nea
Sam
oaSw
azila
ndV
anua
tuC
omm
onw
ealth
of D
omin
ica
Gre
nada
Sain
t Vin
cent
and
The
Gre
nadi
nes
Gui
nea
Bis
sau
0
10
20
30
40
50
60
70
80
90
100
United States30%
Israel94%
Per
cent
32
Percentage of NonPercentage of Non--Banking Credit from Banking Credit from Total Credit (2003)Total Credit (2003)
IsraelGermanyUKUSA
80
60
40
20
0
Percent
33
IsraelIsrael’’s Credit Crunchs Credit CrunchIndex of Outstanding Bank CreditIndex of Outstanding Bank Credit
1210 8 6 4 21210 8 6 4 212200320022001
110
108
106
104
102
100
98
Index 2001=100
34
Bank Credit to Private SectorBank Credit to Private SectorAs Percent of GDPAs Percent of GDP
2004200320022001200019991998199719961995
100
95
90
85
80
75
70
65
Percent
Source: Global Insight/IFS
Lorenz Curve: Lorenz Curve: Credit Market Concentration Indicating InequalityCredit Market Concentration Indicating Inequality
Cum
ulat
ive
Cre
dit D
istr
ibut
ion
(%)
Cumulative Distribution of Borrowers (%)
Line of Perfe
ct Equalit
y
Business Credit General Credit
36
Capital MarketCapital Market
SavingsCapitalMarket
Investments
37
Efficient Capital MarketsEfficient Capital Markets
Savings Investments
Non-BankIntermediaries
Banks
38
The Israeli Capital MarketThe Israeli Capital Market
Savings
Banks
Investments
Non-BankIntermediaries
39
Note: Banks control 66% of the public financial portfolio(Total portfolio – 1.4 trillion NIS)
The Israeli Capital Market The Israeli Capital Market -- OverviewOverview
918
75Mutual Funds
165Provident Funds
678Deposits
BANKING INDUSTRYBillions NIS, December 2003
40
The Israeli Capital Market The Israeli Capital Market -- OverviewOverview
61%67%63%Two Largest Banks
90%87%100%Banking Industry
Mutual Funds
Provident FundsDeposits
41
ConsequencesConsequences
v Lack of Competition – high intermediation cost
vHigh cost of capital
vLow return on savings
v Concentration – Threat to financial stability
v Conflict of Interests
42
Concentrationfertilizes the
Conflict of Interests
Conflict of Interestsenhances the impact
of the Concentration
Concentration Combined withConcentration Combined withConflict of InterestsConflict of Interests
Financing Israeli Economic DevelopmentFinancing Israeli Economic DevelopmentThe ProblemThe Problem
v Fiscal and budgetary limits through government financing of Israel’s economic growth have been reached
vNo sources of alternative finance through capital markets
vMust develop alternative financing to avoid economic stagnation
vProblems in funding pension fund liabilities due to insufficient long-term yields
vAbsence of manager/employee ownership in privatizations and increased ownership concentration
vCapital market illiquidity
vCosts of supporting government deficits and inability of Israeli fiscal policy to support growth
Financing Israeli Economic DevelopmentFinancing Israeli Economic DevelopmentThe Problem (continued)The Problem (continued)
vSecondary market for mortgages, corporate bonds, revenue bonds, need to be developed immediately
vFinancial technologies of securitization
vMobilize alternative capital sources for cross-border, cross community, regional investment
Financing Israeli Economic DevelopmentFinancing Israeli Economic DevelopmentThe Problem (continued)The Problem (continued)
46
Capital Market ReformsCapital Market Reforms
vCapital markets can replace dependency on deficit spending and external aid
vFinancial innovations could create high yield securities attractive to foreign investors
vStimulate the market by redirecting institutional portfolio investments away from government securities
47
Capital Market Reforms (cont)Capital Market Reforms (cont)
vInvigorate Israel’s Stock Marketv Refinance $34 billion of government debt to international markets to unclog local capital marketsv Recharge Local IPO Marketv Create new financial vehicles (e.g., industrial development bonds, REITs, etc.)
vIn sum, democratize Israeli capital markets
48
Municipal and Local IssuesMunicipal and Local Issues
vAging municipal infrastructure cannot meet growing demands
vCentral government cannot afford to finance new construction, repair and maintenance
vMunicipalities prevented from accessing capital markets
49
Municipal and Local ReformsMunicipal and Local Reforms
vTransition from political patronage to market discipline in financing economic developmentvCreate Municipal Bond Program for domestic/international capital markets
vProject Revenue Bonds (not General Obligation Bonds)vPilot Project: Los Angeles-Tel Aviv Partnership---Parking Garage Debt/ Rishon LeZion Water BondsvReward fiscally responsible municipalities with permission to utilize new financial technologies for local projects
50
Israeli Capital Markets IssuesIsraeli Capital Markets Issues
v70% of assets in government fixed-income securities.vMost private savings in government bonds.vBank concentration of ownership is high.vPension funds invested almost entirely in inflation-linked government bonds.vInability for small- and medium-sized companies to access capital.
51
Housing and Mortgage MarketHousing and Mortgage Market
52
Mortgage Mortgage ––Backed SecuritiesBacked Securities
Problems of Mortgage Problems of Mortgage Lending in Emerging Lending in Emerging
MarketsMarkets
Demand:Demand:••Excess demandExcess demand••High interest ratesHigh interest rates••RationingRationing
Supply:Supply:••High riskHigh risk••Illiquid assetIlliquid asset••Few playersFew players
53
v Mobilize domestic savings for housing
v Diversify fixed-income markets, supplement government bonds for institutional investors.
The Dual role of MortgageThe Dual role of Mortgage--Backed Backed SecuritiesSecurities
54
PreconditionsPreconditions
v Underlying Mortgage Loan Marketv Security interest and legal preconditions
v Underlying Mortgage Loansv Data and structure
v Primary Market for Mortgage Securitiesv Legal, tax, accounting, supervision
55
v Legal framework, contract enforcement, data, developing capital markets, tax treatment, fostering local investor base
v Overall, government support should be targeted, transparent, budgeted, and temporary
Implications for IsraelImplications for Israel
56
GovernmentGovernment AssistedAssisted HousingHousing
v Israel offers housing assistance through three established channels which are managed and maintained by eight companies.v Loans granted for first-time home buyersv Rent subsidization for limited periodsv Government owned public housing to low-
income families
57
Companies by Number of Units Companies by Number of Units and Ownershipand Ownership
107,927Total
50649Heled
941ShikunVePituach
99.85506Afridar
501,560Shikmona
502,192Prazot
502,660Chalamish
29,451Amigur
10069,968Amidar
% Government Ownership
Number of Public Housing Units
Company
Source: Ministry of HousingSource: Ministry of Housing
58
Factors Affecting Israel’s Housing Factors Affecting Israel’s Housing MarketMarket
v Economic stagnation 2000-2003v Increasing populationv Continuing decline in new construction
(worst since 1989)v Renewed growth in 2004v Continued strong rally of Shekel to the
US dollar
5959
To develop an efficient To develop an efficient capital market that will capital market that will compete with the banks compete with the banks
credit marketcredit market
ISA’s Vision
6060
ØØScopeScopeüüOver 600 Listed Companies (37 dually listed) Over 600 Listed Companies (37 dually listed) üüOver 800 Mutual Funds Over 800 Mutual Funds
ØØEquity MarketEquity MarketüüMarket cap Market cap -- $98 billion$98 billionüüDaily volumeDaily volume-- $228 million$228 million
ØØFixed Income MarketFixed Income MarketüüMarket cap Market cap -- $73 billion$73 billion
üüDaily volume Daily volume --$310 million$310 millionüüDominant treasury bond market Dominant treasury bond market -- 96% of the 96% of the
tradetrade
Israel’s Capital Market
6161
Concentration of ControlConcentration of Control::
ØØOver 90% of the listed Over 90% of the listed companies are closelycompanies are closely--held by held by
majority shareholdersmajority shareholders
ØØOn average, they hold close to On average, they hold close to 70% of the company70% of the company’’s sharess shares
Israel’s Capital Market Structural Problems
6262
Concentration of the banking sectorConcentration of the banking sectorØØCorporate Bond market in Israel is only 3% of Corporate Bond market in Israel is only 3% of
GDP Compared with 70% in the US, 28% in the GDP Compared with 70% in the US, 28% in the UK, 40% in Japan UK, 40% in Japan
ØØOwn the majority of mutual funds, provident Own the majority of mutual funds, provident funds, underwriters, portfolio managers and funds, underwriters, portfolio managers and
investment advisersinvestment advisers
ØØDominant traders on the TelDominant traders on the Tel--Aviv Stock Aviv Stock Exchange (TASE)Exchange (TASE)
Israel’s Capital Market Structural Problems
6363
Banks dominate all intermediate fields
7777
1919
5353
55
--
--
--InsuranceInsurance**
--PensionPension****
165165Provident fundsProvident funds
7575Mutual fundsMutual funds
918918
678678DepositsDepositsBillion NIS, Dec. 2003Billion NIS, Dec. 2003
** Participating portfolios of lifeParticipating portfolios of life--insuranceinsurance**** New pension fundsNew pension funds
BankingBankingIndustryIndustry
InsuranceInsurance&Pension&Pension
6464
Banks dominate all intermediate fields
88%88%
75%75%
69%69%
60%60%
56%56%UnderwritingUnderwriting
87%87%Provident fundsProvident funds
90%90%Mutual fundsMutual funds
100%100%DepositsDeposits
FromFrom this:this:PoalimPoalim & & LeumiLeumi
BankingBankingindustryindustry
6565
Low liquidityLow liquidity
ØØOnly 30% of listed equity is floatingOnly 30% of listed equity is floating
ØØLack of appointed Market Makers to provide Lack of appointed Market Makers to provide liquidityliquidity
ØØInefficient short selling and Inefficient short selling and RepoRepo marketsmarkets
ØØTurnover Velocity (Volume/Market Cap) Turnover Velocity (Volume/Market Cap) -- 33% 33% Vs. LondonVs. London--106.6%; 106.6%; NasdaqNasdaq –– 280.7%280.7%
Israel’s Capital Market Structural Problems
6666
Insufficient contribution to the Insufficient contribution to the economyeconomy
Israel’s Capital Market Characteristics
115%UK106.5%USA49.5%Japan 39.8%Israel
2002 Market Cap/GDP
6767
ØØDevelopment of Capital MarketDevelopment of Capital MarketØØIncrease investor baseIncrease investor baseØØIntroduce a new variety of financial Introduce a new variety of financial
productsproducts
ØØEfficient EnforcementEfficient EnforcementØØImprove TransparencyImprove TransparencyØØImproving enforcement capabilitiesImproving enforcement capabilitiesØØImprove internal and external corporate Improve internal and external corporate
controlcontrol
Strategy
6868
ØØIntroducing new products and new playersIntroducing new products and new players
ØØImproving trading, accounting and legal Improving trading, accounting and legal infrastructuresinfrastructures
ØØIntegrating with the globalization processIntegrating with the globalization process
ØØEnhancing transparency and disclosureEnhancing transparency and disclosure
ØØImproving means of supervision and enforcementImproving means of supervision and enforcement
ØØStrengthening internal and external corporate Strengthening internal and external corporate controls (controls (““Gate KeepersGate Keepers””))
ISA’s Current Agenda
Structural Reform in the IsraeliStructural Reform in the IsraeliCapital MarketCapital Market
Reform objectiveReform objective
To establish a competitive, efficient and global capital market which will support high levels real growth and welfare
7070
Reform principles
Ø Separation of activities with competitive potentialØ Prevent “migration” of the core problemsØ Reduce conflicts of interestØ Efficient use of the banks’ distribution
networks
7171
MainMainRecommendationsRecommendations
7272
1. Separation of activities with competitivepotential
ØBanks will not be permitted to hold interest in provident nor mutual funds
ØBank Poalim will sell its holdings in Bank Otzar Hahayal till December 2005, according to existing government decisions
ØBanks will sell their holdings in Insurance companies as a condition for distributing insurance products
7373
2. Prevent “migration” of the core problems
ØSetting criteria for holdings in institutional entities (permits)ØFixing similar norms for managing financial
assetsØLimiting relative size of purchasers of
provident funds – 15% (post purchase) of long term savings market
ØLimiting relative size of purchasers of mutual funds – 20% (post purchase) of the mutual fund market
7474
3. Reduce conflicts of interest
ØSeparation of provident & mutual funds
ØUnderwriting –ØRestriction on underwriting major debtorsØRestriction on selling underwritten
securities to connected institutional entities
ØSeparation of occupations –ØUnbiased distributor (advisor)ØMarketer
7575
3. Efficient use of banks’ distribution network
ØBanks will be allowed to distribute life insurance & pension products, under the following limitations:
provident fundsEquity over 10 NIS billion
& mutual funds
& insurance companies
After selling their holdings in:"Big Banks”
& insurance companies
provident fundsEquity under 10 NIS billion
After selling their holdings in:“Small Banks”
76
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