A Growing Economy Stabilizes Prospects For Israeli Banks, Despite Some Risks
Primary Credit Analyst: Beni Peer, Tel Aviv 972-3-753-9742; [Link]@[Link] Secondary Contact: Michal Gur Kagan, Tel Aviv (972) 3-753-9708; [Link]@[Link]
Table Of Contents
The Ratings Hinge Largely On Israel's Economic Fortunes Relatively Low Household Debt Will Likely Support Credit Growth Asset Quality Will Likely Remain Buoyant, But Profit Margins Slim Tighter Regulation Could Strengthen Capitalization Cost Efficiency Will Be Crucial In Securing Potential Loan Growth Related Research
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A Growing Economy Stabilizes Prospects For Israeli Banks, Despite Some Risks
Credit quality in the Israeli banking system should hold steady in 2014, Standard & Poor's Ratings Services believes. On the one hand, low interest rates, and possible risks from domestic banks' high single-name credit concentrations and exposure to the local real estate sector could limit growth and profitability. On the other hand, the economy is still expanding and unemployment is low. These factors should in our view see the banks post a relatively stable performance this year. Last year, GDP growth was 3.3%, and we observed weak credit demand from the corporate sector. Still, banks' retail loan books kept increasing, thanks to higher demand for mortgage loans, and despite the Bank of Israel's measures to curb housing loan growth. We expect these trends to continue in 2014. What's more, we believe ongoing regulatory changes ahead of Basel III will support banks' stability in the longer term, although it may limit their growth and profitability in the short term. Overview We believe the stability of the Israeli banking industry should endure through 2014. We expect mortgage lending to continue to outpace corporate lending, as it has done over the past years. In addition, stricter capital requirements will force banks to strengthen their capital reserves, further supporting our stable outlooks on the banks we rate in the sector.
In our base-case scenario, we assume that in 2014 Israeli banks' asset growth will keep pace with GDP growth at about 3.4%. Specifically, we expect the retail segment to continue delivering most of the forward momentum, while interest rates remain low. Housing prices will likely remain steady, due mainly to a favorable supply-demand balance. In turn, we anticipate that the banks will maintain stable asset quality, with nonperforming and restructured loans accounting for only about 3% of their loan books. Overall, we expect system funding to remain sound and banks to maintain strong liquidity because of robust domestic deposit bases. These factors underpin the stable outlooks on our ratings in the sector (see table 1).
Table 1
Rated Israeli Banks*
Global Scale Bank Hapoalim B.M. Bank Leumi le-Israel B.M. Israel Discount Bank Ltd. Mizrahi Tefahot Bank Ltd. First International Bank of Israel Ltd. (The) Mercantil Discount Bank Ltd (core subsidiary of IDB) Jerusalem Bank Ltd. Dexia Israel Bank Ltd. BBB+/Stable/A-2 BBB+/Stable/A-2 BBB-/Stable/A-3 NR NR NR NR NR National Scale ilAA+/Stable ilAA+/Stable ilAA-/Stable ilAA+/Stable ilAA/Stable ilAA-/Stable ilA+/Stable ilAA-/Developing
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A Growing Economy Stabilizes Prospects For Israeli Banks, Despite Some Risks
Table 1
Rated Israeli Banks* (cont.)
*Ratings as of Feb. 26, 2014. Standard & Poor's Maalot (Israel) national scale rating. NR--Not rated.
The Ratings Hinge Largely On Israel's Economic Fortunes
Despite our forecast of steady performance for the Israeli banking industry, we might revise a number of rating outlooks to negative if the economy were to slide into a recession. This could occur because of deterioration in global markets or a heightening of geopolitical tensions in the country. In addition, considering high single-name concentrations, continued financial stress for some big borrowers could weaken the system's asset quality. At the same time, substantially higher unemployment or a sharp drop in housing prices would add to the pressure on asset quality and, in turn, on our ratings on Israeli banks. Although we consider it unlikely, stronger economic performance than we currently anticipate could mean better results for Israel's banks. Improved economic conditions could also further support asset quality. We may also take a more positive view if single-name credit concentration continues to decrease and some large local borrowers' liquidity problems ease. A significant improvement in capitalization could also lead us to take positive rating actions on some banks.
Relatively Low Household Debt Will Likely Support Credit Growth
We believe that, for Israeli banks, 2014 will in many ways mirror 2012-2013, with modest credit growth overall. Higher retail and mortgage lending, as well as loans to small and midsize enterprises, will in our opinion partly offset the continued decline in new corporate lending. Furthermore, the demand for housing and low interest rates should continue to fuel retail credit growth, as it did in the first three quarters of 2013. Housing prices continued to rise last year as a result, and we expect demand to stay robust due to the limited supply of housing and relatively low household debt (see chart 1).
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A Growing Economy Stabilizes Prospects For Israeli Banks, Despite Some Risks
Chart 1
Credit demand from the corporate sector kept decreasing in 2013, a situation that we expect will continue in 2014. Also, companies are increasingly turning to the capital markets as an alternative and sometimes cheaper source of funding. Even so, we believe that, this year, companies will maintain their focus on reducing and refinancing debt rather than take on new borrowing. Consequently, we expect businesses to continue using bank funding alongside other sources.
Asset Quality Will Likely Remain Buoyant, But Profit Margins Slim
Under our base-case scenario, banks' asset quality will remain stable, and we forecast their average cost of risk at about 0.5% in 2014, compared to a low 0.3% as of Sept. 30, 2013. One key reason is that local corporate borrowers have been actively boosting their liquidity positions through capital market and loans from institutional investors. In addition, the stable housing market and low unemployment, which we forecast for this year, should support asset quality. As of Sept. 30, 2013, the Israeli banking system's loan loss coverage ratio (loan loss reserves/nonperforming assets) was 52%, which is relatively low in a global context. Although this might indicate higher loan losses in the future, this is
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A Growing Economy Stabilizes Prospects For Israeli Banks, Despite Some Risks
not our base-case assumption for 2014. In our view, this demonstrates the overall good quality of banks' loans. We base our conclusions on data from Israel's five largest banking groups, which account for 97% of the market (see chart 2).
Chart 2
Still, loan growth and stable asset quality may not translate into profitability gains. We believe that domestic banks' profitability will remain subdued in 2014, due to lower credit growth prospects and low interest rates, which depress margins. Also, we consider operational efficiency at Israeli banks to be fairly low at 67% among the five largest local banking groups. The average return on equity in the sector is therefore unlikely to materially differ from 2013, and stay in the high single-digit range.
Tighter Regulation Could Strengthen Capitalization
The Bank of Israel requires domestic banks to comply with Basel III regulations by the end of 2014. Among other requisites, banks have to achieve a core Tier 1 capital ratio of at least 9.0%, a level that we believe would improve their ability to withstand negative economic pressures. Moreover, for the two banks whose assets represent more than 20% of the system assets (Bank Hapoalim Ltd and Bank Leumi Le-Israel B.M) the ratio must be at least 10.0% by Dec. 31,
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A Growing Economy Stabilizes Prospects For Israeli Banks, Despite Some Risks
2016. We therefore assume that the system's average dividend payout ratio for 2014 will be low as banks preserve capital ahead of the regulatory deadlines. We believe all local banks would be able to reach these capital targets on time. In our opinion, the regulatory directives to increase banks' capital requirements and decrease borrower concentrations should help strengthen the banking system in the long term. In addition, capitalization is relatively low, as measured by our risk-adjusted capital (RAC) ratio average projection of 6.0% for 2013 , which is at the middle end of our "moderate" range. We forecast the five largest banks' average RAC ratio will move more firmly into this category by year's end.
Chart 3
However, an improvement would also depend on banks' ability to curb their risk appetites, despite possible short-term pressure on revenues resulting from the new regulations.
Cost Efficiency Will Be Crucial In Securing Potential Loan Growth
Israel's banking system is mature, with a stable level of competition. It also has an institutional framework that, in our opinion, is of a similar standard to those in developed countries. However, Israeli banks' profitability and capitalization are moderate in a global prospective, considering the banks' risk and asset profiles. This means they have a relatively
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smaller cushion against exceptional or unexpected losses. The weaker profitability is due, among other reasons, to low operational efficiency. This is mainly because of strong labor unions and collective wage agreements that limit the flexibility of banks' cost structures. We believe that, due to the pressure on revenue growth, banks will increasingly focus on reducing or limiting costs in the near future. That said, we believe banks should continue to benefit from their robust and diverse funding sources to finance growth. Liquidity should remain adequate, though, with most liquid assets in the form of deposits with the central bank and investments in Israeli government bonds. All in all, we believe the negative and positive scenarios that could develop in the sector in 2014 will likely offset each other, resulting in little change from 2013.
Related Research
Banking Industry Country Risk Assessment: Israel, Aug. 28, 2013. Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook
Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@[Link]
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