Discount laughing all the way to the bank

The banks must increase their liquidity or a dangerous credit crunch could ensue
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The heads of Israel Discount Bank are probably grinning as they read their rivals' financial statements.

They are not gloating. They are relieved.

Discount's Giora Offer and Arie Mientkavitch were used to being seen as the enfants terribles of the banking establishment, writing off huge amounts of credit every quarter and sustaining major losses that took the bank to the edge of liquidity requirements.

Now the big, fat, shiny successful banks¿ particularly the First International Bank of Israel and Bank Hapoalim - turn out to have skeletons in their closets. Now they have to write off credit all the way to the edge of liquidity.

Discount may be close to the end of its massive write-offs. But the others are just beginning their journey. While Offer and Mientkavitch have already combed the bank's credit portfolios and scrabbled for ways to raise new capital, Bank Hapoalim's Amiram Sivan and First International's David Granot are just kicking into gear. What the heads of other banks have not yet learned, the heads of Discount have already forgotten.

The banks' looming crisis was that the credit they extended to the general public grew far faster than the economy did, especially thanks to leveraged buyouts of major corporations. In fact, the banks themselves were taken over with LBOs ¿ Hapoalim was purchased by Arison-Dankner group in late 1997 using loans.

All the following huge transactions were financed with borrowed money: the controlling interests in Bank Hapoalim, Africa Israel Investments and the Israel Corporation changed hands. So did the cable companies. Businessman Gad Zeevi bought 20% of the state-run Bezeq phone company. Large blocks of stock in Bank Leumi changed hands. The Bronfman-Kolber group bought Koor Industries (NYSE:KOR) and Koor itself invested enormously in ECI Telecom (Nasdaq:ECIL). Granite Hacarmel was also sold off.

Not long ago the Bank of Israel estimated NIS 23 billion in credit had been granted towards LBOs, and that doesn't include certain massive investments large corporations made using credit.

As long as the economy thrived, so did the companies bought with credit. Collateral sufficed and the lenders were confident they would get their money back.

Furthermore, again provided the economy prospered, the acquired companies generated profits that could be distributed as dividends to the buyers, who used that income to repay their loans.

Now, not only isn't the economy growing - it's receding. Only a handful of investors believe rapid growth will resume soon. It's a small minority that thinks the banks' crisis will be short-lived. This is the swamp in which the banks have become enmired.

Banks, unlike other businesses, are under constant supervision. Very close supervision. One fundamental requirement of the watchdog is minimal liquidity, and that capital should comprise at least 9% of all the bank's risk components, which is mostly credit.

Reality has changed. What now?
Banks are in the business of lending as much money as possible. Otherwise they are like machines going rusty in the corner of the factory. Which means they usually stay pretty close to the 9% limit, but keep at a "safe" distance.

What to do now? The first step is to stop handing out dividends. Since the Arison-Dankner group assumed control of Bank Hapoalim in 1997, the bank has handed out NIS 3.4 billion in dividends. This has to stop, and for some time.

The next step is to contain costs. You won't find a bank today that isn't slashing its spending. Cost-cutting has taken the dimensions of a moral value, even when it cuts into the flesh. It can ease the profit slump, which can in turn boost capital.

Speaking of capital, two things can be done to increase it: Either a stock offering or a secondary capital issue, which can be considered capital for the purpose of minimal capital requirements.

Israel Discount for example has recently completed an NIS 135 million funding round through a stock issue to institutionals, even if it had to offer the stock at about half its book value. Which just goes to show how badly it needed the cash.

A secondary capital issue is nothing new. The banks have done it before. According to the Bank of Israel, the ratio of primary capital versus risk components has dropped from 9% in 1995 to a little over 6% in 2000, while the secondary capital to risk components ratio has climbed from 1% to 2.5%.

Back then banks were doing it to enable dividend distribution and to increase the return on capital. Now they are doing it to stave off the 9% capital adequacy ratio limit.

Sorry solutions
Thing is, it's getting harder to offer stock, and the banks don't want to do it ¿ it dilutes their shareholdings.

Furthermore, they can only raise that much secondary capital: the Bank of Israel allows the ratio between deferred notes, the main component of secondary capital, and primary capital to be 50% at the most.

For every shekel in deferred notes, there should be at least two shekels of primary capital.

According to Bank of Israel figures, at the end of 2000 the primary to secondary capital ratio in Mizrahi Bank was 49.7%, which means it simply could not increase its capital. Though Discount Bank had a high ratio as well, it was better off, having previously raised NIS 135 million in primary capital.

The banks' main goal now is to increase liquidity in order to meet the central bank's liquidity requirements, as explained above.

These developments are within the scope of the banks' business as usual. They affect mainly the banks' own results. The real danger is that the banks will savagely reduce their lending, becoming pickier despite the rate cuts and consequent rising demand.

The worse their profits slip, the weaker their ability to raise capital, the less flexible their control of their expenses becomes and the deeper the recession will become ¿ the greater the chance of a huge credit crunch.

That is terrifically dangerous right now. With the stock markets dead as a source of capital, the banks have been the main source of resources for business.

As alternative sources dwindle and as the recession deepens, it is of the utmost importance that the banks function properly. The danger is that the recession will get the banks into trouble, and when the banks are in trouble, then the recession can only grow worse.