The Israeli bank crisis of 1983 rocked the Middle Eastern financial world. The Israeli economy was believed to be strong and has been able to navigate many wars since its inception in 1948 without breaking down. However, in 1983, the economy faced major shocks even in the absence of any major war or political upheaval. In this article, we will have a closer look at the factors that caused this economic upheaval as well as how the Israeli government resolved it.
During the early 1980’s the Israel economy started experiencing extreme hyperinflation. The economy had gone from a 13% inflation rate in 1971 to 111% inflation in 1979. During the early 80’s inflation was hovering at the 400% mark. This was shocking for the markets since Israel was a country with a sound financial track record. However, it was not the rising inflation rates that were the direct cause of economic turmoil in 1983. Rather, it was the banking system which had crashed the Israeli economy. Let’s have a closer look at how the banking system faced a major crisis during that period.
Fire Sales and Bank Runs
The Tel Aviv stock market faced a period when bank stocks were being hammered. 7 of the largest national banks which controlled over 80% of the commercial banking in Israel were facing fire sales. Investors were literally dumping the shares at whatever prices they could and there were no buyers in the market which was causing the share prices to plummet to levels never seen before.
In order to stop this, the Israeli banks started buying back their own shares. This helped them momentarily stabilize the price of their shares in the market. However, investors noticed that the banks have utilized their capital in buying up shares. Therefore, they believed that banks would now be facing a liquidity crisis. That indeed turned out to be the case. When investors queued up outside banks to withdraw their cash, many could not do so. As a result, panic spread amongst investors and all seven major banks faced a bank run virtually brining the entire Israeli economy to a grinding halt!
The Israeli government had to quickly intervene in order to prevent a total and absolute breakdown of the monetary system.
Shares Converted To Bonds
The Israeli government intervened by closing the markets for 18 days. This caused further panic amongst Israeli investors. However, the government took some drastic measures in order to overcome the situation. The Israeli government converted the stock of all the banks to government bonds. This meant that the people who invested in banks would have the direct security of the taxpayer’s funding in the event of a collapse of the financial system. By doing so, the government effectively linked its future with the future of the bank’s stocks. If the banks failed then so did the government. However, the situation was so bad that even such an explicit guarantee from the government did not help bail out the banks. The first day that the markets opened for trading after the closure, these bonds took a 40% hammering. The government somehow managed to save the day with great difficulty. However, probes were issued in order to find out the root cause of this financial debacle.
Earlier Manipulation Discovered
After the government agencies conducted their investigation, it came to light that the real reason why the bank stocks were being hammered was because of the earlier manipulation that the banks had done in the markets. The banks had virtually propped up their stocks for a very long time now and when traders took notice of this manipulation, they resorted to correcting the market prices by selling the shares.
- Maintaining Capital Ratios: The banks were propping up the value of their shares in order to be able to maintain capital ratios. The hyperinflation in Israel was making it considerably difficult for banks to maintain the required ratios and still be able to conduct operations profitably. Hence, banks took advantage of some of the loopholes in the system and maintained their capital ratios by converting overvalued stock into cash.
- Benefitting From Sale Price: The existing shareholders of the banks also stood to benefit as stocks were being sold at inflated prices. Hence they too turned a blind eye when the banks used their capital to manipulate the markets and inflate the stock prices.
- Weak Insider Trading Laws: The Israeli regulators were also at fault because of the weak insider trading laws that were in place when the crisis erupted. There were no restrictions on the banks when they indulged in trading their own stocks. Therefore, the banks could manipulate the value of their stocks without being afraid of any legal consequences. After this crisis was averted, Israel created new insider trading laws in order to prevent this situation from reoccurring.
- Reduced Transaction Costs: To make the situation worse, Israel decided to exempt banks from paying turnover tax post the war with Lebanon in 1982. Thus, not only were the banks allowed to trade in their own stocks, they could also rampantly indulge in this trading without any transaction costs hindering the process. This too contributed significantly to the speculative activities conducted by banks.
The Israeli government took cognizance of these factors and created regulations that prevented such economic upheavals from happening again. Hence even though, Israel has faced small crisis when the world economy tanked in 2001 and 2008, no major catastrophe has rocked the Israeli economy ever since.