Israeli banks can now pledge their assets more freely

Introduction
Context
Key requirements
Comment

Introduction

For many years, Israeli banks have been subject, under the directives issued by the Bank of Israel, to specific restrictions on their ability to create pledges over their assets. Subject to very narrow exceptions, Israeli banks have only been permitted to pledge assets to secure liabilities that amount in total to 2% or less of the amount of the bank's shareholders' equity (as defined by the directives). Due to the practical difficulties relating to monitoring compliance with this quantitative restriction – given the fluctuations from time to time in the amount of the banks' shareholders equity, as well as in the amount of the obligations to be secured – the general position of Israeli banks has been a total reluctance to create pledges on their assets.

However, under a new directive published by the Bank of Israel, such quantitative restriction will be cancelled. Instead, Israeli banks are required to determine a proper policy for pledging their assets and to adopt proper checks, balances and monitoring mechanisms in connection therewith. The new directive will enter into force on 1 January 2022. However, Israeli banks may already deviate from the current quantitative restriction if they adopt the required mechanisms under the new directive, and so notify the Bank of Israel.

Context

Fortunately, this development coincides with the compliance date for the implementation of what is known as "Phase 5" of the globally applicable regulatory initial margin (IM) requirements for transactions in derivatives, which – as of 1 September 2021 – are extended to apply also to transactions with counterparties whose average aggregate amount (AANA) of derivatives transactions exceeds €50 billion. This threshold now includes some of the largest Israeli banks, which were not included in the thresholds under the former phases of the IM reform due to the volume of their AANA. The International Swaps and Derivatives Association (ISDA) IM documentation requires the counterparty to pledge assets as IM, hence the importance of the adoption of the new directive at this point in time.

Indeed, as the Bank of Israel explains in the preamble to the new directive, the background for the regulatory change is the recent global regulatory reforms implemented following the global financial crisis, which led to a material increase in the financial activities for which pledges are required, such as:

• an increase in the activities of central clearing houses;
• the move for central clearing of derivatives; and
• the requirement for the deposit of initial and variable margin in transactions in derivatives that are not centrally cleared.

The Bank of Israel further explains that due to the increase in the scope and variety of the activities in connection with which Israeli banks are required to pledge assets (whether under law, regulation or market practice), it was decided to cancel the quantitative restriction on pledges and to replace it with a requirement from the banks to adopt and monitor appropriate policies.

Key requirements

The Bank of Israel stresses that a bank must maintain a proper balance between its business needs and the protection of the rights of the depositors in the event of its insolvency. Therefore, the main two requirements in the new directive are as follows:

• Banks may pledge assets only when this is required under law, regulation or the relevant market requirements, such that without the pledge the bank would not be able to conduct the relevant activities on reasonable market terms.
• The bank must ensure that the volume of the pledged assets does not materially adversely affect the bank's ability to raise funding sources, including in extreme case scenarios.

The board of directors of the bank should designate a strategy regarding the creation of pledges. The bank's management should propose a policy in this respect based on the approved strategy. The policy, which is also subject to the approval of the board of directors, should address the following main matters:

• for which transactions and activities pledges can be created;
• in favor of which types of counterparties pledges can be created;
• the types of assets that can be pledged;
• the margin calculation mechanisms;
• internal limitations on pledges; and
• the chain of authority to decide on the creation of a pledge.

In addition to the requirement to adopt an appropriate policy, the new directive includes requirements as to its internal implementation. The risk management function of the bank should be involved in this process to ensure that the relevant risks and their implications on the liquidity and financing risks are properly taken into account, and the internal audit function of the bank should monitor the proper implementation of the policy. Further, the bank must implement proper monitoring measures over the pledged assets and ensure that its information systems can provide up-to-date information on these matters, so as to enable proper decision-making, as well as ensuring compliance with the pledges policy.

Comment

In light of this new regulatory development, Israeli banks recently began to register pledges over their assets, after many years of this being unheard of. Until now, banks have done this primarily in connection with IM ISDA documentation, but it is expected that following the adoption of the strategy and the policy, as required under the new directive, this new option will enhance the flexibility of Israeli banks in their transactions, and will allow them to enter into types of transactions which were almost impossible before.

For further information on this topic please contact Shiri Shaham or Shai Margalit at Yigal Arnon & Co by telephone (+972 3 608 7777) or by email ([email protected] or [email protected]). The Yigal Arnon & Co website can be accessed at www.arnon.co.il.