CHAPTER 3 ACTIVITY OF THE BANKING SUPERVISION DEPARTMENT The main function of the Banking Supervision Department is to maintain the stability and resilience of the banking system, with the goal of providing optimal protection to the public. Within this context, the Banking Supervision Department seeks to strengthen the framework for the management of risks and capital by the banks, to increase the competition and efficiency in the system and to maintain fairness in the relations between banks and their customers. These activities are intended to protect the public’s financial assets, as well as to ensure continuity of banking activity and fair pricing of banking services. In 2011, the activity of the Banking Supervision Department focused on strengthening the ongoing monitoring of the banking corporations, in light of the developments and risks in the global and domestic environments. At the same time, the Banking Supervision Department strove to introduce international standards of risk management and corporate governance, and in particular sought to strengthen capital adequacy in the banking system, as part of the preparations for implementing Basel III in Israel. This chapter is composed of three parts: The first reviews in detail the main activities of the Banking Supervision Department in 2011 to strengthen the resilience of the banking system and to increase its competitiveness and proper conduct. The second describes the organizational structure of the Banking Supervision Department and the third lists the supervisory activities that took place in 2011. 1. PRINCIPAL ACTIVITIES OF THE BANKING SUPERVISION DEPARTMENT IN 2011 During 2011, the Banking Supervision Department strengthened its ongoing monitoring and auditing of banking activity and made its position clear to each bank regarding the capital targets appropriate to its risk profile and its risk management and internal auditing methods. This was carried out in light of recent developments in the global and local environments, which included an increase of risk in global markets, particularly in Europe, the developments in the domestic capital market and the increase in asset prices. As a result, Banking Supervision broadened its disclosure requirements for the banks’ financial statements and for the banks’ reporting to Banking Supervision and strengthened the ongoing relations with the executives of the banks. With regard to the evaluation of risk concentrations, emphasis was placed on housing loans and on credit to the construction and real estate industry and to the large borrowers in the economy. The risks and threats were analyzed from a forward-looking perspective using new methods and various stress tests, In addition, the Banking Supervision Department promoted the preparedness of the banking system for business continuity and reinforced the management of operational risk at the banking corporations and their emergency preparedness. In view of the developments in global regulation, Banking Supervision continued to work toward the adoption of international standards for risk management, capital and corporate governance, while preparing for the implementation of Basel III in Israel. These measures, accompanied by ongoing cooperation with regulators in Israel and abroad, positioned Israel’s banking system on a par with leading banking systems in developed countries. Along with strengthening the banking system’s stability, Banking Supervision also worked to enhance the system’s competitiveness and fairness, by means of, among other things, the implementation and 65 BANK OF ISRAEL: ISRAEL’S BANKING SYSTEM 2011 enforcement of legislation and directives in the area of bank-customer relations, consumer education for banking customers and the investigation of customer complaints. a. Ongoing monitoring activities in light of the implementation of a supervisory review process (1) Examination of risk and capital adequacy The measures taken by Banking Supervision in 2011 were a direct continuation of those in previous years, which were aimed at strengthening capital adequacy in the banking system, improving the process of identifying and monitoring risks, developing appropriate infrastructure for risk management and strengthening corporate governance. During the course of the year, Banking Supervision worked to evaluate the activity of the banks with respect to their risk profiles and to analyze changes in the economic environment, with the goal of influencing their capital planning and risk management processes. In accordance with the decided-upon work processes, the banks submitted ICAAP1 (Internal Capital Adequacy Assessment Process) reports in May 2011. These included an internal evaluation of their capital adequacy relative to their risk profile and their strategy for ensuring capital adequacy. These reports were examined and analyzed by Banking Supervision, in order to formulate supervisory principles on across- the-board issues and improvements and in relation to each individual bank as well. Within this framework, Banking Supervision held numerous discussions in various forums, and maintained a dialog with each individual bank. At the end of this process, an overall risk profile was created for each bank. In addition, the banks were required to adopt corrective measures, including the strengthening of corporate governance, risk management and internal auditing. As part of this process, Banking Supervision formulated its position regarding capital adequacy and the capital targets the banks had set for themselves, the main weaknesses in corporate governance and risk management and the main challenges that require forward-looking managerial attention. These and other findings were communicated to the banks through correspondence and at meetings held with the banking corporations’ executives and boards of directors. As part of this effort, the banks were required to formulate capital targets and plans with upward-sloping paths that resemble the actual capital ratios (core and overall) of comparable banks in developed countries and that reflect the guidelines for Israeli banks, in view of global developments. (2) Banking Supervision Department activity in the area of corporate governance This year, the Banking Supervision Department continued taking measures to evaluate the quality of banks’ corporate governance, including the performance of the board of directors, senior management, the chief risk officer and internal auditing, relative to the requirements of best practice and of the Supervisor of Banks. In December 2010, Proper Conduct of Banking Business Directive 301 regarding the Board of Directors was revised. As part of the revision, the function of the board of directors as a strategy maker and as the supervisor of the bank’s executive was more clearly defined, while the functions of the executive are related primarily to day-to-day management. As part of the new directive, the banks’ boards of directors are required, as a rule, to avoid intervening in the ongoing management of credit and their authority to approve 1 For further details, see the Annual Survey of Israel’s Banking System for 2009, Box 4.2. 66 CHAPTER 3: ACTIVITY OF THE BANKING SUPERVISION DEPARTMENT deviations from established credit policy was narrowed; they are to focus on creating adequate systems for control and supervision of the executive’s activities and its jurisdiction. In 2011, Banking Supervision held a large number of discussions in a variety of forums in order to formulate supervisory principles related to the implementation of the new directive and evaluated the plans submitted by the banks based on those principles. As part of the effort to reduce the involvement of the board of directors in the credit approval process, the banks were asked to examine, among other things, the integrity of their credit policy, the appropriateness of their credit approval process and its documentation, and their monitoring and control mechanism in its very layers. Emphasis was placed on strengthening the board of directors’ means of supervision and control, enhancing the procedures for reporting to the board of directors and developing additional control tools that are appropriate to the new structure of authority. b. Reinforcing the supervision and monitoring of developments in the global environment (1) Increasing the frequency of reporting and communication with the banks In view of the developments in global markets, including the debt crisis in Europe, Banking Supervision closely monitored the activity of Israel’s banking system. Within this framework, it maintained ongoing contact with the executives of the banks, received data and weekly reports on actual exposures and assessed the measures taken by the banks. Banking Supervision closely monitored the potential exposures of the banks to global markets, including credit exposures, direct and indirect exposure to countries and foreign financial institutions and exposures implicit in the nostro portfolios and compensation funds; verified that the banks are maintaining adequate processes to monitor exposure; and if necessary demanded that they reduce exposures, including by proactive measures. In this context, special emphasis was placed on the managerial preparedness of the banks for global developments and their effect on the domestic market. The Banking Supervision Department carefully assessed the results of scenarios developed by the banks, as part of the risk management process, with regard to potential developments and stress scenarios