Fitch Ratings says that a period of solid economic growth in Israel, helped by structural reforms and fiscal consolidation, has lead to a strengthening in key banking system indicators, according to a special report. Various regulatory reforms have, however, yet to achieve the desired impact of reducing the dominance of the two main banks in the system.

"Strong economic growth in recent years has supported improved core profitability trends, as well as better asset quality and capital adequacy indicators in the Israeli banking sector," says Zarema Lyanova, Associate Director at Fitch Ratings. "Profitability was helped by a favourable economic environment, the increasing share of higher-yield business, fees and commissions from financial management services as well as cost management efforts and a decline in loan loss provisions. However, the low level of provisions reported by banks in 2007 is unsustainable in the long term, especially given a forecast of a slowing economic growth in 2008 and 2009. Fitch expects the change in economic outlook to weigh on the banking sector's profitability and asset quality in the short- to medium-term."

The impact from the US crisis has been manageable for the sector overall. The Israeli banking sector as a whole is now better positioned to weather an expected slow down in the economy than it has been in the more recent past, having managed to strengthen their balance sheets since the last 2001-2 recession. Fitch views that the capitalisation of Israeli banks remains only adequate, given high concentrations and levels of unreserved NPLs. However there has been an improving trend and the agency views the regulator initiative to raise banks' capital ratios to 12% by end-2009 as a positive one.

Various regulatory reforms including the so-called Bachar reforms have had some impact; however desired changes towards a less bank-centric financial sector and competitive banking sector are yet to be seen. The highly concentrated Israeli banking sector is dominated by two financial groups - Bank Hapoalim (rated 'A-' (A minus)) and Bank Leumi (rated 'A-' ('A minus')), which together controlled around 60% of the market at end-2007.

"Capital market reforms have encouraged disintermediation, with a broad range of corporates increasing leverage by raising funding outside the banking sector," says Mark Young, Managing Director at Fitch Ratings. "While positive, the concentrated nature of the financial system and its lack of depth means that there is a risk that banks become exposed to the refinancing risks should these markets become closed to the corporate sector."