Israeli Bank Stocks Face Challenge Justifying High Valuations

Shares of Israeli banks, led by a 6% drop in International Bank stock, fell significantly following the release of lukewarm third-quarter financial reports. The TA-Banks index lost 3.6%, with International Bank reporting a 12.6% decrease in net profit to NIS 508 million and a decline in return on equity from 16.2% to 13.8%, despite a 22% annual growth in its credit portfolio. This quarterly weakness is seen as indicative of a broader trend affecting the entire sector. Over the past six months, the bank stock index has declined by approximately 5%, and by 12% since February, after a long period of leading the stock exchange's gains.

The decline raises questions about why bank stocks, which continue to generate billions in profits and pay generous dividends, are struggling to replicate past performance. A key factor is the shift in foreign investor behavior. In the first nine months of the year, foreign investors sold a net NIS 4.9 billion in bank stocks, a stark contrast to NIS 6.7 billion in net purchases during the same period last year, representing a total shift of NIS 11.6 billion. Foreign investors, once a major source of demand, have become significant sellers, with Bank Leumi and Bank Hapoalim identified as among their largest sales. No Israeli banks appear on their list of purchases.

Israeli institutional investors, such as pension funds and insurance companies, also play a role. While managing vast sums, their options for significant investments in the local market are limited due to the scarcity of large, liquid companies. A slowdown in their purchasing pace, combined with continued foreign selling, can alter the supply-demand balance. Furthermore, as investment managers increasingly favor overseas markets, banks may lose a crucial demand driver. While data until September showed net purchases by domestic institutions and mutual funds, the continuation of this trend is uncertain.

Private investors are also less drawn to bank stocks, which are typically evaluated on profitability, return on equity, and dividends, rather than high growth potential associated with tech or growth companies. With declining profitability, justifying further stock price increases becomes difficult. Bank stocks currently trade at an average price-to-book ratio of 1.52, significantly higher than the historical average of 1, reflecting a nearly 56% average increase in the bank stock index in 2025. This surge was partly attributed to increased reliance on technology, staff reductions, and improved profitability.

However, profitability is being eroded by a 1.25 percentage point interest rate cut by the Bank of Israel over the past year, reducing banks' financing income. Moderating inflation, exchange rate fluctuations, and competition for deposits further impact revenues. Major banks also continue to pay a special tax on their profits. Despite these pressures, the growth in business activity, particularly credit portfolio expansion, has partially offset the decline. For instance, International Bank's credit portfolio grew, but its net interest income fell 11.2% in the third quarter. The bank is also implementing efficiency measures, including a voluntary retirement program expected to reduce labor costs in the long term.

Industry insiders suggest that much of the negative impact is already reflected in the results, with the interest rate environment nearing stability. Continued business growth and efficiency measures are expected to support profitability. Adding to the competitive landscape, the Bank of Israel recently granted a conditional banking license to digital banking giant Revolut, signaling its upcoming entry into the Israeli market. Revolut's planned services in banking, payments, and integration with Israeli payment systems could intensify competition for customers and deposits, further pressuring bank margins.