With world attention focused on the Gaza war, another crisis is brewing in the Israeli-occupied West Bank, one that could also have grave implications for stability in Israel-Palestine. Palestinian banks may collapse after 1 July, unless Israel renews a waiver that allows Israeli banks to transact with them by that date. The waiver is critical for imports of essential goods into the Palestinian territories, payments of essential services and salaries, and all banking activity. Without it, the Palestinian economy could face a liquidity crisis and a meltdown with dire consequences for West Bank Palestinians – and maybe for Israel as well. 

Bezalel Smotrich, Israel’s far-right finance minister, issued a three-month waiver for transactions in March, but indicated that he did not plan to extend it further. In addition, he has refused to transfer hundreds of millions of dollars in tax revenues that Israel collects on behalf of the Palestinian Authority (PA), pursuant to deals the two sides struck in the 1990s. The U.S. and other major powers have urged Israel to renew the waiver, fearing calamity in the West Bank, where economic and security conditions have already deteriorated markedly during the Gaza war. But the Israeli government has yet to yield, and many U.S. officials believe that Smotrich in fact intends to bring about the PA’s collapse. With the deadline fast approaching, the U.S. and its partners must intensify their pressure on the Israeli government while preparing for the worst.

The Palestinian economy is dependent on Israel: the shekel is Palestine’s de facto currency (though the Jordanian dinar and U.S. dollar are also in use), and Israel is by far its largest import and export market. The shekel began replacing the dinar as the working currency in 1967, when the Israeli army occupied the West Bank. During the Oslo negotiations in the 1990s, Palestinian leaders agreed to measures that consolidated the shekel’s position. The Paris Protocol signed by Israel and the Palestine Liberation Organization in 1994, and later incorporated into the second Oslo accord, requires the PA to use the shekel in its banking transactions with Israel. It also states that the PA may accept certain other currencies as means of payment. In 2022, Palestinian (West Bank and Gaza) exports to and imports from Israel constituted more than 90 and 57 per cent, respectively, of total trade.

Since 2016, Israel’s finance ministry has routinely granted two Israeli banks – Israel Discount Bank and Bank Hapoalim – an annual waiver that allows them to maintain business relationships with Palestinian banks, acting as intermediaries for transactions with Israel (both the private sector and government) and the rest of the world. The waiver essentially shields the banks from legal and other risks stemming from money laundering and terrorist financing offences in their dealings with Palestinian banks, allowing them to act as clearinghouses for Palestinian transactions with global markets. It also facilitates payments for services and salaries linked to the PA and imports of essentials such as food, water and electricity into the occupied territories. Moreover, it is the only mechanism through which tax revenues collected by Israel on the PA’s behalf can be transferred to the Authority’s coffers. It is also the only means by which Palestinian banks can convert shekels into other currencies through the Bank of Israel.

For the better part of the last decade, the Israeli government has issued the waiver of indemnity following the receipt of an annual comfort letter from the U.S. Treasury. The U.S. letter affirms that by facilitating transfers to Palestinian banking institutions, Israeli banks are not running afoul of U.S. counter-terrorism laws. The impetus for the letter was the Jesner v. Arab Bank case before the U.S. Supreme Court, in which non-U.S. petitioners alleged that the Arab Bank, a major Middle Eastern financial institution headquartered in Jordan with branches in Gaza and the West Bank, had facilitated terrorist attacks by routing money through its New York branch. The Arab Bank won the case, but the lawsuit spooked Israeli and international banks so much that they did not want to transact with their Palestinian counterparts without assurances from the U.S. government. The case was particularly worrying for Israeli banks because two of them were brought into the litigation due to their correspondent relations with the Palestinian branch of Arab Bank.

The U.S. Treasury has continued to issue its routine comfort letter, but if Israel fails to indemnify Israeli banks before 1 July, most Palestinian banking services will be disrupted in short order – within no more than several days, according to international financial officials – and the Palestinian economy will immediately feel the shock waves. Palestinian banks would no longer be able to carry out most transactions, and Palestinian depositors would not be able to pay, or get paid by, Israeli businesses, unless they resorted to cash transactions, for which the legal limit in Israel is 6,000 shekels ($1,600). Convoluted workarounds involving foreign banks using other currencies, while conceivable for certain types of transactions, are unlikely to offer an alternative – and certainly not on the scale required, given that foreign banks have told U.S. officials that they will limit transactions from Palestinian banks if Israeli banks cut these off due to increased risk concerns. These supposed remedies, moreover, could exacerbate the liquidity problem, as foreign currency holdings of Palestinian banks are likely to fall while shekel deposits soar, triggering inflation.

A U.S. official predicted to Crisis Group that, should Israel fail to renew the waiver, the West Bank would face a financial crisis on a scale like that in Lebanon, where GDP plummeted by almost 40 per cent between 2019 and 2021, and an ensuing economic collapse so vast and complex that international actors “won’t be able to manage the flood”. A senior Palestinian official told Crisis Group that non-renewal of the waiver would be tantamount to a “political decision to put an end to the PA, because it would stop all its trade relations”. The stakes are thus enormous. In effect, the PA is at risk of no longer being able to buy fuel, water, electricity or any other materials or services from Israel, upon which it is dependent; it might stop receiving the tax revenues Israel collects for it, meaning it might not be able to pay salaries or deliver services; and traders and importers might no longer be able to buy goods on either Israeli or foreign markets. Commerce risks being curtailed to local exchanges and cash transactions with Israelis that are under $1,600 in value. Inflation could be paired with a general stoppage in economic activity. Security conditions could worsen, with consequences that are hard to foretell.

U.S. Treasury officials have had no objection to issuing the annual comfort letter, and they argue that Israeli banks should be willing to transact with Palestinian banks, which Washington believes are adhering to global anti-money laundering and countering financing of terrorism (AML/CFT) standards. They say years of scrutiny from foreign treasuries and international financial institutions, as well as technical assistance provided by the U.S. government and others, including from a Treasury attaché working with Palestinian financial institutions for the past decade, have helped give the Palestinian banking sector a strong structural framework. According to a U.S. official, a U.S. and UK Treasury department study of the Palestinian banking sector, completed in June, concluded that it still has a robust AML/CFT framework and enforcement record.

When the last indemnity period expired on 31 March, Finance Minister Smotrich extended the waiver for a mere three months rather than a full year or six months, as has occurred in the past. U.S. officials say Smotrich is using the issue to score political points, while Palestinian officials argue that Israel’s readiness to imperil the economy is part of a broader plan to dismantle the PA and annex the West Bank to Israel. The minister, a settler who is notorious for his anti-Palestinian stance, has indeed publicly called for the PA’s “collapse” in response to two events: the International Criminal Court prosecutor’s application on 20 May for arrest warrants for Prime Minister Benjamin Netanyahu and Defence Minister Yoav Gallant; and the late May decisions by Norway, Spain and Ireland to recognise Palestine as a state. Smotrich ascribed these actions to the Palestinians’ advocacy, saying “the Palestinians are operating against Israel with political terrorism and are promoting unilateral steps vis-à-vis the world, and therefore we should not continue transferring money to them. … If this causes the collapse of the PA, let it collapse. … I will not artificially revive the PA so that it can work against me”.

U.S. officials think Smotrich wants to sow chaos: “he is busy devising plans to blow up the West Bank”, one told Crisis Group. It would be a natural extension of the minister’s far-right views. Smotrich has openly written and spoken about his schemes to dramatically expand Israel’s settlement enterprise and annex the occupied territories, some of which he has begun carrying out. Some European diplomats are concerned that Netanyahu may go along with Smotrich, at least part of the way, and back the notion of ginning up a crisis for the PA as way to divert attention from the failures of the Gaza war, sidestep U.S. demands that the PA play a role in the enclave’s post-war governance and undermine European moves to recognise a Palestinian state.

The threat to Palestinian banks follows months of enormous strain on the West Bank’s economy since the onset of the Gaza war. Israel has imposed a stringent set of restrictive measures, which Israeli officials say have become necessary due to security risks. Internal closures throughout the West Bank, the suspension of work permits for 148,000 Palestinians who were commuting to jobs in Israel and the loss of an additional 144,000 jobs in the territory have already resulted in a massive economic shock for Palestinians, with the West Bank’s GDP falling by close to 20 per cent in the last quarter of 2023 compared to the year before.

In addition, Israel has been withholding PA customs and tax revenues, a practice which predates the Hamas-led attack in October 2023 but has intensified since then, with transfers shrinking by over 50 per cent. Under the terms of the Paris Protocol, all imports to PA areas must be cleared by Israeli customs agents, under a common system. Customs duties and taxes are then deposited with Israel, which deducts a management fee of 3 per cent. This agreement was reached to allow for the establishment of a single customs area, and although the arrangement continues to this day, it was intended to be a transitional measure while negotiations were advancing. Palestinian officials describe the situation in which Israel collects (and then withholds) the money as a “sword on our necks”. Israel also makes deductions from these revenues for outstanding debts such as for electricity provision and medical transfers of Palestinians to Israel. Since the Knesset passed a controversial law in 2018, Israel also deducts for the monthly stipends that the PA pays to Palestinian prisoners, their families and the families of Palestinians killed by Israeli forces in counter-terrorism operations. Now Smotrich is also withholding sums equivalent to the amount the PA pays to those of its employees who continue to work in Gaza as well as to pensioners in the strip.

By unilaterally withholding the bulk of these revenues, Israel is in breach of the Oslo accords, at great cost to the PA and Palestinians. The funds Israel collects constitute roughly 65 per cent of the annual Palestinian budget (which is around 18 billion shekels, or $5.27 billion), and a large proportion of them are used to pay the salaries of public-sector employees. Without them, the PA struggles to pay these wages; in May, the Authority announced that it could meet only half its obligations in this regard. To cover the deficit, the PA has been borrowing cash from commercial banks and has accumulated sizeable arrears to private-sector suppliers and to its pension fund. According to the Palestinian Monetary Authority, public debt to banks now amounts to $3.82 billion, while the total amount owed by the PA (including arrears and to the public pension fund) is now in excess of $11 billion, according to figures from the Palestine Cabinet.

The Biden administration, as well as several Democratic U.S. lawmakers, have urged the Israeli government to release customs revenues and are also lobbying Netanyahu to extend the waiver, but staffers are privately criticising senior officials for not being forceful enough. The administration appears disconcerted by the sheer number of competing priorities in its advocacy with Israeli officials, the most urgent of which are a ceasefire, a deal releasing the hostages still in Gaza and humanitarian aid access to the strip. The U.S. is already facing pushback from Smotrich because of its sanctions on violent settlers in the West Bank, which it has levied in several tranches since February. Smotrich has threatened to paralyse the Palestinian economy in retaliation. Yet without concerted U.S. pressure to safeguard the PA’s financial lifelines, the administration could soon face a far worse predicament in the West Bank and throughout the region. 

Smotrich’s actions and statements have also drawn the attention of U.S. lawmakers. Democratic Senator Chris Van Hollen of Maryland has suggested that Washington should sanction him as well. In February, the Biden administration issued an executive order providing a legal basis for sanctioning non-U.S. citizens deemed to be undermining peace, security and stability in the West Bank. The U.S. also published a notice alerting financial institutions about the risks of financing settler violence. U.S. officials have indicated to Crisis Group that they have developed sanctions packages against Smotrich and his fellow extremist, National Security Minister Itamar Ben Gvir, that could be imposed in short order. But officials are also wary that any such designation might instead embolden Smotrich, hastening the outcomes they seek to avoid.

The most straightforward way to avoid economic breakdown is for Israel to extend the waiver, ideally for at least a year to avoid an imminent repeat of this doomsday scenario. Doing so would not just spare the Palestinian economy from collapse, but it would also be in Israel’s self-interest. An economic and social debacle in the West Bank could have a detrimental impact on Israel’s security, a point made to Crisis Group by an Israeli defence official. Israeli press reports suggest that the Israeli military, Shin Bet and Mossad all oppose Smotrich’s plan. They have reportedly presented Netanyahu with scenarios in the event of an economic crash, ranging from the least severe – an end to security cooperation between Israel and PA – to escalating violence in the West Bank that features Hamas exploiting public discontent to inflame the West Bank, launch terror attacks and push for violent popular protest. Daily Israeli military operations in localities throughout the West Bank, mounting settler violence, including attacks on villages, and a harsh closure regime that severely restricts movement have already stoked tensions. These would in all likelihood get worse in the event of an economic collapse. Israel’s own economy could feel the spillover effects. The World Bank has warned that Israel could experience disruptions in trade and payment settlements, increased transaction costs, a general decline in economic confidence, and a surge in informal or unregulated financial transactions.

In light of all these dangers, U.S. officials should ramp up pressure on the Netanyahu government to renew the waiver. The probable consequences of a non-renewal are too grave to relegate the issue to a lower tier on the administration’s list of concerns for the Israelis. While Treasury Secretary Janet Yellen has publicly stated her alarm and other senior U.S. officials are reportedly lobbying Israeli officials privately, the administration could do more to emphasise the urgency of renewal to the Netanyahu government and make clear that non-renewal would hurt the U.S.-Israeli relationship. Israel’s other allies should likewise push for renewing the waiver. 

If Israel declines to do so, the U.S., European and Arab states should plan to put stopgap measures in place that would mitigate the likely economic fallout in the West Bank. In this vein, they should consider taking steps to inject foreign currency into the Bank of Palestine. They should also plan for alternative long-term structural reforms, such as creation of special purpose mechanisms for financial clearing and payment, although these would face serious political hurdles in Israel and would be unlikely to offer a rapid remedy. 

The U.S. could also consider providing comfort to Israeli banks in the form of a guidance letter or an opinion (called a “no-action letter”) from the Department of Justice, assuring Israeli banks that it does not intend to take enforcement action against them for facilitating transactions for Palestinian banks. Such a letter would have to come from the Justice Department, given its primary role in enforcing criminal laws, particularly counter-terrorism laws. Treasury already provides a comfort letter, but according to U.S. officials, this document alone is not enough because Treasury is not mandated to enforce counter-terrorism law. U.S. officials are sceptical that administration lawyers and senior decision-makers would clear such a move, but given the high stakes, there are strong reasons to pursue this approach.

Non-renewal of the Israeli banking waiver before 1 July risks precipitating a severe financial crisis and economic crisis in the West Bank, doing enormous harm to the Palestinian population. Israel should renew the waiver. The U.S. should urge it to do so, clarifying the costs of inaction to bilateral ties. The U.S. and others desiring a just and durable settlement of the Israeli-Palestinian conflict should also make contingency plans in the event that Israel does not renew the waiver or renews it for significantly less than a year. Washington should also consider providing its own, more robust assurances to Israeli banks that would enable them to continue to act as clearinghouses for Palestinian banks. Without decisive action, the Palestinian economy is headed for a catastrophe that could destabilise the West Bank and the wider region.