(Repeats Tuesday item)
* Government plans to split banks from credit card companies
* Finance minister wants to supervise new card firms
* Proposals provoke row with central bank
* Kahlon denies banking system's stability at risk
* Top 3 banks control 73 pct of Israel's credit supply
By Tova Cohen and Steven Scheer
TEL AVIV, March 8 (Reuters) - Israeli Finance Minister Moshe Kahlon took the job promising consumers to cut the cost of banking, just as he once did for mobile phones. His drive to spur competition, however, has provoked a row with the central bank and raised questions over the future stability of the financial system.
Kahlon's campaign to lower fees and borrowing costs for Israelis began as a plan to force the top two banks to sell their credit card operations.
Now it includes more drastic steps, such as preventing the two banks - and possibly others - from issuing credit cards at all and removing some of the central bank's supervisory powers.
The resulting dispute between Kahlon and Bank of Israel Governor Karnit Flug is causing unease on financial markets.
Critics say the reform will do nothing to create more competition and could instead harm Israel's banks, which weathered the global financial crisis well thanks partly to close cooperation between the finance ministry and the central bank - something which now seems in short supply.
Such opponents argue that should the banks have to sell their profitable credit card businesses, they will face unfair competition from the less-tightly regulated card companies which might be tempted to flood the market with cheap lending, creating a credit bubble.
Bank of Israel officials privately warn of the danger of the banking system being destabilised, but Kahlon rejects the notion, worrying more about consumers' welfare.
"There is no danger to the banks' stability. They profit when they are sleeping and shaving," he said after Israel's top five banks reported last week a combined $2 billion in profits for 2015. "All the time we are scared the banks will collapse but in the meantime, citizens collapse."
Prime Minister Benjamin Netanyahu, whose main concern is preserving a fragile coalition that hinges on Kahlon's centrist Kulanu party, has remained silent.
GRAPHIC: Israel's banking reform:
Kahlon gained popularity after a wave of protests against the high cost of living in 2011. As then communications minister, he brought in new mobile phone operators which introduced rock bottom rates for calls.
He became finance minister last year after his party won 10 seats in parliament, promising to lower housing costs and shake up banking, which is dominated by Hapoalim, Leumi and Discount. Together, they control 73 percent of the country's credit.
Flug became the Bank of Israel's first female governor in 2013, replacing Stanley Fischer who led the central bank through the global crisis and is now vice chairman of the U.S. Federal Reserve. However, Netanyahu appointed her only after two other candidates had pulled out.
Initially she supported the plan to require Hapoalim and Leumi to sell their credit card businesses. But as more details of the plan emerged, industry sources said she felt she had been backed into a corner.
In particular, she opposes Kahlon's proposal to set up a new authority within his ministry to supervise credit card firms.
"The transfer of supervision over these companies from the Bank of Israel to a regulator with a different focus and different expertise raises a real concern that the damage from separating the credit card companies will be greater than the benefit," she said in a speech.
"It is also important that an apolitical entity, which is not measured according to its day-to-day popularity, will have responsibility for maintaining stability."
She also opposes forcing Discount and the No. 5 bank, First International, to sell their joint credit card unit, a move Kahlon is considering.
Flug's deputy, Nadine Baudot-Trajtenberg, said there was no economic rationale behind preventing banks from issuing credit cards, while there was no "smoking gun" showing credit interest margins were too high.
Uncertainty over the reform has contributed to a sharp fall in the share prices of Hapoalim and Leumi, which have lost 14 percent and 23 percent respectively since August.
Yair Seroussi, chairman of Hapoalim, Israel's leading bank, said he could not recall such a big disagreement between an Israeli finance minister and central bank governor.
"The implications of this rift go beyond personal matters," Seroussi told Reuters, noting that cooperation between the two institutions helped the Israeli economy to navigate the 2008 crisis successfully.
A source close to the Finance Ministry said Flug's problem with Kahlon was a matter of retaining power. "They had all the power all the years of the Stanley Fischer period and now someone is ... challenging their authority," the source said.
However, a source close to the central bank said Flug is trying to protect the financial system and blamed Kahlon for turning banking reform into a political issue.
A spokesman for Netanyahu declined to comment.
Flug and the banks contend that Israel's banking system has become much more competitive in recent years. Credit to consumers and small businesses has grown by over 10 percent annually in the past few years. The ratio of consumer credit to GDP in Israel is similar to that in the United States and higher than in Britain, France and the Netherlands.
Average annual interest on credit cards, at 7.6 percent, is low in comparison with other countries.
Preventing banks from setting up new credit card businesses after they sell their current operations will leave only three players in the market, Flug, bankers and economists point out.
"I believe that the proposal to separate the credit card companies from the banks could damage competition and may create an economic distortion," Seroussi said.
Such distortions could include a credit bubble. "If you can take loans with much less tight control you will have a huge amount of consumer credit, which could blow up," said Micha Goldberg, banking analyst with Excellence Nessuah.
A report prepared for Hapoalim by U.S. economic consulting firm Compass Lexecon called mandatory ownership separation "a drastic measure" and a ban on the issuance of cards by the banks "drastic intervention".
It said the proposals would fail to achieve their objective: "We expect that by their very restrictive nature they will tend to reduce and constrain competition."
In the United States and Britain, credit cardholders frequently pay off only the minimum amount monthly, meaning they run up sizeable interest costs on their balances.
By contrast, many Israelis pay off their entire card bills each month, getting interest-free but only short-term credit. They do, however, pay interest on overdrafts in their bank accounts, whose limit is typically linked to a customer's salary, which averages 9,500 shekels ($2,429) a month.
Citi analyst Michael Klahr said there was an opportunity for growth in Israeli credit-card credit, which at nearly $2 billion in the first nine months of 2015 is only 6 percent of non-mortgage consumer credit. He noted there are 7 million active cards in Israel, equal to an 83 percent penetration rate.
But potential buyers of the credit card businesses, he said, "will be wary of buying into a sector that has been at the centre of this cost-of-living debate, and where regulation and business economics can change almost overnight at the behest of politicians."
Credit cards account for about 12 percent of banks' profits, mostly from customer and merchant fees rather than credit and financing. Goldberg estimated that if banks can retain part of their operations, such as distribution or clearance, than the loss to earnings will be 8 percent to 9 percent.
But the long-term implications are greater, he said, noting credit cards can be developed into a regular banking business, which is what the finance minister would like. This could lead to unfair competition as regulation will be less strict and capital requirements will be lower.
Goldberg noted that issues that really matter to consumers such as high costs for housing and cars are difficult to solve but as a politician Kahlon must have accomplishments to present to voters. The banks are "an easy way out", he said.
editing by David Stamp