The Icelandic authorities were assuming, however, that the banks were solvent. Their published CAD ratios were well above the 8% threshold, and as late as August 2008, the Icelandic Financial Supervisory Authority had deemed them able to withstand severe capital shocks. Now, however, we know that this was probably not truly the case, as there were hidden vulnerabilities in their capital positions. Be that as it may, with the solvency assumption in mind, the authorities tried to build defences against potential foreign currency liquidity problems at the banks by negotiating swap lines and tapping foreign capital markets, in both cases with limited success. 2  BIS central bankers’ speeches  There was also a failed attempt to nationalise one of the banks in late September. It was fortunate that it failed, as nationalising the bank would have turned a bank foreign currency refining problem into a sovereign problem, with the serious risk that the sovereign might have defaulted on such foreign currency payments. In this light, and given the lack of international co-operation, the Icelandic authorities were forced to consider radical solutions. Although they were not necessarily articulated fully at the time, these solutions entailed several goals: to preserve a functioning domestic payment system, ring-fence the state in the case of bank failures, limit the socialisation of private sector losses, and create the conditions for rebuilding a domestic banking system. The adopted solution included a declaration that all deposits in Iceland were safe and all deposits in Icelandic-headquartered banks were given priority over other unsecured claims.

The Financial Supervisory Authority was granted broad-based powers to intervene in failing institutions, and the Government was authorised to inject capital into new domestic banks. This so-called Emergency Act thus allowed new domestic banks to be created when the old cross-border banks failed and were placed in special resolution regimes followed by winding-up proceedings. The new banking system amounted to around 1.7 times GDP, compared to 10 for the old banking system. As a result of these measures, the domestic payment system functioned more or less seamlessly throughout, and customers had continuous access to their deposits. I have expanded at some length on the measures taken when the banks failed, as there are still a number of misconceptions about the process in international discussions. There have been claims that Iceland allowed its banking system to collapse, with what now seem reasonable results, and that others should consider doing the same. The fact is that Iceland kept the domestic part of the banking system running throughout; otherwise, the consequences would have been dire. Some have claimed that the banks were nationalised. They were not. The old banks are private companies. They are in winding-up proceedings governed by law; they are not under the control of the Government. The Government has a majority stake in only one of the new banks. Others have claimed that Iceland defaulted and got away with it. The opposite is true. The credit of the sovereign was preserved, and all debt obligations have been paid on time.