Although the adjustment would ultimately be greater if it occurred slowly, a very rapid contraction would deliver such a jolt to the finances of many households and businesses that loan losses would result. It is likely that a range of risks will have to be faced, but efforts must be made to minimise the probability of a financial crisis that could harm potential output and living standards. In the final  2  BIS Review 41/2007  analysis, the critical factor is how strong and well equipped the financial system is to withstand shocks, i.e. its resilience. The crucial factor behind the Central Bank’s assessment that the financial system is now more resilient to shocks is the banks’ stronger liquidity and equity positions than a year ago. The major commercial banks have a diversified income base that extends to many countries. Another advantage is the somewhat different business models they have used in their expansion. Their diversified assets give less reason to fear the consequences of an unexpected strain on the financial system. Iceland’s strong fiscal position underpins the banks’ international credit ratings. Other important factors have been the strengthening of Iceland’s foreign reserves and the Central Bank’s capital. Both measures represent natural responses to changes caused in the Central Bank’s operating environment by the very rapid expansion of the commercial banks, especially abroad. Although the main function of a financial stability report is to highlight risks, factors conducive to strengthening the long-term economic outlook should also be duly noted.

Iceland’s economy is advanced, transparent and dynamic. The population is relatively young, well educated and quick to adapt to technological and scientific innovations. A strong fully funded pension system has been built up and, unlike other countries, there is no reason to fear for its sustainability. GDP per capita ranks with the highest in the world, and the economic and social infrastructure is solid. The openness of the economy results in a smaller effect from a contraction in domestic demand on employment than might be expected. The authorities shape the framework in which businesses and the financial system operate. Through its membership of the European Economic Area, Iceland enjoys similar operating conditions to those within the European Union. Nonetheless, it retains various features that influence economic advancement, such as a rather business-friendly tax environment, efficient public administration and flexible labour market. Extensive and rapid transformation of the financial sector puts supervisory agencies under pressure. The Financial Supervisory Authority (FME) has been granted an increasingly wide remit in recent years and its activities have been strengthened. One task is to monitor the banks’ transactions with main shareholders and executives. Payment and settlement systems are a key component of an efficient and sound financial system. Steps have recently been completed towards bringing their regulatory framework into line with international best practice. Although such work tends to go relatively unnoticed, it is crucial for enhancing security of settlements and reducing technical risks. The main financial sector vulnerabilities are presented in the table below.