Work is currently being done, both in Europe and globally, towards reforming the regulatory framework for international banking operations. Until the framework for those operations is more secure, however, the wisest course for Icelanders may be to proceed with caution and adopt tighter rules on cross-border financial activities than are set forth in the minimum requirements. A clear example of this is a restriction on the accumulation of deposits in foreign bank branches. The long-term need for such more stringent rules will be determined to a degree by Iceland’s future currency and exchange rate regime. Experience shows that maturity mismatches between banks’ assets and liabilities that are not backed up by a lender of last resort represent a substantial risk. The global financial crisis has revealed a variety of weaknesses in the regulatory framework and the supervision of the financial sector. On the whole, the quantity and quality of financial  2  BIS Review 136/2009  institutions’ capital was insufficient to provide the necessary shock absorption. In particular, there should have been more unpledged common equity. The risk assessment of assets and liabilities was distorted because it was based on historical data that did not assign sufficient weight to bad states of the world. Liquidity risk was vastly underestimated, and the procyclical tendencies within the financial system were not sufficiently offset by the regulatory and supervisory framework. On the contrary, it can be argued that the interplay of regulatory provisions and financial reporting rules based on mark-to-market exacerbated these tendencies.

One of the roles of the Parliamentary Special Investigative Commission is to compile information on these topics and present an analysis of them. The Central Bank neither has the capacity nor the will to front-run that analysis. The Bank will probably need to revise its operational practices in these areas in view of experience and the Commission’s findings, as will other supervisory institutions. In addition, the Bank will soon review its precautionary rules, such as those pertaining to financial institutions’ liquidity and foreign exchange balance, in light of recent events. Various elements of payment intermediation and settlement will also be reviewed in the near future, with the aim of promoting financial stability more effectively. Because of the uncertainty still surrounding assets, capitalisation, and ownership of Icelandic financial undertakings, it is difficult to assess the main risks in Iceland’s financial system at this time. However, those risks are clearly related to asset quality, on the one hand, and foreign exchange and indexation mismatches, on the other. For this reason, among others, it is important that financial institutions maintain capital adequacy ratios well above the statutory minimum in the near future. At present, deposits form the backbone of the banks’ funding, as foreign investment in Iceland and access to global credit markets are limited. Lifting the capital controls entails a certain risk, partly because it involves liberalising capital flows while the ownership structure of the banks is still being clarified.