The Central Bank candidly expressed these concerns in its financial stability reports, most notably in the spring of 2001. At that time the IMF also issued its Financial Stability Assessment which questioned the strength of the financial system in Iceland in view of the tremendous imbalances in the economy and what was perceived to be an underlying weakness in the banking institutions. The IMF identified a potential risk of a rapid depreciation of the currency, which it felt could further weaken the banks and pose a threat to them. Early on in the upswing, amidst a rapid expansion of lending and external indebtedness of the banks, particularly their short-term foreign debt, the Central Bank imposed a liquidity requirement on the commercial banks. Its purpose was to stem the growth of foreign borrowing and to shift the weight of foreign indebtedness from the very short end of the maturity spectrum. Another prudential rule set by the Central Bank concerns the foreign exchange exposure of commercial banks. This sharply limits their scope for taking direct foreign exchange risk. Beyond these prudential regulations, the means which the Central Bank has to affect the practices of the banks are through public pressure, for example in its semi-annual financial stability reports or in other public or private statements. The Bank has used all these methods with varying degrees of success. In line with the traditional role of central banks, the Central Bank of Iceland can serve as a lender of last resort if a domestic bank experiences a liquidity shortfall.

A logical part of that process was that in 2000 the Bank began to publish semi-annual financial stability analyses in its quarterly Monetary Bulletin. One reason for the increasing focus of the Bank on systemic financial stability issues in the late 1990’s was the growing perception in a liberalised financial market that a weak financial system could undermine economic and monetary stability just as much as economic imbalances and weak policies could undermine an otherwise sound financial system. A sound financial system, including safe and secure payment and settlements systems, is also an important precondition for the effective implementation of monetary policy. Capital movements were fully liberalised in the 1990’s, as was the domestic financial market which also underwent significant structural change, including the withdrawal of the government from direct ownership in banking institutions. These developments stiffened competition at home and linked the domestic financial system much more closely to international markets. Consequently, in its analyses, the Central Bank consistently draws attention to the potential vulnerability of the domestic financial system to changes in the external environment, including the ready availability of foreign credit for refinancing purposes, and its vulnerability to sudden changes in the exchange rate. The developments in the Icelandic economy towards the end of last decade and into this one resembled in many ways those experienced in some of the other Nordic countries a decade earlier. Needless to say, and in view of the experience of other Nordic countries, these developments caused considerable concern about the underlying stability of the financial system.