The remuneration schemes in financial undertakings and the decisions made by credit rating agencies added fuel to the fire. Financial supervisors tended to focus on risk attached to individual financial institutions more than on system-wide risk. There was also a tendency to practise somewhat lax supervision in order to stimulate the development of financial centres. As a result of all of the above factors, the financial system became far too leveraged. At this writing, a variety of efforts are being made internationally towards correcting these flaws, as is described more fully in this report. The Central Bank of Iceland is following these developments closely, not least through its membership in the Bank for International Settlements in Basel, which is the venue for a number of the committees and institutions that assess risk in the global financial system and formulate the regulatory framework and standards that govern it. The experience of this financial crisis – both in Iceland and abroad – calls for a reassessment of the most effective architecture for financial supervision, with particular emphasis on the nature of the relationship with the central bank. For some time, the trend was towards separating central banks from financial supervision, particularly in countries with developed financial systems. But as is discussed in this Financial Stability report, banking supervision has remained within the central banks of a majority of European countries, and the pendulum might be swinging in that direction once again in countries with developed financial systems.

On the contrary: The response to Iceland’s crisis was characterised by ring-fencing and hostility, yet it is well known that such an approach creates a worse outcome in the aggregate. Iceland’s rescue efforts focused on keeping payment intermediation and domestic banking operations up and running to the extent possible, and then on rebuilding the financial system and the economy on new foundations. As is described in this report, attempts to keep domestic payment intermediation functioning were broadly successful under the circumstances. This is due in large part to attempts made over the past several years to improve the efficiency and security of payment intermediation, in line with international standards. Cross-border payment intermediation was disrupted when the banks fell, however, partly because of the actions taken by the British authorities. But a variety of measures described in some detail in this report restored the functioning of cross-border payment intermediation, which is largely back to normal as of this writing. Rebuilding the domestic banking system is part of the economic programme prepared by the Government in collaboration with the International Monetary Fund (IMF). The restructuring of the three commercial banks is well advanced. The savings banks’ restructuring is still incomplete, and it remains unclear how large a capital injection will be required from the Treasury. The cost of recapitalising the commercial banks will be much less than originally assumed, however. Although the banks’ restructuring is proceeding apace, there is still considerable work to be done before the long-term structure of the new Icelandic financial system is complete.