which clearly facilitated the cross - and off - border expansion of the icelandic banks through the so - called european passport. it was and is deeply flawed. the basic problem is that the freedoms are not matched by public action and frameworks at the eu and eea level. bank size relative to country size was assumed to be a matter of no concern, and fx risk was largely ignored. based on the icelandic experience, a banking union makes perfect sense, but only fully for the eurozone, and even then it has to include all three elements – common supervision, resolution, and deposit insurance – in order to break the deadly embrace of banks and sovereigns. in the interim, i think small countries, especially those with their own currencies, will have to impose their own prudential measures in order to defend themselves against the risks they face. the third lesson relates to the structure of the financial sector in small, open economies in the absence of robust and credible international or regional safety nets. to my mind, international financial centres cannot be located in such countries without some ex ante mechanism that at least partly insulates the domestic economy from the risks involved. in some sense, this is what iceland did in the nick of time in early october 2008. furthermore, in very small, open economies with their own currency, like iceland, the international activities of domestic banks and fx risks on their balance sheets must be limited and regulated. in this context, we have been thinking about the prudential regime that must be in place in iceland when we have lifted capital controls and icelandic banks are again free to use their european passporting rights. we will have more stringent restrictions on permissible currency mismatches than in the past, also taking into account positions of unhedged households and companies, but more importantly, we will, through some combination of lcr - and nsfr - type ratios in foreign exchange, put strict limits on fx maturity mismatches. the combination of these and other measures will make it impossible for the banking system to attain the size and cross - border reach it had before the crisis. the big question is whether it will be deemed compatible with the eea agreement. bis central bankers ’ speeches more generally, i think the distinction between macroprudential measures and capital controls can be more complex than many make it out to be. the fourth lesson is on capital flows : deal with the inflows if you want to avoid the risk of having to introduce comprehensive capital controls

the balance sheet of the three cross - border banks was denominated in foreign currency. as is typical for banks, the fx part of the balance sheet had a significant maturity mismatch. however, there was no safety net of the type that we have in a national setting to back it up. this turned out to be the fatal flaw in the whole setup, although we now know that these banks were also undercapitalised, which might have done them in at a later stage. but so were several european banks that were considered solid at the time – and some of them are still around! in the panic that gripped global financial markets after the collapse of lehman brothers, iceland ’ s big banks were faced with a wholesale run on their foreign currency liabilities and were therefore heading towards a default on those liabilities in the absence of lolr assistance in foreign currency. however, given their size, it was impossible for the icelandic authorities to provide such assistance on their own. given the lack of international cooperation, the icelandic authorities were forced to consider radical solutions. although they were probably not articulated fully at the time, these solutions entailed several goals : preserving a functioning domestic payment system, ring - fencing the sovereign in the case of bank failures, limiting the socialisation of private sector losses, and creating the conditions for the reconstruction of a domestic banking system. in essence, the adopted solution saved the domestic operations of the banking system and let the international part to go into a resolution process. the new banks were created by carving the domestic assets and liabilities out of the old, failing banks. the new banking system amounted to 1. 7 times gdp. to a significant degree, these measures were successful in keeping the domestic payment system and basic banking services up and running, which was a key factor in dampening the effect of the banks ’ failure on the economy. there were two key elements to the policy response during the autumn of 2008. the first was crisis management vis - a - vis the failing banks, which i have just mentioned. the second was the economic programme developed by the icelandic authorities in co - operation with the imf. the programme had three key goals : stabilisation of the exchange rate, fiscal sustainability, and reconstruction of the financial sector. comprehensive capital controls were an important element in the programme, but their rationale was to help to stabilise the exchange rate in a situation where the currency had fallen more than 50 % in 2008, where foreign krona positions that