derived more than half of their overall income from activities outside iceland and the biggest bank derived about two thirds of its income from operations outside iceland. they are therefore much less sensitive to cyclical developments in iceland than before, or in any one country for that matter. the risks are much better spread than before. central bank of iceland : monetary bulletin 2008 / 1. in their expansion, the banks exploited the particularly favourable opportunities offered in the global financial markets in the form of abundant liquidity at historically very low prices. thus, they relied on capital markets funding for their operations, raising the share of borrowed funds on the liability side of the balance sheet. the rapid expansion of the banks did not go unnoticed. it drew the attention of many observers at the end of 2005 and the early part of 2006, resulting in considerable headwind for the banks in that period. questions were raised about their business model, their reliance on wholesale funding in international markets and low level of deposits, lack of transparency and cross ownership among other things. the banks responded effectively to the criticism levelled at them. they increased transparency, reduced cross ownership, and placed emphasis on raising the share of deposit on their funding side. they also significantly strengthened their capital base and last but not least greatly improved their liquidity position. as a result they were much better prepared for the sudden change in global financial conditions after the middle of last year. most importantly, they had a strong liquidity cushion. the icelandic banks have been the focus of considerable international attention in recent months. questions have been raised about their viability and those have been reflected in their extraordinarily high cds spreads since late last year. these spreads began to rise following the turnaround in the international markets and they had a tendency to rise more on the icelandic banks than on other banks with every event or news that prompted a general rise in risk aversion and in cds spreads. the spreads peaked around the end of march and have come down quite considerably this month. the cds market is an opaque and unregulated one but, nevertheless, cds spreads are a reference for the terms that would be available to the banks if they were to go to the market. in our view, the cds levels on the icelandic banks have been out of proportion to their underlying financial strength, their credit rating and spreads on comparable banks in other countries. it also seems that the cds market is thin, turnover in cds transactions on icelandic banks appears to be limited. one reason behind relatively high cds

. the entry of the banks into the market led to significant changes. households could now borrow against collateral in their existing real estate, that is, they could take equity out of their investment. this they did with vigour. the overall result was that credit grew briskly, real estate prices rose rapidly and private consumption expanded sharply, leading to inflationary pressures and a widening current account deficit. the third important factor that contributed to the overheating of the icelandic economy was the reduction in both direct and indirect taxes which, in addition to relatively large increases in general pay, led to a rapid increase in real disposable incomes. all of this happened during a period of an international liquidity glut and historically low interest rates which further facilitated domestic demand growth. the expansion of private consumption and the investment in the aluminium production capacity and the related power sector led to a widening of the current account deficit. it reached the equivalent of more than a quarter of gdp in 2006, a phenomenally large deficit both in icelandic economic history and by international comparison. the part of the deficit that resulted from the investment in aluminium and power evaporates as construction is completed and exports of aluminium picked up as of late last year. however, the larger share of the deficit, which resulted from other domestic demand, will only subside as restrictive economic policies have their intended effects. the current account deficit fell towards 15 % of gdp in 2007, it will remain more or less unchanged this year but fall further in 2009, aided by the depreciation of the krona which i will touch on later. needless to say, inflationary pressures emerged early in the expansion phase. the central bank began to tighten policy in the spring of 2004. inflationary pressures mounted and, to make a long story short, the central bank raised its policy rate in successive steps up to the present level of 15. 5 %. since 2001, the framework for monetary policy is an inflation targeting one, the target being a 2½ % 12 - month rise in the cpi. the regime was introduced under trying conditions and inflation rose rapidly immediately after its adoption but fell subsequently and was close to or below the target for about a year and a half before picking up in 2004. it has remained above target since 2004 and the most recent measure of the 12 - month increase in the cpi was 8. 7 %. the reasons for inflation significantly exceeding the target are manifold. i have mentioned the shocks to the economy, the construction of aluminium