major unexpected losses when house prices in the us started to decline. credit default swaps ( cds ) – some insurance companies and other financial institutions are involved in insuring structured products linked to the us mortgage market in the form of cds. some of them experienced large losses and had to be rescued by the government ( for example, aig ). the bankruptcy of a big credit risk insurer threatens the insured financial institutions, which often undervalue counterparty risk. the crisis may be exacerbated in this way. off - balance - sheet vehicles – banks have transferred their credit risk to off - balance - sheet vehicles, such as sivs and conduits, in order to save capital costs. the business model of these vehicles built on maturity transformation broke down leading to liquidity problems of the sivs and conduits. owing to reputation concerns, the banks took the suffering sivs and conduits back on to their balance sheet. this transferred the credit and liquidity risk back to the banks and triggered the loss of confidence in the money market. all these examples show that we are experiencing severe problems with crt. i would therefore like to pose two questions. what are the weaknesses in crt markets? how can we change the institutional framework in order to profit from the social benefits of crt? weaknesses in crt markets concerning weaknesses in crt markets, i would like to draw your attention again to general economic theory as this enables us to identify fundamental problems that are well known to an economist. we deal with problems such as wrong incentives for economic agents, insufficient transparency, and regulatory arbitrage. let me point out just a few examples. moral hazard – one possible weakness in the crt market results from the securitisation and subsequent distribution of credit risk. once the credit risk is forwarded, there is no incentive for the originator of the credit risk to monitor the debtor. hence, we are dealing with the classical phenomenon of moral hazard. the empirical results of a paper by mora and sowerbutts at the conference indicate that this is not only a theoretical reflection, but a present mechanism in the securitisation market. they show that retaining a greater fraction of credit risk in the balance sheet of the originator significantly lowers the probability of default of the underlying loan. the same problem may arise in the case of crt via cds, as parlour and winton show in their paper. in their theoretical model, the

a significant part of it was really off - border, having little to do with iceland, as both financing and investment took place abroad. towards the end, around two - thirds of the combined balance sheet of the three cross - border banks was denominated in foreign currency. on the liabilities side, the share of fxdenominated debt was actually higher, as can be seen from figure 2, with almost half of the financing in the form of fx deposits and other short - term fx financing. the fx part of the balance sheet therefore had a significant maturity mismatch. however, there was no safety net of the type we have in a national setting, in the form of liquidity provision and lender - oflast - resort ( lolr ) to back it up. it was an accident waiting to happen, and happen it did, with a vengeance, at the peak of the international financial crisis in autumn 2008, when there was a wholesale run on the fx financing of internationally active banks. when the icelandic authorities were dealing with the failing banks, they assumed, based on published cad ratios and stress tests, that the banks were solvent. now, however, we know that this was probably not truly the case, as there were hidden vulnerabilities in their capital positions. be that as it may, with the solvency assumption in mind, the authorities tried to build defences against potential foreign currency liquidity problems at the banks by bis central bankers ’ speeches negotiating swap lines and tapping foreign capital markets – in both cases, with limited success. given the lack of international co - operation, the icelandic authorities were forced to consider radical solutions. although they were not necessarily articulated in full at the time, these solutions entailed several goals : to preserve a functioning domestic payment system, ringfence the state in the case of bank failures, limit the socialisation of private sector losses, and create the conditions for rebuilding a domestic banking system. the adopted solution was embedded in the so - called emergency act, which was passed by parliament on 6 october 2008. the emergency act saved the domestic operations of the banking system by creating new banks, which involved carving domestic assets and liabilities out of the old, failing banks. the rest – and the much larger part – went into a resolution process. in order to reverse the ongoing run on domestic deposits, a declaration was made that all deposits in iceland were safe, but this did not include deposits in foreign branches. furthermore, all deposits in