in recent years, the central bank has engaged in broad - based contingency work in preparation for a possible financial crisis, in collaboration with domestic authorities and supervisory institutions, and with foreign central banks. that work is not discussed in the present report. one of the roles of the parliamentary special investigative commission is to compile information on these topics and present an analysis of them. the central bank neither has the capacity nor the will to front - run that analysis. the bank will probably need to revise its operational practices in these areas in view of experience and the commission ’ s findings, as will other supervisory institutions. in addition, the bank will soon review its precautionary rules, such as those pertaining to financial institutions ’ liquidity and foreign exchange balance, in light of recent events. various elements of payment intermediation and settlement will also be reviewed in the near future, with the aim of promoting financial stability more effectively. because of the uncertainty still surrounding assets, capitalisation, and ownership of icelandic financial undertakings, it is difficult to assess the main risks in iceland ’ s financial system at this time. however, those risks are clearly related to asset quality, on the one hand, and foreign exchange and indexation mismatches, on the other. for this reason, among others, it is important that financial institutions maintain capital adequacy ratios well above the statutory minimum in the near future. at present, deposits form the backbone of the banks ’ funding, as foreign investment in iceland and access to global credit markets are limited. lifting the capital controls entails a certain risk, partly because it involves liberalising capital flows while the ownership structure of the banks is still being clarified. it is also clear that restructuring and recapitalising the savings banks is in the offing, and this could also pose some risk. the risk that had accumulated in the icelandic financial system prior to the crash has materialised, however, and it is unlikely such a situation will arise again in the near future. broadly speaking, the risk in the system should abate over time, particularly if reforms of the regulation, supervision, and governance of the financial system are well and speedily implemented.

. a clear example of this is a restriction on the accumulation of deposits in foreign bank branches. the long - term need for such more stringent rules will be determined to a degree by iceland ’ s future currency and exchange rate regime. experience shows that maturity mismatches between banks ’ assets and liabilities that are not backed up by a lender of last resort represent a substantial risk. the global financial crisis has revealed a variety of weaknesses in the regulatory framework and the supervision of the financial sector. on the whole, the quantity and quality of financial institutions ’ capital was insufficient to provide the necessary shock absorption. in particular, there should have been more unpledged common equity. the risk assessment of assets and liabilities was distorted because it was based on historical data that did not assign sufficient weight to bad states of the world. liquidity risk was vastly underestimated, and the procyclical tendencies within the financial system were not sufficiently offset by the regulatory and supervisory framework. on the contrary, it can be argued that the interplay of regulatory provisions and financial reporting rules based on mark - to - market exacerbated these tendencies. 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