. 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

davið oddsson : the central bank of iceland ’ s commitment to price stability speech by mr davið oddsson, chairman of the board of governors of the central bank of iceland, at a seminar organised by the iceland chamber of commerce, reykjavik, 5 december 2005. * * * on december 2, 2005 the central bank of iceland raised its policy interest rate by 0. 25 percentage points before last weekend. i do not expect that decision came as a surprise. some people may well have read into what the bank wrote in connection with the policy rate hike in september that the increase this time would be greater, by 0. 50 or even 0. 75 percentage points. no such decisions were embodied in those writings, although the bank made a clear commitment that it takes its mandatory role seriously and would not flinch at following it with full force. those declarations stand firm. monetary bulletin, which was published on the central bank ’ s website last friday, includes a detailed account of the bank ’ s assessment of economic and monetary developments and prospects, and the arguments underpinning its decision to raise the policy interest rate now. the scenario that we faced on september 27 has changed in several ways. uncertainty about wage settlements has been dispelled, although admittedly at considerable cost. the consumer price index fell somewhat at the last measurement. house price inflation has slowed down and there are signs that a turning point has been reached. credit institutions are now proceeding more cautiously in their lending to this sector and interest rate terms are changing. oil prices seem to be stabilising, and in spite of mounting labour market pressures, wage drift has been contained. the central bank ’ s policy rate hike is beginning to spread through the economy ; monetary policy is transmitted with an inherent lag in all cases, and this has even been exaggerated by iceland ’ s unique economic conditions at present. the most important change in the wake of the september policy hike, however, was that indexed bond yields began to rise at last. it was vital for monetary policy to begin to have an effect in the parts of the economy which showed the clearest signs of overheating, i. e. soaring private consumption growth. although all these points represent an interesting and positive development, on their own they do not justify changing the policy that the central bank has been pursuing. substantial pressures still exist in the economy, demand is buoyant and there are undeniably sizeable imbalances. these factors must be seen in context