, pushed the real exchange rate higher than it would have been otherwise and exacerbated macroeconomic imbalances, as could be seen most clearly in a sizeable current account deficit. these developments and the banking crisis contributed to the currency crisis that struck in the first half of 2008. the bank ’ s two publications on post - capital controls monetary policy and prudential rules have stood the test of time, as many of the proposals in them have already been implemented. we now intervene in the foreign exchange market with the aim of smoothing out fluctuations due to temporary capital flows and mitigating short - term exchange rate volatility. we no longer have a free - floating currency, but a managed float. we have adopted prudential rules that severely limit the banking system ’ s ability to take risk in foreign currencies. we have established a financial stability council and a systemic risk committee in order to monitor financial system risk more effectively than we did previously, and we are developing prudential rules and macroprudential tools to respond to systemic risk. this will also support monetary policy. one important step remains, however : to develop policy instruments that can be applied so as to curtail carry trade - related capital inflows when such inflows interfere significantly with the transmission of monetary policy along the interest rate channel, as was the case last summer and autumn. analysis of the options available has been underway in the recent term, but these mainly involve a tax or a special reserve requirement. in both instances, statutory amendments would be necessary. it can be argued that such policy instruments should be on the law books by the time the auction of offshore kronur takes place because, if the auction is as successful as we intend, it is possible that confidence in iceland will grow still further and capital inflows will increase. bis central bankers ’ speeches why do we need all of these additional tools and contingency measures? an important reason is the risk to financial stability that accompanies excessive and volatile capital movements that are unconnected to economic fundamentals. another important reason is that in an increasingly financially integrated world, it is more difficult for small countries to deviate too far from the monetary policy pursued in the larger countries that determine global financial conditions. we saw this before the financial crisis, in new zealand and here in iceland. and we have seen it more recently, in countries like switzerland and sweden. we can better understand why this is so if we consider a situation where

mar guðmundsson : preserving the credit of the sovereign through a financial sector meltdown – the case of iceland speech by mr mar guðmundsson, governor of the central bank of iceland, at the international monetary seminar 2013 “ sovereign risk, bank risk and central banking ”, organised by the bank of france, paris, 8 july 2013. * * * i would like to thank banque de france for inviting me to speak at this interesting seminar. this session is on resolving sovereign debt crises and the relative roles of the public and private sectors in that process. my comments will obviously be based on my own country ’ s experience during the financial crisis, which is a case of a sovereign debt crisis being avoided in spite of the meltdown of a large part of the financial sector and the country ’ s deepest recession since the interwar period. that result was achieved by relatively good fiscal position prior to the crisis, by a refusal – based on need rather than stubbornness – to rescue private cross - border banks with public money, and by on - going medium - term fiscal consolidation that was an important part of the economic programme developed in cooperation with the imf. the bottom line is that all sovereign obligations have been honoured ; the sovereign has maintained investment - grade credit ratings and market access. in order to distinguish between the parts of this story that provide lessons that are applicable to the rest of the world and those that do not, we need to get some of the facts straight, because to this day there are still several misconceptions floating around about what was done in iceland during the crisis. the collapse of iceland ’ s three cross - border banks in early october 2008 was the most noticeable event in the unfolding of the financial crisis. the combined balance sheet of these banks was 10 times iceland ’ s gdp ( see figure 1 ), and their combined bankruptcy, measured in terms of balance sheets, ranks second in size in the international history of corporate failures, only after lehman brothers. and this happened in a country that ranks among the smallest in the world! we are still dealing with the complications that this entails, as can be seen in our overblown and unbalanced iip and the controls on capital outflows. figure 1 source : central bank of iceland. bis central bankers ’ speeches before the collapse, the banking system had expanded very rapidly, growing in just five years from a combined balance sheet of less than 2 times gdp at the end of 2003 ( see figure