##preciation of the krona and large contractual wage increases. we know now that monetary policy achieved good results in its response to this situation. the response consisted of interest rate hikes and signalling of further ones to come, but also of more active use of other policy instruments such as foreign exchange market intervention and, later, the special reserve requirement on capital inflows into the bond market and high - yielding deposits. monetary policy was successful in bringing inflation — and thereafter, inflation expectations — back to the target after 2012, without sacrifice costs in terms of employment furthermore, the use of new policy instruments helped ensure that the exchange rate of the krona was countercyclical rather than procyclical, as it had been to some degree before the crisis. inflation remained close to the target for about five years. when the banks failed in autumn 2008, new banks were established virtually overnight. these banks received deposits in iceland and matching assets, and became a new channel for domestic payment intermediation. there was hardly a hiccup in domestic payment intermediation, which has to be considered quite a feat. as i mentioned earlier, the task of recapitalising the banks and finalising the new - bank - old - bank split remained. it was decided that the old banks should take an equity stake in two of the new ones. to begin with, there were sizeable imbalances in the banks ’ balance sheets, including foreign exchange imbalances, and non - performing loan ratios were very high. as a result of various measures and the economic recovery, the imbalances subsided and non - performing loan ratios fell rapidly from 2011 onwards. since 2015, they have been relatively low in historical context. the banks ’ capital adequacy ratios increased, both for these same reasons and because the financial supervisory authority prohibited dividend payments without explicit approval during the banks ’ first years of operation and the capital controls made dividend payments to foreign creditors less feasible. at the same time, the regulatory framework for the banks ’ operations was improved significantly. now we have a banking system that primarily serves domestic households and businesses and, in terms of total assets relative to gdp, is about 15 % of its precrisis size. as can be seen in their high capital adequacy ratios and sound liquidity position, the banks are quite resilient. their capital ratios have fallen in recent years as a result of dividend payments, and it can be said that there was

. 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