markedly, though they were still far from their prior state. on the other hand, the fundamentals of important financial undertakings became an ever greater source of concern. the general economic outlook deteriorated significantly, spurring greater pessimism in the global equity markets. iceland certainly did not escape the effects of these global developments. here in iceland, those developments emerged in the form of higher interest rate premia, shrinking credit supply, and risk aversion. risk aversion means, among other things, that companies and regions at the periphery – if it can be expressed that way – feel the effects of the changes more than others do. this periphery includes iceland and its banks. among icelandic banks, these changed conditions emerge most clearly in wide cds spreads. cds spreads among icelandic banks are much wider than among foreign banks with comparable credit ratings, and much wider than many – including respected financial analysis institutions abroad – consider appropriate and consistent with the banks ’ financial strength and performance. 1 it is worth remembering that iceland ’ s financial system has grown by leaps and bounds recently, and the operations of icelandic commercial banks extend to a large number of foreign locations. iceland ’ s three largest commercial banks now generate more than half of their income through their operations in other countries. those operations are distributed over a wide geographical area. while they are most prominent in the nordic region and the uk, they are also visible in continental europe and farther afield, though to a lesser extent. through these operations, iceland ’ s banks have fortified their foundations and distributed their risk. they are international banks with headquarters in iceland, and they are much less dependent on economic developments in iceland than they were previously. at the end of january, the banks published their annual accounts for the year 2007. these reflected both the success of the past several years and last year ’ s changes in the global capital markets. for the year as a whole, the banks demonstrated excellent performance. profits were good, and core operations yielded strong returns. as can be expected, profits dropped in the fourth quarter, as was the case with banks all over the globe. nonetheless, all three of iceland ’ s large commercial banks recorded a profit in the fourth quarter of 2007, and they concluded the year with an ample equity position. banks all over the world have been forced to write off large amounts of money because of their investments in securitised assets related to the us mortgage market. icelandic banks ’ investments in obligations of this sort were small. that being the case

ingimundur friðriksson : interest rates and financial markets in february speech by mr ingimundur friðriksson, governor of the central bank of iceland, at a rotary club meeting, reykjavik, 28 february 2008. * * * on thursday 14 february 2007, the board of governors of the central bank of iceland announced its decision to keep the bank ’ s policy interest rate unchanged at 13. 75 %. in its announcement, which can be found on the bank ’ s website, the board of governors explained the rationale behind its decision. it mentioned the fact that inflation was higher than november forecasts indicated, and that the short - term inflation outlook had deteriorated since november. this is borne out by the rise in the consumer price index in february. the board of governors emphasised that uncertainty has increased, and that the central bank intends to monitor developments in economic indicators very closely, particularly those that reflect the impact of poorer financial market conditions on lending and demand. in the conclusion of its announcement, the board of governors stated that, as before, it was critical for households and businesses that inflation be controlled and inflation expectations anchored successfully. the policy rate decision was based on these considerations. the central bank is required by law to promote price stability. currently in effect is a joint declaration issued by the icelandic government and the bank in 2001, stating that the bank must aim at keeping inflation as close as possible to 2½ %. inflation is well above that target for a multitude of reasons, which will not be itemised here. these contributing factors have been discussed numerous times by the central bank, in verbal and written form. suffice it to say that enormous investments, radical changes in the domestic financial markets, ready access to inexpensive credit from abroad, and – last but not least – the substantial increase in disposable household income, especially in the past year, have played their part. critics maintain sedulously that the central bank ’ s tools are weak, that its policy of restraint is ineffective, and even that its inflation target is a failed experiment. the bank rejects this. it can be considered established that, were it not for the central bank ’ s tight monetary policy, inflation would have been much higher than it has indeed been – with the concomitant strain on households and businesses. it is not the central bank ’ s objective as such to keep interest rates high – indeed, the bank is of the opinion that it is disadvantageous if