, ireland, and cyprus. in all three countries, the balance sheets of the banks were around 8 – 9 times gdp. all three are members of the eu single market – in iceland ’ s case, through the agreement on the european economic area. that includes free movement of capital and provision of financial services. the underlying principles are those of home licensing for operation anywhere in the area and of a level playing field for competition, where size and location are not supposed to matter. it therefore goes against the underlying principles of this framework to consider the size of banks relative to gdp as a metric for concern, as is now so rightly in fashion. we know now that there are deep flaws in this framework and that these flaws are important elements in the current euro area crisis, but they also played a significant role in the case of iceland ’ s banking crisis. a key issue here is the contradiction between these so - called european passport rights, on the one hand, and national supervision, national deposit insurance, and national crisis management and resolution regimes, on the other. this is what recent european union proposals of a banking union are supposed to address. membership in the eu single market, along with the global conditions of cheap, abundant credit, made it possible for the icelandic banks to expand phenomenally in the course of only five years, from less than two times gdp to more than 9 times gdp. earlier in the decade, the banks had been privatised and became managed by relatively young, risk - loving former investment bankers. much of the expansion was really off iceland ’ s border, with both financing and investment taking place abroad. in iceland ’ s case, there was a substantial additional risk compared to ireland and cyprus, as nearly 70 % of the banks ’ balance sheets were denominated in foreign currency, with the traditional maturity mismatch that is the bread and butter of banking but without a credible lender of last resort to back it up. in other words, icelandic banks had only limited access to ecb liquidity ( although there was some access through subsidiaries in luxembourg ), which proved fatal during the global run on crossborder liabilities of banks that immediately followed the collapse of lehman brothers. but there is always a silver lining. the lack of an adequate safety net and the absence of international or regional co - operation at the peak of the panic forced iceland to adopt a radical solution in order to ring - fence the sovereign from the collapsing banks. these were private banks, and a bail

and how potentially difficult cross - border crisis management and bank resolution would turn out to be in the european context. but there were also very important elements missing from my list – elements that have turned out to be of major importance for the unfolding of the crisis and the reform agenda. key among them are the interaction between sovereign debt and banking fragility and the problem of big banks in small countries – of which my country, iceland, was a prime example and cyprus is the latest. i will expand on this shortly. the financial crisis and the policy responses to it, especially some of the drastic decisions taken in the heat of intense crisis management, have changed the structure of the financial sector and will do so more profoundly going forward. there are several reasons for this, such as the plain collapse and disappearance of financial institutions, the non - viability of certain business models and practices in the new environment, the need for the financial sector to shrink and deleverage after the real risks in this world had been revealed, the intended and unintended consequences of new prudential regulation, the coming effects of structural regulations that at least partly ring - fence insured deposits and payment systems from the “ casino ”. then there is the shrinking of cross - border banking through the retreat of banks see http : / / www. bis. org / speeches / sp081119. htm bis central bankers ’ speeches behind their national borders and the weakening and, in some cases, collapse of international financial centres in smaller countries. we can see where this is heading : towards a financial sector that is smaller, less leveraged, less complex, more fragmented, more regulated, and more national. some of that is inevitable, and some retrenching from the excess levels of finance in relation to the real economy is probably beneficial at this stage, both at the national and the global level. the risk, however, is that the process could go too far. yes, there are risks to financial globalisation, but there are also benefits. in order to reap those benefits, we need a safer framework for cross - border banking at the regional and global level and some ground rules for capital flows and capital controls. let me briefly turn my own country, iceland, into a case study of some of the issues involved. during the financial crisis, three small european countries that had relatively big banking systems but no apparent fiscal problems prior to the crisis have suffered very serious financial and economic crises. these are iceland