to the economy and financial markets, to mediate credit and payments, and to redistribute risks appropriately. in other words, it is capable of performing its function in an orderly and efficient way. iceland ’ s banking system meets the demands made of it and performs well on stress tests conducted by the central bank and fme. table 1 main vulnerabilities risk explanation exchange rate developments macroeconomic imbalances are pronounced. the current account deficit poses the risk of a depreciation of the krona. shifts in carry trades and other exposures could catalyse a sudden turnaround. the fx market relies on three market makers and is still relatively thin. some borrowers from the commercial banks have little or no hedge against exchange rate movements. global interest rates and in recent years, interest rates and premia have been at a historical low. premia interest rates have begun to climb and sooner or later premia will rise again, increasing corporate financing costs. terms of trade export prices could drop and oil prices rise. unfavourable developments could widen the current account deficit and erode national income. economic and social infrastructure is sound. the central bank ’ s macroeconomic forecast assumes a deterioration in the terms of trade. international market high dependence on market funding and deposits on call makes credit funding ratings and global market conditions crucial for the commercial banks. experience shows that credit assessment can shift suddenly. asset quality of rapid credit growth often eventually leads to poorer loan quality. loans commercial banks with equities as collateral are substantial. prices of equities and real estate are buoyant. although arrears and impairment are at a low, they are unlikely to remain so over the next few years. table 2 resilience resilience explanation economy the economy is flexible and in the past has shown itself capable of tackling cyclical swings through adjustment of imports. investment and output growth have been robust. the long - term economic outlook is favourable. strength of the commercial banks the commercial banks ’ liquidity and capital ratios have never been higher. they have built up liquidity in foreign currency and secured refinancing into 2008. profitability is strong from the bank ’ s diverse operations and assets are diversified. institutional and supervisory framework iceland ’ s framework is the eea agreement and its guidelines are international best practice and transparency. economic and social infrastructure is sound. financial supervision has been boosted and extensive cross - border cooperation is in place. payment and settlement systems payment system infrastructure

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