arnor sighvatsson : guidelines issued to financial institutions due to non - binding clauses linking loans to the exchange rate introduction by mr arnor sighvatsson, deputy governor of the central bank of iceland, about guidelines issued to financial institutions due to non - binding clauses linking loans to the exchange rate, reykjavik, 1 july 2010. * * * this morning the central bank and the financial supervisory authority issued guidelines to financial undertakings in order to instruct them on how to respond to the supreme court judgement on non - binding exchange rate linkage clauses. with these guidelines, the supervisory bodies concerned declare that their unequivocal understanding of the situation resulting from this supreme court decision is that, in cases involving loan agreements that have been ruled unlawful, the settlement and repayment of those agreements shall take account of articles 4 and 18 of the act on interest and price indexation, no. 38 / 2001, unless the parties agree otherwise. the guidelines are intended to create stability in financial market transactions and promote a secure and effective financial system. the financial supervisory authority and the central bank are required by law to ensure financial system stability, which is a matter of vital public interest. with the issuance of the present guidelines, these institutions are acting in accordance with the legal obligation resting on them. the guidelines are based on the above - specified supervisory bodies ’ considered opinion that there is no legal or substantive rationale for the maintenance of the previous interest rates ( which were determined with reference to foreign interbank rates ) after the portion of loan principal bearing such interest has been uncoupled from the exchange rate of the currency concerned by means of the recent supreme court decision. the supervisory bodies are of the opinion that such an interpretation of the supreme court judgement, were it implemented to the fullest extent possible, would represent such a heavy blow to financial undertakings ’ equity that the treasury would be forced to contribute substantial new capital to them. that expense would ultimately be borne by other members of society. the method recommended by the central bank and the financial supervisory authority will preserve the stability of the financial system even in the event that a majority of loan agreements with exchange rate linkage clauses are deemed unlawful, although it could take quite a long time to determine this conclusively. financial undertakings ’ equity will sustain a considerable blow in any case, if judgements by the supreme court ultimately extend to a large portion of their loan portfolios. offsetting this is the fact that uncertainty will have been eliminated, which could

to lift the comprehensive controls on capital outflows that were introduced at the peak of the crisis. we will work through all of the avenues that i have just mentioned, and many of the reforms have already been implemented. what i call it - plus – or plus - plus – will replace it of the precrisis type. a managed float has already taken the place of the free float. foreign exchange intervention is thus used to reduce excess volatility in the fx market and lean against capital flow cycles. the financial stability framework has been strengthened, and macroprudential tools are being developed that should mitigate adverse interactions between capital flows, on the one hand, and domestic credit growth and asset prices, on the other. foreign currency borrowing by unhedged domestic agents will be very much restricted. prudential limits on banks ’ fx balance sheets, in the form of specific lcr and nsfr in fx, have been imposed. in practice, this will greatly limit the size of their fx balance sheets and the associated maturity mismatch that was the proximate cause of the demise of the old banks that failed during the crisis. finally, a tax or other equivalent measure of the type i just mentioned is being contemplated. 3 taken together, this will amount to a very different paradigm for economic management than the one prevailing before the crisis. history will tell whether it is sufficient to preserve monetary and financial stability in the rougher seas of freer capital movements that we intend to embark upon. in any case, we need to strike a balance between dynamism and freedoms, on the one hand, and stability, on the other. thank you very much. further details on these proposals can be found in central bank of iceland special publication no. 5 : monetary policy in iceland after capital controls, december 2010, and no. 6 : prudential rules following capital controls, report of the central bank of iceland to the minister of economic affairs, august 2012. www. cb. is. bis central bankers ’ speeches