In this context, I wish to cite the Central Bank’s 2007 Financial Stability report, which appeared in April that year. It contained the following statement: “The Central Bank underlines that global market conditions can take a sudden turn for the worse and it is important to be on the alert and prepared for such a contingency.” The report goes on to say: “The current episode of ample liquidity and lower interest rates which has been ideal for riskseeking investors may change unexpectedly. Short-term interest rates have been rising in most markets recently and capital costs are no longer so favourable.” With this warning, the Central Bank was merely stating what should have been obvious, at least to those engaged in banking. The time had come to prepare for a change in the economic and financial climate. In the global arena, it had been stressed time and time again that risk premia were far too low, risk was not correctly priced, and that change would come. One of the side effects of the dramatic developments in the global financial markets starting in mid-2007 was the sharp rise in risk aversion among investors and the rapidly shrinking supply of credit. CDS spreads began rising, including those of Icelandic banks. Around midAugust 2007, Kaupthing Bank announced its intention to acquire the Dutch bank NIBC, which was roughly two thirds its size. Kaupthing’s CDS spreads widened as a result, as the proposed acquisition would have increased its need for re-financing in the years to follow.
Some critics have maintained that, in the May 2008 issue of Financial Stability, the Central Bank contradicted its own knowledge of the state of the banks – or even that it did not know any better. This is untrue. The report examined in a transparent manner the financial system’s weaknesses, as well as its strengths. The developments in the global arena since the spring of 2008 rendered the risks mentioned in Financial Stability far more serious than was foreseen. In its monetary policy statement in July 2008, the Board of Governors said inter alia that “Iceland’s commercial banks play an important role in maintaining confidence in the financial system. Under the current global financial market conditions, they must protect their liquidity and capital position, seek all possible ways to reduce their need for foreign credit, and adapt the scope of their operations to dramatically changed circumstances.” Throughout 2008, the Central Bank of Iceland focused increasing attention on the developments and operational outlook at the nation’s financial institutions – particularly its large banks. Among other things, it monitored their liquidity much more closely and frequently than is stipulated in the Bank’s rules on liquidity requirements, and considerably more than had been customary. The Central Bank met with leaders from the large commercial banks and reviewed various aspects of their operations, requesting information on and explanations of the developments in certain areas, such as liquidity, funding, changes in lending and deposits, asset sales, etc.