The Icelandic banking sector experienced a dramatic expansion in just a few years, funded by cheap foreign financing, which allowed it to boost its assets from 100 to almost 900 percent of GDP between 2004 and end-2007. This expansion made the Icelandic banking system one of the largest in the world in relation to GDP. As global conditions deteriorated in early 2008, banks’ CDS spreads rose to unprecedented levels. In response, banks slowed lending growth, enhanced liquidity buffers, reduced costs, and started a process of downsizing non-core operations and laying off staff. But their ability to deleverage was limited by the global risk aversion. A recent FSAP update and Article IV Consultation conducted in June 2008 pointed to several risks that were mounting throughout 2008: (i) liquidity and funding risks, associated with the banks’ reliance on market funding and their large funding needs over the short run; (ii) credit and market risks, resulting from foreign currency, equity exposures, and high indebtedness of domestic borrowers, as well as collateralized lending, connected lending, and large exposures; (iii) operational risks, associated with the banks’ rapid expansion in recent years; and (iv) quality of capital risks, related to complex ownership structures. In this light, the Staff Report concluded that “if risks were to materialize in full, Iceland could face severe financial strains.” Despite the authorities’ attempts to prepare for contingencies earlier in the year, the crisis brought down the three main banks within a week.
As the US is the primary supplier of liquid and safe assets, it attracts inflows of capital, a process which accentuates global imbalances. Excess demand for those assets pushes their prices up, which triggers financial bubbles. Financial development in surplus countries would go a long way to solve that problem by reducing the asset shortage, thus the probability of future bubbles. BIS Review 85/2009  1  •  Third, there is no denying that weaknesses and failures in financial markets played a major role in the build up to the crisis. Over the last decade, financial innovation has been organized to "transform" illiquid and risky instruments into (apparently) safe and liquid assets. That unsustainable process has abruptly come to an end with the burst of the credit bubble. During that period, rating agencies, accounting rules, unregulated and off balance sheet entities as well as very poor risk management all contributed, willingly or unwillingly, to fragilize our financial systems. Those weaknesses are at the origin of the crisis. Had they been addressed in due time, most of the problems we are now dealing with could have been avoided. Creating a new regulatory regime and strengthening our supervisory arrangements are at the forefront of efforts conducted at the national and, for the EU, at the European level. Those efforts are closely coordinated worldwide through the G20 process and the newly created Financial Stability Board.