This question is one that the Central Bank and the Monetary Policy Committee must grapple with at all times. In the recent term, monetary policy has been conditioned by the private sector debt crisis, which stems from years of overheating and the subsequent financial crisis. As the debt situation improves and the slack in the economy diminishes, it will become more important to tackle inflation aggressively. Historical and international experience shows that this cannot be done without temporary sacrifices in economic activity and employment levels. We must therefore hope that inflation subsides as forecast in the near future. Lifting the restrictions on capital outflows is one of the most complex tasks facing the Icelandic authorities at present. The controls probably prevented further depreciation of the króna after the banks collapsed, although no one knows how long the depreciation would have persisted. The controls therefore provided shelter for restructuring of private sector debt and the financial system as a whole and afforded monetary policy the room to concentrate more on domestic economic conditions than would otherwise have been possible. The benefits of the capital controls are most pronounced during the resolution of the balance of payments problems proceeding from the collapse of the financial system. If all nonresidents’ so-called impatient claims on residents were paid in a short period of time, Iceland would pay down foreign debt much more rapidly than is desirable. If worse comes to worst, the deleveraging could amount to roughly half Iceland’s GDP in relatively few years.
Banks and investors will not necessarily take into account the overall risk in the financial system. The consequences came into clear evidence during the financial crisis: banks had inadequate equity capital, excessive short-term wholesale funding and insufficient buffers of highly liquid assets. A new and tighter international regulatory framework is intended to remedy this situation. Stricter capital adequacy and liquidity coverage standards are in the offing. The authorities will also be able to tailor banks’ capital requirements to the overall risk in the financial system. During upturns, these requirements can be raised, so that banks will have to hold more capital for their loans. This will smooth out lending growth and better equip banks to bear losses during downturns. It will ease the impact of the marching steps on the bridge. There will be a need for higher capital buffers when economic growth is solid and debt builds up. This may restrain the build-up of imbalances. But when there are no clouds on the horizon, it is easy to lose sight of more long-term considerations. The government authorities should therefore provide a clear mandate that ensures independence and delegates the responsibility for determining capital buffers. In this regard, we can build on the experience with the framework for monetary policy. And any change in capital requirements must be made on the basis of an assessment of the overall risk in the financial system – not only in a single institution.