New legislation When new legislation was adopted for the Central Bank of Iceland in 2001, these international developments were taken into consideration and the Icelandic Act patterned on recent legislation in other industrialised countries. There was broad political consensus on this, as people realised that low inflation is one of the cornerstones of economic growth and improved living conditions. In addition to the legislation, inflation targeting was introduced as the Bank’s objective in a joint declaration by the government and the Central Bank. The decision to float the Icelandic króna was taken at the same time, since experience had shown that in the long run it was impossible to ensure a specific exchange rate with free movement of capital in and out of the country. In such case the exchange rate is determined by the market where supply and demand control the value of the króna. This new framework for monetary policy was immediately subjected to a baptism of fire. The Icelandic economy was overheated and inflation rising rapidly. The Central Bank had to respond by raising interest rates. The fall of the króna played a part in the elimination of the current account deficit much more rapidly than anyone had dared to hope two years ago. The economy is more stable at the moment than it has been for some time and, acccording to the outlook, the current slight slowdown will be short-lived.
The growing reliance on short-term wholesale funding to finance longer-term assets increased liquidity and maturity mismatch risk. This was particularly dangerous because many of the assets being financed were structured-credit products, some of which were opaque, difficult to value and illiquid. Short-term funding of longer-term assets is inherently unstable particularly in the presence of information and coordination problems. It can be rational for a provider of funds to supply funds on a short-term basis, reasoning that it can exit if there is any uncertainty over the firm’s continued ability to roll over its funding from other sources. But if the use of short-term funding becomes sufficiently widespread, the firm’s roll-over risk increases. In this situation, there is a strong incentive for each lender to “run” if there is any uncertainty that could undermine the borrower’s ability to continue to roll over its funding from other sources. This is the case even if the provider of funds believes that the borrower would remain solvent as long as it retained access to funding on normal terms. Of course, this insight is not a new one. Prior to the establishment of a lender of last resort and retail deposit insurance for banks – which came with the quid pro quo of prudential regulation – bank runs were a regular and disruptive feature of our financial system. These innovations solved the coordination problem and stabilized this source of funding.