Credit lines were closed, margin calls were made, and all but the safest assets sold off at fire sale prices. Emerging market assets experienced a sell-off as a part of this process, and funds were repatriated back to the US in order to meet margin calls and repay debt. In normal times, managing liquidity across currencies from countries with free movement of capital and relatively developed capital markets is not much of an issue. In these conditions, FX swap markets can speedily be used to convert liquidity from one currency to another at spreads that closely reflect the differences in domestic money market rates in the two countries concerned. In other words, the covered interest parity condition broadly holds. Visà-vis the US dollar, this relationship showed periodic strain for most currencies after the  BIS Review 9/2010  3  financial turmoil erupted in late summer 2007, but it broke down almost completely after Lehman. There are probably several reasons for this, some of which were analysed in BIS publications such as the Quarterly Review during the period when I was still there. 2 Thus, for instance, we know that before the crisis, European banks had a structural imbalance where they had invested in longer-maturity USD assets and financed them partly in USD interbank markets at shorter maturities. When these dried up, there was probably a scramble to get USD liquidity through FX swap markets, with the result that those markets became dysfunctional as well.
It might be of some interest that the possibility that the Icelandic banks might fail in precisely the way they did was much more widely foreseen than is currently acknowledged. Available on the BIS website is a speech that I gave on 18 May 2007 before the Institut International d’Études Bancaires, entitled Financial globalisation and challenges for prudential policies and macroeconomic management, where I said: “...emergency liquidity assistance will be complicated or even impossible for central banks to deliver when internationally active banks face liquidity problems in currencies other than that of their home country. Iceland is a case in point.” 4 But this was before the breakout of the financial turmoil in August of the same year, and in company with many others, I saw this as a tail event rather than an immediate possibility, although concern was beginning to creep in. However, as the financial crisis intensified, the risks mounted, and by early 2008, both the banks themselves and the Icelandic authorities were acutely aware of it. 5 This is why the Central Bank was actively seeking to conclude FX swap agreements with major central banks and why, in May 2008, parliament authorised large-scale foreign borrowing in order to boost reserves. Both efforts were largely unsuccessful, except for the € bn swap agreement with the Nordic countries. The committee investigating the collapse will probably throw light on why that was. 3  Moody’s Global Credit Research (2009). Corporate Default and Recovery Rates, 1920–2008. 26 February 2009. 4  Gudmundsson, Már (2007).