The Central Bank interest rate that made the greatest impact on other rates was 17% a year ago, when the Bank held its 2009 Annual General Meeting. As of today, the corresponding interest rate – the average of current account rates and the highest CD rates – is just over 8%. But although interest rates have fallen significantly, it cannot be denied that they are still higher than desirable in view of the slack in the national economy, and they could be lower if the inflation outlook were the only criterion. This is the price we pay for the currency and banking crisis, the lack of credibility in foreign capital markets, and the limited access we have to those markets. Simply put, Icelandic interest rates include a large risk premium. If the capital controls are effective, as they appear to be at present, they obviously provide some scope to look beyond this risk premium. But the controls have not yet been tested by sharp and deep reductions in interest rates and a smaller interest rate differential with abroad than currently exists. Until now, there has been no occasion to take interest rate decisions based on the assumption that no steps will be taken to lift the capital controls in the near future. We hope no such circumstances develop. Strictly speaking, monetary policy in Iceland is not following the inflation target at present.
For example, it has been argued that “systemic” financial institutions should be more closely supervised and be subject to a more stringent set of regulations. How exactly to define systemic institutions, and who should deem an institution systemic is far from clear. Closely related reforms are those aimed at reducing interdependence and, therefore, the systemic nature of institutions. The push towards central counterparties, in particular for derivatives, falls in this category. The second category of reforms encompasses those directly related to the specifics of the subprime crisis. I would like to offer some comments on these issues. In particular, I would like to comment on a) accounting methods; b) liquidity; and c) rating agencies. Accounting methods and valuation At the onset of the financial turbulences, there were strong concerns on how precise was the information reported by banks, how large were the losses, and who was bearing these losses. This uncertainty was a critical factor in the shutdown of key financial markets. The International Accounting Standards Board (IASB) and the Financial Stability Board (FSB) have been working and promoting recommendations on accounting and disclosure standards for off-balance-sheet investment vehicles, and fair value methods, among others. However, these “information” requirements by themselves are not enough, and other measures could be necessary, such as forcing originators and other agents to hold part of the risk of the assets created. Liquidity The current financial turbulence has highlighted that for the banking sector liquidity considerations are as relevant as solvency issues.