When making that assessment, we have to take into account that Iceland’s recession was the result  2  BIS central bankers’ speeches  of two stories: the macroeconomic boom-bust cycle in a small, open, and financially integrated economy, and the rise and collapse of three cross-border banks operating on the basis of EU legislation. The first is familiar, and Iceland was already on its way into a recession as a result of it when the banks collapsed. The second was unique at the time, as it occurred during the first international financial crisis since the birth of the EU single market. Iceland lost around 12% of GDP from peak to trough during the recession. But the recovery began in the middle of 2010, and the Central Bank forecast from February is that Iceland’s economy will grow by just over 2% this year. The recovery has already reduced the seasonally adjusted unemployment rate from over 9% at the peak to around 4½%. New banks, smaller and domestically oriented, have been rebuilt. But there are still significant legacy issues and challenges, including capital controls and inflation expectations well above target. Source: Philippon (2008): The Evolution of the US Financial Industry from 1860–2007. Source: Philippon and Reshef (2008): Wages and Human Capital in the US Financial Industry 1909–2006. BIS central bankers’ speeches  3  Before I close, let me expand my scope again and say a few words about possible broad long-term future trends regarding the relative size and importance of the financial sector.
Some of that is inevitable, and some retrenching from the excess levels of finance in relation to the real economy is probably beneficial at this stage, both at the national and the global level. The risk, however, is that the process could go too far. Yes, there are risks to financial globalisation, but there are also benefits. In order to reap those benefits, we need a safer framework for cross-border banking at the regional and global level and some ground rules for capital flows and capital controls. Let me briefly turn my own country, Iceland, into a case study of some of the issues involved. During the financial crisis, three small European countries that had relatively big banking systems but no apparent fiscal problems prior to the crisis have suffered very serious financial and economic crises. These are Iceland, Ireland, and Cyprus. In all three countries, the balance sheets of the banks were around 8–9 times GDP. All three are members of the EU single market – in Iceland’s case, through the agreement on the European Economic Area. That includes free movement of capital and provision of financial services. The underlying principles are those of home licensing for operation anywhere in the area and of a level playing field for competition, where size and location are not supposed to matter. It therefore goes against the underlying principles of this framework to consider the size of banks relative to GDP as a metric for concern, as is now so rightly in fashion.