The Financial Supervisory Authority was granted broad-based powers to intervene in failing institutions, and the Government was authorised to inject capital into new domestic banks. This so-called Emergency Act thus allowed new domestic banks to be created when the old cross-border banks failed and were placed in special resolution regimes followed by winding-up proceedings. The new banking system amounted to around 1.7 times GDP, compared to 10 for the old banking system. As a result of these measures, the domestic payment system functioned more or less seamlessly throughout, and customers had continuous access to their deposits. I have expanded at some length on the measures taken when the banks failed, as there are still a number of misconceptions about the process in international discussions. There have been claims that Iceland allowed its banking system to collapse, with what now seem reasonable results, and that others should consider doing the same. The fact is that Iceland kept the domestic part of the banking system running throughout; otherwise, the consequences would have been dire. Some have claimed that the banks were nationalised. They were not. The old banks are private companies. They are in winding-up proceedings governed by law; they are not under the control of the Government. The Government has a majority stake in only one of the new banks. Others have claimed that Iceland defaulted and got away with it. The opposite is true. The credit of the sovereign was preserved, and all debt obligations have been paid on time.
In these conditions, foreign exchange 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. But as we saw so clearly in 2008, this mechanism has a tendency to break down in a time of a financial crisis – precisely when it is most needed. Central banks can lend out their foreign exchange reserves, of course, but there is a well-known limit to that process. Some form of global liquidity provision is therefore needed. The swap lines granted during this crisis were precisely that, and most studies seem to support the conclusion that they made the crucial difference in relieving strains in banks’ foreign exchange funding. To a significant degree, this was the domestic LOLR process replicated at the international level. We have a solution, then, at least at the conceptual level. But it is not clear that it is a robust solution in practise. The swap lines are not at present a permanent and a reliable feature of the international monetary system; for instance, they have been strongly challenged in political discussion in the US. Furthermore, there are important unresolved governance issues, such as who should decide which countries get a swap line and which do not. It is thus an important item on the reform agenda to clarify the extent to which standing foreign currency LOLR facilities for solvent cross-border banks can be set up without going through national governments.