The traditional form of regulation was to set very strict rules or to forbid banks from conducting certain activities. The modern form is to be more flexible. Regulations set the boundaries while allowing the banks to operate within these boundaries if they can prove that they have the skills and resources to do it in a sound manner. Modern regulation puts much more responsibility on the banks themselves and their owners and management. In Sweden, the former Banking Act actually prohibited the banks to engage in any activity that was not explicitly permitted in the law. The new Banking Act starts at the other end, permitting the banks to do whatever they find suitable except for certain activities that are explicitly forbidden. Today’s financial institutions, instruments and markets are, of course, much more sophisticated than earlier. There is also much broader diversity in the sector. For example, the needs of customers are satisfied in many different ways and by many different actors, certainly not only by banks. As a consequence, modern regulation needs to be more flexible than in earlier days, when the market was more homogeneous. The regulation should encourage competition and innovation, but at the same time discourage unsound risk taking and generally unbecoming or even illegal behaviour. Only when there are strong arguments should the regulator outright restrict or prohibit certain activities. Instead, regulations should provide incentives for banks and others to behave in a sound manner.
The requirement is primarily prudential in nature. It was among other things aimed at reducing the reliance of domestic credit institutions on foreign short-term capital to finance their domestic lending activities which had risen sharply, but has subsequently diminished markedly. Low inflation and macro-economic stability was only achieved in the early part of this decade. Consequently, it is not at all surprising that we have to maintain interest rates that are significantly higher than among our main trading partners. The required difference is variable over time, depending among other things on the credibility of economic policy, relative cyclical positions and so on. The current differential is the widest since capital movements were liberalised and is of course explained to an important extent by the very different cyclical position of the Icelandic economy from that of most of our trading partners, not the least in Europe. It also entails the cost of maintaining an own currency, i.e. a premium for the availability of the exchange rate as an instrument. 1  BIS Review 117/1999  In this connection, I should also note that since the opening up of the capital account of the balance of payments, long-term interest rates, which used to be very high by any comparison, have been on a downward trend despite repeated increases in short term rates. This is not surprising and reflects a narrowing of long term interest rate differentials between Iceland and other countries towards a much lower level than prevailed before capital movements were liberalised.