Restoring the financial sector to health

Iceland is making good progress in establishing the conditions for a return to normal financial intermediation services, which is vital for sustained economic growth, following the collapse of almost its entire financial system in late 2008-early 2009. Financial institutions that failed have been resolved, with the most important resolution entailing the creation and capitalization of new banks out of the three main banks that failed in October 2008. While progress in restructuring non-performing loans to the non-financial private sector has been slow, the government and the main financial institutions have recently agreed measures to speed up the process. Legislation has been passed to rectify the most important weaknesses in prudential regulation and supervision exposed by the crisis and further reforms are planned to strengthen it. Steps have been taken to improve co-operation between the Financial Supervisory Authority (FME) and the Central Bank of Iceland (CBI) so that macro-prudential supervision can be made more effective, although a merger of the two institutions could facilitate the implementation of effective macro-prudential supervision. Deposit guarantee arrangements are being reformed to comply with anticipated EU requirements, which will result in better guarantees for depositors and reduced incentives for risk taking by covered financial institutions, although moral hazard could be further reduced by the establishment of statutory authority to intervene at an early stage in failing financial institutions’ operations.