Address of the Minister of Economic Affairs at the Annual General Meeting of the Central Bank of Iceland, March 25 2010
Ladies and Gentlemen
It gives me special pleasure to have the opportunity to address the Annual General Meeting of the Central Bank of Iceland as Minister of Economic Affairs at this time, when the Bank's fiftieth anniversary is approaching. The recently appointed governors of the bank have an extremely difficult task ahead of them. Like its sister institutions around the world, the Central Bank is the main pillar of the country's financial and monetary systems, and both systems are currently under great distress.
A new financial system has been built, of course, on the ruins of the one that collapsed, but the new system is a long way from earning trust and respect, in Iceland or elsewhere. This is not surprising in light of past events. Financial undertakings cannot be whitewashed simply by changing their management, their owners, their names and registration numbers and leaving their unpaid bills to bankrupt estates.
In some ways the same principle applies to the Central Bank as other financial institutions. It is not sufficient to appoint new management and supply new capital in order to fully resurrect the bank. A clear line has to be drawn between the past and the future.
The new management of a rebuilt Central Bank are not required to answer for the actions of their predecessors, but they do need to show beyond any doubt that they understand what went wrong in the past and that they intend to take an entirely different course.
If the Icelandic nation can be sent any signal on the 50-year anniversary of the Bank, that signal should in my opinion be that the second fifty years in the life of the Bank will be nothing like the first. The experience of the past has come at so great a cost that no other alternative will be acceptable.
This message will have to be clear, and it will need to address both of the principal tasks of the Bank: to ensure the stability of the financial system, on the one hand, and of the currency, on the other hand.
Meanwhile, there is much that needs to be changed in the environment of the Bank, and of the entire financial system in fact, both its legislative framework and other elements. This places the ball in the court of the legislature and the representatives of the executive branch, including myself.
We need to atone for decades of sin. The Icelandic króna has lost more than 99.9% of its purchasing power, as measured against the Danish krone from the time that the two currencies were finally separated over seventy years ago. This is in spite of the fact that there has been inflation in Denmark as well.
The explanation for this trend lies not only, and perhaps only in a small part, with the Central Bank. It lies no less in the dreadful treatment of the Bank at the hands of Icelandic politicians over decades, with their interventions in its decisions and with severely defective legislation. It is therefore not only the Bank that needs to send out a clear message that times are changing. Of no less importance is that the Bank itself receives a clear signal from those who shape its environment that reform is now at hand.
This will partly be accomplished through legislative amendments. The first steps in that direction have already been taken. One of these steps was the appointment of an independent Monetary Policy Committee. This was a recent development, so that as yet we have little experience with the new arrangement. Nevertheless, I believe it is safe to assert that the change has been very much for the better. The minutes of meetings of the Committee, which are disclosed to the public, indicate that decisions are well prepared and reasoned.
Naturally, decisions of a committee of this kind can be open to debate. Such debate is normal, but it is extremely important for the Committee to be allowed to work in peace without unreasonable political pressure. The last person who should attempt to give orders to the Committee is the cabinet minister entrusted with the affairs of the Central Bank.
The independence of the Central Bank needs to be assured, but its independence also brings great responsibility. It is not self-evident for a government organisation to be granted such extensive independent powers to make decisions which affect the interests of everyone, individuals as well as corporations. The institution must exercise these powers with great care and appropriate humility.
It must be kept firmly in mind that the Bank is a part of the Icelandic community and operates in its service. The Bank's decisions, whether on policy in major affairs or in more minor matters, such as day-to-day operations, salaries, etc., need to be consistent with the reality and interests of those for whom the Bank isoperating. The financial independence of the Bank does not exempt it from the requirements made of other public bodies as regards prudence.
The Bank's scope of operations and objectives also need to be clear and demarcated. Even though legislation on the Central Bank was amended only last year, it is evident that further changes will be needed. I have therefore decided to launch a review of the legislation governing the Central Bank with the aim of securing the Bank's independence even better, clarifying its objectives and reviewing the instruments available to the Bank to achieve its objectives. Subsequently, the necessary work will be undertaken to organise the future arrangements of the Bank's co-operation with its sister organisation, the Financial Supervisory Authority, and the division of tasks between these two organisations, each of which has a key role to play vis-a-vis the domestic financial market. I would like to stress that this work will be conducted in extensive consultation with all stakeholders in order to achieve the best possible consensus on its results.
As matter of course, the revision of the environment and activities of the Central Bank will take particular account of the things that went wrong with the Icelandic financial and monetary system. Some of these things were peculiar to Iceland, but many others were of a more universal nature, with the result that solutions are now being sought to similar problems in our neighbouring countries. It is reasonable, and in fact unavoidable, that changes here in Iceland should take account of the discussions and solutions in those countries.
The discussions relate to many aspects of financial systems. Supervision of banks, especially those that operate in more than one country, the legal environment of the financial market, the role of the government when banks get into trouble, deposit guarantees, requirements on equity and liquidity and measures to foresee and even prevent financial bubbles, to mention a few aspects. A number of interesting ideas have been suggested, although few have been implemented as yet.
Basically, the discussions centre on means of preventing a situation where banks and other financial institutions can arrange their business operations so that while everything is going well the owners and key managers make rich profits, but when things go badly the public is left to foot the bill.
It should be clear to everyone by now that financial activities are subject to principles which are different from those that apply to other business activities. The government needs to keep a tight rein on financial undertakings and be prepared to intervene long before disaster strikes. This should be clearer to Icelanders than anyone else.
The framework of the financial system must be designed to ensure that there is little probability of a crisis occurring, and that the cost of any crisis that does strike is not borne by the general public, but primarily by the owners of the financial undertakings and, alternatively, their creditors. One of the ideas that has been proposed and is well worth examining in this context is that banks should, in addition to equity, be required to fund themselves to some extent through the issue of bonds, which are converted into shares under certain circumstances. These rules of the game need to be clear and known to everyone beforehand.
Financial undertakings should not be allowed to obtain funding on the justification that they are so large and important that the government is bound to come to their rescue if they get themselves into trouble. It is not, and must not be, the role of government to absorb losses for the purpose of rescuing the creditors or owners of financial undertakings who get themselves into difficulty. The State has a role to play in minimising everyone's losses, but it should not absorb the losses and thereby pass them on to taxpayers. Of course, the State must step in when necessary to ensure the continuation of basic banking services, such as payment and deposit systems, as was done here in Iceland less than a year and a half ago. If these services fail, the economy will be virtually incapable of functioning.
It is worth giving some consideration to ideas that have been proposed on limiting and dividing the operating licences of financial undertakings so that the undertakings that engage in basic services, and are thereby systemically important, would not be permitted to engage in risky business activities or invest in high-risk assets. In this way, it would virtually be decided beforehand what business activities the government would bail out in a crisis. Another option is to decide in advance what specific aspects of the business of important financial undertakings should be rescued in the event of a financial crisis. Whether the decision is to save the undertakings as a whole or in part, the State would not absorb the losses of the owners of the undertakings in question.
In this context there has been talk of a sort of “financial undertakings' living will and testament”. What this means is a plan on how a company headed for bankruptcy would be divided, which parts would be kept alive and what the order of creditors would be in the hierarchy of claims to each part of the business. The discussion on ideas of this kind is not quite mature yet, but there is every reason to monitor the discussion and respond to the conclusions in Iceland when the time comes. A nation which is used to disasters, whether natural or man-made, should have a deep understanding of the advantages of well-made contingency plans.
Ladies and gentlemen
In the almost fifty years that the Central Bank of Iceland has been working, we have tried two types of financial systems. For most of this time, the Icelandic financial system was largely state-operated and political influence was extensive. We were very poorly served by that system.
Then, the financial system was privatised and almost all restrictions were lifted. That served us even worse. As unbelievable as it may sound, this system managed, in the space of a mere few years, to cause damage that corresponds to many times Iceland's gross domestic product. Neither system will be resurrected.
Instead, we will now build a new financial system. The Central Bank of Iceland will play a key role in the new system. It is already clear that the new system will be subject to greater restrictions by regulatory bodies than before, and it will be subject to a much stricter, clearer and better legal framework than before. It will also be much smaller and simpler than the financial system that collapsed.
However, many questions regarding this new financial system remain unanswered. The biggest question is what currency it will use. Inevitably, the basis of the new system in its first years will be the Icelandic króna, with all its advantages and disadvantages. Shortly, however, we Icelanders will need to make up our minds as to whether this should remain the case permanently, or whether the króna should be replaced by the euro.
In my mind there is no doubt that it will be extremely difficult to build an efficient financial system in Iceland without a more solid foundation than the Icelandic króna. If we make that attempt, Iceland will foreseeably have to endure more unstable price levels, greater exchange rate fluctuations and higher interest rates, both real and nominal, than our trading partners. We will also remain the only country in our region of the world with a split currency: an index-linked króna and an unindexed króna. The advantages of the flexibility that comes with an independent currency do not weigh heavily against these disadvantages. Even if we accept a banking system that will be small and, to a large extent, isolated from the banking systems of our neighbouring countries, as the case was with the Icelandic banking system for a long time, basing the system on an unstable currency would have serious disadvantages.
However, the Central Bank must prepare for both contingencies: continuation of the króna or introduction of the euro. The Bank will also play an important role in explaining the advantages and disadvantages of these two routes.
Ladies and gentlemen
We have numerous extremely challenging tasks ahead of us in rebuilding the Icelandic financial system. Many of these tasks will require significant contribution from the Central Bank. I have full confidence in the new management of the Bank and its employees in the work ahead.
The recent months have been extremely challenging for the Bank and its employees, who have done excellent work under extremely difficult conditions. I would like to use this opportunity to express my thanks for two things in this work, which is, of course, not an exhaustive list of the things to be grateful for. First, the Bank and its staff played a key role in keeping the country's payment transfer system operational, domestic and foreign, in the face of the collapse of the financial system. This was achieved by a tremendous effort.
Second, one year ago the Bank conducted an extremely important study of the debt burden of Icelandic households. Such analysis can be crucial for the work of addressing that problem. No comparable study has ever been conducted in any country, to my knowledge.
Examples of this kind bear witness to the huge human resources that the Bank commands. With strong leadership, this team can play a key role in the reconstruction of the Icelandic financial system. I have no reason to believe that this will not succeed. If it does, there will be every reason for optimism as we look forward to the next half century in the life of the Central Bank of Iceland.