Against the backdrop of the global financial turmoil and recession, Iceland has been struck by a banking crisis of unprecedented proportions and the economy has plunged into a deep recession. The plight of the banking system was in part the consequence of the sudden shutdown of global capital markets. But Icelandic banks’ aggressive expansion strategies in an atmosphere of ineffective supervision rendered them highly vulnerable.

Faced with events having potentially dramatic economic and social consequences, the government sought the assistance of the international community in support of the medium-term adjustment programme to restore policy credibility and economic growth. While progress has been made in implementing the programme, much remains to be done.

Weaknesses in financial supervision revealed by the crisis need to be corrected. Following their privatisation in 2003, the banks expanded rapidly and became so big in relation to the economy that they could not be rescued when they got into trouble. They also became so complex and interconnected that the financial supervisors, with their limited powers, could no longer effectively restrain their activities. In the future, financial stability will require a smaller and simpler banking system, tougher supervision and a strong macro and micro–prudential framework, focusing on both systemic and individual risks.

For the economic recovery to take hold, the banking system needs to function smoothly once again. In the wake of the crisis, the authorities created three new banks by transferring all domestic deposits and claims on residents previously held by the old banks. While an effective temporary solution, the present setup is not viable over time. The new banks hold impaired assets, they are too big and they should not stay forever in state ownership. The authorities should take the necessary steps to prepare their full privatisation and should encourage foreign banks to participate.

Removal of capital controls should be started as soon as feasible. The programme supported by the IMF Stand By Arrangement introduced restrictions on capital flows to prevent massive outflows, stabilise the exchange rate and protect households and firms with large un-hedged foreign currency exposures. These restrictions should be lifted as soon as can be safely done to allow the resumption of normal financial relations with foreign markets.

If it were to become an EU member, Iceland would be advised to seek entry into the euro area as soon as possible, so as to reap the economic benefits. Past monetary policies based both on exchange rate and inflation targeting have produced unsatisfactory results. By joining the euro area, Iceland would share the benefits of ECB’s credibility, including lower risk premiums.

Substantial fiscal consolidation is required to put public finances on a sustainable path. The collapse of Iceland’s financial institutions has increased government debt, while the recession and rising debt servicing costs entail a sharp widening of the budget deficit. Corrective fiscal measures should continue to be implemented. Initially most of the consolidation will occur through tax increases but subsequently the weight of expenditure reductions will have to grow. There is substantial scope to reduce health and education expenditure without adversely affecting the quality of services provided, as discussed in previous OECD Economic Surveys of Iceland.