Iceland has agreed emergency legislation aimed at avoiding further financial chaos as its banking system faltered and its currency plummeted 30 per cent.

The ruling alliance and opposition parties united to approve a bill that gives the state sweeping powers over the island’s battered banks.

In an address to the nation, Prime Minister Geir Haarde said the country’s top financial regulator will have wide-ranging authority to dictate a bank’s operations and could even force it to merge with another firm or declare bankruptcy.

The bill will also allow the government to take over housing loans held by the banks and put them in a government housing fund, an effort to help thousands of islanders who face the loss of their homes amid an ever-widening credit crunch.

Later, addressing parliament, the prime minister raised the spectre of a complete financial collapse if the bill had not been agreed.

“We were faced with the real possibility that the national economy would be sucked into the global banking swell and end in national bankruptcy,” Mr Haarde said.

“The legislation is necessary to avoid that fate," he added.

This morning, Iceland suspended trading the shares of six major financial institutions.

The stock exchange said that it had decided to temporarily suspend trading in the big three Icelandic banks — Kaupthing, Landsbanki and Glitnir — plus three other institutions — Exista, Straumur and SPRON — to protect equality between investors while waiting for a government announcement on its plans.

All the major credit ratings agencies moved today to downgrade Iceland’s four big banks and its sovereign credit rating. Fitch cut Iceland's long-term foreign-currency IDR rating by two notches to A-, while Standard & Poor's cut Iceland's long-term foreign currency sovereign credit rating to A- from A and Moody's put its Aa1 rating on review.

The Icelandic currency droped 30 per cent against the euro.

The Government has asked pension funds to repatriate cash to bring home desperately needed foreign currency.

Icelandic state radio reported over the weekend that the country’s association of pension funds had agreed to transfer 200 billion Icelandic kronur (£1 billion) to the state.

He said that Iceland’s banks would sell some of their overseas assets, which will increase speculation that groups such as Baugur, which owns several British high street chains and is backed by Icelandic banks, may be forced to sell some of their stakes. The country’s banking problems led to the nationalisation last week of Glitnir, one of its largest lenders, as depositors pulled their funds.

Iceland’s banks have been under pressure for most of the year, struggling with rampant inflation, the collapsing value of the currency and the general fallout from an overheated economy. In an attempt to curb inflation, the country’s central bank raised interest rates to 15.5 per cent, making it even more difficult for the banks to fund themselves.

The banks expanded rapidly after the deregulation of domestic financial market in the 1990s and now have combined foreign liabilities in excess of $100 billion, dwarfing the country’s gross domestic product of $14 billion.

Further speculation over the health of the country’s banking system will heighten concerns about Iceland’s other two big banks, Kaupthing and Landsbanki.

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