The Central Bank of Iceland, Seðlabanki Íslands, was established by an Act of Parliament in April 1961. It is a state-owned institution administered by a Board of Governors. The Board of Governors consisted of three members appointed by the Minister. From 2009 there has been one Governor which is appointed by the Minister of Finance and Economic Affairs. There is also a seven-member Supervisory Board, elected by the Alþingi (Parliament), which acts in a supervisory and advisory capacity.

The Central Bank was assigned most of the traditional central banking functions, including the sole right to issue notes and coins and manage the foreign exchange reserves. The Central Bank acts as banker to the government and was for a period allowed to grant short-term credit to the Treasury. It was also given powers to regulate interest rates and also to influence the liquidity of the banking system both through short-term lending and by requiring the banks to hold blocked reserves with the Central Bank. Supervision of the operations of all institutions authorised to accept deposits from the public was also put in the hands of the Central Bank. <9 />

Although formally independent, the Central Bank was required by law to support the economic policy of the government. This was interpreted as meaning that the Bank could not make major changes in, for example, interest rates or reserve requirements, if these were objected to by the government. During the sixties no severe problems arose in policy coordination between the Bank and the government. This changed after inflation accelerated in the seventies, particularly following the oil crises, and monetary policy came under increasing strain. Interest rates, through government policy, were kept relatively low in spite of accelerating inflation, leading to strict rationing of credit and the erosion of monetary savings.

New role in deregulated finance market 1984

A radical change in monetary policy did not take place until after 1984 when the first steps were taken to deregulate interest rates. Two years later, in 1986, the Central Bank Act was revised, abolishing the Bank's powers to regulate the interest rates of commercial banks and savings banks. This quickly led to greater competition in financial markets and initially to rising interest rates. After these changes it became a priority task of the Central Bank to encourage the development of active markets in bonds and short-term government paper. An important step in that process was an agreement between the Bank and the Treasury limiting government access to credit from the Central Bank. Instead, the Treasury started selling both Treasury bills and bonds at regular auctions, laying the foundation for more effective money markets and market-determined interest rates.

The 1986 Act also strengthened the position of the Bank Inspectorate of the Central Bank, a supervisory department which was also given responsibility for the supervision of non-bank financial institutions.

Various changes took place during the last decades of the twentieth century. New markets were introduced and the Central Bank either took the initiative or participated actively in making these markets, amongst others the Iceland Stock Exchange, markets for long- and short-term paper and the currency market. Currency movements were liberalised. In 1999 the banking supervision was moved to a new Institution, the Financial Supervisory Authority (FME).

In May 2001, a new Act on the Central Bank of Iceland entered into force. The main elements of the new Act are as follows:

The main objective of monetary policy is to maintain price stability. With the approval of the Prime Minister, the Bank is authorised to adopt an inflation target as a framework for the conduct of monetary policy. An inflation target had been adopted on March 27, 2001 through a joint declaration of the Government and the Central Bank. By law, the Bank shall also promote other objectives, such as an efficient and safe financial system, including payments systems, and other tasks consistent with its role as a central bank. The Bank shall support the economic policy of the Government as long as it does not deem it inconsistent with the objective of price stability. The Act thus gives instrument independence to the Central Bank. The de facto ban on credit to the public sector that has been in force since the early 1990's becomes law with the new Act. Exchange rate policy is decided by the Central Bank, subject to the approval of the Prime Minister, but it has to be consistent with the main monetary policy objective of price stability. A lender of last resort function is provided for.

Monetary policy decision-making authority was then vested in a Board of three Governors. They should be appointed by the Prime Minister for seven-year terms with possible reappointment for a second seven year-term. The Minister specifically appointed the Chairman of the Board, also for a seven-year term with the possibility of one reappointment. 

In order to ensure the highest degree of professionalism in the shaping and implementation of monetary policy, the Act instructed the Governors to set internal working rules on the preparations of, arguments for and presentation of monetary policy decisions. The rules shall, inter alia, cover the internal procedures to be followed, what information and indicators should be primarily relied on and which staff should participate in the process, although ultimately the decision-making authority rested with the three Governors. Minutes of meetings did not have to be published and the Bank was not required to disclose the position of individual Governors. The Bank must, on the other hand, publicly explain in detail its monetary policy decisions and the rationale behind them. The Bank is obliged to issue an annual report detailing its activities and quarterly reports on monetary developments and policy and monetary measures. The process described above was to enhance the transparency of monetary policy.

The role of the Supervisory Board was spelled out more clearly than before and its membership was expanded to seven. It supervises the activities of the Bank and must approve various rules which are issued by the Governor(s), including those on the internal working procedures described above. The Supervisory Board also has to approve the operating budget for the Bank at the beginning of each year.

The Bank was relieved of expenditure obligations which more appropriately belong in the fiscal budget.
The Act provides for a build-up of the Bank's capital and reserves. When they are below a certain level defined in the bill, the Bank shall pay a third of its annual profit to the Treasury. Once they have reached the stipulated level, two-thirds of the profit shall be paid to the Treasury.

In sum, the Bank was granted instrument independence, its financial independence is better ensured and the legal demands on transparency and accountability are strengthened.

The new Act is explained further in Monetary Bulletin 2001/3.

In February 2009, the Act on the Central Bank was further amended. The main changes were that one Governor (and one Vice Governor) was appointed instead of three and that a Monetary Policy Committee, consisting of five members makes the decision on policy interest rates. The Act on the Central Bank was amended in July 2013, and the Central Bank was given an explicit mandate of promoting financial stability. A Financial Stability Council was established in 2014. The chairman of the Council is the Minister of Finance and Economic Affairs. A Systemic Risk Committee working for the Financial Stability Council was also established in 2014. The Governor of the Central Bank chairs the Systemic Risk Committee.