Cabinet Office
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Banks safer in the United Kingdom

A detailed analysis by Treasury officials outlines the benefits the UK provides for Scottish financial service companies and their customers

On Monday the UK Government published a detailed analysis by Treasury officials of the benefits the UK provides for Scottish financial service companies and their customers.

The latest Scotland analysis paper – the third in the series - shows that the scale of the UK economy, relative to the size of our banks, allows the UK to resolve a banking crisis and maintain the financial stability of the whole of the UK.

The paper says that the UK has the capacity to manage the risks associated with a financial crisis given the size of the economy compared to the size of the sector (with banking assets of around 490 per cent of GDP).

This means that Scotland enjoys a best of both worlds position - maintaining a large financial sector headquartered in Scotland and also benefitting from being based within the world-leading UK regulatory system that manages financial stability risks.

The paper also explains that while the Bank of England is the resolution authority, it is acting on behalf of the UK Government. The paper sets out the important role that HM Treasury and the Chancellor have in resolving any large banking failures.

In contrast to the position of the UK, the Scotland analysis paper reveals that an independent Scotland would have an exceptionally large banking sector compared to the size of its economy – with banking assets of more than 1250 per cent of Scottish GDP - making it more vulnerable to financial shocks and the volatility of the sector. The paper concludes that Scottish banks (and their customers) could either have to accept higher risks and costs associated with this volatility or restructure and diversify their assets.

The paper points out that Iceland (2008) and Cyprus (2013) have both encountered significant difficulties in recent years and the scale of their banking assets relative to GDP was identified as a contributory factor. Iceland and Cyprus had banking assets that were the equivalent of 880per cent and 700per cent of their GDP respectively. The OECD described this position as banks being ‘too big to rescue’.

Other findings in the Scotland analysis paper include:

  • the total support provided to RBS in 2008 would have been the equivalent of 211 per cent of Scotland’s GDP. By contrast the total UK interventions across the whole banking sector were 76 per cent of UK GDP;

  • a serious banking crisis in an independent Scotland could pose a significant risk to Scottish taxpayers. Banking sector contingent liabilities for the UK in September 2012 were around 100 per cent of the whole UK GDP – or around £30,000 per capita. This would be more than double in an independent Scotland at £65,000 per capita.

  • that any attempt at shared regulatory arrangements between the continuing UK and an independent Scotland would be ‘significantly more complex than those that currently exist, and would not effectively recreate the existing advantageous position.’ More complex regulatory arrangements are likely to increase the costs for firms of complying with this regulation – for example they may have to develop separate products to comply with the different regulation in different markets – would be likely to be passed on to consumers through higher prices.

Key quotes from the Scotland Analysis paper

Best of both worlds

‘As well as the advantages of being headquartered in (and operating out of) Scotland, Scottish financial services firms also benefit from the UK’s stability and markets’ confidence in the larger UK economy. The UK-wide regulatory framework, which maintains the stability of the financial system, is vital to all firms that operate in the UK. Location in a larger economy also helps to reduce firms’ cost of borrowing because markets perceive these firms as less of a risk.

‘Scotland’s financial sector currently enjoys the best of both worlds: its size and historic strengths and specialism helps to create wealth and jobs in Scotland; while being part of the UK gives regulators, firms and individuals confidence in managing financial risk.’

Scale of UK economy allows us to resolve banking crises

‘There is a consistent UK-wide regulatory framework for managing stability risks to the financial system as a whole. The size of the UK economy relative to its financial sector means that the UK authorities are in a position to effectively coordinate the resolution of failing firms, and to stand behind any resolution arrangements.

‘Resolving large banking failures with confidence is likely to be impossible unless there is a strong and large fiscal base underpinning actions to mitigate financial risk.

‘Banking sector assets for the whole UK at present are around 492 per cent of GDP. Although this is larger than some other states, the experience of the financial crisis that began in 2008 demonstrates that even in a situation of extreme stress, the UK has the capacity to manage these risks.’

Scale of the Scottish banking assets compared to GDP - 1254%

‘The Scottish banking sector, by comparison, would be extremely large in the event of independence. It currently stands at around 1254 per cent of Scotland’s GDP.

‘By way of comparison, before the crisis that hit Cyprus in March 2013, its banks had amassed assets equivalent to around 800 per cent of its GDP – a major contributor to the cause and impact of the financial crisis in Cyprus and the ability of the Cypriot authorities to prevent the systemic effects when it hit;

‘At the end of 2007 Icelandic banks had amassed consolidated assets equivalent to 880 per cent of Icelandic GDP. As noted by the Organisation for Economic Cooperation and Development (OECD), this created risks for the Icelandic economy: “the banks grew to be too big for the Iceland government to rescue. Banking in these circumstances became very dangerous when the global financial crisis deepened”. The size of the sector relative to GDP was a major contributor to the cause and impact of the financial crisis, and the ability of the national authorities to prevent the systemic effects when it hit.

‘Overall, the experience of financial crises shows that countries with a large banking sector compared to the size of their GDP are significantly more vulnerable. Furthermore, in September 2012, banking sector contingent liabilities for the UK were approximately 100 per cent of the whole of UK GDP (or around £30,000 per capita). If Scotland were to become independent, its contingent liabilities would be more than double those of the UK as a whole, amounting to approximately 220 per cent of Scottish GDP or £65,000 per capita. This means that faced with serious banking crisis, the possibility of bank failures would pose a very serious risk to taxpayers in an independent Scotland.

‘If Scotland became independent it could cause significant difficulties for financial services firms, particular around their cost of borrowing. There is a substantial area of uncertainty around the reaction of large firms to these risks. These would be difficult decisions for industry, particularly those firms that have strong historic and cultural links to Scotland.

‘There would likely be significant incentives for large firms to make changes to their group structure in order to address the funding and financial stability risks arising from independence, most importantly moving their domicile from an independent Scottish state to the continuing UK, or to another jurisdiction.’

Shared arrangements

The paper also assesses proposals from the Scottish Government and their Fiscal Commission suggesting maintaining some sort of UK-wide approach to managing financial risk. The papers says:

‘These proposals seems to be an attempt to recreate the benefits of the current constitutional setup, in which Scotland maintains a large and prestigious financial sector while sharing the risks with the rest of the UK. However, any such arrangements would be significantly more complex than those that currently exist, and would not effectively recreate the existing advantageous position. Notably the case for fiscal support across international boundaries to another state would be far less clear, and would be crucially dependent on one state’s taxpayers being willing to support another’s.

‘If responsibility for regulation and resolution were to be “shared” in the way that it is implied in proposals above, it would weaken the UK authorities’ control over macro prudential supervision and dilute the UK Government’s responsibility for fiscal decisions about bank failures and resolution. These proposals would also not give the government of an independent Scotland the levers it needed, particularly as the smaller partner in the partnership. Overall, these alternative approaches to managing financial risk are likely to be unappealing to both parties in the longer term, even if in practice they are deliverable, which is uncertain given the significant additional complexity they would entail.’

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