Scottish separatist momentum shock shakes up banking

Sid Verma
Published on:

The course of unrequited love never did run smooth and financial markets are only just taking stock of the threat to the banking and capital-market landscape in the event of a break-up of the UK in its current formation.

Scotland referendum-R-envelope

UK financial markets are reeling after two polls in recent days that reveal a marginal lead for the Scottish independence campaign. 

The pound fell to a 10-month low against the dollar on Wednesday while front-end gilt yields have tumbled, amid speculation the Bank of England (BoE) would be forced to delay its tightening cycle if Scotland secedes, given the economic volatility that would ensue. 

Few expected a referendum, to be held on 18 September, to be this close. If Scotland votes yes, a massive sell-off for banking and capital-market assets, governed by Scottish law given currency-denomination concerns, is expected while a cloud of doubt will hover over financial institutions with notable cross-border business, given uncertainty over the legal, political, regulatory and economic climate. 

You don’t know what you’ve got till it’s gone.

Here is Credit Suisse’s sobering assessment in a Wednesday research report:

In our opinion Scotland would fall into a deep recession. We believe deposit flight is both highly likely and highly problematic (with banks assets of 12 x GDP) and should the BoE move to guarantee Scottish deposits, we expect it to extract a high fiscal and regulatory price (probably insisting on a primary budget surplus). 

The re-domiciling of the financial sector and UK public service jobs, as well as a legal dispute over North Sea oil, would further accelerate any downturn. In our opinion, as North Sea oil production slows, we estimate that the non-oil economy would need a 10% to 20% devaluation to restore competitiveness. This would require a 5% to 10% fall in wages, driven by a steep rise in unemployment. 

Here is a sense of the scale of the challenge for the financial-industry in Scotland, from an albeit institutionally biased UK government-commissioned report, published in May 2013:

The assets of the whole UK banking sector (including Scotland’s banks) are around 492% of total UK GDP.

This is large by international standards, but as the financial crisis showed, still manageable. By contrast, Scottish banks have assets totalling around 1254% of an independent Scotland’s GDP.

In comparison, at the end of 2007, Icelandic banks had assets equivalent to 880% of GDP – a major contributor to the cause and impact of the financial crisis in Iceland. Cyprus, which has had serious financial difficulties more recently, has total banking assets around 700% of GDP.

It adds:

The banking sector in an independent Scotland would be dominated by the two largest banks – the Bank of Scotland and the Royal Bank of Scotland (RBS). There could be questions about an independent Scotland’s ability to stabilize its banking system in the event of a future financial crisis. 

In 2008, the UK government spent £45 billion recapitalizing the RBS in order to protect the deposits and savings of households and small business. In addition, the bank received £275 billion of guarantees through the UK government’s Asset Protection Scheme. This combined support from the UK government to RBS is equivalent to some 211% of Scottish GDP in 2008.

Credit Suisse, in an April report sounding the alarm over the size of the Scottish banking sector to the would-be independent economy, agrees with this 'Westminster village’ view, adding:

The balance sheet of Scotland’s legacy banking sector would be disproportionately large … The prospective currency arrangements for an independent Scotland would render the central bank’s ability to provide liquidity to its banking sector subordinate to the need to maintain a currency peg.

Given the scale of the Scottish banking sector, a Scottish central bank could not be a credible lender of last resort, in our view. And as well as the obligations on and risks to the central bank from the banking sector, there are also the implied contingent liabilities of the sovereign from bank deposit insurance schemes. In Scotland they would likely sum to over 100% of GDP.

Once again, the central bank could not be a credible lender of last resort. UKLS [the remaining Kingdom] would be faced with a choice of providing support or suffering the consequences.

Scottish ref 1
Scottish ref 2

Credit Suisse analysts add the key lesson from the eurozone crisis will be priced into Scotland’s risk premium in the event it keeps the pound, a currency union known as "sterlingization", or under a fixed exchange-rate regime pegged to the pound:

… A critical lesson from the euro-area crisis is that uncertainty over the ability of an 
economy – and its banking system – to remain part of a currency union can lead to self-reinforcing monetary and capital flows that prove financially and economically damaging to the country in question.

Banks legally incorporated in Scotland would face higher liquidity and capital costs for retail and wholesale activities, serving as an incentive for banks to move offshore, triggering capital flight and a negative bank-sovereign feedback loop, the analysts warn.