The National Institute of Economic and Social Research has warned the possible ‘plan B’ for an independent Scotland to use sterling as its currency without Westminster’s permission could create costs and put additional stress on financial institutions in Scotland.
Westminster has already stated it will refuse to share the pound in a formal currency union, which would see an independent Scotland continue to use the Bank of England as its lender of last resort.
This has led to some speculation that Scotland may opt to use the pound on an informal basis known as ‘sterlingisation’ that would not require any agreement with Westminster but would mean the country would have to set up its own backstop to support its large financial services sector.
A report issued this week by NIESR explores different possibilities for Scotland’s own lender of last resort including the creation of a Scottish Insurance Fund or using the Bank of England or European Banking Union as a form of ‘third-party’ backstop.
However the report argues that the sacrifices required to set up any of these options would involve “terms that are unlikely to be acceptable to an independent government” while Scottish financial institutions could also bare much of the financial burden.
“Each of these options involves a trade-off between the intensity of regulation, the fairness of insurance premiums and the incentives for moral hazard,” it adds.
The paper outlines the option for what it describes as self-insurance in Scotland which would see the country create a specialised Scottish Insurance Fund “to hold assets in anticipation of a crisis at the same time as significantly reducing public sector debt.”
It draws on examples of small economies such as Hong Kong where informal currency unions have been successfully supported by building up large fiscal reserves in this way, but argues that this would not be a viable option for Scotland because of the significant amount of debt that the country would start out with after independence.
It says: “Put simply, the strength of financial system reflects the strength of the government that stands behind it. These countries effectively self- insure their own banking industry by choosing to maintain high levels of fiscal and foreign reserves. This option would not be available to an independent Scotland for many years because it would inherit a high debt burden. An alternative way of providing lender of last resort would need to be found.”
The lack of fiscal capacity available may mean that Scottish financial institutions have to be charged a premium to help create a banking insurance fund, according to the report. It adds: “While an independent Scotland has no fiscal capacity to create a public fund, it could begin to create a fund from premiums charged to financial institutions.”
However NIESR also warns that the pressure on financial institutions to collect these premiums from Scottish financial firms during difficult times “may end up causing the very failure the insurance fund is designed to prevent. This is more like ‘anti-insurance’.”
Using either the Bank of England or the future European Banking Union as a form of third-party lender of last resort are also alternatives for Scotland, says the report, but both of these options are likely to be “in exchange for a fair premium” that would once again fall on the Scottish financial services sector.
The paper argues that it would be reasonable for the rest of the UK to “seek compensation” from an independent Scotland because providing a lending backstop to it’s banking system will “impose an externality on the rest of the UK’s banking system”.
For example the Bank of England could look to collect premiums from Scottish banks “based on the size and some measure of the riskiness of their balance sheets”, according to the report, in exchange for providing liquidity during a crisis.
But the report also points out that it is “unlikely” that the central bank would agree to this arrangement without being “strongly involved” in both the regulation and supervision of Scottish banks given the additional risks involved for the BoE.
It adds: “Premium structures that are smooth enough to be collectible in practice and to build up sufficient capital, could expose the Bank to quite severe risks of moral hazard.”
An independent Scotland could also join the European Banking Union when it completes, the report argues, but this may only act as another incentive for Scottish banks to pull out of Scotland.
“If Scotland wished to join the EBU, it would therefore surrender supervision of its major banks – if indeed these retain their Scottish domicile – to the ECB. While there may be some advantages to ECB supervision, the change of supervisor from the Bank of England might encourage the large Scottish banks to move their domicile to the UK,” it says.
The report adds that becoming part of the EBU will take away the power for Scotland to create its own sterling reserves or provide liquidity insurance to its own banks.