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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. |
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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.
After all, as any emerging-market sovereign DCM banker will tell you: a small, open economy, dependent on the price of oil, without monetary autonomy to stabilize its financial system, faces large borrowing premia in the absence of excess foreign-exchange reserves – typically requiring primary budget surpluses – and draconian capital ratios on its financial institutions.
The risk of losing international confidence is particularly worrisome since the Scottish economy is not driven by domestic consumption, with around half of its GDP export-driven. Investors domiciled outside of Scotland account for the majority of the claims on these institutions, which according to JPMorgan equates to £750 billion of assets under management in insurance and pension funds, while banking assets amount to more than £1,600 billion.
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Since a vote for independence would call into question the Scottish sovereign’s firepower in running an independent monetary policy, and providing a backstop for contingent liabilities, analysts expect most banks would move south of the border.
This calls into question whether financial services in Scotland would continue to contribute around 13% of onshore economic activity and 7% of employment.
RBS’s credit-default swaps have underperformed peers during the past month amid jitters over the momentum posted by the pro-independence campaign.
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The fund-management has reason for fear, too, according to the aforementioned UK report:
Scotland has historically been a centre for asset management, with an estimated £750 billion of assets under management and an estimated 3,600 people employed (directly and in ancillary services). The Scottish share of the UK asset management sector increased from 5.6% in 2009 to 6.4% in 2010. The Treasury estimates that there are around 80 investment firms in Scotland, including the headquarters of two of the UK’s largest: BlackRock International Ltd (the largest in the UK) and Standard Life Investments (the ninth largest). Scotland is also a centre for fund administration, with strong corporate links with firms based in London and elsewhere. |
A regulatory risk premium will also hover over Scottish assets and UK assets with strong links north of the border, with scant debate about the regulatory structure for Scottish institutions.
Indeed, on Wednesday, the Financial Conduct Authority attempted to reassure markets with a vaguely worded statement that it was working on contingency plans in the event of deposit flight, amid currency risks, and a lack of clarity over the regulatory structure for Scottish-domiciled institutions.
UK economist Charles Goodhart proposes one solution: the EU’s banking union project could be replicated in any Scottish-UK economic arrangement.
In other words: Scottish voters, investors and bankers have no idea if cross-border burden-sharing in the event of bailouts could be negotiated on an ex-ante basis – with Scotland effectively getting the economic benefits of an outsized financial system, but with the costs socialized with the rest of the UK. If not, the comedy of errors witnessed in the eurozone – before the banking and fiscal-union push – underscores the risk of a negative sovereign-bank feedback loop in the would-be independent nation. The financial costs associated with banking instability, especially in the event of solvency, rather than liquidity, issues, suggests the need for fiscal prudence.
However, macro risks will remain even if Scotland votes no and instead is granted maximum devolution, including full fiscal powers. As Neil MacKinnon, global macro strategist for VTB Capital, concludes:
While the financial markets currently see a ‘Yes’ vote as the worst-case scenario, it might be that a small ‘No’ vote is not the happy outcome that some commentators think. A small ‘No’ majority that results in more devolved fiscal powers could mean more liabilities not just for the English taxpayer but also the Bank of England. |