Reform Scotland

“Citing the banking crisis as an argument to prove Scotland could not be governed independently has no moral or legal foundation” – Scotsman

This article by Professor John Kay appeared in the Scotsman.

Suppose Scotland had been independent in 2008 when its major banks faced failure. Three courses of action would have been open. The Scottish government could have underwritten their liabilities. The Scottish central bank could have tried to orchestrate an international support organisation.

Or the Scottish Government could have taken control of their operations in Scotland and allowed the other activities of the two banking groups to collapse.

Ireland adopted the first option and it was a mistake. No similar decision could responsibly have been made in Scotland. The liabilities of the two Scottish banks amounted to about 30 times Scottish GDP, or almost £750,000 per inhabitant of Scotland – much larger than the corresponding figures for Ireland or even Iceland.

Once the scale of the problems faced by the Scottish banks become evident, the Scottish Government’s guarantee would simply not have been credible. Any government which had made such a commitment would have been turfed out, and deservedly so, as the Irish government was. Before that point the Scottish Government, like the Irish one, would have had to seek international assistance, or abandon its pledges.

What of an international rescue? An independent Scotland would have already decided on its currency arrangements – most likely a monetary union with England – but might have been expected to make its own arrangements for financial regulation. In that case, the Bank of England would have retained responsibility for the monetary policy of an independent Scotland, but neither the Bank of England nor the English Financial Services Authority would have exercised a regulatory role north of the Border.

These monetary arrangements imply that it would have been to London and Washington, rather than Brussels and Frankfurt, that the first emergency calls would have been made. RBS had large retail operations in England and the United States, and London was the central location of its wholesale trading. The Scottish central bank governor would have attempted to broker a support operation in which the US and English governments took a principal role.

In October 2008, willingness to provide such support would probably have been forthcoming, but it would not have been easy to reach agreement in the short timescale available. In the only analogous case – that of Fortis, the unhappy partner of RBS in the acquisition of ABN-Amro – such agreement was reached, but disintegrated in acrimony. And Fortis, partially nationalised after the intervention of the European Central Bank and the Netherlands, Belgium and Luxembourg in 2008, was a far smaller problem. The conditions of the rescue would likely have been harsh – the English government would have expected to assume control of RBS and probably HBOS also, and the international community would have sought substantial underwriting of liabilities from the Scottish government.

In the absence of such agreement, resolution would have been inevitable. The Scottish Government would take control of the Scottish retail activities of the bank while the company as a whole went into administration. The presumption would be that the English and US governments would do the same in respect of commercial banking operations in their own countries while investment banking and trading activities were wound up. The English government would have been under pressure from the international financial community to assume responsibility for these latter liabilities. Scotland could not realistically have considered such a course of action, and the results of doing so would have been disastrous.

The implications of such resolution for wholesale financial markets would have been severe. The deposits of retail customers would have protected, and everyday banking activities in all countries would have continued as a result of the nationalisation of these operations by respective governments. But the impact on global markets would have been far greater than those that followed the collapse of Lehman. The process of administration, and the litigation that would inevitably have surrounded it, would have provided lucrative employment for Edinburgh professionals for many years.

This resolution process would have been the least bad option for the Scottish government – and unless the Scottish Government had been willing to contemplate it, no acceptable terms could have been exacted in the fraught negotiations which might have led to an international support operation. Might regulation of RBS and HBOS by an independent Scotland regulatory authority have averted collapse? There are two conflicting considerations. Small countries are more vulnerable to crony capitalism. The business and political elite is small. The homogeneity of outlook and informality of process that results can be a national competitive advantage, and in some countries, has been. But in both Iceland and Ireland the links between politics and finance were certainly inappropriate if not actually corrupt.

It is hard to believe that Scotland would have entirely avoided similar dangers. The justified pride which was taken in Scotland over the international expansion of the Royal Bank would almost inevitably have encouraged an identity of interest between the Scottish Government and Scotland’s largest business. This would have made regulatory action to constrain excess of ambition and risk-taking difficult.

On the other hand, some countries were more effective than others in anticipating and restraining financial excess; in Australia and Canada, regulators took a more conservative stance. A Scottish central bank might have sustained traditionally more conservative Scottish values in the face of international and market pressures in the years up to the crisis. We do not know. We do, however, know that distinguished boards of RBS and HBOS failed to restrain senior executives mostly drawn from that Scottish banking tradition.

The cost, or strictly speaking the exposure, which the UK government incurred in bailing out the Scottish banks would have been beyond the resources of the Scottish Government. Some have drawn from this the conclusion that Scottish independence, even if desirable, is an impracticable dream. The premise that Scotland could not have handled the bailouts as the UK government did is correct. But the conclusion that this demonstrates the impossibility of independence is wrong. The Scottish Government probably would not, and certainly should not, have done what the UK government did.

And although the UK government was able to do what it did, the UK government should not have done it and should certainly not do it again. The calculation that treats the liabilities of banks whose head offices are in Scotland as liabilities of the population of Scotland cannot be appropriate. There is no possible justification for the proposition that Scottish taxpayers should pay off foreign institutions which made loans to ABN-Amro. The size of the liabilities of the Scottish banks makes the absurdity of that assertion particularly clear. But it does not matter whether the denominator of the calculation of liability is the population of Scotland, the population of the UK, or the population of Edinburgh. The liabilities of Scottish headquartered banks are not liabilities of the Scottish people, either morally or legally.

It is preposterous to suggest that since modern diversified conglomerate banks are too big to fail, it is necessary to create governments whose resources are many times larger than those of diversified conglomerate banks. Neither a democratic society nor a market economy can contemplate private sector organisations that are “too big to fail”. Such a concept represents not only an unacceptable concentration of unaccountable private power but destroys the dynamism that is central to a market economy. The “too big to fail” problem must be tackled in other ways than adapting our political system to the aspirations and needs of megalomaniac financiers, and can be tackled in other ways.

Retail banking in Scotland and elsewhere should return to a conservative model. The risk-taking activities that brought RBS and HBOS to their knees should be undertaken not by retail banks but by those who share losses as well as profits and derive capital, both debt and equity, from external investors who have a direct commercial relationship with the risk takers. The best future model for Scottish financial institutions is one in which the utility of normal commercial banking is separate from the casino of investment banking – Vickers on steroids.

Professor John Kay is a visiting professor of economics at the London School of Economics and was a member of the Scottish Government’s council of economic advisers