Scotland has limited lender of last resort options in an informal currency union

8th August 2014

If an independent Scotland chooses an informal currency union (called ‘dollarization' or 'sterlingization') as Plan B, its financial institutions cannot be sure they will have access to emergency liquidity in the next financial crisis. This is likely to have important consequences for Scotland's financial sector, and therefore its capacity to export financial services, its new balance of payments and general economic prosperity.

This is according to new research published by Dr Angus Armstrong and Dr David McCarthy from NIESR, which explores the options for an independent Scotland to be lender of last resort to Scottish institutions in a financial crisis. The strengths and weaknesses of each option are reviewed in the paper. The authors conclude that the only viable option they see to the lender of last resort problem would involve terms that are unlikely to be acceptable to an independent government.

This paper looks at three possible solutions to this lender of last resort problem: create a new Scottish Insurance Fund, negotiate a commercial lender of last resort line of credit with the Bank of England, or have the nascent European Banking Union assist with lender of last resort. Because of the complexity of insuring liquidity risk, the authors suspect that the only realistic option would involve terms that would not be in the interests of an independent government.

Bringing about an end to the UK's existing monetary union would require legislative change. The UK government would be likely to pass primary legislation to amend the Banking Act (2009) so that HM Treasury and Bank of England is longer responsible for managing the issuance of Scottish notes (necessary to prevent any impression that the UK state would provide financial support to an independent Scotland in the event of a crisis).

The Bank of England carries out regular sterling liquidity operations with banks from all over the world, and would surely do so for banks from an independent Scotland. But in times of financial distress, when liquidity insurance is most valuable, the Chancellor decides emergency sterling liquidity assistance, presumably in the rest of the UK's interests.

An independent Scotland would require a financial border to create its own balance of payments accounts. This would include cross border trade and capital flows to and from the rest of the world and the rest of the UK. Under dollarization, the balance of payments would become the key barometer of whether the Scottish economy prospers or declines.

Banking groups will also have to decide which side of the financial border to register. Where banks are registered (or incorporated) matters for which government provides the deposit insurance, who regulates the banks, who is likely to receive emergency support and which taxpayers might pay if there are losses in the case of failures. Without a credible solution to the lender of last resort, the Prudential Regulatory Authority is likely to require systemically important banks using sterling to be domiciled in the UK. Shareholders, customers and rating agencies are also all likely to prefer systemically important banks to be located in the UK.

The back-stop for lender of last resort is the state (or the IMF). The Scottish government could, in theory, use fiscal reserves to provide lender of last resort support to its banks. But if Scotland accepts its 'fair share' of the existing UK debt, then it will have a high debt burden rather than surplus fiscal reserves.

The European Banking Union (EBU) may have some attractive features for an independent Scotland. It diversifies the residual cost of bank failure across member states, which would be beneficial to countries with large banks and high debt burdens. But it would not help with liquidity insurance for a country which would be using sterling rather than the euro. Joining the EBU would lead to two divergent sets of regulation with one currency which would invite regulatory arbitrage.

Exports of financial services accounts for 15% of total Scottish exports (or almost 9% of GDP), and most of these are to the rest of the UK. The prospects for financial services exports matter for the balance of payments, and therefore for Scotland's economic prosperity. Finding a credible solution to the lender of last resort problem is important if Scotland ends up with dollarization. Part of the solution may require Scotland to have its own currency instead.

Note
This research is funded by the Economic and Social Research Council's (ESRC) Senior Scottish Fellowship award as part of the Future of the UK and Scotland Research Programme.

Summary at -
http://niesr.ac.uk/sites/default/files/files/Exec%20sum_final.pdf