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Fiscal Commission Working Group – First Report – Macroeconomic Framework


7: Monetary and Financial Stability - Design Options

  • Chapter 7 provides a summary of the design options available to an independent Scotland for a framework to deliver monetary and financial stability.
  • With independence, the Scottish Parliament would be fully responsible for the design of policies to deliver monetary and financial stability in Scotland.
  • It could seek to implement its own policy and/or look to work with key partners to deliver shared objectives.
  • Central to the operation of monetary policy would be the choice over which currency to adopt, either establishing a separate Scottish currency or seeking to be part of a monetary union.
  • Overall, the choice of currency will have a significant impact on the future performance of the Scottish economy, influencing trade flows and investment.
  • There are on-going moves at the EU level and internationally which provide important context for the design of a framework for financial regulation and tools to ensure financial stability in an independent Scotland.
  • Given the close linkages between these two pillars of the macroeconomic framework - for example, the importance of the commercial banking sector in transmitting monetary policy to the real economy - they are discussed jointly in this chapter.
  • The design options for a fiscal framework are considered in Chapter 8.


7.1 As highlighted in Chapter 5, central to any macroeconomic framework is a stable and credible framework for monetary and financial stability.

7.2 At the time of independence, the Scottish Government would be required to identify a new monetary framework for Scotland. This could involve seeking to continue to use the existing framework through a negotiated settlement with the rest of the UK, or establishing a distinct approach in Scotland. Timing is important, and there may be opportunities to establish temporary or transitional arrangements.

7.3 Central to this is the choice of currency. It is this decision, above all others, that has the greatest implications for the overall structure of the framework. It also has implications for the type of institutions to be established.

7.4 This chapter sets out the currency options that would be available for Scotland post-independence and identifies a number of key issues with regard to the choice of monetary and financial stability arrangements. The chapter then sets out three key foundations of financial stability (supervision, resolution and deposit protection) and the arrangements that could be established to support this.

7.5 Monetary and financial stability are discussed together in this chapter. This reflects the substantial overlap between these two policy areas and the important role of the central bank in both elements of the macroeconomic framework.

Currency Options

7.6 There are a variety of economic factors which are worthy of consideration when assessing the merits of currency options open to an independent Scotland.

7.7 The choice of currency, by dictating both the fundamental structure of the monetary framework and the relationship with other countries, will also have implications for decisions over the overall shape of the public finances and financial stability.

7.8 For example, if Scotland sought to join a monetary union then it would be likely to commit, not just to the operation of monetary policy of that currency area, but also a range of conditions that may be associated with that membership.

7.9 The principal currency options open to an independent Scotland are highlighted in the diagram below.

Figure 7.01: Currency Options for an Independent Scotland

Figure 7.01: Currency Options for an Independent Scotland

New Scottish Currency

7.10 The creation of a new currency would give policy makers in Scotland maximum policy flexibility, subject to any practical constraints associated with establishing and operating a credible and sustainable currency.

7.11 The economic area of Scotland is sufficiently large to support its own currency.

7.12 In the long run, the creation of a new Scottish currency would represent a significant increase in economic sovereignty, with interest rate and exchange rate policy being two new policy tools and adjustment mechanisms to support the Scottish economy.

7.13 In the short-run there would however, be a number of practical challenges associated with moving to a new currency, including the not insignificant steps required to re-denominate contracts and maintain intra-UK supply chains.

7.14 Ultimately the value of a Scottish currency would depend upon Scotland's balance of payments position. The handling of currency receipts from the North Sea - including the extent to which such transactions were denominated in Scottish currency - would be important both for managing the balance of payments and exchange rate movements. In the short-run, the credibility of any new currency as a medium of exchange would be a key determinant of its value.

7.15 There would be a choice regarding whether to adopt a fixed or flexible exchange rate.

7.16 The currency could 'float', adjusting automatically in value in response to changes in the demand and supply for the Scottish currency.

7.17 Alternatively it could be pegged to another currency or a basket of currencies. This is the case for a number of countries which have their own currency. An obvious option would be to aim to peg 1:1 with Sterling.

7.18 Within this, one possibility is establishing a currency board. This is the strictest form of currency peg and aims to maintain a permanently fixed rate of exchange between one currency and a "reserve currency" supported by full convertibility. It requires sufficiently large reserves of the pegged currency (e.g. Sterling) at the legally enforceable rate [86].

7.19 Under each of these scenarios, new institutions would need to be developed - the principal one being a Scottish Central Bank. It would be responsible for delivering monetary policy (either to target inflation or to peg the value of the currency), providing liquidity to the financial sector and ensuring the credibility of the currency as a medium of exchange.

Monetary Union

7.20 An alternative to establishing a new currency would be to enter into a formal monetary union.

7.21 Joining a formal monetary union would be subject to agreement and cooperation from partners within the union. In a monetary union, monetary policy is set for the entire currency zone [87].

7.22 Joining, or remaining part of, a monetary union could have the benefit of adopting a system which is well established and has credibility in international financial markets.

7.23 The key benefit of a monetary union is the positive effect on trade. By adopting the same currency, a monetary union eliminates transactions costs and exchange rate risk [88]. In addition, a single currency can facilitate price comparisons and encourage competition.

7.24 The other key benefit is a stability and uniformity in financial conditions across the currency zone. This can help to create a single investment area boosting liquidity and capital deepening. This should enhance the efficiency and volume of investment; indeed this appears to have been one of the main achievements of the Euro Area's single market.

7.25 Against this, a monetary union means that there will be one interest rate and exchange rate for the entire economic union. This requires broad alignment of business cycles (close enough to enable fiscal policy to smooth any divergences) and similar economic structures so that changes to the common monetary policy have similar effects across the monetary union.

7.26 As an aside, there is the option for Scotland to adopt Sterling through an informal process of 'sterlingisation'. While this option would retain some of the benefits of a formal monetary union there would also be some additional drawbacks. In this instance, the Scottish Government would have no input into governance of the monetary framework and only limited ability to provide liquidity to the financial sector - this would depend on the resources and reserves of the country. The amount of currency available would depend almost entirely on the strength of the Scottish Balance of Payments position.

7.27 The two clear options for Scotland are therefore to seek to join a formal monetary union with Sterling or the Euro.

Monetary Union Options for Scotland


7.28 Entering a monetary union with sterling would largely be a continuation of the current monetary framework. The Bank of England could operate day-to-day monetary policy independently from both the Scottish and UK Governments.

7.29 There are a number of ways that this could be achieved.

7.30 Two key issues relate to i) governance and ii) whether or not separate central banks are created in each jurisdiction. Both would be subject to negotiation and agreement with the UK Government. Discussions on such arrangements would focus on the objective of financial and economic stability.

7.31 In respect of governance, it is important to note that negotiations would begin from a position where the Bank of England is currently the central bank for both countries.

7.32 Going forward, one option would be to create a formal monetary union with two equal partners each having the same degree of oversight and input into the governance of the 'shared' central bank. An alternative model would be to establish governance on a 'shareholder' basis, according to the relative economic (or population) size of the partners.

7.33 In terms of the creation of a new institutional and governance structure, two options are possible. The first option would be for a supranational central bank to be established for the Sterling Zone (similar to the ECB) with two satellite central banks (Central Bank of UK and Central Bank of Scotland) tasked with carrying out day-to-day monetary and liquidity operations and implementing the decisions of the 'Sterling Zone Bank'. A second option, and the most straightforward option at the outset, would be to retain one independent central bank (i.e. the Bank of England) across both countries but subject to accountability, oversight and indemnification from two separate fiscal authorities on an agreed basis.

The Euro

7.34 In principle, an independent Scotland could apply to join the European Monetary Union, adopting the Euro as the currency.

7.35 Within the Euro Area, monetary policy, including control of both the interest and exchange rate, would be the responsibility of the ECB and set for the entire Euro Area.

7.36 Determining eligibility to join the Euro would not be straightforward for a newly independent Scotland as a number of conditions have to be satisfied before this can be achieved (See Box 7.01). Establishing whether Scotland meets those criteria is not immediately possible since the nature of the current devolved settlement means that measurement of these economic criteria does not yet exist.

7.37 It is also not the case that a newly independent Scotland could be obliged to join the Euro. As highlighted in Box 7.01 for example, a requirement to join the Euro is to be a member of the Exchange Rate Mechanism II for at least two years. The decision to join the ERM II is voluntary.

Box 7.01: Steps Required to Joining Eurozone

There are a number of criteria required to be satisfied by countries before joining the Euro Area. These criteria are set out in Article 140 of the Treaty of the Functioning of the European Union.

In particular, there are four main convergence criteria:

  • Inflation rate: No more than 1.5 percentage points higher than the three lowest inflation member states of the EU;
  • Government finance: Ratio of annual deficit to GDP less than 3% and ratio of gross debt to GDP less than 60%;
  • Exchange rate: Applicant countries must have been a member of the Exchange Rate Mechanism II for 2 consecutive years and should not have devalued its currency during that period; and
  • Long-term interest rates: The nominal long-term interest rate must not be more than two percentage points higher than in the three lowest inflation member states.

From the perspective of an independent Scotland, all four criteria would be difficult to meet immediately - not from the perspective of the relative strength of the Scottish economy but simply due to current system creating an inability to demonstrate a track-record of having met the criteria.

Assessing the options

7.38 There are a number of important issues to consider when choosing the optimal currency arrangement for Scotland post-independence.

7.39 The most straightforward way to assess the options is to compare the benefits of monetary policy targeted to developments in the national economy (and in particular the opportunity to devalue/depreciate the currency) against the benefits of membership of a common currency area which include lower transaction costs, price transparency, a single investment area and reduced exchange rate risk.

7.40 The criteria typically used to make such an assessment includes a range of considerations such as -

  • trade (both intermediate and final goods & services) between members of a proposed currency area compared to trade with countries outside the proposed currency area;
  • capital and labour mobility;
  • wage and price flexibility;
  • productivity; and,
  • alignment of economic cycles.

7.41 Alongside this report, the Working Group has published a summary of the strengths and weaknesses of the major currency choices for Scotland, across five broad areas of assessment -

  • Are the fundamental structures of the Scottish economy currently suited to such an arrangement?
  • Are there any benefits/implications for short-term macroeconomic stabilisation?
  • What are the potential implications for trade and investment?
  • How straightforward would the transition arrangements be?; and,
  • What policy levers would be open to a future Scottish Governments to address the key challenges and take advantage of new opportunities in the Scottish economy?

7.42 In practice, any assessment of the optimal monetary framework is open to interpretation.

7.43 Moreover, the best structure may vary over time depending upon developments in both the Scottish economy and possible partner economies within a currency union. All things considered, the current evidence points in favour of retaining Sterling as part of a formal monetary union.

7.44 This would also be in the benefit of the UK, given the trade links with Scotland, and the nature of integrated markets, such as in financial services.

7.45 Box 7.02 provides a summary of the suitability of retaining Sterling.

Box 7.02: Summary of arguments in favour of retaining Sterling

An independent Scotland would have a range of positive choices with regard to its macroeconomic framework.

On Day one of independence, the Members of the Working Group agree that retaining Sterling would be a sensible currency choice that would be attractive both to Scotland and the UK.

There are a number of reasons for this.

Firstly, Scotland is an open economy with the UK as its principal trading partner, accounting for two thirds of onshore Scottish exports. Export sales to the UK are equivalent to around 17% of total turnover in the Scottish economy. While robust figures on imports are not yet available, it is clear from the modelled data that does exist - both from Scottish Input-Output tables and new SNAP experimental data - that imports from the Rest of the UK are likely to be at least as large as the figures for Scottish exports.

Secondly, while less than 2% of registered enterprises operating in Scotland are ultimately owned by enterprises from the UK, they account for approximately 20% of employment and turnover [89]. There is also clear evidence of the existence of a number of significant pan-UK companies operating in Scotland (and vice versa) with complex cross-border supply chains.

Thirdly, there is also labour mobility between Scotland and the UK - helped by strong transport links, culture, recognised education qualifications and a common language. Historically, the vast majority of inward migration into Scotland has been from the UK. This has changed somewhat in recent years following the accession of new Member States to the EU. In 2010-11 however, over 50% of migration flows into and out of Scotland was still from the UK [90].

Fourthly, as highlighted in Chapter 4 on long-term measurements of economic performance, the Scottish and the UK economies are broadly aligned. For example, the latest data for 2011 has Scottish productivity at either 97% or 99% of the UK average depending upon the measure used, while GVA per head in Scotland (even excluding the contribution of the North Sea) during 2011 was 99% of the UK average - 3rd behind London and the South East.

Fifthly, past evidence of business cycles shows that while there have been periods of temporary divergence, overall there is a relatively high degree of synchronicity compared to other closely related economies. Analysis has shown that Scotland and the UK have closer economic cycles than most other European economies (see accompanying paper on the Fiscal Commission Working Group web page). The chart below shows that on only two occasions have the business cycles of the UK and Scotland diverged by more than 2 percentage points, and this was only a temporary divergence. The scale, length and frequency of asymmetric shocks is also limited, based upon historical evidence.

Chart 7.01: Estimated Output Gaps UK and Scotland

Chart 7.01: Estimated Output Gaps UK and Scotland

Employment levels are also broadly similar between Scotland and the UK.

Historically, there have been different patterns in house price levels and movements in Scotland compared to the UK. House prices in Scotland were broadly flat in real terms from the early 1970's until the late 1990's, whist in comparison there were greater fluctuations in the UK over this time period. Since then, price movements across the UK (excluding Northern Ireland and to a lesser extent London and the South East) have tended to be more aligned. The most recent data shows that house prices in Scotland tend to be lower than the UK average but similar to most areas outside London and the South East.

Due to links between the short-term interest rate and consumer spending, variations between housing market structures can influence the way in which monetary policy, through the interest rate transmission mechanism, has an impact on different parts of a single currency area. Over the last two decades, home ownership in Scotland has significantly increased to broadly converge with the UK [91].

In summary, this assessment suggests that monetary policy set to promote price and financial stability across a Sterling Zone would, as an initial assessment, appear to be consistent with the objectives of delivering a stable macroeconomic system for Scotland.

Finally, retaining Sterling would be a useful mechanism to help assist with the transition to independence. Adopting Sterling would give any new governance institutions time to establish credibility, and the new economic institutions (a Scottish Treasury, tax collection, fiscal monitoring/oversight agencies) time to develop effective institutional capacity.

It would also provide a stable environment to resolve negotiations on the division of public sector debt and assets. It would also give lenders certainty over the future value of debt repayments and would provide stable conditions for investment in the Scottish economy.

Frameworks of successful Monetary Unions

7.46 As highlighted above, the choice of currency has implications not just for monetary policy, but also other aspects of the macroeconomic framework including financial stability and fiscal policy (and vice versa).

7.47 There are a number of existing institutional structures and mechanisms in place for the Euro Area which continue to be developed. Given recent lessons from the Euro Area, a more carefully engineered framework would be beneficial for a Sterling Zone. These could be devised to build upon recent experiences in Europe.

7.48 Key institutional requirements for a robust monetary union are:

  • Commitment to common goals on financial stability and fiscal sustainability - with national institutions that share these goals;
  • Clear democratic accountability of supranational authorities;
  • The ability to manage systemic risk across the monetary union - requiring an integrated financial system, with elements of a 'banking union' that includes aligned prudential supervision and clear procedures for crisis management;
  • A clear framework to ensure fiscal discipline and credible commitments to adhere to fiscal sustainability, whilst providing national discretion to target instruments of fiscal policy to address key local challenges and to take advantage of new opportunities; and,
  • A commitment to promote cross-border competition and flow of factors of production (i.e. eliminate barriers to trade and factor movements) to not only drive innovation and improve competition but also facilitate the macroeconomic adjustment process. Wage and price flexibility can help facilitate changes in relative production costs and competitiveness.

7.49 Recent events in the Euro Area show that the initial framework for that monetary union was under-designed. The countries were not convergent in terms of economic criteria and as a result the framework was not sufficiently robust to mitigate or respond to significant economic or financial shocks.

7.50 This posed challenges for both financial stability and fiscal policy.

7.51 For example, the creation of the Euro led to moves towards closer financial market integration without there being a common approach to financial stability, supervision and crisis management. During the recent financial crisis, some of the instabilities that developed within the Euro Area were partly as a result of poor oversight of banks with significant cross border operations. A system in which responsibility for oversight of multinational financial institutions lie primarily with national governments is insufficient to safeguard financial stability [92]. The emerging proposals on Banking Union aim to address these shortcomings - see Box 7.04.

7.52 In response to fiscal imbalances in the Euro Area, the European Fiscal Compact has also been developed as part of the larger Treaty on Stability, Coordination and Governance. This is an intergovernmental agreement to abide by a set of pre-determined fiscal rules. Euro Area members must (and non-Euro Area states can choose to) introduce a legally binding correction mechanism that is automatically triggered if a Member States' deficit exceeds pre-determined limits or fails to converge within a pre-determined time frame.

7.53 It has been suggested that a currency union between Scotland and the rest of the UK could immediately lead to a Euro-style crisis. This is a false argument. Ultimately suitability to a currency union depends upon the unique structures of the particular countries and currency union in question. It is simply not a fair or accurate comparison to contrast a currency union between Scotland and the UK with that of a currency union with 17 members ranging in economic performance from Germany to Greece - see the discussion in the accompanying currency paper. Currency unions between economies that broadly share the same macroeconomic characteristics and have in place effective and well-designed structures and institutional frameworks can be successful.

7.54 An example - albeit not a model directly replicable in Scotland - is the Belgium and Luxembourg currency union (see Box 7.03).

7.55 Overall, a Sterling Zone currency union would be starting off from an institutionally and structurally stronger position compared to the Euro Area.

7.56 For example, both Scotland and the UK have experienced the same structural and institutional changes over time (e.g. labour market reforms, free capital markets). This has led to integrated and flexible product markets and relatively free movement of factors of production - important in responding flexibly to Sterling Zone economic events.

7.57 In the context of designing a monetary framework, many institutions are also already established. For example, a framework for managing day-to-day monetary policy exists (the 'Sterling Monetary Framework'); key financial infrastructure (e.g. payments and settlements system) is already established on a pan-UK basis; and financial supervision and oversight of banks and financial institutions which operate across the UK are already aligned.

7.58 As the following sections in this chapter outline, it is important to design effectively the foundations of supervision, resolution and deposit protection across a monetary union. This approach to financial stability is also an important foundation for sustainable fiscal and monetary frameworks to be successful.

Box 7.03: Belgium and Luxembourg Currency Union (i.e. BLEU)

The Belgium-Luxembourg Economic Union (BLEU) was established in 1922.

Luxembourg is now ranked as one of the richest countries in the world, with a nominal GDP per capita more than twice that of Belgium's [93].

Reflecting the considerable disparity of size (Belgium's population is roughly twenty times Luxembourg's), Belgian francs under BLEU formed the largest part of the money stock, and enjoyed full status as legal tender in both countries.

The BLEU framework demonstrates therefore that relative differences in country size and economic structure do not prevent successful monetary union. It was characterised by:

  • Monetary and Financial Stability.
  • Successful monetary union (between one larger country and one smaller one).
  • Fiscal freedoms within monetary union.
  • Coordination of monetary institutions (i.e. Belgian Central Bank and Luxembourg Monetary Institute).
  • Co-operation in key systemic risk areas (i.e. MoU on financial regulation).

Only Belgium had a full-scale central bank. However, this was supported by formal joint decision-making bodies.

Whilst both countries were in a monetary union, there were significant differences in the particular spending and tax policies adopted. For example, differences in the VAT rates which have persisted to the present day - standard VAT remains at 21% in Belgium and 15% in Luxembourg.

There were also significant differences in the corporation tax rates of Belgium and Luxembourg - for example, in the 1990's the central government corporate tax rate in Belgium averaged 40% compared to an average rate of 33% in Luxembourg. In 2012 differences still remain, the combined corporate income tax rate in Belgium is 34% compared to 28.8% in Luxembourg [94].

  • Implementation of Monetary Policy

7.59 In addition to deciding on the appropriate currency for an independent Scotland, new monetary arrangements would follow to deliver an effective monetary policy strategy.

7.60 If Scotland were to join a monetary union, these arrangements would be harmonised to ensure a consistent delivery of monetary policy across members.

7.61 For example, there is an established framework for the delivery and implementation of monetary policy across the Euro Area. This includes guidelines on the requirements of each member country to deliver the policy and wider objectives of the monetary system of the Euro Area, which Scotland would follow if it were part of the Euro Area.

7.62 Retaining Sterling would require establishing a new framework for delivery of monetary policy across the Sterling Zone. This should be relatively straightforward and be able to take advantage of institutions already in place and which currently operate monetary policy for the whole of the UK. For instance, as part of a formal monetary union, there could be continued use of a shared central bank.

7.63 Another option, including if there was a separate Scottish currency, would be to set up a central bank in Scotland. Within an own currency model, choices would also be made on the practical operation of monetary policy, including the remit of the central bank, its goals, objectives, transparency and accountability.

7.64 Alongside ensuring the smooth operation of the monetary system, a Central Bank for Scotland with its own currency would also be the responsible for other functions, such as the management of currency reserves and foreign asset reserves.

7.65 As part of the option of setting up a new Scottish Central Bank, the central bank could be capitalised using a fair share of existing Bank of England assets [95].

7.66 As highlighted in previous chapters, another important role for central banks, in conjunction with the relevant fiscal authority, is to act as the provider of liquidity to financial institutions operating in their jurisdiction.

7.67 Under independence, and with a separate Scottish currency, financial institutions operating in Scotland may require liquidity support and it would be the role of the relevant central bank to provide this support.

Financial Stability

7.68 Under independence, the Scottish Government would have the opportunity to judge the most appropriate framework for delivering financial stability for Scotland. Key decisions would be required in respect of supervision, crisis management, resolution and deposit protection.

7.69 Given the importance of financial stability to the global economy, there is important international context which needs to be considered as part of the design of a framework. For example, the UK Financial Services Authority have estimated that around 70% of their policymaking effort is driven by EU initiatives [96].

7.70 For an independent Scotland there would however, still be a wide range of institutional and regulatory options to be considered within these overarching parameters. Across the EU there is no single financial stability or regulatory framework model adopted by Member States. As will be set out below however, there are moves toward greater coordination and cooperation.

7.71 The emerging proposition for a macroeconomic framework, which is set out in Chapter 9, outlines a preference for financial stability to be coordinated across Scotland and the UK post-independence. However, as part of the development of this proposition full consideration has been given to the range of alternative options available.

7.72 As part of this assessment - and as discussed in the next section - it is important to recognise that a successful financial sector is of key importance to the Scottish economy both as a direct employer and through facilitating growth in the wider economy through the range of financial products and services it provides, including lending to businesses and households. However, because of the public good nature of financial stability, the sector requires effective and efficient supervision and oversight.

Scottish and UK Financial Services Sector

7.73 Scotland is home to a successful and diverse financial services industry with key international strengths across a range of activities including banking, asset management, pensions and insurance.

7.74 These institutions have significant presence across the UK. Their activities are therefore vital, not just for the Scottish economy, but the UK economy as a whole.

7.75 Scotland's share of GB financial services employment stood at 8.1% in 2011. The share of employment varies across subsectors. For example, there is a particular concentration of activity in the life and pensions in Scotland which accounts for 28.5% of total GB employment in the industry [97]. Scotland also continues to experience growth in the asset management sector - employment in the sector increased from 13,500 in 2010 to 15,600 in 2011.

7.76 Scottish companies have a prominent role in the market for personal current accounts (PCA's). For example, in 2010 it was estimated that Lloyds Banking Group [98]and RBS hold approximately 46% of all PCA's in the UK and around 35% of all mortgages. Key corporate and headquarter functions of these institutions are also spread across different parts of the UK. For example, RBS's investment banking arm is located in the City of London.

7.77 At the same time, institutions headquartered in other parts of the UK have substantial operations in Scotland and play an important part in the success of the Scottish economy. For example, commercial banks such as Barclays, HSBC and Santander have substantial operations in Scotland. New entrants to the financial services sector - such as Tesco Bank and Virgin Money - have also established a strong presence in Edinburgh and Glasgow whilst many insurance companies - such as Aviva - have major corporate operations in Scotland.

Chart 7.02: UK Market Share of Personal Current Accounts (2010)

Chart 7.02: UK Market Share of Personal Current Accounts (2010)

Source: OFT, Review of barriers to entry, expansion and exit in retail banking, November 2010 [99].

7.78 This provides important context for the design of policy to ensure financial stability in an independent Scotland. In particular, given the nature of the existing financial sector in the UK there would be a clear shared interest for both Scotland and the UK in maintaining a stable, integrated and well-functioning financial system across both countries.

7.79 In reality a future UK Government and central bank post-independence would have a major self-interest in the adequacy of supervisory arrangements for institutions based in Scotland and operating in the UK, and vice versa.

7.80 For example, the UK Government's support for RBS and Lloyds Banking Group in 2008 and 2009 was not, as some have suggested, a bail-out for the Scottish financial services industry. But instead it was part of a series of decisions designed to support the entire stability of the UK financial system (see Box 6.04).

7.81 This suggests that there are likely to be significant benefits for both Scotland and the UK from relatively close coordination of key aspects of financial stability policy post-independence. This would ensure effective oversight and guard against free-riding and burden shifting. Such cooperation is likely to be of benefit irrespective of the choice of currency or monetary system, although it is likely to be of greater importance in a monetary union.

7.82 Indeed such an approach would be consistent with the growing trend toward greater international cooperation between national authorities in the common interest of financial stability, particularly in the light of the increasingly global nature of modern financial markets and financial institutions (see Boxes 7.04 and 7.06).

Framework for Financial Stability

7.83 As highlighted in Chapter 5 and 6, certain aspects of financial regulation relate directly to macroeconomic stability. There are also other aspects of financial regulation, which include consumer protections issues. These elements will be considered further in future work by the Scottish Government. The focus of this chapter is on the main aspects which relate to macroeconomic stability.

7.84 In addition to a robust monetary framework to underpin the smooth operation of money markets and the efficient provision of liquidity, when considering the options available for financial stability this chapter focuses on the key aspects of financial stability policy:

  • Supervision and Oversight
  • Crisis Management, Resolution and Deposit Protection

7.85 As highlighted in Chapters 5 and 6, a number of these areas are currently under reform. For example, the UK Government is in the process of establishing a new regulatory framework while moves are afoot in Europe toward the establishment of a Banking Union (see Box 7.04).

Box 7.04: EU Frameworks and Banking Union

Prior to the financial crisis, each of the 17 Euro Area Member States had their own regulatory frameworks in place. The failure of regulators to monitor risks within individual institutions, and the subsequent potential contingent liabilities of the public sector, was a key driver of the sovereign debt crisis in a number of Euro Area countries.

It also became apparent that a number of financial institutions had significant cross-border operations and so required a co-ordinated response between national governments and regulators. In the light of both experiences, there is growing recognition of the benefits of greater international supervision and burden sharing.

In response, there have been a number of reforms related to financial stability policy in Europe. The European Commission is also developing plans for a Banking Union based upon four pillars [100]:

  • Single Rulebook - Three European Supervisory Authorities (ESAs) have been established to create a single EU rulebook. The European Banking Authority (EBA), European Securities and Markets Authority (ESMA) and European Insurance and Occupational Pensions Authority (EIOPA) will develop technical standards, and also issue guidance and recommendations. This includes a set of common standards for bank capital as provided by BASEL III.
  • Supervision - In December 2012, the ECB was formally tasked with the key role in the Single Supervisory Mechanism [101] for the largest Euro Area banks. National supervisors will undertake day-to-day operation of supervision activities for smaller institutions (subject to the authority of the ECB) but for the largest institutions authority will pass from national regulators to the ECB.
  • Deposit Guarantees - The EU requires that Member States offer deposit insurance set at €100,000 or the local currency equivalent. In 2010, the European Commission proposed a new directive to further harmonise the EU system of deposit guarantees.
  • Resolution - To avoid the need for future interventions that require taxpayer support, proposals for an improved framework for national resolution systems are being developed. The EU has proposed for a significant proportion of any cost to be borne by the private sector under a "bail-in" mechanism. In addition, the European Stability Mechanism (ESM) was established in September 2012 as a permanent mechanism for providing financial assistance to Member States for the purpose of re-capitalising financial institutions. Over time, the ESM may be able to provide support to Euro Area banks directly.

7.86 The Working Group believe that it is essential for any proposed macroeconomic framework for Scotland to be consistent with such trends - and be sufficiently flexible - to be able to respond to emerging developments at the EU level and internationally. Indeed it is highly likely that by 2014, the landscape for financial stability - and in particular the degree of cross-border cooperation - will have changed dramatically.

Supervision and Oversight

7.87 As part of the macroeconomic framework, an independent Scotland would be required to establish a framework which ensures the effective regulation of financial institutions.

7.88 Working Group members have considered a range of options as part of the process to develop the proposed framework that is detailed in Chapter 9. In this regard, the options considered in this chapter assume that an independent Scotland remains a member of the European Union. Therefore, it is important to note that in order to meet financial supervisory and regulatory roles, EU Member States are required to designate one or more competent authorities to oversee financial regulation.

7.89 There are a number of institutional structures and arrangements that Scotland could adopt to achieve this.

7.90 Indeed, it is evident that there is no definitive or universal definition or model for financial supervision and oversight. Arrangements to maintain financial stability vary significantly, for example:

  • Countries can use different institutional and technical structures such that financial services regulators can have different roles and objectives.
  • There is no optimal regulatory framework, although there is consensus that a greater focus on total system risks is needed and that the bodies regulating them should be independent of government.

7.91 The exact design of the operational independence of the regulators from government is also a key factor that can vary between countries as set out in Box 7.05.

Box 7.05: Considerations for Establishing Financial Sector Regulators [102]

Government has a role in setting and defining regulatory and supervisory goals. However, once a framework is in force, there is a general consensus that regulators should be free to determine how to achieve these goals - and should be accountable for delivering them. The IMF identify several key forms of independence:

  • Regulatory independence - Authorities that are able to set regulations independently are more likely to be motivated to enforce them. They are also able to adapt the rules quickly and flexibly in response to changing conditions in the global marketplace.
  • Supervisory independence - Supervisors should work closely with financial institutions, inspecting and monitoring them and also enforcing sanctions.
  • Institutional independence - Clear rules must govern the appointment and dismissal and tenure of senior personnel. Decision making should be open and transparent.
  • Budgetary independence - Senior personnel should have the budgetary freedom to staff the agency as they see fit and to respond quickly to emerging agency needs.

7.92 The institutional arrangements put in place as part of a framework would need to ensure that regulators were independent, but accountable to government. Within this, there are a range of structural arrangements for the regulation and oversight of financial institutions that Scotland could adopt. These can be broadly classified into four main types of regulatory structure: Institutional, Functional, Integrated and Regulation by Objective (i.e. 'twin-peaks') [103]. The main distinction between these structures is the approach used to allocate regulatory and supervisory tasks to different authorities.

7.93 For example, an institutional approach is one in which a regulated firm's legal status - i.e. a bank or insurance company - determines which authority is tasked with overseeing its activity. This contrasts with a regulation by objective approach where regulatory activities are grouped by the type of regulation (i.e. prudential or conduct regulation) but discharged by a single authority across the entire industry regardless of the type of financial institution.

7.94 The Working Group acknowledge that when considering the options for a regulatory, supervisory and oversight structure appropriate for an independent Scotland, consideration should be given to the impact on financial markets, institutions and regulatory environment that already exist in Scotland.

7.95 Given the close linkages between macroeconomic stability and financial stability, and consistent with the moves toward 'Banking Union' in the EU, the members of the Working Group believe that it would be beneficial for supervision and oversight (e.g. microprudential regulation) to be broadly co-ordinated with other partner countries (principally the UK), irrespective of currency choice. In reality, given the inter-linkages with the UK and European financial markets the opportunities to offer a different and distinct approach are likely to be constrained and of limited benefit.

7.96 Such an approach would ensure that systemically important institutions which operated across both Scotland and the UK were regulated and supervised on a common and consistent basis. This would be in the shared interest.

7.97 There are in theory a variety of different ways through which this regulation could be delivered institutionally. For example, an independent Scottish regulator could be established with its actions and activities aligned with those of the regulator in partner countries.

7.98 In the context of a Sterling Zone framework, the Bank of England would be best placed to coordinate significant microprudential regulation. This could be discharged directly by the Bank on behalf of the Scottish Government or by a Scottish Monetary Institute working in partnership with the Bank. In a monetary union, macroprudential regulation also requires broad alignment given its increasingly important role in providing a valuable additional tool for promoting macroeconomic stability alongside monetary policy. In the context of the Sterling Zone, the Bank of England could continue its role in this regard. In time, there may be scope to consider options for spatial variation of macroprudential regulation.

7.99 With an independent currency, macroprudential regulation could be undertaken by a Scottish central bank.

7.100 Other areas of financial regulation (i.e. non-prudential elements), such as consumer protection and other conduct of business regulation, also contribute to a stable and well-functioning financial sector. The institutional arrangements for the discharge of these functions in Scotland could also take a number of forms.

7.101 In the context of a monetary union with the UK, these functions could be discharged by a Scottish office of a Sterling Zone regulator or discharged by a separate Scottish financial regulator. Even under alternative currency options, there are likely to be benefits from a coordinated approach with key partners such as the UK and EU, which partly reflects the opportunity for firms to operate across the EEA.

7.102 Ultimately, the extent to which there is a common-rule book applied across these regulatory functions will be a key consideration when choosing the most appropriate approach for Scotland.

Crisis Management, Resolution and Deposit Protection

7.103 As highlighted in Chapter 5, in addition to supervision and regulatory issues, a successful macroeconomic framework needs to enshrine an effective crisis management, resolution and deposit protection.

7.104 An independent Scotland would need to consider carefully these arrangements given the well-developed financial services sector, links to the rest of the UK and the potential contingent liabilities to the public sector. A number of options would be available for Scotland.

7.105 Important lessons are being drawn from the financial crisis and these are shaping improvements to both crisis prevention and crisis management tools. In many countries, governments and regulators are introducing new frameworks that should be better able to respond to a developing crisis. Members of the Working Group recognise that Scotland needs to learn from these experiences, this is reflected in the preferred framework, which is set out in Chapter 9.

7.106 Serious financial crises require close coordination of monetary, fiscal and financial stability policy. The choices available to Scotland will therefore depend upon the nature of the macroeconomic regime adopted post-independence and the architecture of its institutions.

7.107 New tools are now emerging to deal with the effective resolution of financial institutions at risk of insolvency. For example, the Dodd Frank Act (US) includes powers to 'bail-in' and a similar approach has also been set out as part of emerging EU proposals.

7.108 In the context of crisis management and resolution, a number of options would be available.

7.109 Under the option of Scotland having its own currency and monetary policy framework, the Scottish fiscal authority and central bank would be required to set up a framework to provide liquidity to financial institutions. In doing so, they could work with other central banks internationally to provide support to cross border banking groups. Scottish authorities would also require an effective resolution mechanism for failing banks. The working group members note that, given the complex structure of the financial services sector, emerging international trends, and shared self-interest, cross-border cooperation would be beneficial to both Scotland and the UK even if separate currencies were used.

7.110 In a monetary union with the UK, key design options would still exist and some would require negotiation, these include:

  • the mechanism and process for central bank and public sector intervention;
  • the arrangements for any burden sharing agreements between the fiscal authorities for cross-border institutions; and
  • other emerging aspects of resolution - including the potential to use bail-in procedures (i.e. some of the burden of the recapitalisation placed on bond and shareholders).

7.111 The principle of such an arrangement could build upon the UK Banking Act 2009 and reflect the integrated nature of the current financial services market in the UK. This could include decisions on which resolution tools to use and referring decisions on temporary ownership to both fiscal authorities. The swift resolution of such decisions is vital and would need to be facilitated - see for example the proposed Macroeconomic Governance Committee in Chapter 9. Such an arrangement would be consistent with the motivation of a coordinated supervisory and oversight arrangement.

7.112 Irrespective of the exact arrangement - and both within a monetary union and outside - there is a growing recognition that given the increasing importance of multinational institutions and moves to better align supervision across borders, crisis management and resolution issues should be coordinated on a supra-national basis.

7.113 In the context of Scotland this is important. Institutions which pose a systemic risk to Scotland are also integral to the entire UK system - and vice versa. The Working Group believes that the design of a framework should reflect this shared interest in financial stability. It should ensure that nation states contribute to the potential costs in a fair manner to reflect the shared benefits of financial stability.

7.114 Members of the Working Group believe that the final design for crisis management, resolution and deposit protection in an independent Scotland should take on board the trends in international coordination - see Box 7.06 for a summary of some recent developments. This is reflected in the proposal set out in Chapter 9.

Box 7.06: Trends in International Coordination

International regulations are becoming increasingly important given the inter-connectedness of national economies and the global financial system. With multinational institutions and open markets, there is a growing recognition of the need to consider a common approach to financial regulation, if stability in the global economy is to be ensured.

There have been a number of developments in recent years. For example, the Financial Stability Board (FSB) [104] set up by the G20 aims to advise and coordinate policy on a wide range of regulatory topics. Membership includes monetary authorities, regulators and supra-national institutions such as the IMF, ECB, BIS and World Bank.

In Europe, closer financial regulation is seen as pivotal to helping resolve the crisis in the Euro Area. The European Commission has recently published its vision for a Banking Union (see Box 7.04).

There is also emerging evidence of greater bilateral cross-border co-ordination. For example, the Bank of England and the US FDIC have recently set out their approaches to future crisis management, including consideration of cross-border institutions that operate in both countries [105].

7.115 The final design option considered by the members of the Working Group is the arrangements for deposit protection in an independent Scotland.

7.116 An independent Scotland would be required to have in place an officially recognised scheme to provide deposit protection and investor compensation.

7.117 There are a number of approaches in place across countries in respect to the design and funding of such schemes. Box 7.07 provides a summary of existing deposit protection schemes in a number of countries. Under independence, the Scottish Government would have an opportunity to put in place a system that best reflected Scottish circumstances, and the nature of the financial services industry. It would also reflect decisions taken in other areas such as the arrangement put in place for regulation.

7.118 As a member of the EU, deposits would for example be guaranteed up to the equivalent of 100,000 Euros.

7.119 The range of international approaches to deposit protection highlights that while there is consistency around the general principle underpinning deposit protection, the institutions and mechanisms to deliver this protection can vary.

7.120 Regardless of the design option adopted in an independent Scotland, key considerations for the Scottish Government would include: the mandate or remit of the scheme; the scope of its powers; governance arrangements; funding mechanism; and coverage of the scheme.

7.121 As part of a formal monetary union, and a common approach to supervision of banks which are systemically important across the Sterling Zone, an independent Scotland could seek to establish arrangements that allow the continuation of a shared scheme across the Sterling Zone. This would be subject to negotiation. It would however, place a lower administrative burden on financial institutions, would offer economies of scale and guard against free-riding.

Box 7.07: Deposit Protection - International Context

Countries approach deposit protection in a variety of ways. Differences exist with regards to the exact responsibilities of particular schemes, as well as the mechanism through which they are funded [106].

UK - The Financial Services Compensation Scheme (FSCS) insures retail deposits up to £85,000. The FSCS is funded by an ex-post levy, which is collected from the financial sector depending upon the amount required each year.

US - The Federal Deposit Insurance Corporation is responsible for the guarantee of deposits in the US. Each retail depositor is insured to at least $250,000. The scheme is funded by premiums levied ex-ante on financial institutions. The FDIC acts as the receiver and liquidator of failed banks and other systemically important financial institutions.

EU - There is not yet a common EU-wide system of deposit protection, but the EU requires Member States to have one or more schemes in place to provide coverage, set at €100,000. The specific design of each scheme currently differs between Member States. However, deposit protection makes up one of the four pillars of the proposed Banking Union and there is also a clear direction of travel toward greater harmonisation of national schemes [107]. It is envisaged that any new approach will be funded by ex-ante levies applied to participating institutions and that national authorities will work more closely together - including through the provision of lending and borrowing between themselves to fund potential shortfalls. The proposals also state that schemes can be merged across countries.

7.122 An independent Scotland would also have the option to establish its own scheme. As outlined in Chapter 6, there are a complex business structures in place across a number of Banks in the UK. Members of the Working Group, believe that as a result of the complex organisational structure of many of the financial institutions operating in Scotland and the UK, a joint scheme would be the more attractive option, and would be in the interests of both Scotland and the UK. However, alternatives are clearly possible and if they were to be considered would not undermine the proposals in other areas.


7.123 Following independence there would be an immediate choice to either be part of a monetary union or to establish a separate Scottish currency.

7.124 There are a variety of economic factors which are worthy of consideration when assessing the merits of currency options open to an independent Scotland.

7.125 The choice of currency, by dictating both the fundamental structure of the monetary framework and the relationship with other countries, will also have implications for decisions over the overall shape of the public finances and financial stability.

7.126 The international financial crisis highlighted a number of deficiencies with the existing regulatory framework in the UK and internationally with respect to overall financial stability.

7.127 One of the clear lessons of the financial crisis has been that the previous arrangements for regulation and stability were inadequate. The future design of financial regulation, crisis prevention and crisis management will increasingly need to take into account the international context, and reflect the need for cooperation between national authorities in the common interest of financial stability.

7.128 It is highly likely that - post-independence - the design of a regulatory framework would reflect the Scottish and UK common interest in financial stability. Part of this could include discussions around shared-interests in cross-border supervision of major institutions and possible intervention frameworks.