Scottish Affairs CommitteeWritten evidence submitted by John Kay


If Scotland had been independent in 2008, and events in the banking sector had evolved in a similar way, there would have been three broad categories of action available to the Scottish government:

The support option: the Scottish government would guarantee most or all of the liabilities of Scottish banks.

The internationalist option: the Scottish central bank would take the lead in an international support operation for these banks.

The resolution option: the companies would go into some form of administration while the Scottish government took control of their retail and commercial activities within Scotland.

Although the head offices of both banks were in Edinburgh, both had substantial activities elsewhere. Only about one in six of the more than 200,000 employees of HBOS and RBS worked in Scotland, and both employed more people in England than in Scotland. Any government faced with the collapse of banks whose head offices are located within its territory, but whose activities are mostly located outside it, faces similar.

Ireland adopted the first option, of guaranteeing all liabilities, and it was a mistake. Certainly it is not a decision which could responsibly have been made in Scotland. The liabilities of the two Scottish banks amounted to about 30 times Scottish GDP, or almost three-quarters of a million pounds per inhabitant of Scotland. Both these figures are substantially higher than the corresponding figure even for Iceland. Not only do most inhabitants of Scotland not have three quarters of a million pounds, but they do not expect to earn three-quarters of a million pounds in the course of their lifetime. The rationale of such support is even less persuasive in the Scottish case. As in Iceland (and in contrast to Ireland) the activities which led to the collapse of the Scottish banks mostly took place outside the country.

Once the scale of the problems faced by the Scottish banks become evident, the Scottish government’s guarantee would simple not have been credible. Markets would have asked whether Scottish taxpayers would be willing or able to meet the potential liabilities. They would not have been readily convinced that political support for such action would continue even if Scotland had the capacity to meet these obligations. The 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 would have had to seek international assistance, or abandon its pledges.

Of course, there are assets on the other side of the balance sheet, and assets of better quality than those on the balance sheets of the Icelandic banks. But not only could the Scottish government not have known, even approximately, what their assets were worth, it is now evident the banks themselves did not know, even approximately, what these assets were worth. Senior executives of HBOS and RBS continued to give Panglossian accounts of their situation—evidently in good faith—until they were removed from office. The quality of Lloyds’ due diligence on HBOS appears to have been execrable although Lloyds had greater capacity to undertake such diligence than any government, more time, and more incentive to do so.

But the central point is that a 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 explanation of why a Scottish taxpayer should pay off foreign institutions which made loans to ABN-Amro. The size of the liabilities of the Scottish banks makes the absurdity of such an assertion particularly clear. But it does not matter whether the denominator of the calculation 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. The support option would have been extremely risky, was almost certainly not sustainable, and could not in any event have been justified to Scotland’s taxpayers.

The specific nature of the second option, the international alternative, depends on the monetary arrangements adopted by an independent Scotland. The logic of independence might point to a freely floating Scottish currency. The experience of small European countries which have followed this route, such as the Scandinavian states which remain outside the eurozone, is that there is a strong de facto link to European monetary and exchange rate policy.

The experience of Iceland illustrates the extent to which vulnerability is the corollary to freedom of action. Iceland considerably aggravated its difficulties by failing to accept advice or practical help from other Nordic countries until its crisis was unmanageable. There are serious limits to the reality of economic independence in a global world.

An independent Scotland might have broken the link to sterling and joined the eurozone. The Irish comparison offers a mixed verdict. Ireland’s link to the euro and particularly to European interest rates contributed substantially to the inflationary boom in Ireland during the years up to 2007. But after the virtual collapse of the Irish banking system in the autumn of 2008, the resources of the European Central bank, and the implied support of European institutions, put Ireland in a stronger position as a eurozone member than if the country had enjoyed monetary independence. But the cost of European support was a serious loss of autonomy, as the new Irish government elected in 2011 would soon learn.

Probably the best alternative, and probably also the likeliest, is a continued monetary union with England. A Scottish peg to the pound sterling might be an informal arrangement. For many decades following Irish independence, that country linked its currency to the pound sterling in this way, effectively bound by UK monetary policy but playing no part in its formulation. But an informal peg would leave Scotland almost as vulnerable in the event of a specifically Scottish crisis—such as the collapse of Scottish banks—as with a freely floating currency.

An alternative possibility involves a formal monetary union with England. The specific institutional arrangements for this would no doubt have been negotiated as part of the overall discussions surrounding any independence settlement. Plainly, if there were such a monetary union, there would also need to be some kind of growth and stability pact. An English government would not in future be likely to agree to enforcement mechanisms as ineffectual as those of the European Growth and Stability Pact. Although a formal monetary union might offer some Scottish influence—probably slight—on the monetary policies of the currency union, the price is a significant loss of the fiscal autonomy which might be an aspiration of independence. Of course, the apparent loss of political freedom is only an acknowledgement of the limited economic autonomy available to a country whose principal trading partner is its much larger neighbour.

If Scotland pursued the internationalist option within a British monetary union it would have been to London and Washington, rather than Brussels and Frankfurt, that the first calls would have been made when the Scottish banks faced failure. 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 might reasonably have been asked to explore a support operation in which the US and English governments took the principal role.

In the circumstances of October 2008, it is likely that willingness to provide such support would have been forthcoming. That is not, of course, the same as saying that it would have proved possible to reach an agreement. In the most closely analogous case—the collapse of Fortis, the equally unhappy partner of RBS in the ABN-Amro takeover—an agreement between the governments of Belgium, the Netherlands and Luxembourg to provide support fell apart when the scale of the losses became apparent. The Dutch and Belgians took unilateral action to assume control of operations in their own countries, and the dispute was acrimonious. The failure of Fortis led to the fall of the Belgian government—not, it should be acknowledged, an infrequent occurrence.

The funds provided to Fortis by the national governments and the proceeds of sales of divested units were, however, sufficient to enable the holding company to remain solvent. The liabilities of the wholesale creditors of the bank were therefore discharged and insolvency avoided. But Fortis was predominantly a retail financial institution and its wholesale liabilities were not remotely on the scale of those of RBS.

That draws attention to the third option available. The resolution option is the default option—it is the one that will follow if there is no unilateral bailout (the support option) or international agreement (the internationalist option). Understanding the consequences of the resolution option is therefore necessary to determine how much effort, if any, should be devoted to pursuing the alternatives.

In the case of RBS and HBOS, resolution would imply that the Scottish Government would take control of the Scottish retail and commercial 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.

The English government would have had the option of acquiring the investment banking and trading operations of the Scottish bank. Such an option might be exercised through emergency legislation in England, purchase from the administrators, or an immediate offer to the holding company. The Scottish government would have a similar option, though it would have been extremely foolish to have exercised it. It would also have been extremely foolish for the English government to have exercised that option, but perhaps more likely that it would. There would have been strong pressure from the international financial community to follow that course.

Even if Scotland had been part of a monetary union with England, there could—and probably would—have been a distinct Scottish regulatory authority. The issues of monetary policy and financial regulation are substantially separable. In this scenario, although the Bank of England would have retained responsibility for the monetary policy of an independent Scotland, neither the Bank nor the FSA would have exercised a regulatory role north of the border. Regulation in Scotland would, however, have to be undertaken in an international and European context.

Would an independent Scotland regulatory authority have managed matters better than the United Kingdom’s FSA? There are two conflicting considerations here. Small countries are more vulnerable to what is often called crony capitalism. The business and political elite consists of a limited number of people, who know each other well. There is a perception of common interest. In many respects this community of interest is valuable—homogeneity of outlook and informality of process can be a competitive advantage in business, and small European states have derived economic benefit from it. But in both Iceland and Ireland the links between politics and finance were certainly inappropriate if not actually corrupt. Crony capitalism contributed centrally to the financial crisis in both countries.

It is hard to believe that Scotland would have entirely avoided similar dangers. The palpable—and 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. Nor would such an involvement have been wholly a bad thing. But it would almost certainly have been a bad thing when regulatory action to constrain excessive risk taking or to discourage unduly ambitious acquisitions was required. Excess of ambition and willingness to accept risk was characteristic of both major Scottish banks in the years before 2007.

There is, however, an opposing consideration. Some countries were more effective than others in anticipating and restraining excess in their financial services industry. Many of the states who achieved this are small, and Australia and Canada are conspicuous among them. The more restrictive and conservative stance of financial services regulators in these countries was one differentiating factor. Scotland might plausibly have been more like Australia and Canada than England or the United States.

But the issue is complex. The regulatory stance is not exogenous. Regulatory capture—the tendency of regulator to see the industry through the eyes of the principal firms in the industry—is endemic in financial services. If Britain and the United States got the regulation the City and Wall Street wanted, Canada and Australia got the regulation Toronto and Melbourne wanted. Regulation in these countries bolstered what was already a more conservative banking culture. The influence of retail bankers on conglomerate banks in Canada and Australia was much greater than in the UK where American investment banks, and other banks which had adopted their culture, have been the dominant force.

It is certainly possible that Scotland might have been more like Canada and Australia, and that a relationship between regulators and bankers might have sustained the traditionally more conservative Scottish financial services culture in the face of international and market pressures in the years up to the crisis. We do not know. We do know that distinguished boards of RBS and HBOS failed to restrain excessive ambitions and risk taking on the part of senior executives mostly drawn from that Scottish banking tradition. A Scottish regulatory authority might have done better but there is no compelling reason to think it would.

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. This view has been canvassed since the events of October 2008, and the crisis of the Scottish banks has substantially damaged the cause of Scottish independence among thoughtful people in Scotland and outside it.

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. But although the UK government was able to do what it did, the UK government did not need to do it, should not have done it and should certainly not do it again.

RBS and HBOS, like other financial institutions, received support from the UK government because these organisations were viewed as “too big to fail”. But neither a democratic society nor a market economy can contemplate private sector organisations that are “too big to fail”. Such a company represents a concentration of unaccountable private power, answerable neither to an electorate nor to a market place.

And “too big to fail” destroys the dynamism that is the central achievement of the market economy.

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. 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 it can be tackled in other ways.

Limits on the size of banks are urged by some, but it is more important to limit their scope than to limit their scale. Financial conglomerates are riven by clashes of culture and conflicts of interests: contagion within institutions has meant that failures in relatively small parts of their operations have jeopardised the survival of the entire company. The government guaranteed retail deposit base has been used as collateral for speculative trading in wholesale financial markets.

Far from making financial conglomerates necessary, financial innovation has reduced the necessary size and scope of banks by establishing active markets in risk and maturity transformation. These developments mean that diversification need no longer be managed within a single institution. Financial innovations are capable of reducing substantially the risks associated with retail banking, but have been used inappropriately to bring about precisely the opposite result as the wholesale operations of banks have not only assumed but magnified the risks that their retail arms have discarded.

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. Retail banking should return to a conservative model. Risk-taking activities should be undertaken only by people who not only have skin in the game—who share losses as well as profits—but who derive capital, both debt and equity, from external investors who have a direct commercial relationship with the risk takers. The history of financial services in Scotland since the eighteenth century has been one in which a reputation for prudence has been no obstacle to ambition. The events of recent years, in which ambition ran ahead of prudence, proved in the long run to damage rather than to enhance competitive advantage.

But the banking crisis and the 2007–08 crisis more generally does illustrate the limits of the economic independence or autonomy which Scotland—or any small country—can enjoy while it participates in a global trading environment and capital market. Scotland will inevitably either be part of an explicit currency union, or at least have its currency formally or informally linked to the currency of larger states. Such linkage has implications not only for monetary policy, but also for policy towards the financial sector and inevitably involves restrictions on fiscal policy as well. But the banking crisis neither strengthens or weakens the case for greater autonomy or independence for Scotland.

February 2012

Prepared 4th May 2012