To be published as HC 140-xvii

House of COMMONS




the referendum on separation for scotland

wednesday 26 February 2014

owen kelly and iain macneil

mark neale and sean martin

andrew bailey

Evidence heard in Public Questions 4583 - 4861



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Oral Evidence

Taken before the Scottish Affairs Committee

on Wednesday 26 February 2014

Members present:

Mr Ian Davidson (Chair)

Mike Crockart

Jim McGovern

Graeme Morrice

Pamela Nash

Sir James Paice

Mr Alan Reid

Lindsay Roy


Examination of Witnesses

Witnesses: Owen Kelly, Chief Executive, Scottish Financial Enterprise, and Iain MacNeil, Alexander Stone Chair of Commercial Law, University of Glasgow, gave evidence.

Q4583Chair: Gentlemen, could I welcome you to this meeting of the Scottish Affairs Committee? As you know, we are conducting a series of inquiries into the potential impacts of separation on Scotland. Today, we are looking at the impact on Scottish financial services. Perhaps we can start off by asking you to introduce yourselves and, for the record, indicate your background.

Owen Kelly: I am Owen Kelly, chief executive of Scottish Financial Enterprise. We are the membership representative body for financial services in Scotland. Our member companies come from all sectors of the industry and also from industries that support the financial services industry.

Iain MacNeil: I am Iain MacNeil. I am professor of commercial law at the University of Glasgow. Before I became an academic, I worked for about 10 years in the banking and investment sector.

Q4584Chair: To set the context, perhaps you could tell us very briefly how significant the financial services sector is in the Scottish economy, and also what are the main components of that sector.

Owen Kelly: In terms of employment, we as an industry employ roughly 100,000 people in Scotland. There are roughly another 100,000 whose jobs depend on the financial services industry, so we are a big employer. We contribute between 7% and 8% of GDP, which is quite a big slice, and we are the fourth largest centre for investment management in the EU after the UK, France and Germany. Scotland is fourth. That reflects the strength of our asset management sector, which is very, very successful, and internationally recognised.

The other important sectors for our industry are life and pensions. Roughly, one in four jobs in the UK pensions industry is in Scotland, so we are a big part of the UK pensions industry. Asset servicing, which is predominantly done by large international financial institutions, is a big slice of the industry, and a big success in recent years. Scotland is the UK’s centre for asset servicing, so again it is a big and important part of the overall UK financial services industry. Our professional services-accountancy, banking and so on-are also a key part of the overall ecology, if you like, of the industry, and serve clients throughout the UK and internationally. I am summarising quite a lot here. Of course, there is then banking. Of all the sectors of our industry, banking is the largest employer. That is a quick overview from an industry perspective.

Iain MacNeil: I have perhaps only one point to add from a consumer perspective. The majority of the consumers would be outside Scotland, predominantly in England. Some are in Europe, but we have not had as much branching and passporting business as was originally envisaged in the European model, so there is a big focus on exporting into the English market.

Q4585Chair: Could you give an indication of what you believe are the reasons for Scotland’s success in the financial sector? Why are we so good? Is it to do with location, and what in particular about location? What are the relative strengths of the Scottish end of this industry?

Owen Kelly: Scotland has been a successful international financial services centre for about 300 years, so the pedigree, or history, of the industry in Scotland is certainly an attractive factor for a lot of international investors. In the modern world, perhaps putting the history to one side, what we hear from our members in terms of the attractiveness of Scotland as a place to do business is that it is the skills, the legal and regulatory frameworks-of course, these are UK frameworks-and equally being in the same regulatory and legal frameworks as the largest financial centre in the world, which is London. Clearly, that is a good thing and a good situation to be in. Many international investors and other businesses can operate from Scotland, and yet participate fully in the jurisdiction that contains the largest financial centre in the world.

The other important factor for those investing in Scotland and setting up new businesses in financial services in Scotland is the supply of talent we get through the universities, and having professional bodies like the Institute of Chartered Accountants in Scotland and the Chartered Institute of Bankers in Scotland, both of which, incidentally, are the oldest of their kind in the world. We have an infrastructure of knowledge and a history of having that infrastructure that is very attractive to new investors, and a very good reason for companies operating in Scotland to succeed.

Iain MacNeil: I do not have much to add to that.

Q4586Mike Crockart: Is it as simple as the fact that there is a symbiotic relationship between Scotland’s financial services sector and London’s? Is it the regulatory framework that overpoweringly makes Scotland successful in this?

Iain MacNeil: I would be careful about attributing Scotland’s success to regulation in a general sense, because I do not think regulation is necessarily what drives success. Regulation can hold back the success of a particular country, but I am not sure that regulation in itself makes for international success. Specifically in the UK context, it has been important for Scotland to be integrated into the UK framework and, probably more significantly in recent times, into the European framework, because so much of the entire UK framework is coming down from Europe.

Owen Kelly: I agree with that, but would add only that, although what Professor MacNeil said about the customer base being mainly in the rest of the UK is entirely true, for a good number of our members almost all of their clients are overseas in some cases. They are serving clients in markets all around the world, not through London, so many of the relationships are direct, but the jurisdiction that the foreign entity is dealing with in regulatory terms is the UK jurisdiction. One aspect of that is the UK’s network of double taxation treaties. Double taxation treaties for companies running operations anywhere in the UK are important, because that affects how their profits are taxed. I think it is generally accepted that the UK has arguably one of the best networks of international double taxation treaties in the world. That is one of the aspects of the tax and regulatory structures that support international business. The UK is widely perceived to be one of the best.

Q4587Mike Crockart: Can I probe you a little further on that? You seem to be suggesting that the European dimension in regulation is potentially more important than the UK dimension. Equally, earlier you said that we have a single market across the European Union, yet the trade in financial services products between the UK and Europe does not seem to have followed that.

Iain MacNeil: I may need to clarify. I think you can analyse the European influence in two aspects. One is what you might call the trade flows in terms of business being done. It is true to say that the cross-border trade flows have not been as great as was originally envisaged when the single market was established. The second aspect is: where do the rules come from? Predominantly, nowadays, the rules come from Europe. That is why I think there is a slightly different picture depending on how you look at Europe as between flow of business and source of rules.

Q4588Chair: Why do you believe that the trade flows are not as big as was originally anticipated? Is this just the EU being oversold, or are there other reasons?

Iain MacNeil: The EU set up what it referred to as a passporting system, which would enable firms authorised in one member state to do business in another without setting up a local subsidiary. The experience over time has been that it was more difficult to do that than was originally envisaged, for a range of reasons, for example, related to conduct rules and compliance with those rules. Over time-this is looking back 20 years-we have not had the growth that was envisaged in that segment. That has meant that the business that is done has tended to be on more of a local subsidiary basis-locally established companies.

Owen Kelly: From a company or provider perspective, one of the big drivers is also the tax environment of the jurisdiction into which you are selling. For example, if one is purchasing a long-term savings product or pension in the UK, one probably would not purchase it from a company regulated in Ireland, because the tax system is different and the product will not be correct. The products tend to be determined by the tax environment. This is still at member state level across the whole of the EU. The EU single market is still very much a patchwork, and it is not routinely the case that people buy products, particularly at retail level, from outside their own jurisdiction. For example, one of our members has a UK and Ireland business unit, but of course it has to provide separate products for Ireland and comply separately with Irish regulation. It has to recognise the distinct nature of the market it is operating in, and that market is constructed largely around tax and regulation.

Q4589Mike Crockart: On that point, can we assume that regulation and tax more widely are pretty much the same across Scotland’s financial services and the rest of the UK’s financial services, as it stands at the moment?

Owen Kelly: As it stands, we are one jurisdiction, so it is the same tax code. All of that is reserved to Westminster anyway, and financial regulation is a UK-wide thing, so it is a wholly single market. You can sell exactly the same product in Penzance as you can in John O’Groats.

Q4590Mike Crockart: That is really what gives it the success it has in the UK.

Owen Kelly: From a provider perspective, that is a market of 70 million-odd people, and it is one market.

Iain MacNeil: It avoids the complications that arise with the example of, say, selling into Ireland or another European country.

Q4591Mike Crockart: It is the only true single market in the European Union.

Iain MacNeil: The single market is a misnomer as far as financial services are concerned. It has not really happened.

Q4592Graeme Morrice: Good afternoon, gentlemen. We are looking into the whole issue of financial services in Scotland, if indeed Scotland was to vote for independence. What would you see as the advantages and disadvantages to the Scottish financial sector if Scotland went independent?

Owen Kelly: It seems fairly clear that, if Scotland becomes a separate country and a separate jurisdiction for tax and regulatory purposes, the current market we have just been discussing, effectively, for financial services purposes, becomes two markets. That then introduces a requirement to have a new regulator-a Scottish regulator. We do not think that is optional. I think everybody would agree that that is part and parcel of fulfilling your obligations as an EU member state and in many other contexts. You have to have a new regulator, and that will be so for most but not all cases. If you run a business where you do not have any UK clients or customers, you might see that as replacing one regulator with another, but I venture to suggest that probably all of our members will have customers in England, and in the rest of the UK. They will still need to be regulated in the rest of the UK by the Financial Conduct Authority and the Bank of England in order to continue to serve those customers. In addition, they will need to deal with the new regulator in Scotland. It is hard to see that that is going to be anything other than a straight additional cost and complexity. That is one change that seems to be a necessary and inescapable consequence of independence, which is going to be paid for ultimately by customers and by the companies in the financial services industry. We have already discussed separation of the two markets and the complications and costs that brings.

The other factor we are very conscious of is that the nature of the debate is such that none of the questions business would really like to know the answers to can be answered until after a yes vote, if there is one. If there is a yes vote, we then begin a period of time. The duration is uncertain, although I respect the Scottish Government’s statement that it would all be done and dusted quite quickly, or certainly within an 18-month period. There are other views on that, but, even if you accept that 18-month period, it is a period when questions such as what currency we will use and many other things will still not be resolved, so, following a yes vote, inevitably we seem to have to deal with a period of transition and uncertainty. Some of that, which we may or may not come on to, will relate to membership of the European Union and all sorts of other things. These are some of the inevitable consequences of a yes vote.

In terms of independence, if one looks ahead a few years beyond the transition period to some steady state where everything has been negotiated and Scotland is a separate country, I think the predominant change-I guess that by then the industry would have had to reconfigure-would be the market. You would then be a separate, smaller jurisdiction and that would put you in a different place from what we are used to. That is an inevitable consequence of becoming a separate country.

In terms of opportunities, it is not easy to see that any opportunities arise simply by dint of becoming that separate country. It is possible to hypothesise-some people do-that you might in that steady state future have a more effective regulator. Perhaps it could be a better regulator than we have. It might be that you could have a better tax environment. It is possible to imagine a world where the tax environment is better; perhaps one could invoke comparisons with Luxembourg, Switzerland or whatever, but all of that has to remain in the future. We cannot know if any of it would materialise, and it would probably take a while to establish, and for reputation to grow and so on, to reap the benefits.

Having said all that, you would have to counterbalance it against the fact that some of the jobs in our industry are serving UK customers. It is an open question whether you could continue to do that from a separate jurisdiction. There are so many unknowns, but at the moment it is difficult to see, simply in terms of the institutional changes that become necessary, anything other than more cost and complexity.

Q4593Graeme Morrice: That is very useful. One of the fundamental issues would be whether there would be a currency union, and whether Scottish-registered banks would be able to depend on the Bank of England as lender of last resort and so on. We will probably come to those issues in due course. Iain, would you like to respond to my substantive question?

Iain MacNeil: Owen has covered a lot of the issues. Perhaps one thing to pick up and comment on a little more is the cost of regulation and the double regulation system as between Scotland and England. While the most likely outcome would be double regulation, one can envisage models which would avoid that, such as passporting from Scotland into England, or vice versa. The double regulation outcome is not necessarily set in stone. Coming back to the point I made earlier that consumers generally do not like the passporting model because of the uncertainties it raises with regard to regulation and tax, and more general reputational issues about the provider being in another state, those consumer doubts about the passporting model would probably drive us ultimately back to a double regulation model where firms are being regulated in England and in Scotland.

One of the major concerns of financial services providers generally right now is the increasing cost of regulation. It has gone up since the financial crisis, for various reasons. The prospect of another major recalibration in a few years’ time, when firms are in the process of going through the very recent recalibration, would be a very unattractive proposition for many firms.

Q4594Graeme Morrice: In the event of separation, Scotland’s financial services industry would be very large indeed in relation to GDP. In Scotland, I think it would be over 1,000%. Do you think that increases risks-having lots of eggs in one basket?

Owen Kelly: I absolutely get the question, but it is difficult to separate it from the currency question. If you posit a currency union, as some do-although it has been as much ruled out as I think it is possible for the UK Government to rule anything out at the moment-that necessarily has to have some element of shared regulation and responsibility for acting as lender of last resort to the banking system. If you do not contemplate a currency union and you look at other currency options, it all becomes quite complicated. If you use the pound sterling outside the sterling currency area, as has been floated, and you are using it on the same basis that Montenegro uses the euro, it is difficult to see how you can provide liquidity to the banking sector, and lender of last resort facilities. That is a bit of a problem with that particular proposal.

If you think of introducing a new currency, it would be a complex and difficult process, but it is at least possible to theorise that you could support a banking sector using a lender of last resort, but a lot would then depend on the strength of the currency in international markets and the overall strength of the economy. That would be the bigger determinant, rather than anything structural, because by then you would have your own currency and central bank.

Q4595Graeme Morrice: Iain, would you like to add to that?

Iain MacNeil: If you envisage a scenario in which, as I think we are suggesting, some of the bigger players were moving to an English base as a result of Scottish independence and becoming subsidiaries, they would by definition, being within the rest of the UK system, have access to the money market operations of the Bank of England. In that sense, there are elements of support available. Once we get into lender of last resort territory and its sister, which is bail-out, we are into political territory. We need to be careful about how we frame the lender of last resort debate, because to me it becomes a political question. It is not necessarily a question of having institutions and frameworks that are already in place, because clearly the experience of the financial crisis has been that political will is essential when substantial lender of last resort facilities are going to be made available and bail-outs are going to take place. The political nature of intervention needs to be borne in mind, and the fact is that ultimately we can be talking about taxpayers’ money if it comes to bail-out; we are not talking about just the balance sheet of a central bank.

Graeme Morrice: I was going to raise the point about companies currently based in Scotland in a post-independence situation, who wished to migrate risk, relocating. [Interruption.] Is it something I said?

Chair: I think I’m losing the will to live after the discussion of that last question.

Q4596Graeme Morrice: I know the feeling. In terms of migrating risk for companies currently based in Scotland in a post-independence situation, we have heard press reports that a number of Scottish institutions would do exactly that. Is this plausible? Is this a possibility, a probability or a likelihood?

Iain MacNeil: Moving is not really difficult. The process of transferring legal entities is not problematic. The process of transferring people is more problematic, and whether in fact there could be agreement for that to take place. My take on it is that I do not think there are major barriers to prevent firms from moving, assuming of course that their shareholders consent, which I think they would if they perceived it to be in their best interests. I do not see movement as something that would be difficult.

Q4597Graeme Morrice: I think you are right; it would not be difficult to do, but do you think it is likely to happen? I suppose that is the point I am making.

Iain MacNeil: This issue comes back to perceptions of risk in the transitional period. I do not think anybody doubts that ultimately Scotland could get to a position where it had a viable regulatory framework in place. I do not see any reason to doubt that. The problem is that we have become so integrated into the EU and UK systems that it has become increasingly difficult to withdraw. We are not in the position Ireland was in 20 or 25 years ago, where it built up a relatively good financial sector. It is much more difficult from the starting points that we are now at.

Q4598Graeme Morrice: Owen, would you like to comment on that?

Owen Kelly: Only to say-this is probably not going to be that helpful-that it is difficult to predict at the moment, because there are so many uncertainties. Even the currency is something we are not yet clear on, and probably will not be until after a yes vote. I agree entirely with what Iain has been saying. It will be for boards and shareholders to examine the risks and make a judgment, but at this stage, given the extent of the unknowable, it is very difficult to generalise.

Q4599Chair: You mentioned unknowables. Surely, the unknowns are known; these are not unknown unknowns. I am not clear whether or not it is reasonable for people in Scotland to expect that some of the present unknowns should be known before the referendum, in the way that three main UK parties have all said they will not enter into a currency union. As you yourself said, they could not have been any clearer. To some extent, that is now a known as distinct from an unknown. I am not clear about the other unknowns, and whether or not it is reasonable to expect them to become known through a similar statement between now and the time of the referendum, so that people in your industry would then have a clear idea of what the UK Government’s position was going to be in the event that a Scottish Government which had achieved a vote for separation came with a shopping list. What we are trying to do in this whole series of hearings is clarify for people in Scotland what the consequence of a yes and no vote might be. We are loth to accept that many of the unknowns are unknowable. It just strikes me that a lot of the unknowns are people not wanting to tell, or who tell and then are not believed and it is a question of, "He says, she says. No, you didn’t; yes, you did." It is a bit like a pantomime: "Yes, we will; no, you won’t." It is very difficult to get an agreement in those sorts of circumstances. Does that seem fair?

Owen Kelly: I share a lot of the observations you make. It seems to us that we are in a very unusual situation, where we have a Government in Scotland, who for reasons that are entirely legitimate-of course they are; they have been elected-are clearly pursuing the idea of independence. All of the materials they are producing support the idea of independence, so they are to be seen as more akin to campaigning literature than literature that would give you an overview of what is really going on.

You can make the same claim about the papers and contributions coming from the UK Government. You can say that, fair enough, this is a democracy and there is a Government in the UK that is opposed to independence, so it is only right that the civil service and others support them in making the case against. However, that means that it is extremely difficult to get to what you might call objective views, and we have spent a lot of time trying to do that. The other thing it leaves you with is a state where nobody can get into the business of negotiation. I think that the statement on the currency by the Chancellor, supported by the other parties, is the only example I am aware of where the UK Government have said, "This is a view we currently hold, and expect to hold even after a yes vote." They have not sought to get into negotiation, for reasons, I think, connected with the fact that they do not feel able to represent the interests of one part of the UK against the interests of another part of the UK, all of which I understand.

There are, however, some facts that we could get our hands on. We have already touched on dollarisation. It seems to us that, if you have a dollarised currency, it is not compatible with the terms of EU membership. It would be reasonably straightforward to check that out. If you asked the Commission whether that is the case-and it seems to be, because that is the case with Montenegro-that is the sort of fact we could get our hands on. If we knew that, we would then know that dollarisation, or sterlingisation as the jargon now has it, is actually only an option if you do not want to be in the EU. That would help us to know what the real options are. However, I do not think we are in a position before the referendum to know conclusively which option would or could be chosen.

Q4600Lindsay Roy: We have had a definitive statement from Mr Willetts about the UK research councils in relation to the universities.

Owen Kelly: I am sorry, I was not aware of that.

Q4601Chair: It is not reasonable for us to expect you to follow every announcement by Mr Willetts.

Owen Kelly: I had read that that was unique, but if it is not I stand corrected.

Q4602Jim McGovern: Regarding the currency, is it not the case that, if Scotland separates from the UK, they would have to have their own currency for a number of years to qualify to apply to become part of the EU? My understanding is that any country that applies to join the EU has to prove their currency is stable for a number of years before they join.

Owen Kelly: I think you are right in principle. This is certainly the Montenegro dilemma. They are using the euro on a dollarised basis and they do not have a currency. There is a discussion going on about how they could demonstrate that they meet the terms of EU membership. You are right. There is stuff in the treaties that requires certain things. You have to demonstrate you have the institutional capacity to comply with various requirements. The short answer is that I do not know, but I think you are right; there would need to be a period of transition. I do not know whether that could be negotiated away; maybe it could.

Lindsay Roy: Expert witnesses previously said it would take about five years to set up a central bank and a Scottish currency. It was David Bell and Professor MacDonald.

Q4603Chair: Before we move on to Pamela’s points, can I clarify one other point? You mentioned Scottish institutions relocating to England. I am not clear whether or not that just means moving the plaque from the front door and saying, "We are now in England," in which case presumably virtually everybody in the Scottish financial industry could do that overnight, and effectively it would mean that their domicile legally had changed and they were then presumably liable to be protected by the Bank of England, but in effect there would be no change in real terms. Is that correct, or is it more complex than that? In order to change your domicile, do you have to move a certain proportion of your work, your staff or anything else?

Iain MacNeil: You would have to move your registered office, which would usually be your head office as well; it would move from somewhere in Scotland to England. In doing that, if you were already regulated by the UK authorities, you would continue to be so. Trying to answer your question more directly, is there any substantial change? In terms of the business model, not really. One thing we need to bear in mind here is that the way these financial institutions are managed does not necessarily map on to the legal entities they comprise. You can say there is a business management model and a legal entity model that do not necessarily run in tandem.

Q4604Chair: Am I right in thinking that it would be entirely possible, if people felt that moving away from the regulation and jurisdiction of UK law was a major difficulty, that they would switch their plaque, and the legal entity and everything else remains the same?

Iain MacNeil: The danger is to say that everything else remains the same. To move the legal entity and registered office to England would imply that the management functions go with it. That is not to say that some other functions could not, for example, be contracted back to Scotland. That occurs commonly in any case with certain functions being contracted out to other countries, but the central issue is where the head office and management are located. In other words, where is the main centre of the group for the purposes of regulation?

Q4605Chair: Surely, the main centre of the group could remain in Edinburgh, and the legal entity and the plaque get moved to London in order to get protection there.

Iain MacNeil: Not really. That would be problematic from the regulator’s perspective. The regulators and the regulatory rules cover the senior management function, so that has to go with the legal entity and the head office.

Q4606Chair: Owen, you are nodding enthusiastically. Unfortunately, Hansard does not record it, so you have to say something.

Owen Kelly: The idea that you can just unscrew your brass plaque and move it is not quite correct. There are regulatory requirements, certainly in the UK, and I am sure in other jurisdictions. The term that is used in the jargony world is "mind and management." There are certain roles and levels of seniority that the FCA require to be in the jurisdiction that is the UK. It is not the case that you can simply do something as simple as move a brass plaque. You would have to move a certain amount of decision making and a certain amount of mind and management of the company to show that you were in a position to be subject to the regulation of the UK authorities.

Q4607Mike Crockart: Discussions I have had in the last couple of weeks with one of the big companies in Scotland-I will not go any further than that-covered this exact subject. The view was that for one of the big companies about 50 staff would have to move. It would be the board and the support staff. They would have to move to London. The big effect would not be staffing; it would be the taxation treatment of that company because of the move of the headquarters. Is that a fair representation?

Iain MacNeil: I am guessing, but if I were thinking about mapping the regulatory functions on to a particular organisation, those kinds of numbers would make sense.

Owen Kelly: You are also right to highlight the tax aspect. I am not at all expert on them, so I will not be able to go into them, but there are also tax-related factors which affect this. You have to have a certain amount of things going on within the jurisdiction to comply with tax requirements.

Q4608Pamela Nash: Mr Kelly, please correct me if my paraphrasing is not correct. From what you said earlier, I understand that a new regulator would be unquestionable; it would be absolutely required if Scotland was on its own. From my perspective, you would have to presume that a natural extension of this is that the regulatory framework would differentiate at some point, with a different framework. Could each of you say a bit more about what difficulties that would present to Scottish financial services companies seeking to continue to operate in the rest of the United Kingdom, and possibly the benefits, if any exist?

Owen Kelly: If one thinks beyond the transition period-so we are now in a steady state with some sort of legal cut-over, independence day has been declared and there is a new regulator-it seems quite likely, for all sorts of reasons, that, in the early years of that, regulation would stay broadly the same. You would, however, still need to comply separately. The new Scottish regulator, in order for Scotland to fulfil its obligations as an EU member state, would have to show that it was independent of Government, and it would have to have a certain enforcement capacity and so on. You would have to do something even if the rules were identical. It would not be the case that you just do not have to do anything-just be a kind of postbox-because I do not think that would really fit with the EU framework.

Q4609Pamela Nash: The cost to the company of enforcement and compliance would be doubled; it would be replicated.

Owen Kelly: Whether it would be double would probably be going too far. It would all depend on how their business was configured and the extent to which they needed to continue to be regulated in the rest of the UK, and what was being regulated in the rest of the UK. If it was a subsidiary, for example, that had been set up to continue to serve English or rest of UK customers, that would be one way of doing it; or as Iain said, you could be passporting in certain types of investment products; funds and so on can be passported. It would depend on the nature of the business, but in general terms you would have to fund and respond to another regulator, and for most purposes that would be doing twice what you currently have to do once.

Over time, one would have to expect that there would start to be deviation between the two regulatory frameworks, maybe not enormously, because they all come under the EU umbrella, but it is for each member state to implement EU regulation. That can take place on different timetables. That is one of the issues we see across the EU: different regulators implementing on different timetables. That causes companies problems, because they have to bring in a new regulation in one state and then in another state on a different timetable. Approaches to regulation are different; for example, there are different requirements in Luxembourg over certain things, as to the UK. Those differences would be there.

If you become a separate jurisdiction for tax and regulatory purposes, the regulator will have to be accountable to the Scottish Parliament. The Scottish Parliament will have views, rightly so. Financial regulation is a political issue. You would expect different views to emerge. For what it is worth, in the document "Scotland’s Future" the Scottish Government float the idea of a different approach to regulation in a couple of areas. You would have to expect divergence. It is very difficult to say how long it would take to manifest itself, but the more there was would only make the business of complying separately a little more complicated. I think the business of complying separately is a day one requirement.

Q4610Pamela Nash: Professor MacNeil, you spoke about the difficulties countries have at the moment in the European framework. You might be about to be saved by the bell. Can you think of examples of a successful relationship? We would like to know a bit more about how UK financial services operate in Ireland, and if there are any other examples.

Chair: Perhaps I can interrupt and ask you to think about that. We are being called to a vote. We will start as soon as we can get back again. We will adjourn for five minutes.

Sitting suspended for a Division in the House.

On resuming-

Chair: Apologies for that break. You have had time to think about your answer, so it should be good.

Pamela Nash: No pressure.

Iain MacNeil: We are coming back to the advantages and drawbacks of having an additional Scottish regulatory system.

Q4611Pamela Nash: Yes. It would be helpful to have examples of why it is difficult. You touched earlier on why it is difficult in Europe just now, with the framework that is there. Is that a viable example of what it would look like for Scotland’s partnership with the remainder of the UK?

Iain MacNeil: Maybe one way to focus on it is to come back to the point I made about passporting and try to explain why that has not worked very well. The idea with passporting was that, if you had what the EU referred to as minimum harmonisation, or at least some form of harmonisation, of the regulatory frameworks in every member state, in theory, if you were licensed in one member state you should be able to go to another, and the regulatory framework would be sufficiently similar that you would not really notice any difference in terms of supplying products to customers. In reality, that premise did not hold good-in other words, the idea that there would be a sufficiently harmonised framework in place.

Owen mentioned one factor, which was tax. Each country remains responsible for its own taxation framework, so things like pension products have different tax bases. But even for products where tax is not a major issue, the fact remains that particularly the marketing process is subject to differing rules in different member states. As time has gone on, there has been increasing harmonisation of marketing rules-for example with respect to investment-type products. Nevertheless, as a provider based in one country and licensed in that country, you still face a slightly different regime going to another country to sell. That is not just a case of language. It is a case of rules relating to how you interact with customers: the information you give them; how you treat them; and how you deal with complaints. There is a range of issues. That is looking at it from the firm’s side.

Flipping over and looking at it from the consumer’s side, the issue that the consumer faces is: do they want to do business with a firm that is based in another member state and is not substantively regulated, or not regulated in the main in the state where the service is being provided? That may raise issues with regard to what the compensation arrangements would be, because, for example, the compensation system runs on a home state basis. It is the home state of the licence which controls the compensation arrangements. For things like insurance products, it may also relate to the legal framework that controls your capacity to claim under the insurance policy you have been sold. Therefore, from the consumer’s perspective, we find over time that the preference has been to do business with a local supplier rather than a passporting firm. The local supplier could be a subsidiary of a firm from Scotland or England.

Q4612Pamela Nash: I have two questions on that. In terms of UK companies operating in Ireland, is that largely through passporting, or is it through local subsidiaries?

Iain MacNeil: Mostly my impression of the expansion that has taken place in Ireland has been that this is subsidiary; Ireland is being used as a base for selling particularly investment products into other member states. I think that is mainly where its success has been. This is not a case of people selling into the Irish market; it is the Dublin financial centre effectively being used as a base for investment funds especially to be sold across Europe. Some of that relates to the advantageous taxation treatment available for companies that set up there.

Q4613Pamela Nash: That would not be comparable with the situation we would find ourselves in if Scotland separated.

Iain MacNeil: That remains to be seen, because one of the issues for companies in Scotland would be that, while there might be increased regulatory cost, you have a trade-off against the promise of a reduced corporation tax rate. Whether the reduction in the corporation tax rate will or can be delivered remains open to doubt, but companies looking to relocate would have to weigh up potential corporate tax savings against increased compliance costs.

Q4614Chair: You have used the Irish example, saying that the Irish have managed quite successfully to sell into Europe. Surely, the Scottish financial network, because we are so good, would be able to do that into England, Wales, Northern Ireland and the whole of Europe as well. Therefore, a change of nationality, as it were, would not make any difference.

Iain MacNeil: You need to be careful when you are talking about different sectors. Things like investment funds, which are often sold through local advisers, are slightly different from trying to sell products directly, like banking products, on a passporting basis. Where you have got local advice being delivered, say to sell a retail fund that is based in Dublin being sold by a German investment adviser, it becomes a different proposition for the consumer, because there is a local dimension to the selling process. In the retail investment fund sector, yes, you could envisage Scotland making a success similar to Ireland, but that is only part of the story; it is only one segment of a much bigger financial sector.

Q4615Chair: It would be ironic in a sense if Scotland sought independence in order to keep things exactly the same. If a Scottish Government under separation decided to keep everything exactly the same, or followed all decisions made by the then rest of the UK, presumably all these fictional difficulties would be overcome.

Iain MacNeil: In theory, but you are then talking about a kind of shadow regulatory system existing in Scotland. Purely from a legal perspective, that is probably permissible, because the European Union directives require a clear legal framework. Given that many of the rules are sent down from the European Union, one could envisage that taking place, but I would revert to the point Owen made. I would not see that as a realistic option in the longer term; in the short term, perhaps. But in the longer term I think you would have divergence in the regulatory framework, not least because part of the proposition of independence is that you adapt legal and regulatory frameworks to what is suitable to the particular state. If you do not do that, you begin to ask what is the point of independence.

Q4616Chair: To be fair, the point of independence is not being driven by the needs of the financial sector alone. It may very well be that other issues drive it and this is something where you are just making good any difficulties that have been caused by separation. The drive for independence is not nullified by the points you are making, surely.

Iain MacNeil: I accept that. I think that in a general sense your point is ultimately correct. You could have a shadow system, but whether that can be maintained for the long term, I doubt.

Q4617Pamela Nash: I think Mr Kelly said that even in that instance you would still have replication of regulation.

Owen Kelly: You would still have to comply separately, so that almost deadweight cost is inescapable. As to whether you could have a word-for-word cut and paste, I suppose it would be worth testing whether that really met the expectation of independence in terms of complying with EU expectations.

Q4618Pamela Nash: One of the other proposals that came about is that there would be a partially shared system between Scotland and the remainder of the UK, so there would be a separate framework in terms of customer regulation. Is that a viable option? Are there any examples of that across the world that you know of?

Owen Kelly: A lot depends on the currency arrangement you have. If you have a currency union, you would necessarily have to have some sort of shared responsibility for the kind of big picture regulation of banking-how much capital and so on-because you would need that in order to manage the currency properly. That is what the Scottish Government posit in their document "Scotland’s Future." They say you would have a currency union and a shared prudential regulator, but you would have an entirely Scottish separate conduct regulator, so that is the regulation of day-to-day business. I am not really aware within the EU of any shared system of that kind. One of the questions that we have long had, which I do not think has ever really been answered-I do not know whether Iain wants to comment on this-is if you have a shared system of any kind and a shared central bank, does that meet the EU requirement to have a central bank? Can you say to the EU, "Yes, we do have a central bank. We happen to share it with someone else, but it is still a central bank"? I do not think that has been tested either.

Iain MacNeil: I agree that it has not been tested. My reading of it would be that it does meet the requirements of the treaty and of the various directives. As I read those requirements, they relate to having a legal framework in place. They do not necessarily control where the legal entity, such as the Bank of England, is incorporated; nor, for example, according to my understanding, does the EU framework restrict the possibility of having a shared regulator, such as the Financial Regulation Authority, because there would be a certain legal framework in place. I do not see any restriction on the competent authority being a legal person incorporated in another member state, but I agree one cannot be conclusive about that, and there would have to be some clarification of that aspect.

Q4619Pamela Nash: My final question is slightly off topic. Professor MacNeil, you have mentioned a few times the effect this would have on consumers of Scottish products outside Scotland, and how it might affect the decision to use those products and companies in future. Would it have a similar impact on Scottish consumers in terms of their use and purchase of products and services from financial services companies throughout the rest of the UK?

Iain MacNeil: Yes. In principle, I do not have any reason to believe that the Scottish consumer is unique in either the UK or Europe, but what is perhaps slightly different and makes the thing a little asymmetric is that perhaps a Scottish consumer is aware that within the rest of the UK there is what you might call the old system they were used to in the past. There might arguably be a little more comfort with that than the other way round.

Pamela Nash: That is really interesting. Thank you.

Q4620Mr Reid: You said earlier that the Chancellor had made it clear there would not be a currency union. Do you regard that as a sensible decision by the Chancellor?

Owen Kelly: I will only offer an opinion on my own part on this. I would not claim that I am in any sense trying to represent the views of our member companies. To be honest, I think it has always been clear that the case for a currency union, once you choose to look at it from the point of view of the rest of the UK and not only, as I think the Scottish Government’s own Fiscal Commission working group did, on the basis of what would be the right option for Scotland-they were asked the question, "What would be the right option for Scotland?"-is a different question from what would be the right option for both entities once you start to view them as separate. There are quite big questions. If I try to put myself in the shoes of an official in the Treasury being asked on day one after an independence vote, "We’ve had a request for a currency union. What do you think?", I think largely you would get something similar to the paper prepared by Nick Macpherson. There are a lot of questions.

A point that is perhaps not often mentioned is that, even if you thought there should be a negotiation about a currency union, it would take some time. That official sitting in the Treasury could not immediately say, "Well yeah, why not?" because you would need to see how Scotland would be governed, what its economic policy would be like and what the public finance was like. You would have to answer some quite fundamental questions before as the rest of the UK, now a separate entity, you could make the decision to enter into a currency union. Even the process for negotiating a currency union would have to take some time and would, I think, be fairly fraught. It was in some ways an unusual step to declare a position, but, if they had not done that, we would have been going into the referendum with simply no knowledge of whether or not a currency union would be negotiated. To the extent we can know very much at all, we know that that is not going to happen.

Q4621Mr Reid: In response, the Scottish Government have said that, in the event of a yes vote, Scotland would use the pound anyway. I think you referred to that earlier as being similar to Montenegro with the euro. What implications would that have for the Scottish financial sector?

Owen Kelly: I know Iain will comment as well. The big and obvious ones are could you adopt that position and still expect to be in the European Union? I think that is a question that needs to be tested, because I am not sure you can be a member of the EU if you are using somebody else’s currency on that basis. That is the dilemma facing Montenegro at the moment, as it tries to negotiate entry to the EU.

The other two big obvious issues would be that you would then put yourself in a position where you really did not have any control of monetary policy. I think the ratings agencies would mark down. This is all on their websites; control of monetary policy is one of the factors in assessing a sovereign rating. It is very difficult to say what the impact would be, but I think there would be some negative impact on the rating if you really were in that position.

The other obvious question is one we have already touched on. If you do not have a central bank with the powers of a central bank, how can you act as lender of last resort? You would then only be able to provide liquidity to the banking system if you had very large reserves of currency, which in very general terms is the Hong Kong model. Hong Kong has enormous financial reserves because of its long-standing peg against the dollar. These are some of the big challenges that would come from it. It is also quite an unusual policy position. As a voluntary choice-I think Montenegro came into it just out of historical processes-it would be an unusual one.

Q4622Mr Reid: I take it Montenegro does not have much of a financial sector.

Owen Kelly: Not at the moment, no.

Q4623Mr Reid: Let me just explore what in practice it would mean for the financial sector. You mentioned some of the defects, but what would it mean in practice for these companies?

Owen Kelly: If you go back to the point about ratings, the rating of the sovereign within which you operate has a certain impact on the rating you as a company can command in the markets. It is not, as I understand it, an iron rule, but it does have an impact. There would be impacts there, and that would be something for companies to think about.

In terms of the lender of last resort point, that would have to be thought about quite carefully by all banks. How you would then do the prudential regulation of other sectors would also require careful thought. Having said all of that, Panama has a financial services industry. I am not familiar with it in detail, but it is certainly there. Other countries do it, but it is an unusual thing to contemplate.

Q4624Mr Reid: In practice, would the banks still be able to operate in
Scotland without the lender of last resort?

Owen Kelly: I think banks could operate in Scotland. Whether they could operate on the same basis as they currently operate is much more open to question, but there would certainly be banks operating.

Q4625Mr Reid: In practice, would it mean higher interest rates?

Owen Kelly: The interest rates would be set entirely separately for the currency you were using; they would be set in London. Scotland would have no involvement at all under this scenario in the setting of interest rates. In terms of practical implications, I guess that the pound in your pocket would still be the same. You would not have the transaction costs that would arise from a new currency, which I suppose would be a plus, but overall it would be an unusual position for a country to adopt, and it would be hard to imagine the industry as it currently exists; it would have to reconfigure with that new economic environment.

Q4626Mr Reid: Say I was a depositor and I wanted to put a significant amount of money into a bank. At the moment there is a deposit guarantee scheme. Would that be possible without a lender of last resort?

Owen Kelly: I guess it could be, if you could fund it from your reserves. It would have to be funded differently; or rather, what stood behind it would obviously be different. I think we are now getting into the realm of fantasy policy making, but if you were not in the EU because you had decided to go down this route and it was not compatible with EU membership-that seems to be the case, but it would be good to get a definitive view on it from somewhere-in that case you might find you did not have to comply with EU requirements to have a certain level of financial services compensation scheme. I am straying now.

Q4627Mr Reid: If you were a depositor, would you put your money into such a bank?

Owen Kelly: It would depend on where I lived.

Q4628Mr Reid: If you lived in Scotland.

Owen Kelly: If I lived in Scotland, I would have to look at the overall circumstances.

Q4629Chair: That was hardly a ringing endorsement, was it? Earlier you said that such an arrangement would be unusual. That is a bit like Sir Humphrey saying, "It’s a very brave decision." Is that correct? Does "brave" mean "irrational"? You are using the euphemism "unusual." What do you actually mean by that? Is it unwise?

Owen Kelly: It is not for me to say, because obviously this is a political choice.

Chair: Well, you are here.

Owen Kelly: Okay. I think it would be un-I will not repeat what I said. I think it would not be a policy choice you would make unless you had to, in my opinion.

Iain MacNeil: Maybe I could add a couple of points. The first is to compare dollarisation with UK monetary union and the potential influence that Scotland would have in setting monetary policy and interest rates within a monetary union framework. Depending on how you look at it, there might not be that much difference. Assuming Scotland was a minority player in the Bank of England Monetary Policy Committee implies that it does not have a very substantial influence in terms of the whole process, which may not be that different from dollarisation. I suppose you could counter that argument by saying that at least if you had a monetary union there would be an obligation on the MPC to consider the bigger picture within the UK, but Scotland is a relatively small part of the whole picture. My feeling is that probably the issue of influence and monetary policy is overplayed in making the comparison between monetary union and dollarisation.

Q4630Sir James Paice: Wouldn’t removal of virtually the whole of the North sea oil industry from the UK economy have a major effect? You might be right about Scotland in terms of people not having a big influence, but the removal of the Scottish economy and most of the North sea oil sector from the UK economy would have a big influence, would it not?

Iain MacNeil: But when you say removal of the North sea oil sector-

Q4631Sir James Paice: It would be part of an independent Scotland outwith the currency union.

Iain MacNeil: My understanding is that if there were a monetary union-

Q4632Sir James Paice: It would be in.

Iain MacNeil: Yes, it would be in.

Q4633Sir James Paice: But your point was that there would not be a lot of difference in the influence of Scotland inside or even outside a currency union. I am saying that if it was out it would be quite dramatic, not by people influence, but the impact of the loss of a major part of what is currently the UK economy.

Iain MacNeil: Yes. Clearly, you would have a big part of the UK economy coming out, and in terms of tax and whatever that would be significant.

Q4634Sir James Paice: But the whole monetary policy system run by the rest of the UK would be done completely outwith any influence from North sea oil.

Iain MacNeil: I think in a currency union North sea oil would just be another sector that would be taken into account. There would be no special consideration.

Q4635Sir James Paice: My point is that there is a difference between being within the currency union and outwith it under a dollarised system. I am suggesting that the lack of influence of Scotland on sterling in a dollarised system is bigger than perhaps you are implying.

Iain MacNeil: You may be right. My point was thinking more about the governance arrangements within the Bank of England and the FPC and, in terms of decision making within the MPC, what influence Scotland could expect to bring to bear in a currency union. My answer would be to say that, generally speaking, it is a small minority party and therefore it is not going to drive decision making.

Owen Kelly: Although on a related point, I think I am right in saying that oil and gas represent roughly 20% of the Scottish economy. If you were thinking of running a dollarised system, you would have to find a way of coping with any volatility in the oil price within that, which potentially could be challenging.

Q4636Lindsay Roy: Would it be fair to say that in terms of a common currency agreement or sterlingisation, a separate country, far from being independent, would have quasi-colonial status?

Owen Kelly: The way it wouldn’t really be independent would be more that, in a dollarised system, how would you borrow in the money markets? You would be much more susceptible to influence by your borrowing costs and so on in the money markets. I am not sure I would call it "quasi-colonial." Certainly, the relationship would be a very distant one.

Q4637Lindsay Roy: How much influence?

Owen Kelly: It is hard to say, but I do not think there would be any. The model such as we see it in some of the countries that have been mentioned is that there is none. The European Central Bank simply does not take account of Montenegro. It is probably too small.

Q4638Lindsay Roy: That was what I meant when I said "quasi-colonial status." Iain, have you any comment to make?

Iain MacNeil: I would hesitate to call it a quasi-colonial situation. First, that dollarisation arrangement would exist only with the consent of Scotland and it could be unilaterally withdrawn from-for example by setting up your own currency. If you take the example of Hong Kong, it was a British colony while being pegged to the US dollar, so the colonial relationship was quite separate in terms of the monetary situation.

Q4639Lindsay Roy: Is sterlingisation a better option than a common currency agreement?

Iain MacNeil: I do not think so. I would have thought that a common currency would be the better option, if it were available, because it continues the framework that is in place in terms of lender of last resort, and the whole structure of the payments system that is built around the Bank of England.

Q4640Lindsay Roy: But you would have no influence over interest rates and mortgage rates.

Iain MacNeil: Within a common currency union?

Lindsay Roy: Yes.

Iain MacNeil: Coming back to the point I have just made, in terms of decision making you are a minority player and therefore you do not have a huge influence, but one would have to say is that very far distant from where we are now?

Q4641Chair: There is an imbalance here, is there not? I think you are saying that the best option for Scotland is a common currency area. Yet the Chancellor and others are saying that that is not the best option for the UK. Am I right in thinking that you take the view that the Chancellor’s decision is an entirely rational one? It has been suggested that it is irrational for him to do that because of transaction costs and so on. I want to clarify whether or not you think it is a rational decision, as distinct from asking you whether or not it is correct.

Iain MacNeil: I find it hard to understand that it is a rational decision, because I do not have a clear impression of why it is bad for the rest of the UK. If I can just clarify that a little more, a lot of reliance was placed on the fact that the rest of the UK would not want to assume the lender of last resort function to a large banking system based in Scotland. To me, that seems to give too much significance to the function of lender of last resort within the decision on whether there should be a currency union. One of the reasons it puts too much focus on it is that all the efforts towards banking reform that have taken place since the financial crisis have been geared towards preventing the kind of lender of last resort and bail-out arrangements that have been necessary in recent years. As we stand now, my impression with regard to the perceived risk relating to bank failure and lender of last resort is that it is not as great as it has been in the past. It should not be. If our banking reforms have been successful, the risks inherent in lender of last resort should not be as great as they have been in the past.

Of course one cannot remove risk from the system; it would be silly to claim that, but my impression is that this dimension has been overplayed. I do not have a clear impression of what other aspects of currency union would be specifically bad for the rest of the UK.

Q4642Chair: That is very helpful. To be clear, if you think that the Chancellor has taken a decision that you would not have taken, unless I am very much mistaken, do you think he is bluffing when he makes the statement he has? I think "bluffing" has been used as a euphemism for "lying." Do you think he is just making that up and that, in the event of a vote for separation, he will collapse and agree that, yes, a currency union is, after all, the best thing?

Iain MacNeil: I have to take what the Chancellor says at face value. I do not have any grounds for doubting his good faith in terms of what he said. Looking at it from a more detached level, in any negotiation one would expect that the positions people put forward are subject to change as the game closes.

Q4643Chair: Basically, you think that the Chancellor’s position is a negotiating position.

Iain MacNeil: Given that nothing has been finalised and he is not in a position to commit the Government irrevocably to that outcome as of now.

Q4644Chair: Sorry. Why not?

Iain MacNeil: Because it is a political statement; it has not been transposed into law. It does not have anything about it which prevents it being reversed.

Q4645Chair: But nothing ever does, does it, in politics?

Iain MacNeil: That is true.

Q4646Chair: No Parliament can bind its successor, because there are people who had a view yesterday that they will not have tomorrow.

Iain MacNeil: That is true.

Q4647Chair: Leaving that aside, they are free to change their opinion on these matters, but presumably the Chancellor did not make this up just when he got up that morning. Presumably it was actually subject to negotiation and discussion with his governmental colleagues. Therefore, it is a consensus view that has come forward.

Sir James Paice: And the other two parties.

Chair: Indeed.

Iain MacNeil: I am sure it is. All I am really saying is that I do not have a clear understanding of the specifics of why it is bad for the rest of the UK.

Owen Kelly: As Iain observed earlier, this is really a political decision. That much is obvious. It seems to me that, for a currency union really to be relied on by the markets and for the markets and investors to have real confidence, it has to be a currency union that all parties have entered into and all parties are committed to protecting. That is probably one of the lessons of the eurozone in recent years-the sacrifices made by Greece; Germany obviously played a big role. There is political commitment to the euro, and it looks at the moment as if it is going to come through.

In the initial stages of this discussion, I think the first substantive response from the Scottish Government to the idea of there not being a currency union was that the debt would not be accepted. If that negotiating tactic succeeds, you would contemplate the rest of the UK rather grudgingly going into a currency union because, if they did not, something terrible would happen. Politically, in the aftermath of a yes vote, I find it quite hard to imagine that a strong political consensus between the participants could be achieved.

The other political dimension, which I do not think has been touched on, is what would the attitude be of the other EU member states to a new currency union being created within the European Union, which is what we would be asking for. The UK and Scotland would need to go to the other member states and say, "Look guys, we’ve decided that we want a currency union." The other member states might have a view on that, because then you have the euro and all the treaties built around the concept of people moving ultimately towards the euro, except those with opt-outs of course. You are now creating another currency union. I completely accept that, as Iain says, it may be that their currency union will comply with current requirements around central banks and so on, but there are several layers of political decision making that sit atop the idea of a currency union, and that almost conditions this more than the technical and professional, if I can say that, aspects of the debate. The politics are complicated.

Q4648Lindsay Roy: A local constituent asked me whether, if two business partners decided to go their separate ways, it would be sensible to retain a joint account. He drew the analogy of lender of last resort. Is there any merit in that analogy?

Iain MacNeil: There is some. Whether it maps over entirely on to the case for a currency union is less clear to me.

Q4649Lindsay Roy: Particularly if one of the two partners who were dividing had a bigger asset base than the other.

Iain MacNeil: Your analogy is persuasive, but I would stand by what I said about the currency union.

Q4650Lindsay Roy: If there is not to be a currency union, what currency option in your view would be best for Scotland? Would it be sterlingisation, a separate currency or what?

Owen Kelly: Again, I can only venture a personal view, because it is not a matter on which any of our members has an opinion. I do not want anyone to misinterpret anything.

Q4651Lindsay Roy: Or the euro.

Owen Kelly: We were discussing this. I do not think the euro is an option in the immediate term. To join the euro you have to demonstrate that you comply, and to do that you have to go through quite a process, so it is not an easy option and it would take some time.

Q4652Lindsay Roy: It is not an 18-month option.

Owen Kelly: I do not think so.

Q4653Sir James Paice: What about euroisation, i.e. the precise Montenegrin situation?

Owen Kelly: Before entering into that, you would want the Montenegrin dilemma to be resolved. You would want to know that that was not going to trap you in a position where you were unable to join. You would need to know that it was compatible, and that would require the other member states to agree. In any case, you would then introduce transaction costs and all the other things with your largest trading partner. As some have said on the proindependence side of the argument, having your own currency creates an environment where you have full autonomy and other things. It also solves some of the questions we have been airing a little today about EU membership, compliance and so on. It does not solve all of them, but it is a more established route, if you like. It is not unusual to have a currency and then join the EU. Everybody does it, apart from those in the eurozone. If one were in the position of having voted yes and having to reach a decision on how to take it forward, and the currency union has been ruled out-perhaps that has been confirmed in some sort of post-referendum discussion-I guess that a separate currency is where you end up.

Iain MacNeil: I tend to go along with that. In many ways a separate currency is the logic of independence. It gives you the controls that would typically be associated with it. It might imply a more difficult transition, but perhaps in the longer term it gives a better foundation to start from and to work for the long term.

Q4654Lindsay Roy: Are there any examples throughout the world of that kind of transition? We are told it would take about five years to set up a central bank and a separate currency.

Owen Kelly: I know people who could answer that question, but I am afraid I cannot. I cannot think of an example where this has happened and a new currency has been created.

Q4655Mike Crockart: I want to take Iain back to a point he made. You were saying there was not much difference between monetary union and dollarisation, certainly in terms of the rate-setting of the Monetary Policy Committee. Surely, the larger difference between the two is when you look at the larger picture of monetary union as outlined by Mark Carney, because then it is not just currency union or monetary union; it is fiscal union as well. If you go down the dollarisation route, that is then ruled out and that is where the bigger problems come. Perhaps that is why it is rational for the remainder of the UK to rule it out.

Iain MacNeil: That may be right. I think you are correct to say that currency union is bigger than simply control of monetary policy. The UK rules out the currency union because in your view it cannot have fiscal controls over Scotland.

Q4656Mike Crockart: To make it blunt, it would not want to create a situation like Germany and Greece, where, if the economies diverged massively, you would have to have some sort of fiscal transfer between the two parts.

Iain MacNeil: I accept that. In principle, it has to be accepted that fiscal powers have to go along with monetary union for it to be workable. I think that in principle that is a reasonable argument.

Q4657Mike Crockart: That could be a rational reason for rejecting.

Iain MacNeil: That can be one of the rational reasons. Perhaps it has been spelt out and I have not seen it in sufficient detail.

Q4658Chair: Maybe the Chancellor is more rational than you initially thought.

Iain MacNeil: Maybe. He has much better resources than me to do that.

Chair: You have the whole of Glasgow university behind you, surely.

Q4659Jim McGovern: If Scotland were to vote to separate from the United Kingdom, they have now heard the Chancellor, the shadow Chancellor and the Chief Secretary to the Treasury saying there will be no currency union. We have heard the First Minister, Deputy First Minister and Finance Secretary in Holyrood say that, if there is no currency union, they will renege on their part of the national debt. Do you not agree that reneging on that debt would make an independent Scotland, if that happens, the laughing stock of the world’s economies? Who would take them up for loans, bonds and so on?

Owen Kelly: Many others have observed, and I suppose I would have to agree, that yes, inevitably, if that position were to arise, investors would take some persuading. It would probably take a bit of time to get through it. I do not know how long it would last, but if that were to arise and if it were to be perceived by the markets in the way you describe, assuming that is what happens-of course we are trying to anticipate a negotiation process where maybe there would be a settlement of some kind-I think investors would obviously see that as perhaps calling the reliability into question.

Q4660Jim McGovern: It would look like a bad bet.

Owen Kelly: To some extent.

Iain MacNeil: I agree with that.

Q4661Lindsay Roy: As a Scot, obviously I want what is best for Scotland, and I believe that is within the union. However, how do you see the industry devolving if we are separate in terms of progress in future?

Owen Kelly: Do you mean in terms of further devolution?

Chair: Evolving rather than devolving.

Owen Kelly: With independence or without it?

Q4662Lindsay Roy: With separation. If we are separate, how do you see the financial services industry evolving in the future?

Owen Kelly: As with everything, there is a range of optimistic and pessimistic, but I will go for the optimistic. If one imagines that we are through the transition, Scotland is an EU member state, the currency is sorted out and we are in a steady situation, I think it is perfectly plausible that Scotland could have a well-regulated, successful financial services industry operating in that context. It would look different. I do not think it would have the same configuration, with, for example, lots of people working and serving UK customers as part of the same single market, because we would not be that any more. But as was said earlier, Ireland has had amazing success in the last 20 years or so in attracting international financial services jobs. Ireland employs about 60,000 people in financial services, and roughly half of them serve international clients through the fund networks. Scotland could not replicate that entirely, because that market opportunity has probably passed, and I do not think that is part of the mainstream.

Q4663Lindsay Roy: What I am driving at is how best they would manage the transition period. We are saying it would take five years to get a Scottish currency and then perhaps join the euro. What are the tensions around that?

Owen Kelly: Uncertainty, obviously. One of the things that are probably knowable at this stage is that, at the moment, all of the uncertainties we are talking about are hypothetical because we have not had a yes vote. If you have a yes vote, from the moment that is announced many of these questions become real and live rather than hypothetical. In those circumstances, there would have to be very rapid work to explain to customers and investors how this was going to be managed and why everything was going to be okay. If we have the current state of knowledge at that point in time and no more, it would probably be quite challenging, but it would be very important very quickly to explain to investors, not only retail but international and institutional investors, how things are going to be managed and how they are going to unfold. The longer you cannot explain that, the less good it is, so you need to move quickly.

Q4664Lindsay Roy: Is that a complex task?

Owen Kelly: I think it would be a very complex task. It seems to me that one of the facts-going back to my pursuit of knowable facts-is that we obviously have a UK general election coming up in 2015. That is a fixed timetable event; we know that is going to happen, so it is probably reasonable to assume that there will not be an awful lot of agreement between a yes vote in September, if that happens-it is a big if-and the general election, so the timetable is already beginning to elongate.

Q4665Lindsay Roy: It is truncated.

Owen Kelly: I do not know. You will know much better than I do because you are all Westminster politicians, but experience suggests that in the run-up to a general election you are not going to get Governments signing up to long-term, far-reaching commitments with a country that has just voted to become a different one.

Q4666Lindsay Roy: Iain, is that your interpretation as well?

Iain MacNeil: Yes. The only thing I would pick up is the projection of five years to set up a currency and a central bank. You may have reliable sources that are talking about that length of time. To me, that sounds a very long period of time-an unlikely long period of time-to engage in those things. I would have thought that the transitional period might be shorter, but the essential point remains that, even if you significantly shortened the transitional period, you still have the uncertainty that may trigger actions that will have an effect on the Scottish financial sector. I envisage that it will be smaller; the shape will be a little different, in the sense that the proportion of banking would probably become smaller, because of the willingness of investors to support a very large banking sector in terms of the state back-up. Longer term, it could be successful, but the killer is the transitional period.

Q4667Chair: Can you clarify what you mean by "killer"?

Iain MacNeil: I mean that, even if firms and customers can envisage the steady state after the transitional period, the risks associated with the transitional period are likely to cause them to make decisions, say, to relocate or not to buy products from that firm, for example in the case of English customers who may be concerned about how the transition is going to work out.

Q4668Chair: Most people coming into contact with killers do not survive. Therefore, a future steady state having gone through a transitional period and a dance with a killer are almost incompatible, aren’t they? A substantial amount of the industry will not survive this transitional period because of the killer effect, and therefore the steady state in the future that you are imagining is a myth.

Iain MacNeil: In principle, you are correct. What is difficult to judge is how different parts of the financial sector would react to the changes taking place. Some of them might cope better than others. For example, some aspects of funds management might survive better than, say, banking. It is wrong to think that the entire financial sector in Scotland would respond in the same way. There might well be some differences in the way different parts would feel they were affected.

Q4669Lindsay Roy: You are not scaremongering here. You are saying there would be much greater risk and uncertainty.

Iain MacNeil: Than things remaining as they are?

Lindsay Roy: Yes.

Iain MacNeil: I think that is inevitable.

Q4670Lindsay Roy: What about the impact of Scottish separation on the rest of the UK’s financial sector? Would you like to say a word or two about that?

Iain MacNeil: From that perspective, I guess the impact is much less. Scotland is not a huge market. The impact on the rest of the UK is probably more in terms of the customer base than the providers, because Scotland becomes a small EU market, assuming it is in the EU, that is adjacent to England. I am not sure that it is such a big deal.

Owen Kelly: One thing would be lost. We spend a lot of our time working with colleagues in London promoting the UK financial services industry because we are one jurisdiction. Scotland is a good part of that-well, I would say that, wouldn’t I? It is good to be able to say to international investors, if you are talking up the UK as a place to do business in financial services, "We’ve got London, that’s all marvellous, but we also have Scotland, and other bits of the UK as well." A substantial part of the employment in the industry is in Scotland, so I cannot see any benefits for the rest of the UK’s financial services industry in Scotland becoming a separate jurisdiction and country. In terms of the task of promoting the UK as a financial services centre, something would be lost.

Q4671Chair: Are there any final points? Before we started, I said to you informally that at the end we would give you the opportunity to give any answers to questions we had not asked. I think there are very few thoughts that have been unexpressed so far, but is there anything at all that you think we have not touched on?

Iain MacNeil: Not really.

Q4672Chair: I certainly have a much greater idea of what I do not know than I did when we started. Am I right in thinking that at the moment, with the present state of knowledge, separation for the financial services industry really is a pig in a poke? There are so many unknowns-many of them are known unknowns-that it is almost impossible to say what would happen, apart from the likely consequences of meeting a killer. Is that a fair assessment?

Owen Kelly: Up to a point. As I said earlier, there are some things you can know; there are some anchor points in this. You know you have to have a new regulator. You know that for all intents and purposes the current market and the current jurisdiction become two. These are structural things that have to happen because you are becoming a separate country, but you cannot know all the stuff that would ultimately follow, which would be subject to political decision and discretion. Unfortunately-I say unfortunately, but it is just a matter of fact that that currently includes some very big issues like the currency. There are some institutional changes you can know about, changes that simply come about as the necessary consequences of becoming a separate country, so it is not that we do not know anything, but many things still remain subject to political negotiation.

Q4673Chair: Is it inevitable that these things will remain unknowable until after the referendum? There is an issue here about whether or not the Chancellor was either rational or bluffing in terms of the decision. I take the view that, the three parties having come to that decision and made it, that has effectively sailed. Is there a whole number of things like that that can be settled between now and then, or do they all have to wait until after a referendum decision is made?

Owen Kelly: The political process that has been created for us by the two Governments does not allow that to happen. That was obvious from the outset. We have been pointing that out for many months. It was completely obvious from the outset. I guess both Governments have always known that this would be the process we would be going through, and neither side, apart from the institutional changes we have talked about, would be in a position to give any definitive description of what would follow a yes vote.

Chair: I think that has covered everything. Thank you very much for coming along. This has been very interesting.

Examination of Witnesses

Witnesses: Mark Neale, Chief Executive, Financial Services Compensation Scheme, and Sean Martin, General Counsel, Financial Conduct Authority, gave evidence.

Q4674Chair: Could I thank our witnesses for waiting so patiently while we had our previous discussions? As before, perhaps you would start off by introducing yourselves and telling us a little about your background and the context in which you are helping us in our inquiry into the impact of separation upon the financial sector.

Mark Neale: I am Mark Neale, chief executive of the Financial Services Compensation Scheme. The scheme is to protect consumers when financial services businesses go bust. We protect deposits up to £85,000 in UK banks, building societies and credit unions, and, unusually, internationally we also protect insurance policies, investment and home finance business.

Sean Martin: I am Sean Martin. I am the general counsel of the Financial Conduct Authority, which is one of the main regulators for the financial services industry. I am also a member of the FCA’s executive committee.

Q4675Chair: Can we assume that the Scottish financial services industry is entirely regulated in exactly the same way as everywhere else in the UK at the moment?

Sean Martin: That is broadly right.

Q4676Chair: What does "broadly" mean?

Sean Martin: There is a slight difference in terms of the criminal prosecution function, so if the FCA wanted to take criminal action in Scotland the criminal regime is a little different from the rest of the UK.

Q4677Chair: That is a consequential point. What about the regulation itself?

Sean Martin: The regulation itself is very much the same.

Q4678Chair: What do you mean by "very much"? I want to be clear whether or not it is exactly the same.

Sean Martin: It is exactly the same.

Q4679Mike Crockart: I would like to set the scene a little. We are not experts in the regulation of banking and financial services. Given that they have changed relatively recently under this Government, could you explain the different roles of the Financial Conduct Authority and the Prudential Regulation Authority?

Sean Martin: It is probably worth thinking about this as a tripartite structure. If one starts with the Bank of England, the bank has a general objective to enhance and protect the financial stability of the United Kingdom. That is the overriding piece. Sitting as a subsidiary of the bank is the Prudential Regulation Authority whose objective is concerned with the safety and soundness of about 2,600 firms-banks, insurers and a small number of major investment firms. The Financial Conduct Authority regulates a much larger number of firms; we regulate 26,600 firms, and our objective is to ensure that markets work well. Within that, we have the objective of consumer protection, promoting competition in the interests of consumers and enhancing the integrity of the financial system.

Q4680Mike Crockart: Broadly, we have one arm looking at the day-to-day conduct of the companies within it and the other looking at the structure of those companies and making sure they are properly constituted to be able to carry out their role.

Sean Martin: That is right. The only qualifier I would put is that the FCA is also responsible for what we call prudential supervision of all the firms that are not regulated by the PRA. The PRA has 2,600. We have 26,600, and that includes both the conduct and financial soundness of all those firms not regulated by the PRA.

Q4681Mike Crockart: Those functions were previously integrated under the FSA. How does the new structure affect the relationship between the two parts and the way the industry acts on a day-to-day basis?

Sean Martin: It means that for the 2,600 bigger firms they have two regulators, not one, and that the regulators have a very different focus. Whereas the PRA is looking very much at whether the firms are financially sound, we are looking at how they behave, how they treat their customers and whether they are committing some sort of market abuse, so there is a very different focus from the two authorities. The relationship between the two regulators is set out to a large extent in statute in the Financial Services and Markets Act 2000, as amended in particular by the Financial Services Act 2012.

Q4682Mike Crockart: Mark, how does the Financial Services Compensation Scheme fit into this? Is it there to pick up the pieces when things go wrong?

Mark Neale: That is right. We protect firms that are regulated by both the Prudential Regulation Authority and the Financial Conduct Authority. We protect deposits, insurance and investments, as I said. Although we are independent in our decision making, we are accountable to both the FCA and the PRA for the way in which we operate. We have slightly different relationships with both bodies. With the PRA, we are part of the arrangements for the safe resolution of failing banks, building societies and other systemically important businesses; that is to say, those businesses can only fail safely if you can protect consumers, and depositors in the case of banks and building societies. That is where the Financial Services Compensation Service comes in. It ensures that, in the event of a failure, consumers are protected and get their deposits back, up to the £85,000 limit.

Q4683Mike Crockart: We have a tripartite, with the Financial Services Compensation Scheme sitting to one side to pick up the pieces, but is it fair to say they are all very closely integrated?

Sean Martin: There are two other players in the jigsaw that I should mention. One is the Financial Ombudsman Service, which is responsible for adjudicating individual disputes between consumers and firms, and the other is the Money Advice Service, which has an overriding consumer education function.

Mike Crockart: Thank you. I think I have teed up nicely for the next question.

Q4684Pamela Nash: Carrying on from my question to the earlier witnesses, it seems clear that if Scotland was a separate country there would be a different regulator and, therefore, eventually a different regulatory framework. Can you tell us what effect it might have on the financial services industry based in Scotland at the moment, if they were in a separate Scotland?

Sean Martin: The Scottish Government have said that they would like to see some shared prudential supervision across an independent Scotland and the remainder of the UK. That would mean their preference is the PRA and the Bank of England spanning the remit, whereas for conduct regulation the proposal is to set up a new conduct regulator.

Q4685Pamela Nash: To take that separately, is it a viable option?

Sean Martin: In terms of having a single prudential regulator for the two?

Pamela Nash: Yes, and separating that from the customer regulatory framework?

Sean Martin: That is probably not something I can offer any informed comment on, because my interest is very much on conduct regulation. As to whether it would work, Andrew Bailey, deputy Governor of the bank, would be able to speak to that. Clearly, the issues would be around currency union and possibly the extent of wider integration. That is something he will be able to offer a more informed view on than me.

Q4686Pamela Nash: The reason I push that is that, if it is not a viable option, there is no point in discussing what the differences would be, because other people have offered the opinion that there would have to be a completely separate regulatory framework.

Sean Martin: What is clear is that it would be viable to have a separate conduct regulator, which is the current proposal. If that is the policy, intention and political wish, it would be possible.

Q4687Pamela Nash: Do you think it would be completely dependent on whether or not there was a currency union?

Sean Martin: Not for conduct regulation.

Pamela Nash: No, for prudential.

Sean Martin: On prudential, it is not something where I can offer an informed view.

Mark Neale: In the case of financial compensation, European Union law varies a bit between the different sectors of the industry. If we take deposits in banks, building societies and credit unions to start with, European law is very clear. Each member state must have a deposit protection scheme. The implications of that are that, if Scotland voted to separate, the new Scottish state would need to establish a separate scheme.

Q4688Pamela Nash: It has to have its own scheme-it can’t be incorporated.

Mark Neale: It has to have its own compensation scheme. An independent Scottish state would need to set up a compensation scheme which would protect depositors in Scottish-based banks, on the same basis that we now protect depositors in the UK banks up to the £85,000 limit.

Q4689Chair: Can I be absolutely clear about what you are saying? A separate Scotland would have to have its own compensation scheme. Are you sure that rules out having its own scheme that is shared with somebody else? You can say, "I’ve got my own scheme and I happen to share it with my pal." The fact that we are in the process of divorcing is, to some extent, neither here nor there, but it would be your own scheme even though it was shared, surely.

Mark Neale: My understanding of European law is that if Scotland became a member state it would have to have its own compensation scheme-that is to say, it would have to have its own means of meeting the costs of compensating consumers in the event of the failure of banks, building societies or credit unions. It is conceivable that the Scottish Government could ask us to run that scheme, but it would have to have its own scheme.

Q4690Pamela Nash: I apologise for showing my ignorance on this subject. As Mike said, we are not experts by any means on this topic, but we are learning rapidly today. If there was a separate scheme in Scotland, would that only protect Scottish consumers, or would it have to protect Scottish bank consumers throughout the rest of the UK and beyond?

Mark Neale: If we continue to focus on deposits, it would protect consumers with deposits in Scottish-based banks; that is consumers with deposits in Scottish-based banks living outside Scotland as well as Scottish consumers with deposits in those Scottish banks, building societies or credit unions.

Q4691Pamela Nash: That is a considerable point. Because we have such a big and successful sector at the moment, that new scheme would have to cover consumers in the rest of the UK.

Mark Neale: That is right. The extent of the coverage and the liabilities that go with it would depend a bit on the structuring of the Scottish banking deposit-taking sector after a vote for independence, but if the current Scottish-based banks continued to be based in Scotland and operated their services through branches in the rest of the UK, the Scottish scheme would protect all those consumers, wherever in the UK or Scotland they were.

Q4692Pamela Nash: That would mean that those Scottish-based banks would not have to be involved in the remainder of the UK’s continuing scheme.

Mark Neale: There are other models that the Scottish banking and deposit-taking sector could take. Banks currently based in Scotland could decide to set up separate subsidiaries in the rest of the UK regulated by the Prudential Regulation Authority, with their own separate capitalisation. If that came about, we in the Financial Services Compensation Scheme would protect the depositors in those UK subsidiaries.

Q4693Pamela Nash: Would that come at considerable additional cost to those companies?

Mark Neale: I think you would have to put that to the companies themselves. All I can do is set out what some of the options are for the structuring of the industry.

Q4694Pamela Nash: To be clear, if they set up a subsidiary in England, would it cost them to be part of the scheme?

Mark Neale: They would then contribute to the Financial Services Compensation Scheme, as they do now as UK-regulated financial businesses.

Q4695Pamela Nash: Is that contribution per customer?

Mark Neale: In the case of deposit-takers, it is based on their share of UK insured deposits.

Q4696Pamela Nash: Would that be an additional cost, or would it depend on what the Scottish scheme would be?

Mark Neale: You would have to ask the banks themselves their view about the costs of setting up separate subsidiaries in the rest of the UK in the event of independence.

Q4697Pamela Nash: I understand that, but I am talking specifically about the cost of being part of the FSCS.

Mark Neale: They would contribute both to the Financial Services Compensation Scheme in respect of their UK subsidiary and to the Scottish scheme in respect of their Scottish operation. I am not sure that would necessarily lead to higher compensation costs. It would depend on what happened within the sector after independence.

Q4698Mr Reid: Mark, if Scotland adopted the sterlingisation model and therefore did not have a lender of last resort, how would that affect its ability to set up a compensation scheme?

Mark Neale: I am not sure it would have any particular bearing on setting up a compensation scheme. It would still have to set up a compensation scheme, and that scheme would then be liable to meet the compensation costs of the Scottish-based banks, building societies and credit unions. It would look to banks, building societies and credit unions in Scotland, as we do, to meet the costs of compensation; and it would look to the Scottish Government to provide the stop-gap in the event that the costs of compensation exceeded what the industry could absorb at any one time. It is quite important to distinguish that from lender of last resort facilities; those are facilities that the Bank of England provides in terms of liquidity support to solvent banks and building societies, not the support that the sovereign provides to us in the event that we have to make very large compensation payments.

Q4699Mr Reid: Am I right that the Scottish Government would then have a responsibility to ensure that funds were available in the event of a crash?

Mark Neale: The Scottish Government would have to ensure that there was a scheme in Scotland that could meet the compensation costs in the event of a Scottish-based bank, building society or credit union failing. It would almost certainly look in the first instance to pool those costs across the industry, which is the way we fund compensation now in the UK. If the costs of compensation, as occurred in the 2008 failures, are greater than the industry can absorb, just as we borrowed from the Treasury in 2008 to meet those costs-indeed, we still owe the Treasury £17 billion-the Scottish scheme would need to look to the Scottish Government for financial support.

Q4700Mr Reid: That would be to support all banks based in Scotland.

Mark Neale: That would be to deal with any compensation costs arising from the failure of a Scottish bank, building society or credit union.

Q4701Mr Reid: Can you give a rough breakdown of how the Scottish banking sector is made up at the moment? Who are the big players?

Mark Neale: At the moment it is heavily dominated by two players: the Bank of Scotland and Royal Bank of Scotland.

Q4702Mr Reid: My interpretation of an insurance scheme is that you have a lot of players, so that if one goes bust the income from the others is sufficient to compensate, but I am not sure about the concept of an insurance scheme where you have only two big players.

Mark Neale: You are right. Insurance schemes work best where there are broad, deep pools across which to pool insurance costs. In the case of a separate Scotland, assuming that the structure of the banking industry remained the same, it is possible that banks in Scotland would choose to set up subsidiaries in the rest of the UK rather than continue to operate entirely from Scotland. If that structure remained, in the event of the failure of one of the big Scottish banks, those costs would fall to be met in the first instance by the rest of the Scottish banking industry.

Q4703Mr Reid: By the other bank.

Mark Neale: By the other bank, and some of the smaller building societies and credit unions. To the extent that they were unable to meet those costs, the costs would fall on the sovereign, on the Scottish Government.

Q4704Mr Reid: Say I am living in Scotland and I want to put a lot of money in a bank. I look at that set-up and I am not very sure if the assets are there to cover it. Can I walk into a branch and say, "I want to put my money into a bank based in England"? What is the difference between being based in England and based in Scotland? Is it the bank that makes the choice?

Mark Neale: It is the consumer who makes the choice. The protection would in principle be exactly the same. Consumers putting their deposits in Scottish banks or banks in the rest of the UK would be protected up to £85,000. In the case of deposits in Scottish-based banks, building societies or credit unions, the protection would come from a separate Scottish compensation scheme, whereas if you put your deposit in a UK-based bank, building society or credit union the protection would come from us-the Financial Services Compensation Scheme.

Q4705Mr Reid: The bank makes the choice as to where it is based, and I then choose the bank.

Mark Neale: The consumer chooses the bank, and then the consumer would be protected by whichever compensation scheme was protecting deposits in that particular bank or building society, depending on its location.

Q4706Mr Reid: Is the £85,000 an EU decision or is it a member state decision?

Mark Neale: That is an EU decision. The European Union harmonised compensation. It is €100,000, which translates into £85,000.

Q4707Chair: Can I seek clarification? Am I right in saying that you are suggesting that, in the event that the Bank of Scotland and Royal Bank of Scotland remain domiciled in Scotland and one of them collapses, the liability for all of that would fall on the other; failing which, the other sections of the financial community; and, failing that, it would fall on the Scottish Government? I was under the impression that in the UK at the moment the lender of last resort was the Bank of England rather than the UK Government.

Mark Neale: That is not quite right in the case of compensation. The Bank of England is the lender of last resort for banks in the UK for liquidity purposes-that is to say, the Bank of England will lend to solvent banks or building societies in order to see them over liquidity problems. It obviously will not lend to insolvent banks. In the case of compensation, you are dealing with a bank, building society or credit union that has gone bust, so if we need to look beyond the industry for support, we look to the Government.

Q4708Chair: Is it realistic to expect that in the event of the collapse of Royal Bank of Scotland or the Bank of Scotland, or both, the Scottish Government would be able to fund that, given the imbalance between the financial resources of those banks and the estimated GDP of a separate Scotland?

Mark Neale: The liabilities falling on the Scottish Government in that event would depend on decisions that those banks had taken about where they wanted to be located.

Q4709Chair: I understood that, but what would happen in the event that they did not relocate outside Scotland?

Mark Neale: In the event that they didn’t, there would be significant liabilities, and the Scottish Government would have to manage public finances in Scotland with that contingent liability in view.

Q4710Chair: What does that mean in English? I did not understand that. Am I right in thinking that the amounts of money involved are so enormous that the Scottish Government could not meet those costs?

Mark Neale: No, I am not saying that. I am saying that there is a contingent liability associated with compensating Scottish bank consumers, and the Scottish Government would have to consider how to manage the Scottish finances in order to be sure it could meet that cost.

Q4711Chair: What does that bit mean?

Mark Neale: It might mean, for example, that the Scottish Government created a fund to ensure it was in a position to meet those liabilities in the future.

Q4712Chair: To be clear, if I can, on the off-chance that the two main Scottish banks went bust, the Scottish Government would have to create a fund in order to balance any contingent liabilities that might arise. Presumably, that fund, which for the sake of argument we could call an oil fund, would not then be available for anything else.

Mark Neale: It is not for me to say how a Scottish Government would elect to manage that liability, but there would be a contingent liability that would need managing.

Q4713Chair: What does that mean? I genuinely do not understand this. How could a Scottish Government manage that contingent liability other than by having a big deposit of their own that might be called on in the event that these two banks, or one of them, collapsed?

Mark Neale: That would be one option. It could no doubt borrow on the markets to some extent as well, but these are decisions for a Scottish Government to make rather than for a compensation scheme to decide.

Q4714Chair: I understand that, but I am trying to clarify what options the Scottish Government in these circumstances might have. Unless I am mistaken, it would be sensible for the Scottish Government to try to persuade as much as possible of the Bank of Scotland or the Royal Bank of Scotland to move out of Scotland and, therefore, have the burden in those circumstances fall on somebody else, like the English, Welsh and Northern Ireland taxpayers.

Mark Neale: That is probably a question to put to those in the Scottish Government rather than the compensation scheme.

Chair: But you are here.

Q4715Sir James Paice: Among the options, could they have the option of effectively doing nothing and, if called upon to fund the deposit guarantee, they could decide to do it in that year out of their current budget supplemented by international borrowing, if necessary?

Mark Neale: They might take that option, but again I think you would have to put that question to them.

Q4716Sir James Paice: I just want to clarify that it is an option.

Mark Neale: You would have to put that to them.

Q4717Sir James Paice: I am not trying to establish whether they would choose it, but it would be an option, would it, among the list of possibilities?

Mark Neale: You will forgive me. I am not really keen to start prescribing policies for an independent Scottish Government.

Q4718Sir James Paice: Forgive me, I am not asking you to prescribe a policy. I am just saying that among the range of options, is this one of them?

Mark Neale: I guess that might be an option, yes.

Q4719Mr Reid: In the scenario where a large bank based in Scotland collapsed and the Scottish Government were unable to pay out the amount of money required under the compensation scheme, would depositors who were not Scottish citizens have any practical recourse against the Scottish Government?

Mark Neale: The Scottish Government would under European Union law be obliged to meet the compensation costs associated with the failure of a Scottish-based bank or building society.

Q4720Mr Reid: But, in practice, if they didn’t, what would the ramifications be?

Mark Neale: All I can tell you is that they would be obliged under European Union law to meet that liability.

Q4721Chair: I think the words blood and stone come to mind here. If the Scottish Government simply cannot do it-cannot borrow-Alan’s point is what then happens?

Mark Neale: Again, that is a question you would need to put to a Scottish Government. I am not sure that I, in the position of a compensation scheme, can answer that question for you.

Q4722Mike Crockart: The difficulty about the contingent liability is that it might fall to be met. Given the banking sector as it stands at the moment and the place where it is presently registered-where those liabilities would fall-what is the size of that contingent liability for a financial services compensation scheme for an independent Scotland?

Mark Neale: In the case of deposits, the Treasury published some information about that in the document on the financial services sector that it produced in May of last year, which suggested that the insured deposits in Scottish-based banks are about 110% to 115% of Scottish GDP.

Q4723Mike Crockart: In monetary terms, what are we talking about?

Mark Neale: Scottish GDP is about £150 billion.

Q4724Mike Crockart: You say they would have to put aside a facility to meet that. You do not want to be drawn on what that facility might look like, but there would have to be costs associated with that. Unless you close your eyes and say, "Oh, well, we’ll borrow if we need to," there are costs associated with setting money aside to defray some of the risk. Is there any feeling for what those costs would be?

Mark Neale: I am afraid I cannot answer that question.

Q4725Mike Crockart: What does the UK Government do, for example?

Mark Neale: If we take 2008 as an example, the UK Government itself borrowed to meet the costs of the banking failures and to provide us with the funds we needed to meet the costs of compensating consumers affected by the failures of Bradford & Bingley and the Icelandic banks. The costs were about £20 billion.

Q4726Mike Crockart: You say "itself borrowed." What does that mean in real terms?

Mark Neale: It means that the UK Government sold gilts in the markets to raise the money necessary to meet the compensation liabilities that we had in 2008.

Q4727Mike Crockart: But that is at the point at which the failure has happened.

Mark Neale: Yes.

Q4728Mike Crockart: In the years leading up to a failure, is there a cost associated with managing this contingent liability?

Mark Neale: There are other ways of doing it. You can build up pre-funds, as a number of countries do, in which you levy the industry year on year to build up a fund, which you hope will be big enough in the event of a major failure. Those costs then fall on the industry.

Q4729Mike Crockart: I am not sure you have answered the question I just asked. You might have, but I don’t think you did. That is one way of doing it. It is obviously not what the UK did. Did the UK just sit and wait for a failure and then go out and borrow on the open market, or did it set aside something?

Mark Neale: The UK has always operated on a pay-as-you-go basis-that is to say, we levy the industry to meet the costs of failures as and when they occur. If those costs exceed what the industry can bear, we borrow from the Treasury and in a major failure like 2008, the Treasury will itself borrow from the market. That is not the only model; another model is to build up a pre-fund.

Q4730Mike Crockart: But if Scotland had to go to the open market to meet the contingent liability that it has, given the size of the banking sector in Scotland, it would have to go to the market for a ridiculously large sum, with huge associated costs, too.

Mark Neale: That would depend on the nature of the failure, and also on what option the Scottish Government took to resolve the failing bank.

Q4731Mike Crockart: But given that it is a banking sector that has two very large players within it, the nature of that failure is likely to be pretty catastrophic.

Mark Neale: It might be. Failures come in all shapes and sizes. The Scottish Government might, rather than allowing a bank to fail and go into liquidation, elect to resolve it by recapitalising it, as the UK Government did with Royal Bank of Scotland in 2008.

Q4732Chair: How likely do you think it is that a country could go to the markets to borrow, say, 110% of its own GDP?

Mark Neale: I think that is a question you should put to my friends in the Debt Management Office.

Q4733Chair: Returning to my previous response, they are not physically here, are they? You mentioned selling gilts, or the equivalent, to fund it. Presumably, that would be less advantageous to a separate Scotland in the event that they had already repudiated debt that they owed the rest of the UK. Would that affect their chances of being able to borrow that amount of money?

Mark Neale: That is a very hypothetical question. I am not sure I can foresee what the market reaction would be in those circumstances.

Chair: Indeed.

Q4734Graeme Morrice: I was going to ask some questions about deposit insurance, but you have probably answered a lot of the questions I was going to ask in answer to previous questions by colleagues. I do not know whether you have covered how the FSCS specifically administers the deposit insurance scheme. Perhaps you can add a bit more in terms of the mechanics of it and how you discharge your responsibilities in that regard. That would be useful.

Mark Neale: By all means. It is fundamental to a successful deposit insurance scheme that it has credibility with consumers, and that if we are called on to do so we can get people’s money back to them quickly. We made an investment three or four years ago in what we call fast payout, which means that, in the event of the authorities deciding to put a bank or building society into liquidation and asking us to pay out consumers, we will get that money back to those depositors within seven days in the great majority of cases, without those depositors having to make any application to us. It is an automatic process which we operate based on what we call a single customer view file that all banks, building societies and credit unions must maintain, which sets out the aggregate balances of all their customers.

Q4735Graeme Morrice: That is useful. I think you said earlier that if Scotland became an independent state it would have to have its own deposit insurance scheme. I think it was suggested that European Union law dictated that. Can you clarify that that is indeed the case?

Mark Neale: That is the case.

Q4736Graeme Morrice: You will be aware that the Governor of the Bank of England, Mark Carney, in his speech in Edinburgh recently said that a deposit insurance scheme was an essential part of currency union. What is your understanding of what he meant by that in terms of it being a shared scheme between the two countries?

Mark Neale: What Governor Carney said was that among the attributes of successful currency unions was also a banking union, and one of the attributes of a banking union is a common compensation scheme.

Q4737Graeme Morrice: If there was a common compensation scheme between an independent Scotland and the residual UK, what would you see as the disadvantages for an independent Scotland?

Mark Neale: The first point to make is that clearly the Chancellor has ruled out a currency union. I would take that also to rule out, from the UK Government’s point of view, a banking union, though clearly the Financial Services Compensation Scheme will implement whatever arrangements the two Governments, in the event of a vote for independence, decide.

Q4738Graeme Morrice: That kind of pre-empts my next question. The Governor of the Bank of England said that ultimately it is taxpayers who have to stand behind a central bank and any institutions it supports-how it would all work in terms of two separate independent countries and a central bank, if of course we do not have a common currency and we are not going to have an independent Scotland relying on a central bank, i.e. the Bank of England. What lessons do you think can be drawn from the eurozone in particular? They seem to be edging towards banking union.

Mark Neale: They are edging very slowly towards banking union. The European Union is about to adopt a new directive on deposit protection. That directive, though it harmonises in various respects deposit protection across the eurozone and the European Union, falls well short of mutualising, pooling the risks across the whole of the eurozone or European Union. It still relies on national deposit protection schemes to protect consumers, and that means that the European Union is continuing to put in place a link between the sovereign and the consumer in the event of major crises.

Q4739Mr Reid: Am I right in saying that both the two main banks in Scotland have a majority of their customers in other parts of the UK?

Mark Neale: I think that is right; I am not sure I know it for a fact, but it seems highly likely.

Q4740Mr Reid: Can you think of any other country where that would be the situation-where the biggest banks would have their customers in other countries?

Mark Neale: I do not know of any examples, no.

Q4741Mr Reid: In the event of separation, assuming there isn’t a currency union, do you think it would be in the interests of these two big banks to transfer their base to the rest of the UK, out of Scotland?

Mark Neale: That is entirely a question for the two banks. You would have to ask them what factors they would wish to take into consideration in making that judgment.

Q4742Mr Reid: Your expertise is in the compensation scheme. We have already heard that the Scottish Government could be faced with a bill greater than 100% of their GDP. Do you think that would be a factor in the confidence of depositors?

Mark Neale: Depositors would have the same protection whether they lived in Scotland and deposited their money in Scottish-based banks or in UK-based banks. They would have the same £85,000 protection, but the source of that protection would be different as between deposits in Scottish-based banks and deposits in banks or building societies based in the rest of the UK.

Q4743Mr Reid: If you were a depositor wanting to place your life savings of £85,000 in a bank-we have seen banking crashes, so they can happen again-would you be more confident that you would get your money back in the event of a crash if it was in a bank based in the UK or a bank based in an independent Scotland?

Mark Neale: I think that is a judgment for individual consumers to make, and they would no doubt take into account a range of other factors as well in deciding where to place their money.

Q4744Chair: So that’s a yes.

Mark Neale: That is neither a yes nor a no; it is an answer that says it is for consumers to make that choice.

Q4745Chair: Are there any lessons to be learned from what happened in Icesave with the proportion of banks in Iceland, the size of the economy and all the rest of it? Britain and the Netherlands had to step in to compensate depositors in an Icelandic bank because Iceland could not meet those compensation funds.

Mark Neale: Yes.

Q4746Chair: Is there a potential parallel with Scotland?

Mark Neale: I do not think so directly. The situation with the Icelandic banks was a very specific one, and I would not necessarily read that across to an independent Scotland.

Q4747Chair: Is there not a parallel in terms of the relative proportions-the size of the banks compared with the size of the economy? The collapse occurred in the Icelandic bank, the Icelandic economy was not capable of meeting the compensation, so other people stepped in to protect their nationals, but they need not have done so. Is that not almost an exact potential parallel with Scotland, where the size of the banks is so great compared with the size of the country’s economy that it is very difficult to see how the costs could be met?

Mark Neale: All I would say is that clearly the challenges for the public finances of any country, in terms of the contingent liability to meet compensation costs, are greater where those costs are higher as a proportion of GDP.

Chair: To be fair, that is a statement of the bleeding obvious, isn’t it? You are just telling us what we heard from you earlier.

Q4748Lindsay Roy: Can I move to currency? I think you were party to our discussions earlier on. The Chancellor has ruled out a sterling currency union. If there wasn’t one, what would be the implications for the regulatory system?

Sean Martin: For us, probably the biggest issue, alongside currency union, is membership of the EU. In terms of how firms in Scotland would continue to provide services in the rest of the UK, and vice versa, the key to that would be whether or not Scotland is part of the EU and therefore able to exercise what are called passporting rights. Essentially, that means that if a firm is authorised in one EU member state it is entitled to do business in another EU member state. Critical for us is understanding how the framework would operate.

Q4749Chair: The evidence we have had so far would suggest that there will not be a seamless transition. Scotland might get in eventually-terms unclear and everything else-but it will not be straight from the UK into independence and automatically into the EU. There would be some period of negotiation and then a period of getting it agreed by all the other countries, so there would be an interim period. What are the consequences of an interim period?

Sean Martin: As I understand it, it is still in dispute whether they would be able to enter the EU at the point of separation from the rest of the UK. Assuming there was some interval, firms wishing to do business in the remainder of the UK would need to be authorised by the UK regulators. It is possible that the UK Government could construct a regime that would allow for some sort of recognition of Scottish firms, to try to emulate what might otherwise be the passporting regime one would get on entering the EU, but that would clearly be for the Government and Parliament, not the regulators, to decide.

Q4750Chair: But you could have the regulation of subsidiaries, could you?

Sean Martin: Assuming Scotland were to leave the UK and not join the EU, if a Scottish entity wished to operate in the rest of the UK, it would need to be authorised either as a subsidiary or as a branch. It would still be part of the same legal entity, but it would have to go through the full route to authorisation.

Q4751Sir James Paice: But there would be no obligation on the UK regulators to regulate them. I appreciate there is an element of politics in this, but it is not automatic that a Scottish financial house-financial institution-would be approved to provide financial services in the rest of the UK.

Sean Martin: That is right. Absent any special legislative regime or absent EU membership, we would need to consider Scottish firms in the same way as we do other third-country firms, as we call them.

Q4752Chair: Coming back to the killer analogy earlier, there could be a pause or break in the ability of Scottish firms to trade in the rest of the UK while all these things are arranged.

Sean Martin: The killer analogy being?

Q4753Chair: Sorry, I assumed you were here earlier. The killer analogy is that it is possible to envisage a steady state where the Scottish financial industry is stable; the difficulty is getting from here to there, and the killer period is in the middle. We were discussing whether or not most people survived killers. Therefore, there could be a transitional period where firms in Scotland were not endorsed to trade in the rest of the UK.

Sean Martin: Assuming there is a yes vote in September, we would then have our period through to separation. During that period, Scottish firms would continue to operate as they do now. During that period one would look either for some sort of legislative solution, or you might expect them to seek authorisation to operate in the rest of the UK. It would not necessarily follow that they would be stopped from operating in the rest of the UK, but they would need to go through some form of process.

Q4754Chair: That process and the speed thereof would be entirely at the discretion of the UK.

Sean Martin: It would also rest in the hands of the firms themselves.

Q4755Chair: But presuming the Scottish Government wanted them to do it and the firms wanted to do it, the speed with which it was progressed would be entirely within the control of the Government of the UK. Is that correct?

Sean Martin: And the regulators in the UK who would need to process the applications.

Chair: That is right; fine. Thank you.

Q4756Lindsay Roy: If there is no common currency agreement and no euro, we are left with sterlingisation and a separate currency. What implications does that have for the regulation and deposit insurance schemes?

Mark Neale: It would have no implication for the deposit insurance schemes, because depositors in Scottish-based banks would have exactly the same £85,000 protection, but from a different source.

Q4757Lindsay Roy: What about regulation?

Sean Martin: In the absence of a common currency?

Lindsay Roy: In the case of the adoption of sterlingisation or a separate Scottish currency, what would be the implications for regulation?

Sean Martin: Again, I return to the key question for us, certainly from the FCA’s perspective. The bigger question is EU membership and the entitlement to operate in the UK. That is the key question.

Q4758Sir James Paice: Can we just go back to an earlier answer? You say they would still get £85,000 protection. Why?

Mark Neale: Because it is an EU-mandated harmonised protection limit.

Q4759Sir James Paice: But you are assuming, therefore, that they are in the EU.

Mark Neale: I was indeed making that assumption.

Q4760Sir James Paice: Whereas, as we have just been discussing, we have had a fairly strong body of evidence that there would be an interregnum between independence day and accession to the EU, so in that period of time there would be no obligation to have a deposit insurance scheme in Scotland.

Mark Neale: My assumption is that the Scottish Government in that event would nevertheless wish to put in place arrangements to ensure that happened.

Q4761Sir James Paice: That is your assumption; it is not a fact or any requirement.

Mark Neale: It is an assumption, not a requirement, no.

Q4762Lindsay Roy: To what extent would sovereign debt default by Scotland, or refusal to take on inherited debt, have implications for the stability of the financial system?

Sean Martin: That is probably best addressed to my colleagues in the PRA or the Bank of England. That is not an assessment I could easily make.

Q4763Lindsay Roy: You have no view on the matter.

Sean Martin: No.

Q4764Chair: Mark, I take it you will refer us to an answer you gave some moment ago.

Mark Neale: I will indeed.

Chair: I suspected that.

Q4765Lindsay Roy: Can we get a reference to the individuals who could respond to these questions?

Sean Martin: I believe you are seeing Andrew Bailey later this afternoon. He will be better placed than I am.

Q4766Chair: We will tell him you said he would answer all these points. Mr Neale, would you be referring it to Andrew Bailey as well?

Mark Neale: If you want to ask questions about access to sovereign debt markets, the best organisation to go to is the Debt Management Office and its head, Robert Stheeman.

Q4767Mike Crockart: Mark, I want to go back to a couple of points you made previously and put them together. You said that under EU law an independent Scotland would need a separate compensation scheme, and it could not be a shared scheme. In Mark Carney’s speech he said that a shared deposit insurance scheme is an essential part of a currency union.

Mark Neale: Of a banking union and currency union, yes.

Q4768Mike Crockart: How do we put those two together and end up with a currency union inside the EU?

Mark Neale: As I think one of your previous witnesses said, that is an issue that would need to be resolved.

Q4769Mike Crockart: Is that shorthand for it is a problem and it would have to be open to negotiation?

Mark Neale: I think it would have to be open to negotiation.

Q4770Mike Crockart: But taking those two statements together, you cannot have both as it stands.

Mark Neale: As it stands, there is a legal requirement on member states to have a compensation scheme.

Q4771Mike Crockart: There would need to be a negotiated opt-out from EU law.

Mark Neale: Yes, conceivably.

Q4772Jim McGovern: Staying on the subject of banking and currency, if the overriding aim was to allow Scotland to protect the financial services industry, how could that be achieved? How could we protect the financial services industry in Scotland?

Sean Martin: I am not sure I can answer that question. Certainly the question of a currency union is probably outside the scope of what the FCA would be looking at. It is probably more one for the bank.

Q4773Jim McGovern: I am sure Hansard will record this absolutely accurately and correctly. I do not know if you are being deliberately evasive or you just cannot give a straight answer.

Sean Martin: I am certainly not being deliberately evasive, but I think it is not something that the Financial Conduct Authority has an obvious interest in.

Q4774Jim McGovern: Okay. In the event of separation, if that happens-if the Scottish people vote for separation-what would be the rest of the UK’s best strategy in terms of the organisations you represent?

Sean Martin: In a sense, we are an independent regulator. Our purpose and our aims are set out in statute, so we would continue to advance those objectives in the way we do now, but we would be doing it for the remainder of the UK rather than for the existing UK. In that sense, our purpose and goals would not change.

Q4775Jim McGovern: It would just mean that Scotland would be excluded from that.

Sean Martin: It would.

Mark Neale: My answer would be very much the same. We would continue to protect consumers of financial products bought from UK-based businesses.

Q4776Jim McGovern: I apologise if I offended you by what I said, but it seems to me that it is almost confrontational. It should not be that way. It is as if you do not want to give a straight answer to the questions we are putting.

Sean Martin: That was not my intention.

Jim McGovern: Okay. Thank you.

Q4777Chair: Well, colleagues, I think we have got as much from yourselves as we are likely to get. However, are there any answers you had prepared to questions we have not asked? I know it is a bit like drawing teeth, but is there anything we should have asked you that you think would be helpful to our discussions going forward?

Mark Neale: I do not think so.

Chair: Fine. Thank you very much for coming along.

Examination of Witness

Witness: Andrew Bailey, Chief Executive Officer, Prudential Regulation Authority, gave evidence.

Q4778Chair: Good afternoon. We are sorry for holding you back a bit. We were having so much fun that our previous sessions overran. Anyway, we have to be out of here by 9 o’clock.

Andrew Bailey: I will settle in then.

Q4779Chair: Mr Bailey, could I welcome you to this session? As you are aware, the Scottish Affairs Committee is conducting an inquiry into various aspects of the impact of separation upon Scotland in an effort to try to provide clarification for those who are about to vote. Therefore, we are trying to illuminate a variety of issues. Today, we are looking at matters concerned with financial markets, banking and the like. Could we start off by asking you to introduce yourself and tell us your background and why your experience is relevant to our inquiry?

Andrew Bailey: I am deputy Governor of the Bank of England responsible for prudential regulation. Effectively, I am also chief executive of the Prudential Regulation Authority, which was established not far off a year ago when the UK regulatory system was reorganised. Prior to that, I was chief cashier at the Bank of England, so I had quite a heavy involvement in Scottish bank notes, among other things. During the height of the crisis-I don’t know whether I did something wrong in the past-I was also responsible for sorting out problems in banks as they arose, which included emergency lending to RBS and HBOS. The previous time I appeared before this Committee was in relation to resolution of the Dunfermline Building Society, so I guess I have a bit of form. In a nutshell, that is what I do.

Q4780Chair: We have great expectations of you. The previous witnesses declined to answer a whole number of questions, but they said you would be able to explain everything.

Andrew Bailey: That was what they told me as I came in, which is a bit worrying.

Q4781Chair: No pressure then. Can we assume that the financial services sector in Scotland is regulated in exactly the same way as everywhere else in the UK?

Andrew Bailey: Yes. We are the prudential regulator for banks, insurance companies and major investment firms. We are a unitary regulator, so we regulate in exactly the same way irrespective of the location of the firm.

Q4782Mike Crockart: I asked this question of the FCA, so it will be interesting to see whether we get the same answer. The arrangements for regulating banking and financial services have obviously changed in the very recent past. Can you explain the different roles of the FCA, PRA and, more widely, as was explained by the FCA and FSCS, the Money Advice Service and another one that was mentioned?

Andrew Bailey: The ombudsman.

Mike Crockart: Yes. Thank you.

Andrew Bailey: We are the prudential regulator for banks, insurers and major investment firms. The FCA is the conduct regulator for all of those firms, so we jointly regulate, but with our different objectives, which I will come back to. As they probably explained, the FCA is the prudential and conduct regulator for the rest of the financial services population, which numerically is by far the largest number of firms. The regulator regulates about 25,000 firms altogether, about 2,500 of which we are the prudential regulator for and we share with them. We tend to have the largest firms in our ambit, but we also have credit unions and small insurers.

We have a common objective across all the firms we regulate, which is the safety and soundness of firms in the context of the stability of the financial system. For insurers, we have a second objective-an insurance objective-which is policyholder protection. In an Act of Parliament passed at the tail end of last year, which introduced the reforms of the two commissions, the Independent Banking Commission and the Parliamentary Banking Commission, we were also given a secondary objective in respect of competition.

The FCA, as I am sure they explained, has an overall conduct of business objective, which it operates across all the firms. That includes both market regulation and regulation in respect of consumers.

Q4783Mike Crockart: Your predecessor, the FSA, incorporated the prudential and the customer aspects. What is the benefit of splitting those?

Andrew Bailey: The clear benefit is focus. Let me illustrate that. There are two parts to it. First, these reforms-bear in mind that the PRA is part of the Bank of England-have brought under one roof what we do in terms of individual firm regulation and the new element, which in the jargon is called macro-prudential regulation, and takes a much more macro view of financial stability. I am a member of the Bank of England Financial Policy Committee. The third leg is monetary policy. Already in the first year we are seeing clear evidence that having it under one roof can enable the MPC’s view of monetary policy much more effectively to take into account the state of the banking industry and credit creation.

On the second thing, I speak mainly from about two years of experience. In the last two years of the FSA, I worked mostly in the FSA as head of prudential regulation, in the job to be, as it were. There are two things I would observe. First, within that system I think it was hard for the FSA, given its much larger number of objectives, to create a stable balance between prudential and conduct regulation. On the whole, during its life, I do not think the FSA has achieved that stable balance. It was not always the same way round, but at various points in time one tended to dominate the other, which was not good.

The second observation is a bit more practical but is somewhat in the same vein. I spent two years in senior management. You had issues coming at you from all angles, with 25,000 authorised firms, doing conduct and prudential. It was quite difficult for senior management to balance the issues, particularly in a period when there was quite a severe financial crisis going on.

Mike Crockart: I think that sets the scene well for independence questions.

Q4784Graeme Morrice: In terms of an independent Scotland, if that was ever to happen, what do you think would be the implications of having different regulatory systems for companies based in Scotland?

Andrew Bailey: I cannot give you any view on the question of whether Scotland should or should not be independent. That is not for me.

Graeme Morrice: I am not asking that.

Andrew Bailey: One thing I would say, which is particularly true in our world of prudential supervision, is that quite a substantial part of what I might call the regulatory structure that is applied by us comes from the European Union. That is true both in banking and in insurance. I know there is an open question about European Union membership, on which again I cannot give a view, but if you were to assume hypothetically that Scotland were to be a member of the European Union, there would be a common base of regulation.

But there is a second part of it that is not common. I give three examples I very briefly touched on in the earlier answer, which are major policy initiatives of the Westminster Parliament over the last year. The so-called ring-fence in banks, which came out of the independent commission chaired by Sir John Vickers, is entirely a UK policy initiative passed by the Westminster Parliament. The so-called senior persons regime and the licensing regime for bankers again are products of the Parliamentary Commission on Banking Standards chaired by Andrew Tyrie, again entirely a UK regime. The third one is the competition objective we have and the much larger competition role the FCA has, which again is entirely a UK regime. There are still substantial elements of what we do where an independent Scotland and an independent Scottish Parliament would have to decide what they want. They may decide to follow precedents here, but they may not.

Q4785Graeme Morrice: Very simply, if they decided to choose a different solution, presumably there might be a lot of issues for companies based in Scotland wishing to trade with the rest of the UK.

Andrew Bailey: Up to a point. Major international firms do not like it, but one of the things they have to put up with is that if they are based in many different jurisdictions-typically they are-they are used to operating under different regulatory regimes. They will all tell you that they wish we would adopt common systems, but the fact of the matter is that national Parliaments, for reasons they can well articulate, adopt different approaches.

Q4786Graeme Morrice: You will be aware of the Scottish Government’s White Paper on the whole issue of separation. A section of it relates to the financial services industry. Was your organisation consulted by the Scottish Government prior to publication of that paper?

Andrew Bailey: No. As I think Mark Carney said when he made a speech in Scotland quite recently, there have been some low-key technical discussions with the Scottish Government, but in no sense have we been consulted. By the way, I am not saying that because we felt in any sense we should be consulted; it is not for us to decide these things. We will provide low-key technical advice if asked. That is the limit of it.

Q4787Graeme Morrice: Would you like to have been consulted?

Andrew Bailey: No. It is very clear, because I have read the proceedings of your previous hearings, that we are not in a pre-negotiation phase at the moment. Clearly, that has been put off for later, conditional on the outcome of the referendum. We are very clear that, assuming there is a yes vote, there has to be a set of decisions at governmental level on what I might call some of the constitutional and institutional structures. They are not for us, just as it is not for us to decide the institutional structure of regulation in this country. What would follow though, if we go down that road, is that there would be issues of a more technical nature that must follow from that once the institutional structure is determined.

Q4788Graeme Morrice: You will be aware that in the White Paper the current Scottish Government suggest that in an independent Scotland they would like to see a single prudential regulatory system. Obviously, it would be down to a future Scottish Government to decide that, if indeed Scotland was to become independent; it is not down to the current Government to decide what happens in the future. How might that work in practice, if it was to be adopted?

Andrew Bailey: The question of European Union membership again is important. I am not a lawyer, but my understanding is that, in the event of European Union membership, an independent country is required to have a regulatory authority of its own. I think I am right in saying that the Scottish Government have said they take that point but could, in a sense, almost contract with the UK authority to conduct supervision of institutions, to draw that distinction between the regulatory authority and supervision. That is, frankly, an issue for the UK Government and the Scottish Government.

What I would say, and it comes back to the point I made earlier about the amount of policy that is determined in a common setting in the EU and the amount that is not, is that we would have to be very alive to the question of how much divergence there would be between the two structures. I looked around the world earlier this week to see if I could answer this question. It is not a system, I think, that is used almost anywhere else in the world. The only possible examples I could find were Greenland and the Faroe Islands, and they are not obvious major financial centres. It is not a system that is in place elsewhere. That does not mean to say it could not work.

Q4789Chair: The Faroe Islands share their functions with Denmark rather than doing it themselves.

Andrew Bailey: Yes, but to be honest they are not obvious major financial centres.

Q4790Chair: I just wanted to be clear about what you were saying.

Andrew Bailey: All I can tell you-I am not offering a judgment on this-is that what we observe in other parts of the world is that that is not a model that is used. But it does not mean to say it could not work, but there would be big issues around the institutional structure, and they need to be determined by Governments.

Q4791Chair: Can I clarify? What would be in it for the UK, in the event of separation, to have a shared supervisory function in that way? I can see what might be in it potentially for a separate Scotland, but what would be in it for the UK?

Andrew Bailey: I don’t know. You would have to ask the UK Government that question. One answer I would give is that it very much goes to the question of what structure the two Governments would want to have, particularly in respect of the currency.

Chair: We will come to that later on.

Q4792Graeme Morrice: Do you think a single prudential regulator implies a banking union?

Andrew Bailey: It goes to the question: is this a single regulator applying an absolutely common framework? Again, that would require both Parliaments to agree, "We’re going to set up an institutional structure that is absolutely common, and we’re not going to let this get out of alignment in terms of the non-EU parts," assuming there is EU membership. Or is it a single regulator where effectively you are applying two somewhat different approaches?

Q4793Graeme Morrice: You will probably be aware that the Governor of the Bank of England recently said that ultimately it is for taxpayers who have to stand behind the central bank in any institutions it supports. Can you see how that would work with two separate countries and one central bank?

Andrew Bailey: Again it would be a matter for the Governments to construct very careful, what I might call, institutional structuring. Mark Carney is absolutely right in that respect, notwithstanding the fact-we have it in this country-that the Bank of England has been given operational independence in respect of certain functions. A central bank only exists because, to use a phrase, it is an emanation of the state. We have no other, in a sense, special specialness than that. What does that mean? It means exactly your point, which is ultimately that the resources of the state-the fiscal base of the state-stand behind it. That is why, going back to my past, when you come to areas like emergency lending, lending of last resort and anything of a capital nature, it is really the fiscal resources of the state that are being used.

Q4794Graeme Morrice: Are there any lessons to be drawn from the eurozone, which seems to be edging towards banking union?

Andrew Bailey: There are a lot of lessons, and I think Mark Carney expanded on this in his speech. The lessons of the eurozone in this respect are that-in this case, subsequent to the start of the monetary union-they are going through a process, which obviously has been born of difficult experience, and have had to expand substantially what I call the reach of institutions. I think Mark used the term "fiscal federalism," which is one way of putting it. There has to be some pooling of fiscal resources, because the thing they have experienced in a very difficult way is the link between big problems in the banking sector and problems of sovereign creditworthiness.

Having had these very difficult experiences, as Mark said in his speech, all of us are working very hard to end the "too big to fail" problem and the dependence of the banking system on taxpayer money, but he made it quite clear that there are a number of areas where we do not expect ultimately to break that link. Lender of last resort is one of them. Even if we get to a point where its credit is in capital providers that essentially provide the solvency support, we will still be in a world where lender of last resort will apply. There is still a deposit guarantee scheme. You were talking to Mark Neale about that. That again is ultimately an emanation of the state, and you saw in cases like Iceland what happens when the state cannot support the deposit guarantee scheme. To bring the answer to an end, the euro area has learned, and is going through the process of having to build a larger institutional structure around monetary union.

Q4795Pamela Nash: I want to take you back to an earlier response to Graeme. I was not surprised when you said the Bank of England had not been contacted for discussions with the Scottish Government; you confirmed what the Governor had already said. I was surprised when you said that it was not something the Bank of England would seek to do, because in "Scotland’s Future" the SNP have set out very clearly their expectations of the Bank of England, not a negotiating position, but what they are telling the Scottish people the Bank of England will do. Would you enter discussions with the Scottish Government just now if they wished to consult with you on possibilities for the relationship with the Bank of England in the event of a yes vote?

Andrew Bailey: The reason why I said that is very important. It is absolutely clear, and, in a sense, it goes back to what I said about the central bank being an emanation of the state ultimately, that discussions, in the first instance-critically, in the first instance-have to be between the UK Government and the Scottish Government, not between the Bank of England and the Scottish Government. Obviously, we have a strong understanding of the role of the central bank, but this is ultimately a constitutional point; it is not a point that we can settle as what I might call technicians. We have said, and Mark Carney said it in his speech, that we are providing private low-key technical advice. We are having those sorts of discussions; we are open for those discussions, because we are happy to give the benefit of our technical expertise where it is deemed relevant, but it is not for us to determine the broader constitutional and institutional structural issues. That is for Governments.

Q4796Pamela Nash: I understand that, and I would not expect the Bank of England to wade into a policy area, but we as politicians and the Scottish people making this decision want to know what the possibilities are. It appears to some of us that the possibilities the Scottish Government are putting forward are not possibilities at all.

Andrew Bailey: You will have seen from the speech Mark Carney made that he set out a technical but quite important contribution, drawing on the lessons of currency unions and both the advantages and the pressures that you see in currency unions around the world. Going back to the discussion we were just having, one of the key points he made, which is the lesson from the euro area, is that if you have a currency union, or indeed a sharing of currency, it requires a stronger institutional fabric around it.

Q4797Chair: Can I go back a little to one of the questions Graeme asked about the implications of having a different regulatory system? You seemed to be saying that it was entirely possible to have two regulatory systems, one in Scotland and one in England, and it might be a bit of a difficulty for firms in Scotland but they should get over it, because they are multinationals dealing with a whole number of different regulatory systems and it is not really a problem. Is that a fair summary?

Andrew Bailey: The observation I make is that if you are a major UK international bank you are dealing with us as your lead regulator, but you are dealing with American regulators, who on the whole hunt in packs, and you are dealing with the regulators of other parts of the world. You may be in Hong Kong, Singapore, Germany or France. We have a college structure to bring that together, but you are having to deal with all of them domestically. They will all say to you, and I can understand this, "I wish these people would align themselves better," but ultimately national Parliaments have national interests.

Q4798Chair: But given there is a common base in the EU, the fact that there are differences in regulation between, say, a separate Scotland and UK should not be an insuperable difficulty.

Andrew Bailey: No. Certainly, in the prudential area, more so than the conduct area at the moment, there will be a larger common base, because if Scotland were to be a member of the EU there would be a larger common base of regulation coming out of the EU.

Q4799Chair: Could I also pick up the question of the single prudential regulatory system? You raised the issue about whether or not they would be supervising one scheme that applied to a separate Scotland and the UK, as distinct from having a divergent system. Would it be possible to operate a divergent system with one agency doing the supervision?

Andrew Bailey: I think it is possible, but over time it would probably create more stress than not having divergence. It is a bit like a statement of the blindingly obvious.

Chair: Yes, that’s what I was thinking.

Andrew Bailey: But one has to accept that national Parliaments with sovereignty have the right to do that, if they wish to do so. The UK Parliament has taken a number of big steps in the last two years on that front, and I absolutely understand and support why they have done it.

Q4800Chair: Yes, but are you agreeing with the Scottish Government’s proposal that basically the Bank of England could run two supervisory systems at the same time, even though there was divergence, and there are some stresses and strains but it is all doable?

Andrew Bailey: I have been quite careful. I have said that it is not a system that operates in any other part of the world where there is a major financial presence, and both the rest of the UK and Scotland have that. It is not a model you observe anywhere else. I think it would require very careful thought about how the single regulator would go about managing that operation when essentially you would have two sovereign Parliaments.

Q4801Chair: On the one hand, the fact that something has not been done before is not an argument for saying it cannot be done.

Andrew Bailey: No.

Q4802Chair: Surely, the Bank of England is stuffed full of very clever people who can make almost anything work. You are not going to dispute that, surely.

Andrew Bailey: It is kind of you to say that. I would just observe-it comes back to the point about institutional structure-that we would have to be very careful about the issue of serving two sovereign Parliaments.

Q4803Chair: Clarify for me exactly what are the hazards and difficulties. Spell out some of them. Why do you think that maybe it could not be done? I have not identified any. Clarify where there would be a direct contradiction between what the Scottish Government were doing and the UK Government were doing that meant the Bank of England could not do the two things at once.

Andrew Bailey: You could have a system where there is a commitment by both Governments to keep the two absolutely in lockstep.

Chair: Yes, I understand that. Absolutely.

Andrew Bailey: There is no reason why sovereign Parliaments should agree to that. In some sense, that is not reasonable. You then have to answer the question going forward: at what point do they get out of lockstep to the point where you are really operating two systems of regulation? I do not know the answer to that. Nobody has ever tried it before.

Q4804Chair: We are trying to assess how many of the proposals that the Scottish Government are putting forward are feasible and acceptable, and how many are just nonsense. Unless I am mistaken, what they are saying about having the Bank of England operating two systems of supervision at the same time is, you are saying-unless I am mistaken-perfectly doable, until we get to the stage where divergence is so great that it breaks apart. It would be entirely possible that if the Scottish Government modified or muted a desire for change, that could be there for, say, 10 years, until things were up and running and they felt able to move apart.

Andrew Bailey: I am afraid that all of this has to go back to the Governments. They would have to come to an agreement on the governance of the regulator, because we have our own governance set by the UK Parliament. I have a board; there is a process for appointing members to the board. I have a majority of non-executive members, because that is the constitution. If that were to be the choice of the Governments, there would have to be a whole architecture put round it.

Q4805Chair: But it could be done. This is not a pig which could not fly. It might be difficult but it could be done.

Andrew Bailey: I am sorry to keep coming back to this. It is a pig that I cannot observe flying in any other part of the world, but I am not therefore definitively saying to you that it can’t fly. It has never been done before but.

Q4806Chair: People said to the Wright brothers that it had never been done before, but it didn’t stop them trying.

Andrew Bailey: There are many things in the world that at one point had never been done before.

Chair: Indeed. Thanks.

Q4807Lindsay Roy: I want to move to currency. You will be well aware that the Chancellor, the shadow Chancellor and the Chief Secretary to the Treasury have ruled out a sterling currency union. Can you see the logic and rationale of that decision?

Andrew Bailey: Frankly, it is not for me to comment on what the UK Government wish the future currency arrangements to be.

Q4808Lindsay Roy: I am asking you whether you can see a logic or a rationale to that decision.

Andrew Bailey: I think they have taken a view that, if that were to be the outcome of a referendum and there was an independent Scottish Government, the sharing of the currency between two independent Governments would be something they would regard as too difficult, but you have to ask them that question. It is not a question we have been at all involved in, nor should we be involved in it.

Q4809Lindsay Roy: I am asking you as a professional whether you can understand the logic and rationale behind this.

Andrew Bailey: Let’s contrast it with the discussion we have just had. Currency unions are clearly a pig that has flown and is flying in other parts of the world. I observe that, as I was saying earlier, the euro area lesson is that they require deeper institutional integration than the euro area countries believed was the case on day one. To use Mark Carney’s phrase, it requires a lot more fiscal federalism and an accompanying banking union, which the euro area is moving towards, but it clearly is a pig that flies more or less well in some areas. But you will have to ask the Westminster Government on what basis they do not wish to go into that arrangement. It really is not for me to second-guess what lies behind their thinking.

Q4810Lindsay Roy: Are you saying you cannot see a logic to this?

Andrew Bailey: What I am saying is that you can observe that currency unions are in place in some parts of the world, or have been in the past. Frankly, some of them have not been particularly successful; some of them have endured longer. The euro area is the biggest one ever tried, and it is a living example in front of us as to what has to happen. I can give you that example, but I cannot tell you why the Government here reach the conclusion that that is not what they would prefer in the future. You really have to ask them that question.

Q4811Chair: What I am trying to clarify is the thrust behind this. Could this decision by the Chancellor be described as an irrational one? It has been suggested that this is not a serious proposal at all, that it is just bluff, and all the rest of it. Irrespective of whether or not you agree with it-and we are not asking you to express an opinion about that-is it a rational decision, even as distinct from other rational decisions? Put another way, is it an irrational decision?

Andrew Bailey: I really think you have to ask him. What I can observe is that there are currency unions in the world, and there are clearly many sovereign states-most sovereign states-that are not part of a currency union, where the Government regard sovereignty over the currency as something they attach primary importance to. I take the Chancellor to be saying that he takes the view that having primacy over the currency is an important part of the role of the UK Government. That is the norm in most countries in the world.

Chair: Our previous witnesses said that you would be able to answer everything. That is why we are pressing you on that.

Q4812Graeme Morrice: It is a crucial point in relation to currency union. Would you agree that the reason the Chancellor and others are saying that it would not be in the best interests of not just the residual UK but Scotland is that you would not also have the fiscal, economic and political union that you get in other successful currency unions, such as the dollar in the United States, Canada and Australia, where they have federal systems? Do you not think that is the reason behind it, and therefore would you not agree with that assessment?

Andrew Bailey: If I put myself in the Chancellor’s position for a moment, he is, as was his predecessor and his predecessor, directly exposed to the workings and the issues that the euro area has had to face, through his membership of the Council of Ministers. He will have seen at first hand, for instance, in that case what it takes in terms of institutional integration to make that sort of thing work. He can speak about that far more forcefully than I can, because he has that experience more directly than me or any central banker. He will be able to say, "We observe what is going on in the euro area," as Mark Carney said in his speech, "and this is what it would take."

Q4813Graeme Morrice: But there is a difference in the eurozone and in the EU, where there isn’t complete political union, from the United Kingdom.

Andrew Bailey: I understand that, but all of this is hypothetically on the basis that there would be a yes vote in the referendum and at that point Scotland would become an independent country. That is the hypothesis.

Q4814Graeme Morrice: But we have to make assumptions just in case.

Andrew Bailey: The point I would make, and this is certainly true of the work the UK Treasury has put out, is that they have drawn on the work done on the five tests on euro area membership, with which I was somewhat connected in the past. One of the very good points they are making-this is slightly in reverse-is that in the euro area the whole question was to do with the degree of convergence of independent sovereign states and previously independent sovereign monetary policies, and how that would operate in a world where you lock down the exchange rate. As I think they said in their document, in the Scottish situation you are really looking at it from the reverse point of view, which is, over what period of time would you get real divergence of the two economies under separate sovereign control? They are not predicting how that would happen. It is a question of what would a process of divergence mean, whereas in the euro area the question is how quickly would convergence happen.

Q4815Graeme Morrice: But in an independent Scotland you would probably have a whole range of divergences because there would not be fiscal, political and economic union, and therefore how could a currency union work?

Andrew Bailey: That would be part of the thinking around how robust the institutional structure would need to be and how you would do it, but you would have to ask them those questions.

Q4816Lindsay Roy: If there is not a currency union, what are the implications for the regulatory system?

Andrew Bailey: They would be quite considerable, because you have to regard the regulatory system, particularly the prudential regulatory system, as a structure that is dependent on the choices on currency. I suppose there are four broad choices you can make. You can have a currency union; Scotland could move towards using the euro, although there is a question about how you get there; you could have an independent currency; or Scotland could sterlingise or dollarise, to use a terrible phrase.

Q4817Lindsay Roy: To take the latter two, what are the implications in having a separate currency and sterlingisation?

Andrew Bailey: In the case of a separate currency, Scotland would set up its own set of institutions. It would have its own central bank. Therefore, I imagine it would have its own regulatory system. There is plenty of precedent for that around the world, but you would have to ask the Scottish Government how they would propose to do that.

Q4818Jim McGovern: Are you talking about Scotland introducing its own currency, or sterlingisation?

Andrew Bailey: I sketched out what I thought. Having read the literature, there are four options broadly that you can choose.

Q4819Jim McGovern: Sterlingisation, own currency, a negotiated joint currency and eurozone.

Andrew Bailey: I say that just to create a set of options, to have all the choices there.

Q4820Jim McGovern: When you answered Mr Roy’s question was that in the context of a new currency for Scotland?

Andrew Bailey: I think Mr Roy asked me about a new currency. I think that was the question.

Lindsay Roy: Yes.

Andrew Bailey: My answer is that there are plenty of precedents for that around the world because plenty of new countries have been created in the last 30 years. They have adopted the necessary set of institutions; a lot of new central banks have come into existence in the last 30 years, with currencies and a whole panoply of structures. That model exists out there. Obviously, Scotland would have to think carefully about what would be involved in that, how long it would take and so on, but the model is out there. That is a pig that flies quite often.

Q4821Lindsay Roy: Taking these pigs that fly, can you give us an indication of how long it would take to set up a central bank and a separate currency, especially given the interconnections within the UK?

Andrew Bailey: That is an interesting question. There is quite a lot of precedent, particularly in the former eastern bloc and the former Soviet Union. Institutionally, it depends on how big the institutional structure is and what form of currency would be issued. One example is Ireland, which when it became independent moved quite slowly in that direction, over many years. Other countries, the former Soviet Union being a case in point, had to do it very abruptly.

Q4822Lindsay Roy: Would it be fair to say that it is a complex process and there are increased risks and uncertainties?

Andrew Bailey: It is certainly a complex process. I do not think I am making a particularly controversial statement in saying that it is complex. There is a lot of institutional apparatus around setting up a currency.

Q4823Lindsay Roy: And it would depend very much on good will on both sides.

Andrew Bailey: It comes back to the two Governments coming to an understanding in the event of a vote.

Q4824Lindsay Roy: If there was a separate Scottish currency, what implications would it have for financial services?

Andrew Bailey: All the firms present would have to take a view on the robustness of the structure and the state support for the institutional structure. You will get markets taking a view on it, and firms would be quite alive to the views that the markets will take on it. Rating agencies will take a view on it. It has to be a robust structure in that sense.

Q4825Lindsay Roy: How long does it take to evaluate how robust the structure is?

Andrew Bailey: It evolves over a long period of time.

Q4826Lindsay Roy: It is to do with trust and confidence.

Andrew Bailey: It’s trust and confidence, yes.

Q4827Lindsay Roy: A high degree of trust and confidence is not there in the beginning, normally.

Andrew Bailey: That very much depends upon how the structures would evolve in that situation out of what is there today.

Q4828Chair: Would this trust and confidence, which would be so essential in the event of establishing a new currency, be enhanced or diminished by any refusal by a separate Scotland to undertake repayment of a share of the UK national debt?

Andrew Bailey: That would be very much dependent on the context in which it happened and the arrangements with the UK Government.

Q4829Chair: The Scottish Government have suggested that, in the event of not being allowed to use sterling in a currency union, they would refuse to participate in the repayment of the national debt, so that would be the context. Moving on, given that there was no longer going to be a currency union and they were trying to establish a new currency-you are emphasising, understandably, the role of trust and confidence-I am not clear what would be the impact upon building that trust and confidence of a separate Scottish Government deciding to repudiate their share of the national debt.

Andrew Bailey: I see the point you are making. As a general matter, the whole question of trust and confidence would be dependent on a stable institutional structure, which would have to emerge out of what I might call a reasonably harmonious process between the two Governments. That would obviously condition it.

Q4830Chair: That would be nice, but it does not look as if in the event that the UK sticks to its guns and says no, there is no joint currency union, there will be an entirely harmonious relationship in those circumstances. I am trying to clarify whether or not there are any additional observations you would make about the impact of a refusal or a repudiation of the debt. What would be the impact on the financial sector in Scotland?

Andrew Bailey: I think the greater the degree of disharmony in intergovernmental relations and institutional structures, the more difficult the process would become.

Q4831Chair: Can I go back to the establishment of a new currency? Every witness we have had, when pressed and given the choice between sterlingisation and a separate currency, has said that the less bad is the separate currency. I am genuinely unclear as to how long that might take and what the transitional arrangements might be. If the Scottish Government are saying that 18 months would be the period before separation, could a separate currency be established in that time? If not, what would be the mechanism? Would there be sterlingisation for a period? Can you help to illuminate that?

Andrew Bailey: As has been determined, 18 months is the period between the referendum and the day of independence. In terms of the process of what I call constitutional and institutional settlement, they are going to have to get on with it, frankly. You are right: that would become much more acute in the event of a much deeper change in the arrangements for the currency. Ultimately, if the option is to introduce a completely new currency, that is a big job. I had some involvement in that in Iraq 10 years ago. In that situation it was done quite quickly, but it was not easy, as you can imagine. This would be a much more settled environment. There the comparison ends, as it were, but it is a very big job. To make that type of time period work, there would have to be very rapid progress on the constitutional and institutional decisions.

Q4832Chair: We have already heard from witnesses on other occasions that it is unlikely you would have many decisions reached before the UK general election was resolved, which would obviously eat into that 18-month timetable. Are you saying that in your professional view a new currency could be created within that time scale, or would that run beyond the period the Scottish Government have established as being the necessary one?

Andrew Bailey: All I can say is that I think the risks of doing a very big transformation like that would grow the less time you allow for it. That would be a pretty short period of time.

Q4833Chair: I know that. I am trying to clarify whether or not, coming back to the pigs, that particular pig could fly in that period. If you are saying to us, no, it could not possibly be done, that would give us clarity. If you are saying yes, it could be done, again that gives us clarity.

Andrew Bailey: To introduce a completely new currency during that period would be, frankly, very optimistic in my view, but, as I think you said earlier, you would have choices. You could have a longer transition in that hypothetical situation, which would have to involve some combination of the options we were discussing a bit earlier.

Q4834Chair: If the Scottish Government, as they seem to do, want to stick to their timetable-let us assume for the moment that that timetable is inviolate-and it becomes too difficult to establish the new currency by the time of separation, what then is the transitional arrangement?

Andrew Bailey: The two Governments would have to come to an agreement on that. My strong advice as a technician would be, "Look, sit down and work out what is feasible, and don’t take excessive risks."

Q4835Chair: But not taking excessive risks, which we are all against, is incompatible with the timetable, surely, that the Scottish Government have come forward with.

Andrew Bailey: To be fair to the Scottish Government, they have thought about the timetable and the context. I do not know how many currency options they have considered in thinking about the timetable. The one we have just been talking about is not the one-

Q4836Chair: It is quite clear. The timetable for separation has been set by the date of the next Scottish elections. That is the cart driving the horse, and therefore everything else has to tie into that. What we are trying to clarify is whether or not the establishment of a new currency can be done in that time scale. If not, what is the interim stage until the new currency is established? Is it a sterling zone and then a move to a separate currency, and is that doable?

Andrew Bailey: I do not know, because the way I read the White Paper-correct me if I am wrong-their assumption was based on a sterling currency union. The White Paper was based on that. You would have to go back to them and say, "If that were not the plan hypothetically, do you think that timetable works?"

Q4837Chair: But you don’t. Am I fair in thinking that you do not think it will work?

Andrew Bailey: I can tell you as a technician that there is more institutional and practical change involved in the alternatives. That is obvious, so I do not think that is in any sense a controversial statement. In the land of the hypothetical, you would have to go back and say, "If there were to be an alternative arrangement, do you think this timetable works?"

Q4838Pamela Nash: I think it has been asked and we have been refused an answer so far.

Andrew Bailey: I am not familiar with that, so I cannot comment.

Q4839Chair: You mentioned earlier that you had been involved in establishing a new currency in Iraq and so on. Is there any example you can think of where a developed country like Scotland has set up its own currency? With all respect to Iraq, it is not quite a parallel; it does not have the same financial presence.

Andrew Bailey: It has many problems but they are different.

Q4840Chair: Is there an example you can point to of a developed first-world country having established its own currency from scratch?

Andrew Bailey: There are many examples in the east bloc. I am not going to get into who is developed, who is first world and who isn’t. Obviously, that is a little bit pejorative. The biggest one of all was the establishment of the euro, but that was done quite carefully over a number of years.

Q4841Chair: The timetable of 18 months did not apply to the euro.

Andrew Bailey: In that case, the introduction of notes and coins came after the locking down of exchange rates to establish the monetary union.

Q4842Chair: Is it fair to say that this is something that has never been done before? With respect to the eastern bloc, the parallels are not exact. Parallels never are in these circumstances, but the stage of development in particular of the financial sector in the eastern bloc makes any comparison unrealistic.

Andrew Bailey: I am rapidly trying to run around the world in my head to see if there are any others I can think of. If you think about every element of this, which runs from the rather practical end of notes and coins through to accounting, legal contracts and so on, it is an interesting question as to whether any of them have been done on that timetable. I’m sorry I do not have the answer in my head, but technicians could approximate an answer to that question.

Q4843Chair: Do so.

Andrew Bailey: I do not have the exact comparisons today.

Chair: Maybe you could drop us a note.

Andrew Bailey: I will have a think about it.

Q4844Chair: The previous witnesses told us that you would know the answers to everything.

Andrew Bailey: I shall thank them for that. What I can certainly do-again this is going back to the east bloc-is probably to give you some timelines from those examples.

Q4845Chair: That would be very helpful. Could I come back to a point that was touched on earlier? One of my colleagues has had to go, I’m afraid. If the overriding aim being pursued was to allow Scotland to protect the financial services industry in Scotland following separation, what would be the steps that should be taken to do that?

Andrew Bailey: How would you define protect?

Chair: Support, retain, sustain.

Andrew Bailey: The first answer comes back to the whole question of constitutional and institutional structure. The more stable and assured the plan for how that is going to be done, the more institutions will naturally take assurance from that. That must be the cornerstone of it.

Q4846Chair: What does that mean?

Andrew Bailey: It comes back to the discussion we were having. They would need clear answers on the cornerstones of economic policy-currency, fiscal policy, intergovernmental relations and all the things the major financial institutions would naturally look to.

Q4847Chair: Is it reasonable for the Scottish financial community to expect the Scottish Government to react to what the UK Government have said-for example about not having a currency zone-and to outline exactly what their plan B is and give some thought or clarification as to whether or not the timetable for separation would be reviewed?

Andrew Bailey: I am sure they will be looking at that, yes.

Q4848Chair: In the event of separation, what is the best strategy for the rest of the UK to adopt to safeguard its own financial sector? Are there particular steps that you would be advising the Government to undertake?

Andrew Bailey: The overriding answer would be that, as soon as the decision came out of the referendum, go into the negotiation phase and do it as quickly as possible to limit the uncertainty that would be created around it, because there would be a lot of uncertainty.

Q4849Chair: We have spent quite a bit of time discussing the question of a new currency and so on. What do you see as being the main impact of sterlingisation upon the financial sector in Scotland?

Andrew Bailey: I would say two things, drawing on experience of other parts of the world, because dollarisation, which is the direct parallel with the dollar, has been used and is used in some countries. First, it does require a very clear view on what I might call alignment to the home economy of the currency, because in a sense you are taking monetary policy from another economy. It requires hard thought about how to do that. Secondly, to come back to the financial system, there is an issue about the capacity for lender of last resort, where the currency is not the base currency in terms of the domestic currency. There are countries that have successfully adopted either a policy of dollarisation or a currency board-I slightly extend it. Hong Kong is a good example. They have substantial fiscal reserves which could be used in the event of a problem in the domestic financial system.

Q4850Chair: I wonder if I could clarify the point you made about the need for harmonisation in the event of sterlingisation-the need to try to achieve harmony between the two economies.

Andrew Bailey: Alignment.

Chair: Yes, to make sure they avoid divergence. The whole point of separation is to do things differently. If one of the overriding objectives of the Scottish Government in sterlingisation was to keep their economy in line with that of the UK, to some extent it negates the whole point of having a vote for separation in the first place, does it not? Therefore, it is highly unlikely that that would actually be their strategy.

Andrew Bailey: That is exactly why these are choices for Governments.

Chair: That is helpful.

Andrew Bailey: Sorry.

Q4851Chair: No, I understand that. Can I seek clarification about the lender of last resort? Is there anything you can usefully add to what has been said already about this that would help illuminate the difficulties for us? The Scottish Government seem to be making the assumption that, in the event of a currency union, the UK Government will be prepared to have the Bank of England as lender of last resort for Scottish banks, facilities and so on. Apart from the issue of moral hazard about having somebody else providing a guarantee, are there any other issues we ought to be aware of?

Andrew Bailey: To draw on experience, if this helps, when the Bank of England did lender of last resort for RBS and HBOS in the later part of 2008-I was responsible for it-we had to take a view on the capacity of the Bank of England’s own balance sheet to support this type of lending, bearing in mind that it goes beyond the normal monetary operations we do, which we always do, as a central bank, against high-quality assets or collateral. You are going out into the more exposed parts, by its very nature, because it is emergency lending. In that case-this is no great revelation-we reached a point where we said to the UK Government, "We need a formal indemnity from you for any further lending." With central banks, you can argue that it is there anyway because the Government own us, but we needed a formal indemnity, and the Government gave it to us. There are other cases where we have done that.

The reason why that is important in this context is that that makes it what I might call a fiscal action. The Government are explicitly taking the risk at that point. That is important because, in the context of lender of last resort, if you have more than one Government they would have to be very clear about the burden of risk. Frankly, as the central bank we have to be very clear about how this works-again it is pigs, uncharted waters and all that. This is not a system that operates, so lender of last resort poses those issues, and they ultimately-sorry I keep saying this-come back to being governmental issues because it is taxpayers’ money.

As Mark Carney said in his speech in Scotland, we are working to take out the dependency on taxpayer money, particularly in terms of capital, the sorts of things we had to do in late 2008, but I think there will always be backstop dependence on lender of last resort. You can never be 100% sure that that will not spill over into a fiscal action.

Q4852Chair: Am I right in thinking that, if you require financial indemnity from the Government as the lender of last resort, in effect a separate Scotland with the Bank of England as lender of last resort might still be required to provide financial indemnity to the Bank of England? In which case you are not really the lender of last resort at all, because they are standing behind you and end up potentially with the liability for any enormous cost overruns.

Andrew Bailey: Again I can only say that the two Governments would have to think very carefully about how they structured that, and the Bank of England would have to think very carefully about the implications, were that to be the case, for its own position.

Q4853Chair: In our previous session, we discussed the position of Iceland and the relationship between the size of the banks and the size of the economy. There is clearly a parallel with Scotland, given HBOS and the Bank of Scotland and the size of the Scottish economy. Our view earlier on was that it was almost impossible to see Scotland on is own being able to guarantee those banks, and the banks have to be encouraged, or decide for themselves, to move some of the weight to the rest of the UK, either by transferring or something similar. There is no plan B in those circumstances, since it would appear impossible for the Scottish Government to be seen seriously as the lender of last resort to banks of that size.

Andrew Bailey: The landscape is changing somewhat, but the issue is still there. I know there has been a bit of argument about the number, but I think it is 12 times the size of Scottish GDP, in terms of the size of the banks’ balance sheets. The Scottish Government argue that it is lower. It is certainly lower if you measure it as, "What is financial services as a share of output?" It is lower if you say, "What is the share of banking activity undertaken in Scotland, as opposed to other parts of the world?" The issue, though, is what we tend to call the home authority. One of the cornerstones is that you are ultimately responsible for banks that are based in your country-headquarter-based in your country.

What is changing? As you say, we had bad experiences with Iceland. That is a very good case in point. We are working very hard to end the too big to fail problem. Ending the too big to fail problem will ameliorate this substantially, as I think the Scottish Government have pointed out in their White Paper, or one of their publications, but there will still be a liability as the lender of last resort. It may well be less in quantified terms but there will still be a liability.

Q4854Chair: Can you quantify, or give us some sort of indication of how big that might be? Would it be manageable for a separate Scotland?

Andrew Bailey: I cannot really quantify it at the moment. Unfortunately, it is very much work in progress in terms of the international agenda to reduce the too big to fail problem. Like others, I am absolutely committed to reducing the dependence on public money as far as we can. What is harder to answer is the question you pose, which is: but when you have done all that, what is the backstop? We may not know the precise answer to that question even then, but we certainly will not be able to have a better view until we know how far we get down the road in terms of the too big to fail problem. Speaking not just for UK officials but international officials, we are absolutely committed to doing as much as we can to reduce this problem, because it affects all of us.

Q4855Chair: Is all of that going to be resolved by the time Scotland might become independent? Would that be solved by the time of the Scottish elections?

Andrew Bailey: There has been quite a public commitment internationally to make definitive progress this year in the G20 towards tackling this problem, but if you ask me whether by the end of this year we will know the answer to the question you have just posed, I hope we know a hell of a lot more about it, but I am not sure we will be at the point when I could give you a complete answer.

Q4856Chair: So we will not know the answer by the time people in Scotland are voting.

Andrew Bailey: We will not know definitively by that stage whether the G20 process has come to fruition. There is a summit later this year in Australia, which I believe comes after the vote in Scotland.

Q4857Chair: It is still fair to say that banks are international in life and national in death.

Andrew Bailey: Absolutely. That was a Mervyn King statement. The reason he made that comment was exactly the point I made. When banks fail, it comes back to the home country. The work we are doing on resolution, which I used to run in the Bank of England and am still heavily involved as a supervisor, is all about putting resolution plans in place for international banks to stop that problem happening and coming back to the home authority.

Q4858Chair: But the lesson for us in terms of the referendum is that certainly at the moment, and until such time as new policy is devised, irrespective of how many subsidiaries overseas the Bank of Scotland and Royal Bank of Scotland set up, they will still ultimately remain a potential charge upon the Scottish Government and the Scottish taxpayer, and in the event of separation and a financial collapse they are likely to overwhelm any new-born Scottish Government.

Andrew Bailey: In a sense, you have to freeze the system that is in place today in terms of making that judgment. As you say, there is an awkwardness of timing, because there is an international policy initiative designed to drive progress on this issue irrespective of the referendum. As you say, I do not think that by September we are going to be in a position to say to you definitively, "We’ve cracked it."

Q4859Chair: So that is still a great unknown.

Andrew Bailey: It is, but I can tell you that it is No. 1 on our agenda.

Q4860Chair: That is some consolation. Do colleagues have any other points? Normally, at the end we ask our witnesses whether or not there are any answers they have prepared to questions we have not asked, or anything you feel we have not touched on that you think would be helpful to the discussions on the areas we have been covering.

Andrew Bailey: We have covered a lot of the ground I read through. I apologise. I cannot give you answers on many of the questions you have because I am not a Government official or a member of the Government.

Q4861Chair: You are far more powerful than many of them.

Andrew Bailey: I suspect that is a matter of judgment. What I can say is that, irrespective of the outcome of the referendum, we will go on fulfilling our statutory obligations until such time as any future settlement came into place. That is obviously an obligation that Parliament has placed on us.

Chair: Can I thank you very much for coming along and seeing us today? I apologise, as I did at the beginning, for the delay in bringing you in, because previous sessions overran. I am sorry this has gone on a bit longer than expected, but it has been very valuable to us.

Andrew Bailey: Good. Thank you very much.

Prepared 6th March 2014