Danger of banking on a union of currencies

The Scottish Government's scenario is for an independent Scotland to negotiate a sterling currency union with the Westminster Government; and to have the Bank of England act as supervisor of Scottish financial institutions and, more generally, as crisis manager in the event of future financial instability. There is little doubt that a sterling currency union would be the correct choice among available options. Forming a new currency is out of the question for the foreseeable future. Adopting the euro is clouded in uncertainty regarding Scotland's EU membership: being accepted as a "continuing" member would probably be challenged by the European Commission and existing members.

The recently-mooted suggestion that Scotland could follow the example of Isle of Man, Guernsey, Jersey, Gibraltar, Panama, Ecuador, Andorra and Montenegro in adopting another country's currency without its formal agreement is puzzling. These countries are all client or micro- states or off-shore financial centres, all of which are content to leave the decisions on interest rates to the currency-issuing country. They can protect their residents from financial instability only by amassing reserves of the currency through holding back export earnings, instead of assigning them for domestic consumption or investment. If Scotland were to build such reserves in an amount equivalent to Guernsey or Jersey it would come to some £90-£100bn. This almost certainly underestimates the amount Scotland would need given the size and nature of its financial sector.

The proposal to share financial supervision and crisis management under the Bank of England runs into difficulties of both principle and practice. Public officials appointed to look after the interests of taxpayers of one country cannot perform the same task for taxpayers of a foreign country, especially if Scotland took a different path of economic growth. There is no precedent for a country sharing its currency, its system of financial supervision and its arrangements for managing financial crises with another sovereign state. The potential for conflict, confusion and delay when clarity, speed and authoritative intervention are paramount would be built into such a system.

Even if a shared system were to be introduced, supervisors at the Bank of England would be bound to reassess the risk profiles of Scottish banks in these changed and uncertain circumstances. There must be a presumption that they would judge that Scottish banks were operating from a country going down an untried route and would conclude they should be subject to higher prudential requirements, such as holding more capital, and facing greater borrowing costs. The boards of directors of these banks would surely feel obliged to reconsider their legal structures and the location of their head offices.

What would be the effects of another financial crisis in an independent Scotland? Might a Scottish Government be faced with unsupportable costs in rescuing its banks? Many changes in the arrangements for dealing with the repercussions of the collapse of large banks have been adopted in the UK and internationally with the aim of limiting the financial costs of major bank failures. However these arrangements are as yet untested and are designed to limit the damage, not to remove it altogether. With its large and concentrated banking system Scotland is starting from the wrong position, having a banking sector over half as big again as that in Cyprus or Iceland.

Even with a banking system strengthened by the reforms being adopted internationally, Scottish taxpayers could face significant costs, perhaps amounting to a sizeable fraction of the country's GDP, should one major bank or more fail. Not to mount a rescue would not be a choice.

Brian Quinn is a former acting deputy governor of the Bank of England. His full paper is on the David Hume Institute website.