OPTIONS FOR SCOTLAND Banking and Financial Services Post Independence

OPTIONS FOR SCOTLAND

                 Banking and Financial Services Post Independence

                                         Author Ian Blackford

                                               May 2014

 Ian Blackford spent thirty years working in the banking and investment banking industry. Ian was a Fund
Manager at Mercury Asset Management before becoming an investment analyst and was consistently voted
the top rated analyst in the Netherlands. Ian was head of the Nat West Markets business in Scotland, which
  subsequently became Deutsche Bank where he became head of Dutch equities which became the largest
                               player in the Dutch market under his leadership.

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Banking and Financial Services Post Independence
Banking and Financial Services are a Scottish success story generating not only jobs and wealth in Scotland but
also an industry that generates wealth through competing in a global market for many of its products and services.

The industry, according to Scottish Financial Enterprise (SFE,) employs around 100,000 directly and around the
same number again indirectly. SFE estimate that Scotland accounts for around 24% of those in the UK who are
employed in the life assurance sector and around 13% of all UK banking employment.

Scotland’s strength in Financial Services is rooted in innovation and a capability of providing competitive
financial products, for example pioneering the establishment of life insurance as far back as 1748.

This paper will discuss options for an independent Scottish Government to provide the right framework and
environment that will create the circumstances that will lead to the financial services industry continuing to
prosper as an important element of a desire to deliver sustainable economic growth in Scotland.

For most of the referendum campaign, the position of the major Scottish Banks has been ‘scaremongered’ on the
basis that an independent Scotland would be unable to cope with the risks of a future banking crisis, given that
the country at face value possesses a higher ratio of banking activity than rUK. On the contrary, the problem
facing Scotland is the reverse. Most of the major banks, as will be seen, are controlled from London
Headquarters. We have too few indigenous banks and too many which have ‘brass placques’ nailed to their
nominal Scottish head offices.

This paper wishes to look creatively and positively at the Scottish banking scene and seek to rebalance it in line
with our commercial and domestic needs.

As part of this analysis we need to examine the appropriate regulatory framework for the industry that both
creates confidence amongst consumers and businesses whilst allowing a competitive environment to develop for
the providers of financial services.

The financial services industry can be characterised as being global in nature.

For Scotland to maximise its potential in the broader industry means that not only does the industry have to
compete in offering services to consumers and businesses in the domestic market but the industry has to compete
globally where this is appropriate, such as in Fund Management.

A successful dynamic industry in Scotland will not only allow career opportunities to those currently working or
aspiring to work in the industry in Scotland but will also attract businesses and individuals who seek to develop
their businesses and careers in an independent Scotland.

A number of commercial banks have their headquarters in Scotland, The Royal Bank of Scotland, Bank of
Scotland (part of the Lloyds banking Group, Clydesdale Bank (part of National Australia Bank,) Tesco Bank,
Virgin Money and Green Investment Bank. Many other banks have operations in Scotland.

The financial crisis of 2007-8 is still having its impact as a number of banks seek to de-risk and de-leverage. The
excesses that built up, fuelled by financial deregulation in the 1980s and beyond, has lead to a financial hangover
that is likely to be with us for some time to come.

Economic recovery in Scotland is hampered by the desire of RBS, Bank of Scotland and Clydesdale to improve
their balance sheets and as a result there is a lack of finance available for businesses and consumers.

The Royal Bank of Scotland (RBS) and its excessive growth in the 1990s and beyond is a story we are all

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familiar with. The UK bailout in 2008 means that today the UK state has a 58% stake in RBS ordinary shares
which rises to an 80% economic interest when including “B” shares.

RBS is very much a global bank, which grew by acquisition. Although RBS is formally headquartered in
Edinburgh to all intents and purposes the group is managed from London. As RBS seeks to redeem itself in the
eyes of the public it is hampered by its financial interest in significant non-performing loans, often referred to as
the bad bank parts of its empire. The legacy of these non-performing assets hamper the ability of the bank to do
what it should be doing, lending to consumers and businesses and playing a full part in the economic recovery of
the country.

Given that RBS is effectively a nationalised institution in economic terms it is pertinent to discuss what
opportunities there are for the Scottish Government as part of its discussions with the rUK to make sure that the
interests of Scottish consumers and businesses are protected.

There would be logic and it would be in the interests of Scotland and the rUK for RBS to be broken up into its
constituent parts. There could effectively be three banks created, a Scottish RBS, the rUK/global “good bank”
and a “bad bank.”

As part of this process the Scottish banking assets would be spun off from the existing RBS group and listed on
the stock market. This would be delivered as a settlement as part of the independence negotiations, with the new
independent Scottish Government inheriting a majority stake in the new Scottish Bank. The Scottish Government
would retain an economic interest in the new Scottish bank whilst the rUK would retain an interest in the
remaining bank.

Ring fencing the assets of the bad bank where both Scotland and rUK would retain a financial interest would
allow the two good banks to compete and grow more effectively in their respective markets.

Internally within RBS the “bad bank” is already run separately making this a reasonably straightforward process.

Crucially allowing these new banks to compete effectively may expedite the time required for both governments
to ultimately dispose of their financial interest whilst the economies of both Scotland and the rUK benefit from a
more competitive banking environment.

The intention for any Scottish Government would be to fully return the new Bank fully to the capital markets as
soon as is practical with the intention of delivering a return to the Scottish exchequer on the inherited investment
and freeing up resources to pay down debt and investing in its own priorities for Scotland.

There is a straightforward road map for the RBS assets domiciled in Scotland. This road map sees the
establishment of a Bank that would be able to compete to serve the needs of consumers and businesses in
Scotland and one that could fully play its part in financing and contributing to sustainable economic growth in
Scotland.

At its core it is also about a return to traditional banking and a requirement to return to ethical banking standards
that have been lost throughout the industry. Banking has got to return to its core roots of traditional banking
business but not only focusing on traditional markets but also an appreciation of risk management.

The issues surrounding Lloyds Banking Group, owner of the Bank of Scotland are more problematic. The UK
Government currently own 33% of Lloyds, a Bank that is by far and away the largest provider in the consumer
market, with a retail market share in the UK of over 25%. Whilst the UK Government is a minority shareholder,
the Government cannot force a split up of Lloyds. However a spin off of The Bank of Scotland would clearly be
in the best interests of Scotland.

Although much press and public attention has surrounded the travails of RBS and HBOS/Lloyds, there has been

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investment banking, has not had its problems to seek. Clydesdale was a relatively aggressive provider of loans to
the corporate sector in the years leading up to the financial crisis and is now paying the price with a significant
part of its loan book being invested in non-performing assets. In 2012 it was announced that £6.2 billion of non-
performing loans would be repatriated from the balance sheet of Clydesdale and its partner Yorkshire Bank to its
Australian parent. Clydesdale is encumbered by a high cost to income ratio which limits its ability to withstand
shocks to its balance sheet. It is widely believed that NAB would like to dispose of Clydesdale but in its current
difficulties there are not too many willing buyers.

The success of RBS, Bank of Scotland and Clydesdale are key to the future prosperity of the Scottish economy.
With Scottish businesses and consumers effectively relying on the big three it is self evident that we need a
healthy competitive banking sector.

In this regard what is the solution for Clydesdale?

The Bank can recover and in a sense economic recovery will reduce to a degree the pressure the bank is under.
We need a re-invigorated sector that can offer attractive competitive banking products within Scotland. The best
longer-term solution would be for NAB to float Clydesdale, perhaps together with Yorkshire Bank as its financial
health improves.

There is considerable merit in a future of seeing three Scottish Banks being quoted on the financial markets.

This would allow for Scottish registered and run banks to re-build credibility in the indigenous banking sector
and will add to the number of publically quoted companies based in Scotland.

If Scotland is to fulfill its potential there needs to be an aspiration that companies can grow in Scotland and that
we can create a broad base of publically quoted companies, competing at home and in the global markets.
Broadening the base of publically quoted companies will broaden and deepen our skills base, result in a constant
stream of work for professional advisors such as lawyers and accountants.

The Scottish Banking sector has a key role in being at the heart of the professional life of Scotland as well as
being at the heart and the lifeblood of our urban and rural communities. A return to a culture of banks being part
of their communities, gathering assets and providing appropriate financial support is integral to the delivery of
sustainable economic growth.

That is why a recognition that the problems of the past have to be dealt with and both the Scottish and rUK
Governments recognising that we need a banking architecture that is competitive and where banks have the
financial wherewithal to meet the desire for funding for consumers and corporates in Scotland.

The White Paper on Scotland’s Future sets out proposals for financial stability and financial regulation and does
so under a premise of achieving currency and monetary union. This paper will not re-examine the currency
options for an independent Scotland with the author having adopted a position of being supportive of the
government’s position and in this context would argue that the proposals on financial regulation are fair and
reasonable.

What must be recognised are the circumstances that led to the financial crisis, lessons that must be learnt and
effective consumer protection.

Much of the analysis of the financial crisis is over simplistic with the blame largely being placed at bad practices
within investment banking. Whilst it is the case that so called casino banking was a significant factor it was not
the only issue that led to the crisis. It was not only banks with investment banking activities that suffered in the
financial meltdown, indeed the first casualty with in the UK was Northern Rock which had no exposure to
investment banking.

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funding from the wholesale financial markets. Any student of finance should have seen the shortcomings of a
model that lends long and borrows short.

These same issues were apparent with the demise of HBOS. The crisis was driven by a combination of bad
management practice, an obscene reward culture and a failure of regulation. The seeds of the financial
Armageddon were sown in the 1980’s with the liberalisation of financial markets. The stock exchange had its
“big bang” in 1986 which created the circumstances that saw the emergence of global players in investment
banking as many traditional banks were seduced into investing in “sexier” activities.

The financial collapse of 2007-8 was not the first time that large scale-banking failure took place. There are other
examples in history, not least the Wall Street Crash of 1929 and the accompanying banking failures. The collapse
of 1929 led to the US Banking Act of 1933, often referred to as the Glass Steagall Act, that amongst other matters
restricted commercial banks from engaging in investment banking activity. More is the pity that the Clinton
administration in 1999 repealed the Banking Act which in my opinion contributed to the scale of the challenges
that were faced in the later years of the following decade.

There are many who argue that the world’s financial markets must return to a clear separation of commercial and
investment banking. These are matters that need to be addressed at a global level as to matters of minimum
capital requirements and leverage requirements for banking. Regulation has to be effective in particular to restore
trust and confidence in the banking sector.

It is not just about regulation. The issue of corporate culture has got to be tackled. The last few years have seen
reports of bad practice piled on bad practice allied to a rewards structure that creates a disconnect with the rest of
society. The banking sector has failed to clean up its own act with the penalties for behaviour that in many cases
may have been criminal has resulted in too few individuals receiving effective punishment.

The desire signalled in this report to see RBS and others broken up into their constituent parts deals with the
claim of the banking sector being too big to fail. While consumer protection is harmonised at a European level
offering financial protection to our citizens it is also critical that our banking sector is able to restore its position
of trust and being a vital part of our communities.

The decision to create a Scottish Investment Bank (SIB) as a division of Scottish Enterprise in December 2010
showed that the Scottish Government recognised the importance of playing its part in encouraging enterprise and
critically creating a strong partnership between the public sector and the private sector, both in terms of
leveraging investment capabilities and accessing an appropriate skill set from the private sector. The report of the
SIB for 2012-13 highlights that the Bank has invested in 237 companies to-date, who generate £375 million in
turnover and employ 3942 people on a full time equivalent basis.

Whilst the progress in numerical terms is welcome it is the investment in growth potential and creating a road
map to develop and deliver sustainable economic growth that is key. If we are to see the fruits of independence
being delivered this will above all else be demonstrated by the delivery of sustainable economic growth. The SIB
has concentrated its investments in a number of key sectors that have the potential to deliver high sustainable
growth. If Scotland is to create the necessary wealth that offers greater prosperity and job opportunities for those
living here it can only be delivered if there is a sustained increased in investment and in particular in innovation
which will drive an increase in productivity.

The SIB has a pivotal role to play in acting as a catalyst to focus investment both in business start-ups and in
existing businesses with growth potential.

The White Paper, Scotland’s Future states that: “Independence will provide the opportunity to target policies to
Scotland’s unique circumstances and challenges, and to boost productivity. Our plans for re-industrialisation,
innovation, taxation, investment and internationalization will help to achieve this by delivering the necessary
changes to our economy.” The White Paper also states that the industrial strategy “will include support for

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We would concur with the comments in the White Paper, indeed we would state that the White Paper is
ambitious in its desire to set the conditions that will allow Scotland to accelerate the potential in delivering
sustainable economic growth. This paper has already discussed the framework that will lead to a more dynamic
banking market in an independent Scotland however it is clear that an appropriately funded and managed Scottish
Investment Bank is pivotal to the desire in delivering an enterprise economy, supporting business development
and growth.

The Scottish Investment Bank has made a positive contribution to business investment since its formation in 2010
and critically has shown that investment can be leveraged by the public sector and the private sector developing
partnerships.

The opportunities for delivering sustainable economic growth necessitate the need for the SIB to grow its
capabilities and play a greater role in supporting business growth opportunities. The SIB needs to become a fully-
fledged investment bank, whilst working in partnership with third party providers, where appropriate the bank
needs to recruit and develop a broad range of financial expertise in order that it can play a wider role in
supporting business development.

The SIB should be spun out of Scottish Enterprise and function as a stand-alone investment bank with the aim of
the government listing the Bank on the financial markets whilst retaining majority control.

Creating a stand-alone investment bank will allow the bank to seek additional capital funding from third party
investors, whilst a strengthened equity base would allow the Bank to leverage its own balance sheet.

The Scottish Investment Bank would seek to work collaboratively with the public and private sector whilst also
developing robust relationships with academia.

Amongst other initiatives, the SIB in January 2013 launched a life sciences fund, which as of last year had raised
£26 million of investment with an ultimate planned fund size of £50 million. This is the kind of initiative that
needs to be established across a number of growth sectors. The SIB has to develop the tools required to manage
these funds on their own account creating a level of professionalism and credibility that would see the SIB
attracting funds from pension funds and other investors. Ultimately the funds managed by the SIB ought to be
open not just to institutional investors but also to private investors who wish to invest in Scotland’s future
potential.

Whilst recognising the risks for investors in participating in such equity vehicles it is essential that Government
and private sector investment is available to unlock the potential in Scotland maximizing its potential as an
enterprise economy.

Investment in sustainable growth with an empathise on innovation and productivity will create job opportunities,
drive up living standards whilst creating the taxation income that will drive our desire to invest in appropriate
levels of social protection. This aspiration is one where enterprise and compassion are working in balance for the
common good.

The Scottish Government talks about an appropriate taxation strategy that encourages investment and growth.
Investment in the SIB would need to incorporate appropriate incentives to encourage and leverage investment
opportunities.

 A competitive commercial banking environment and an effective Scottish Investment Bank will create the
environment that the Scottish economy can deliver sustainable economic growth, build our industrial
infrastructure and create opportunities for those that live here.

We also recognise the historic strength of Scotland in Fund Management, Life Assurance and Investment

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that will see the wider Scottish financial community continue to prosper.

We need to consider what appropriate taxation regime would foster sustainable growth of the wider industry and
to make sure that Government plays its part in creating the architecture that allows the industry to be competitive
and best in class. It is recognised that the Labour government that took office in 1997 did enormous damage to
the sustainability and affordability of final salary pension schemes with the withdrawal of dividend tax credits.

It is also recognised that other European governments, such as France encourage longer-term investment by
allowing investment gains on financial assets held for more than eight years to be free of capital gains tax.

As a priority an independent Scottish government should review the tax position of Scottish pension funds and
other measures that would create a competitive advantage for the financial services industry in Scotland to grow.
This is perhaps a project that could be undertaken by the Government’s independent fiscal commission.

OPTIONS	
  

Options for Scotland does not seek to determine future policies which are the preserve of the political parties.
This paper suggests the following options for their consideration when preparing their manifestoes for the first
Scottish General Election post-independence.

   1. It is in the interests of both Scotland and rUK that RBS be broken up into its constituent parts.

   2. When the Scottish banking assets of RBS are spun off from the existing RBS group, the Scottish
      Government will inherit a majority stake in the new Scottish Bank. The Bank should be listed on the stock
      market and have its head office in Scotland.

   3. The RBS ‘bad bank’ containing the dubious loans should be ring fenced on a rUK basis with the Scottish
      Government inheriting a proportionate share of the assets and debts until the purposes of the ‘bad bank’
      are resolved.

   4. The new Scottish Bank should be returned fully to the capital markets as soon as practical with the
      intention of delivering a return to the Scottish exchequer on the inherited investment and freeing up assets
      to pay down debt and re-investment in Scotland.

   5. If and when possible, the Bank of Scotland element in Lloyds Group should be spun-off so that it can
      resume its primary task of serving Scottish consumers and providing competitive services relevant to its
      business and domestic customers in Scotland.

   6. With National Australia Bank (NAB), owners of Clydesdale Bank, wishing to off-load its Clydesdale and
      Yorkshire Bank subsidiaries, it should be the aim of a Scottish Government (if no purchaser for the
      Clydesdale is found) to persuade NAB to follow an alternative path of floating the Clydesdale (with or
      without the Yorkshire Bank) as and when Clydesdale’s financial health improves.

   7. The Scottish Investment Bank should be spun-off from Scottish Enterprise and as a fully fledged
      investment bank should be listed on financial markets and enabled to seek additional capital funding. The
      Scottish Government should retain majority control.

   8. The Scottish Government should review its taxation strategies to encourage longer term investment,
      employment and sustainable growth within the financial services, fund management and pension funds
      industries.

   9. The Scottish Government’s independent Fiscal Commission should be asked to devise measures to