Scots will struggle with currency union

NIESR believes that such a union could have important consequences for Scotland’s financial sector, and therefore its capacity to export financial services, its new balance of payments and general economic prosperity.

New research published by Dr Angus Armstrong and Dr David McCarthy from NIESR, concluded that the only viable solution to the problem would involve terms that are unlikely to be acceptable to an independent government.

The report said: “[There are] three possible solutions to this lender of last resort problem: create a new Scottish Insurance Fund, negotiate a commercial lender of last resort line of credit with the Bank of England, or have the nascent European Banking Union assist with lender of last resort.

“Because of the complexity of insuring liquidity risk, the authors suspect that the only realistic option would involve terms that would not be in the interests of an independent government.”

And should the UK’s existing monetary union end the authors said legislative change would be required.

NIESR added: “The UK government would be likely to pass primary legislation to amend the Banking Act (2009) so that HM Treasury and Bank of England is no longer responsible for managing the issuance of Scottish notes (necessary to prevent any impression that the UK state would provide financial support to an independent Scotland in the event of a crisis).

“The Bank of England carries out regular sterling liquidity operations with banks from all over the world, and would surely do so for banks from an independent Scotland.

“But in times of financial distress, when liquidity insurance is most valuable, the Chancellor decides emergency sterling liquidity assistance, presumably in the rest of the UK's interests.”

An independent Scotland would require a financial border to create its own balance of payments accounts.

This would include cross border trade and capital flows to and from the rest of the world and the rest of the UK. Under dollarization, the balance of payments would become the key barometer of whether the Scottish economy prospers or declines.

Banking groups would also have to decide which side of the financial border to register. Where banks are registered (or incorporated) matters for which government provides the deposit insurance, who regulates the banks, who is likely to receive emergency support and which taxpayers might pay if there are losses in the case of failures.

Without a credible solution to the lender of last resort, the Prudential Regulatory Authority is likely to require systemically important banks using sterling to be domiciled in the UK. Shareholders, customers and rating agencies are also all likely to prefer systemically important banks to be located in the UK.