Uncertain future looms in Scottish vote

At this stage there are a great many uncertainties on how key aspects of the relationships among ISS, the remaining UK (RUK) and the European Union might develop in the event of a Yes vote.

The Yes campaign, headed by the First Minister in Scotland’s current devolved administration Alex Salmond, has outlined its own vision for these relationships.

In many respects the No campaign, headed by pro-Union Scottish politicians, as well as the government and main political parties in the UK, takes issue with the feasibility of the Yes side’s plans for ISS.      

Conduct regulation

In the event of separation ISS would acquire jurisdiction over financial regulation, which is currently a non-devolved area. In respect of contracts with Scottish based customers the Scottish Parliament would in future legislate for the areas currently covered by UK statutes in the Consumer Credit Act (CCA) 1974 and the Financial Services and Markets Act (FSMA) 2000.

In terms of executive regulation it would seem most likely that ISS would establish a single financial regulatory body to exercise the powers currently held in the UK by the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA) division of the Bank of England. In the first instance a relatively small part of business-to-business (B2B) asset finance would be affected by these changes – mainly small CCA-regulated contracts with mostly small unincorporated customers.

Similarly, in those business conduct areas where the primary legislative powers are in FSMA the main impact of regulation to date has been on contracts with retail customers. However, the FCA has recently shown a readiness to extend the impact into B2B areas, as with the redress orders for the deemed mis-selling of interest rate swaps on bank loans to small businesses.

The main initial impact of Scottish separation in conduct regulation would be to duplicate the credit licensing requirement for those lenders, lessors and brokers undertaking regulated business in both Scotland and elsewhere in the UK. The proportional cost impact would be greatest for the small licensed players, principally the brokers.

In the long run there would inevitably be some divergence in substantive requirements of legislation on either side of the Scottish border. It is not likely that the pattern of future changes in primary legislation would be convergent as between ISS and RUK. More extensive divergence could be expected in the CONC regulatory handbook rules for regulated credit business, which replaced secondary legislation under the CCA when the regulatory powers were transferred to the FCA from the former Office of Fair Trading in April this year. All such divergences must to some extent raise the cost of doing business. 

Apart from specifically financial regulations, finance contracts could also be affected by future   divergent law-making in wider areas such as unfair contract terms legislation.

Prudential regulation

Scottish separation from the UK would also lead to a split in the prudential regulation of banks, which affects the financiers and/or third party funders in the bulk of lending and leasing business. Here the potential for substantive divergence of future rules is limited, due to the extent of international convergence under the global Basel regime and EU laws; but it is far from negligible.

It is likely that most regulated banking businesses operating throughout the UK, and with global or European head offices currently in the UK, would base these offices in RUK after separation, and operate in ISS through separate subsidiaries. Those subsidiaries would be subject to prudential regulation in ISS, but at group level they would also be caught within consolidated supervision of the RUK based parent. There would be appreciable added costs from these arrangements.

Currently two of the largest UK banks have their head offices in Scotland. RBS has always been based there, but has had the great bulk of its UK business elsewhere since its acquisition of NatWest group (including the Lombard finance business) in 2000. Lloyds Banking Group placed its head office in Edinburgh after Lloyds TSB took over Halifax Bank of Scotland (HBOS) in 2008. However, both groups have indicated that they would move their head offices to London in the event of separation.

On one interpretation of EU banking law, such moves would be a regulatory requirement since banks must be supervised in the member state where most of their EU business is located. In any event, major banks would be better placed in the wholesale funding market if they continued to be supervised by the PRA rather than by a new and untried regulator in a much smaller country. ISS would nevertheless need to establish a separate prudential supervisor for those credit institutions (including some building societies) whose business is wholly or mainly in Scotland.

Corporate taxation

The fiscal implications of Scottish separation could be far reaching, and very uncertain.

For the business sector, the corporation tax (CT) implications are of most direct interest. The Yes campaign has indicated an intention, though not a firm commitment, to set the rate for IS at 18%, compared with the 20% rate to which UK CT is due to fall from April 2015. This in itself could be a positive incentive to locate potentially mobile business operations in Scotland.

On the other hand compliance costs of CT for all businesses operating throughout the UK would be materially increased. As well as the costs of filing separate ISS and RUK returns, there would be significant extra costs from having to allocate taxable profit between the two territories. In the long run there would be further escalating compliance costs through a likely accumulation of divergences in the statutory definition of taxable profit as between the two jurisdictions’ systems, possibly including such elements as capital allowance rates.

The main UK political parties now envisage a “devo-max” package of enhanced devolution powers for Scotland in the event of a No vote. This will include substantial taxation powers; and specific proposals are likely from the UK government, at least on the possible time scale for this, in the coming days. It is not clear whether it will include powers over CT. If so it is unlikely to extend beyond variations of the tax rate, though even this would bring some added compliance costs through the territorial allocations of profit.

Currency and central banking

The greatest economic uncertainties surround issues affecting the currency, where both Yes and No campaigns at times appear to have made questionable assumptions. Due to the pressures affecting the euro – and in particular the peripheral eurozone countries – since 2010, the Yes campaign proposes that ISS should continue to use sterling as its currency. Its stated first preference, which would seem to have no realistic chance of political acceptance by RUK, is for a jointly agreed monetary union, with both states sharing in some unspecified way in the political control of the Bank of England as central bank.

In reality the Bank would undoubtedly come under the sole political control of RUK. ISS would be using sterling effectively as a foreign currency; and in the absence of any formally agreed monetary union (perhaps short of full joint control), would do so without the agreement of the currency issuing state – in the same way that Panama currently uses the US dollar, and Montenegro uses the euro. While the No campaign has sometimes suggested that this extra-territorial use of RUK’s currency would be impossible, it seems likely in fact that RUK would have neither the ability nor any very strong motive to prevent it.

ISS would, however, in that case lack the kind of control over its currency that every other independent state in the western world currently has, through either a national currency or a joint stake in the euro. The extent to which this would be a major problem in practice, for the Scottish economy in general and for financial services activity in particular, is to some extent debatable.

In the absence of an agreed monetary union, the Bank of England’s lender of last resort (LLR) facilities through its “discount window” in money market operations, would ultimately no longer be available to any banks based in ISS. This would perhaps not be a great additional problem, given the unlikelihood of major banks retaining a Scottish base (see above).

ISS could establish a national central bank, or a state institution combining some central banking and regulatory functions. However, lacking the ability to act as a currency issuer, such an institution’s flexibility in fulfilling a LLR role would be severely constrained.

ISS could be in much the same position as the Irish Republic was in the years up to 1979, when it had a nominally separate currency tied to sterling at a 1:1 fixed parity. In that period Dublin was not able to emerge as a major financial centre, even to the extent that Edinburgh is so now. It did so only in later periods, when Ireland had successively a truly independent national currency and then a position in the eurozone.

In some circumstances a further drawback of using sterling effectively as a foreign currency could concern the operation of monetary policy. Where economic conditions in ISS might diverge from those in RUK, the Bank of England’s Monetary Policy Committee (MPC) would not be bound to take account of Scottish trends in setting interest rates and other monetary actions. Though the Bank has indicated that it would continue to treat Scotland as part of the domestic economy for all purposes during a transition period, in the long run that could not continue.

Other issues

There seems no real risk of ISS being excluded from the European single market for any regulatory purposes. However, it is not clear that ISS could expect to be accepted immediately as a new EU member state, with representation in EU decision making. A possible alternative expedient in the first instance could be for the EU to treat ISS as some form of associated territory.

The former EU Commissioner for monetary affairs Olli Rehn has suggested that ISS would in fact not be eligible for EU membership if adhering to a monetary union (agreed or otherwise) with the UK. As yet, however, this is not widely viewed as the only possible interpretation of the relevant EU rules.

All accessions of new EU member states require unanimous agreement among the existing members. In this respect a very serious obstacle could be Salmond’s suggestion that ISS might refuse to assume its proportionate share of UK sovereign debt if not satisfied with the outcome of monetary union negotiations. There are other issues that would even more clearly require challenging negotiation in any transition to Scottish independence. Given any attempt to make equitable sovereign debt division conditional on these, RUK would probably not be the only EU member state to resist ISS’s accession, considering the significance of sovereign debt sensitivities for other regions of Europe subject to national secession proposals such as Catalonia.

Scotland has always had a distinct legal system, into which UK statute law is fitted in the case of non-devolved regulation. In contract law aspects of finance agreements, independence would seem to have few immediate consequences, except that the UK Supreme Court would lose its current place at the top of the appeal chain for Scottish civil litigation. In the future, however, contracts could come to be affected significantly by divergent regulation as noted above.

“English law” (i.e. the law of England and Wales) is an international jurisdiction of choice for many large contracts, and this is already reflected within the UK. Thus for Scottish customers some large and middle ticket leasing deals are made subject to English law by the contract, while small ticket and consumer agreements are more commonly subject to Scots law. Independence would be unlikely to change this pattern, though the use of English law as the forum of arbitration could not override the effect of future diverging Scottish statutes.

Accounting standards

Accounting standards would seem unlikely to be affected by Scottish independence. Smaller UK companies remain subject to national GAAP rules; while under EU law listed companies are subject to international financial reporting standards (IFRS), where a currently proposed new leasing standard would bring all leases on to the lessee’s balance sheet. At some future stage it is likely that UK GAAP will become fully aligned with IFRS.

It seems likely that UK GAAP rules would be left in place for their remaining life in ISS, although in principle it would be possible to duplicate the UK standard setting body the Accounting Council and create separate Scottish GAAP rules. Extra-territorial application of UK GAAP would follow the practice of the Irish Republic since 1989 (when the first UK statutory standard setter replaced the earlier system overseen by joint British and Irish professional bodies). 

While in some areas Scottish separation could go relatively smoothly, in others it would pose major difficulties.