Festa major de la UAB,

3.58 In a formal sterling currency union the Bank of England would play a role in ensuring

financial stability across the two countries, at least to the extent that this is important to the monetary transmission mechanism and the effectiveness of monetary policy. An important question is whether this responsibility might include a role as the lender of last resort to the financial sector (defined in Box 2B). A framework for crisis management procedures between the two countries would need to be agreed.

3.59 It is not clear how the current arrangements would evolve if the Bank of England were to become the central bank for two independent countries. In particular, if the Bank of England were to act as a lender of last resort in response to a solvency crisis (see Box 2B) in both jurisdictions, this would involve an implicit commitment of public funds. This would require a set of negotiated terms between the continuing UK and an independent Scottish state regarding the conditions of interventions by the Bank of England, and any indemnifications for them.

3.60 The Bank of England’s interventions and the governance and political accountability behind crisis resolution procedures would have to be clearly defined and agreed between an independent Scottish state and the continuing UK, to limit the risks of fiscal spillovers from lender of last resort operations. It is clear that the coordination of crisis resolution procedures would be a lot more complex with two governments and one central bank than under the current system.

3.61 However, the experience of the euro area has demonstrated that crisis management requires both monetary roles (to address liquidity issues) and fiscal roles (to address solvency). Clear rules under which the central bank would be required to act as lender of last resort may not be enough on their own. If the relevant fiscal authority does not have the fiscal space or tools to respond to the solvency problems (e.g. recapitalisation of the banking sector) this is likely to increase the risks of joint banking and sovereign crises. This can result in the emergence of a vicious circle between banks and sovereign debt. In the euro area, recognition of these risks has motivated the development of a banking union to underpin the currency union, encompassing an integrated system of financial sector supervision and a common fiscal backstop for the euro area banking sector as a whole. 3.62 At the other end of the spectrum, it might be possible to design financial stability

arrangements where each member would be responsible for the resolution of solvency crisis in its own jurisdiction (as opposed to a common fiscal backstop). This would require each member to ”self-insure” against the potential liabilities of its financial sector. Under the current domicile arrangements,23 _{an independent Scottish state would have a very} large banking sector relative to the size of its economy. The size of this sector would be a

23 _{It is not clear whether domicile arrangements would remain the same in the event of Scottish independence.} International examples show that the fiscal capacity of the sovereign can influence the domicile decisions of financial institutions: this is the case for example in New Zealand, where all financial institutions are actually registered in Australia.

significant contingent fiscal risk. An independent Scottish state would therefore need to establish sufficient fiscal space to provide implicit insurance against the risk of future crises in the sector.

3.63 Hence one option might be for Scotland to self-insure by pre-funding the risk i.e. by lowering its public debt level. Alternatively it could potentially look to pay a fee to the UK Government to provide this insurance. Either possibility would place a further significant fiscal constraint on an independent Scottish state in a sterling currency union.24 _Carefully designed financial regulation could ensure that the financial sector self-insures, limiting the fiscal burden on the sovereign. The exact financial stability arrangements for a formal sterling currency union would have to be agreed between the continuing UK and an independent Scottish state to minimise fiscal and financial risks.

3.64 Existing supervision requirements defined under European law would also have to be taken into account in these negotiations. Under European law, an independent Scottish state would be required to establish its own competent authority to regulate and supervise financial services and could not amount to banking union with the UK as a separate Member State. Regulation of the UK financial services is carried out under the legislative framework put in place by the UK Parliament.

3.65 It might theoretically be possible for an independent Scotland, with the agreement of the continuing UK, to appoint the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) as its regulators, but this would not allow the FCA and PRA to regulate Scottish firms on a “UK wide” basis. The provision of services by Scottish firms to the rest of the UK would be done under passporting provisions of EU law, meaning that the independent Scottish state and the continuing UK would not be a common jurisdiction – even if the regulator had jurisdiction over both. An independent Scotland would need to establish and maintain a body of financial services legislation and would have a range of specific responsibilities under EU law, which could not be shared with the UK Government. A forthcoming publication on financial services as part of the Scotland analysis series will provide more detail on these questions.

Conclusion

3.66 The current policy proposal of the Scottish Government is for an independent Scottish state to enter a formal sterling currency union with the continuing UK. If such a union could be agreed, sterling would be used as a single currency and the Bank of England would act as a common central bank to both countries. There would be benefits for both an independent Scotland and the continuing UK from continuing to use the same currency and keep transaction costs low, but it would also create significant macroeconomic risks.

3.67 The economic suitability of Scotland’s current use of sterling would decline in the event of independence. Monetary policy would become less well suited to Scottish economic conditions and there would be weaker private sector mechanisms to stabilise the economy. Fiscal policy would therefore need to do more to

stabilise the economy. With independent fiscal policies, and in the absence of fiscal transfers, this extra support would have to be self-funded. This would take the form of large fiscal surpluses in good times providing a buffer for self-insurance against shocks, and/or deficit funded counter-cyclical fiscal policy. However, cost of borrowing would be likely to be higher for an independent Scottish state. Membership of a

24 _{Establishing the costs of self-insuring or the actuarially fair price of obtaining insurance would be extremely} difficult to do given the nature of the risk and complexity of the financial sector. But the current size of the financial sector in Scotland implies that the numbers would be likely to be significant.

currency union could also place constraints on the efficiency of the fi scal policy lever, and the scope for fiscal stabilisation available to an independent Scottish state.

3.68 The experience of the euro area has shown that market conditions and perceptions can greatly limit the ability of members of a currency union to access credit markets to use fiscal policy in response to a large shock, especially if there is no lender of last resort apparatus for sovereign debt. It has also highlighted that, acting individually, members of a currency union tend to provide less fiscal stimulus to their economy than they would with better fiscal coordination.

3.69 In addition, the experience of the euro area has illustrated the difficulty of restricting the consequences of fiscal actions solely to the individual member of a currency union, and the need for enforceable fiscal constraints that could limit the sovereignty of members of the currency union.

3.70 The Bank of England could continue to play an important role to support fi nancial stability in the event that a formal currency union were to be agreed. This may include the provision of lender of last resort facilities to the financial sector. In this case, the implicit commitment of public funds to underwrite any financial stability interventions could also create important fiscal risks for the UK. The UK’s interest would be to minimise these risks through a well designed framework and clear conditions for financial stability interventions.