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On Thursday, Scotland may set out on the bumpy path to independence from the rest of the UK. Its banking system is likely to work only if it is braver and more far-sighted than Alex Salmond, the Scottish National party leader, during the campaign.
There is no inherent reason for Scotland to lack well-regulated banks that offer a solid foundation for its economy, despite the short- and medium-term disruption. Unlike other breakaway countries, its people are very experienced at running them. Most banks would be foreign-owned, at least at first, but that is not a disaster.
But Scotland’s banks would remain fragile if the country clung to Mr Salmond’s timidity. There is little support for a currency union in the rest of the UK; and trying to retain the pound with an arrangement such as a currency board, as he has mooted, would undermine the banks’ foundations.
Scotland would have to take the plunge by creating its own currency and giving its people the incentive they would otherwise lack to keep their money in domestic banks backed by its own central bank and deposit insurance. If it resisted, it would suffer from deposit flight and weak institutions.
Scotland’s problem – that its banking sector is too large in relation to its economy for investors to believe it could handle a financial crisis – is being solved for it. If there is a Yes vote, Royal Bank of Scotland and Lloyds plan to redomicile their holding companies in London to retain Bank of England support.
Mr Salmond has railed against the leaking of their plans but the banks have done him a favour by being honest. An independent Scotland could not support a banking sector 12 times the size of its gross domestic product, and it would not have to. It would lose some jobs, but it would shed a severe liability.
Scotland does not need a huge banking sector, bloated by the reckless growth globally and in the UK of RBS and Bank of Scotland before the 2008 financial crisis. It gains from being an international centre for asset management and insurance but its economy requires only modest-sized banks.
In this context, sterling is a trap. Mr Salmond claims he could cajole or blackmail (by threatening to repudiate Scotland’s public debt) the remaining UK into a currency union but that is deeply implausible. If the SNP kept the pound, it could do so only with a mechanism that made lending treacherous.
First, its banks would lack a lender of last resort. Scotland would re-run its experiment in “free banking”, which operated between the 1707 Act of Union between England and Scotland and the Scottish Bank Notes Act of 1854. Instead of the banks’ liabilities being underwritten by a central bank, they would need to retain more capital themselves.
This worked for a time in the 18th century’s common currency zone – despite bank collapses – winning praise from Adam Smith, the economist, among others. But it would be a sizeable risk and force Scottish banks to have more capital, squeezing their lending capacity.
Second, it would be too easy for Scots to deposit money in UK banks rather than Scottish ones. Both would take the currency and UK banks would offer central bank support and established deposit insurance. Scotland intends to create its own deposit scheme, but that would be new and untested.
RBS and Lloyds announced their moves amid pressure to head off deposit flight, and the problem would worsen after independence. Scottish banks and the Scottish subsidiaries of UK banks would be severely constrained by the double bind of higher capital requirements and flighty deposits.
Banks in an independent Scotland would need an independent currency to solve the capital and deposit problems. That would give them the backing of a central bank, easing their demand for surplus capital, and reassuring both their investors and depositors about their underlying strength.
A new currency would also put a barrier in the way of money being diverted to UK banks operating in sterling. Most Scots would hold cash in domestic banks because there would be no easy alternative (unless and until Scotland joined the euro), just as domestic banks are favoured the world over.
It sounds simple but would be far from simple in practice, which is why Mr Salmond and the SNP have tried to stamp out the currency debate during the campaign. All loans and savings would have to be redenominated and financial institutions – from its government and central bank to banks themselves – would need to establish credibility.
There are many pitfalls to creating a new currency and banking system. Banks in Estonia, Latvia and Lithuania, for example, grew too fast and were hit by crises after leaving the former Soviet Union. It has taken 25 years for them and their regulators to adapt.
Scotland, though, has an advantage. The Baltic countries had not tried it before but the Scots are old banking hands. Bank of Scotland, although it went astray, is nearly as old as the Bank of England, and HSBC was founded and run by Scots expatriates.
It knows how to build strong banks, all right, but that takes time and requires real independence.