As Scotland goes to the polls today to decide whether to split from the rest of the United Kingdom, we take a panoramic view of the regulatory issues. Banks with large private wealth management arms are already planning to restructure south of the border in the event of a 'yes' vote; there is also the issue of whether Scotland might outsource some of its regulation to 'rUK' and how much regulatory arbitrage is likely to take place if the union dissolves.

As Scotland goes to the polls today to decide whether to split from the rest of the United Kingdom, we take a panoramic view of the regulatory issues. In gazing into the near future we are hampered not only by the uncertainty of the vote, but also by the badly-expressed policies, bluffs and counter-bluffs that underpin this fascinating debate.

There are many issues that cannot be resolved – such as currency union – till after the vote. Chancellor George Osborne recently ruled formal currency union out, although the 'yes' campaign has accused him of 'bluffing'. Informal currency union – in the style of the 'dollarisation' of the economies of the British Virgin Islands or the Turks and Caicos Islands or the 'euro-isation' of Monaco and Montenegro – is also possible. For the Scottish financial sector, this is probably the most important issue to be resolved if and when the population has voted in favour of independence.

The size of the financial sector

The Office for National Statistics’ 2010 regional survey suggested that financial services contributed £8.8bn to the Scottish economy, although the Guardian’s analysis of Scottish-registered financial service companies suggests that the UK's revenue generation is dominated by those owned outside Scotland. The Scottish Fiscal Commission Working Group – a sub-group of the Scottish Government's Council of Economic Advisers which has already generated plenty of advice about the development of a robust fiscal and macroeconomic policy for an independent Scotland – has suggested that just under 10% of the UK's financial services workforce is in Scotland. In 2012, Scottish Financial Enterprise estimated that up to 90% of the Scottish financial sector's customers were located in the rest of the UK.

The first minister's wish-list

Alex Salmond, Scotland's first minister and a former economist at Royal Bank of Scotland, has presented a checklist of economic wishes for an independent Scotland. He wants currency union (ruled out), the cross-border sharing of systemically important institutions such as the Bank of England, the regulation of Scottish financial bodies by the Prudential Regulation Authority/Financial Conduct Authority, shared financial crisis resolution procedures, European Union membership (another big 'if' ruled out by the current rhetoric of the EU's leaders) with an opt-out to be agreed with the EU in case Scotland does not want to use the euro, accession to a host of international treaties and agreements to which the UK is already a party, and successful applications for membership of the United Nations (an anti-money-laundering policy-setter), the International Monetary Fund (ditto) and the North Atlantic Treaty Organisation.

These things are not Salmond's to give, and many Scots remain doubtful about the feasibility of attaining all of them. Nevertheless, they represent the best result that Salmond can obtain, one which would result in the least amount of change to the British and Scottish financial sectors, although some change would be inevitable.

The prudential problem of two over-mighty banks

Even if everything goes according to plan, however, a 'yes' vote would lead to problems. Scotland's ability to act as a fiscal backstop for its own financial sector is at best questionable given the relative size of the Scottish banks. HM Treasury estimates that Scottish banks' assets are roughly 1,250% of Scottish GDP. British banks' assets are just under 500% of the whole UK's GDP – a lower figure by far. Speaking at a symposium in Glasgow last summer, Rod MacLeod of the Scottish law firm of Tods Murray explained: “Could a Scottish Treasury have stepped in to bail out RBS and HBOS in 2008, in view of the relative size of the Scottish economy to the size of the banks? It's hard to say. It is difficult to predict whether or not the Scottish banks would still be the same shape or size if Scotland voted yes.”

RBS and HBOS said last week that they would move their registered headquarters south if Scotland became independent, although they would keep their staff in Scotland. This might be just as well, as their operations south of the border – which include massive private client business – are so substantial that this might have cast doubt on where their head offices really are in the eyes of the European Union in the event of a 'yes' vote. HM Government owns both banks. It expects them, once it has sold off its holdings to the markets, to be the repositories of assets 12 times that of the entire Scottish economy. An independent Scottish Treasury, acting on its own, might not be able to stage a second rescue without the help of 'rUK' [the leftover “rump of the UK”]. Standard Life, based in Edinburgh, also plans to move elements of its business south in the event of a 'yes' vote. This might get round the likelihood that rUK will not find it acceptable to refinance a Scottish- headquartered financial institution.

MacLeod rounded off the issue with another observation: “The issue is even more complex for financial groups with member companies registered on both sides of the border, perhaps leading to the splitting-up of these groups for regulatory purposes. Bank restructuring cannot happen quickly or cheaply or be taken lightly.”

Credit rating problems

He went on: “Independence could mean higher funding/borrowing costs for Scottish banks if Scotland has a poorer credit rating than the rest of the UK. Similarly, independence could mean higher capital adequacy requirements for Scottish banks if Scotland is perceived as a higher-risk business environment due to inevitable uncertainty and instability over the formation of a new nation state. Conversely, if Scotland obtains a higher credit rating than 'rUK' then that would be good news for the Scottish banks. Bank funding costs are normally linked to the sovereign state's credit rating, so if Scotland votes yes, I think it's safe to assume that the banks will at least be looking at their own operations on both sides of the border. There could be incentives to restructure in the form of funding costs, tax breaks, or trading reasons.”

Future credit ratings are a hot issue at the moment. In the event of a 'yes' vote, the Westminster government expects Scotland to shoulder its proportional share of the mounting British National Debt. Alex Salmond has recently poured cold water on this idea, suggesting that Scots should not pay for the improvidence of their late masters. ITV News reports that he has rejected calls for Scottish ministers under his control to withdraw their their threat to renege on the debt if they cannot secure a currency union, saying: "the contractual legal liability lies with the UK Government."

He told BBC Sunday Politics Scotland: "Clearly, if Danny Alexander [chief secretary to HM Treasury] wants to take all of the assets then he gets stuck with all of the liabilities, which is why our reasonable position is much better. We're putting forward an argument that we should share assets and liabilities, which is a wholly responsible position."

ITV News reported on 9 September: “Team Salmond are also bullish about the issue of reneging on debt: "What are they going to do - invade?", the First Minister reportedly told colleagues. Mr Salmond's official spokesman denied he had made the 'invasion' remark, but added that he was confident Scotland would be able to continue using the pound.” The two subjects of debt repayment and currency union are clearly linked in the first minister's mind and he seems to believe that he has an unbeatable bargaining chip in any dispute.

Danny Alexander, meanwhile, has issued dire portents about Scotland's future credit rating if it 'reneges,' claiming that it would only be able to borrow money at sky-high interest rates. It remains to be seen whether this is a realistic threat.

Who regulates? The SNP's perspective

Fundweb has reported that in July a report, written by Capital Economics for a Scottish business pressure group called N-56, argued that the Scottish financial services sector had the potential to make Scotland one of the top 30 financial services centres in the world. It reportedly said that should Scotland vote to become independent, it is important that financial regulation in Scotland and the existing UK-wide regulator should remain closely aligned and it even suggested that a single regime should range across both jurisdictions.

The Scottish National Party's independence white paper from last year seems, at one stage, to rule this out: "We will also develop and deliver a streamlined and efficient regulatory model with a combined regulatory body with a single, strong voice, both in Scotland and internationally, on competition and consumer issues..." It adds later, in the same vein: "An independent Scotland will establish our own regulator, as is the case in all other EU countries."

On the subject of prudential regulation, however, it envisages some kind of combined authority: "The Fiscal Commission set out that the Bank of England Financial Policy Committee will continue to set macro-prudential policy and identify systemic risks across the whole of the Sterling Area. There could be a shared Sterling Area prudential regulatory authority for deposit takers, insurance companies and investment firms. Alternatively this could be undertaken by the regulatory arm of a Scottish Monetary Institute working alongside the equivalent UK authority on a consistent and harmonised basis."

It is in the area of 'conduct' that a new regulator seems to be envisaged: "The second aspect of financial regulation covers the monitoring of the conduct and behaviour of firms in local markets, to ensure that financial markets function well, with choice and competition, whilst protecting consumers. It is proposed that this aspect of financial regulation will be discharged by a Scottish regulator which will assume the key responsibilities of the UK Financial Conduct Authority in Scotland.” The SNP also wants a “far more efficient and effective consumer protection system” which, if built, would be guaranteed to affect high-net-worth customers.

The paper explores the 'conduct' regulator's role further: "It will work on a closely harmonised basis with the UK regulators, delivering an aligned conduct regulatory framework, to retain a broadly integrated market across the Sterling Area. The regulatory approach will include the application of single rulebooks and supervisory handbooks.

"The market for financial products between Scotland and the UK - including bank accounts, pensions, loans and insurance - is highly integrated...this will largely continue..."

HM Treasury published a paper last year that suggested that it would be very difficult for Scottish financial regulators to share functions with the established bodies of 'rUK', but this is no guarantee that such a situation is impossible, especially if a formal currency union remains. When one reads what European directives say on the subject of who should regulate, they leave enough 'wiggle-room' for Scotland to outsource its regulatory functions to rUK.

Who regulates? The EU's perspective

Some EU directives assume that a competent authority exists for every country; others require one. The City law firm of Cameron McKenna recently enumerated the expectations that they contain.

* Article 4 of the Capital Requirements Directive IV states: “Member states shall designate competent authorities that carry out the functions and duties provided for in this directive and...shall inform the [European] Commission and European Banking Authority thereof, indicating any division of functions and duties.

* Article 7 of the Insurance Mediation Directive says: “Member states shall designate the competent authorities empowered to ensure implementation of this directive [which] shall be either public authorities or bodies … expressly empowered for that purpose by national law.”

* Article 20 of the Payment Services Directive says: “Member states shall designate as the competent authorities responsible for the authorisation and prudential supervision of payment institutions...either public authorities, or...national central banks.”

* Article 11 of the Market Abuse Directive states: “Without prejudice to the competences of the judicial authorities, each member state shall designate a single administrative authority competent to ensure that the provisions adopted pursuant to this directive are applied.”

* Article 48 of the Markets in Financial Investments Directive states: “Each member state shall designate the competent authorities which are to carry out each of the duties provided for under the different provisions of this directive.”

* Article 44 of the Alternative Investment Fund Managers Directive states: “Member states shall designate the competent authorities which are to carry out the duties provided for in this directive.”

* Article 21 of the third Money-Laundering Directive says: “Each member state shall establish a financial intelligence unit in order effectively to combat money laundering and terrorist financing.” Only this directive calls unequivocally for the national setting-up of something; a Scottish FIU therefore seems inevitable. This could be housed in the new central bank, as many FIUs are, or it might be an adjunct to the existing Scottish Drug Enforcement Administration, or it might be part of a new Scottish 'Gestapo', as the present-day UKFIU is part of the National Crime Agency.

The phrase 'competent authority' means an authority competent to supervise and enforce each EU directive and regulation that asks for it. It has to receive its powers from national law and the EU can 'challenge' the member-state in question if such an authority fails to work properly. The Cameron McKenna report concludes that “Scotland could outsource to the (rUK) Financial Conduct Authority and Prudential Regulation Authority. Of course, these bodies are accountable only to HM Government (or rUK if Scotland votes 'yes') and there is nothing to suggest that this will change in future."

What the experts say

Rod MacCleod of Tods Murray agreed, albeit cautiously: “As I understand it it would be possible, in theory. It might have to operate in Scotland under one hat and in the rest of the UK under another. It wouldn't be considered as a regulator of Scotland and the UK as a whole, but you could in theory have the same entity doing it, albeit under a different name and reporting to each government separately. 

“The Treasury paper suggested that firms that had to deal with two regulators and evolve two sets of products would suffer extra expenses from regulatory divergence. But you can look at it the other way and argue that we already have divergence to some extent because we have separate legal systems. Mortgages are tailored differently either side of the border, as are other, less well-known products.”

Alex Montgomery, chief executive of wealth management business Turcan Connell Asset Management in Scotland, has warned that Scottish independence could have serious consequences for the wealth management industry on both sides of the border.

“Wealth managers are definitely concerned about the potential consequences of a yes vote. The biggest issue is likely to be regulation because an independent Scotland would be required to have its own financial services regulator. Businesses serving clients in both Scotland and the residual UK would have to satisfy two regulators which would be likely to be a significant additional burden for firms. To satisfy the requirements of a new and additional regulator is going to increase costs. There are just no two ways about it.”

The regulatory wicket-keepers

Would there be a Scottish Financial Ombudsman Service and Financial Services Compensation Scheme? If an independent Scotland joins the EU automatically, the latter seems imperative. Article 3 of the EU's Deposit Guarantee Scheme Directive states: “Each member state shall ensure that within its territory one or more deposit-guarantee schemes are introduced and officially recognised.” The authors of the paper, however, seem to be fudging this requirement somewhat. They propose to build up a 'guild regulation' (i.e. fee-extracting) Scottish FSCS which may or may not include insurance and which somehow manages to take part in a shared scheme across the whole 'Sterling Area'. It is not known whether this would satisfy the EU. It would, however, appear to suspicious eyes in Westminster as yet another attempt to use English money to underwrite Scottish bad debts. There seem also to be plans for a Scottish FOS: “Scotland will also be responsible for our own competition and consumer protection landscape, including money advice and financial ombudsman services.” 

Ring-fencing

The Independent Commission on Banking, HM Government's inquiry into structural and related non-structural reforms to the UK banking sector, reported in September 2011. The Scottish government has indicated that it will honour the commission's 'ring-fencing' policy between retail and investment banking. It remains to be seen how far it would go, however. It might impose higher capital requirements than those originally envisaged because of the size of the two largest banks and might feel impelled to break them up. Some believe that HM Government may well do the job on Scotland's behalf, at least with RBS. 

A 'yes' vote without the prospect of a Sterling Area

Additional factors would also come into play if currency switched from Sterling to the Euro or a Scottish pound. Here, as enumerated by Rod MacLeod in his speech, are some of them.

(i) Higher transaction costs for cross-border transactions would be unavoidable if Scotland were to adopt the euro or its own currency. Currency conversion costs, exchange-rate risks and price comparability are all factors that would drive up transaction costs, at least in the short term.

(ii) There would have to be a significant overhaul of the payment infrastructure that British banks use for making and receiving payments in the UK. Intra-UK payments use a number of different systems. Payments include cash machine withdrawals, credit-card payments, direct debits, current-account transfers etc. Bodies that are based in the UK run each system, and all systems operate in Sterling, which means that they would have to be overhauled for payments going back and forth across the new border in a different currency. Again, the cost of upgrading IT systems or designing new ones for a new currency would fall to the Scottish banks or other non-Scottish banks operating in Scotland. It would therefore drive up the cost of bank services in cross-border transactions, at least in the short term.

(iii) If an independent Scotland issued its own currency or adopted the euro, there would also have to be a Scottish central bank. A cross-border regulator would then make less sense. If there were to be little public confidence that this central bank was going to be strong and capable of protecting the integrity of the banking system from systemic threats at home and abroad, making 'liquidity interventions' in times of financial crisis, it would have an effect on Scotland's credit rating and funding costs for the banks. The setting-up of the new central bank and/or regulator might also be funded by a levy on the banks and not from the public purse – another worry. If the deadline for independence was 2016 (as it provisionally is) and Scotland had to establish these institutions, problems might arise if they were not ready on time. This could have a disastrous effect on business planning.

(iv) Other issues will have an effect on the Scottish sector. The re-denomination of Scottish financial contracts is one. These may suddenly be payable in a new currency. Capital flight is another issue, with some claiming that it has begun already. UK bank licences are another issue; nobody knows whether or not these would still apply to the Scottish banks and whether they could use the licences under EU passport arrangements.

Is all this academic?

There is a real possibility that a 'no' vote will kill the current debate about Scottish independence only for a few years at best. At any time the SNP can be re-elected with an overall majority in Scotland, as it has already been once, and there is nothing to stop it from taking the approach of the European Union to constitutional reforms that require democratic votes, which is to have the same vote again and again until the answer is yes. If the SNP loses the current debate but takes this approach in future, we shall be discussing the same topics again before too long.

This, moreover, seems likely. There has been an inexorable groundswell of popular support for independence over the last few decades, with Westminster politicians ditching their powers over Scotland helter-skelter every time that nationalist sentiment needs placating. Neal Ascherson summed this up best in the Sunday Herald on July 6^th: “The 1707 Treaty of Union is already over - it's dead. It was soundlessly blown up at the moment in 1999 when Winnie Ewing said: 'The Scottish Parliament is hereby reconvened.' For the last 15 years, we have been living in an informal, low-rise, lower-case union, its ever-changing skyline made up by Westminster and Holyrood as they go along. The sweep of transformation - now become a torrent since the referendum campaign began - heads towards the completion of self-government. The Yes side may well not win the vote...but it has already, overwhelmingly, won the campaign."