Key Considerations For Rating Banks In An Independent Scotland

Primary Credit Analyst: Giles Edwards, London (44) 20-7176-7014; [email protected] Secondary Contacts: Richard Barnes, London (44) 20-7176-7227; [email protected] Mark Button, London (44) 20-7176-7045; [email protected] Nigel Greenwood, London (44) 20-7176-7211; [email protected] Dhruv Roy, London (44) 20-7176-6709; [email protected] Media Contact: Sharon L Beach, London (44) 20-7176-3536; [email protected]

Table Of Contents
The Six Aspects That Would Determine Bank Creditworthiness Post Independence Strong Banking Systems Are Usually Underpinned By A Strong Central Bank Independence Could Affect Banks' Access To Funding Markets Deposit Insurance Would Be An Essential Component The Level Of Systemic Support Is Unclear Monetary Policy Will Determine The Regulatory Regime A New Banking Market Would Mean Additional Costs--And Risks Other Sovereign And Country Risk Considerations Could Come Into Play Note Related Criteria And Research
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Key Considerations For Rating Banks In An Independent Scotland

Scotland's electorate will go to the polls to vote in a referendum on independence on Sept. 18, 2014. If the "yes" vote wins, the new government of Scotland and the remaining U.K. will enter negotiations on issues such as the allocation of liabilities and assets and the monetary regime, among others. Standard & Poor's Ratings Services is often asked about the potential rating implications for banks in a newly independent sovereign Scotland. Our views on the capacity of banks to service their financial obligations in full and on time take into account a number of factors, namely: Our Banking Industry Country Risk Assessment (BICRA) of the countries in which they operate, primarily the one in which they are domiciled, detailed in our criteria, "Banking Industry Country Risk Assessment Methodology And Assumptions," published Nov. 9, 2011, on RatingsDirect. This determines the "anchor," the starting point for assigning a bank rating. The four subfactors detailed in our criteria, "Banks: Rating Methodology And Assumptions," published Nov. 9, 2011, through which we assess the specific stand-alone characteristics of each institution, which we combine with the anchor to determine the stand-alone credit profile (SACP). Our view of the possibility for any potential future extraordinary support, whether from a parent (in line with our "Group Rating Methodology," published Nov. 19, 2013) or, for systemically important institutions, the government. An institution's potential resilience to the hypothetical default of the sovereign where it has a material exposure to a lower-rated country, and so our willingness to rate the institution above that sovereign. This methodology is detailed in our criteria, "Ratings Above The Sovereign--Corporate And Government Ratings: Methodology And Assumptions," published Nov. 19, 2013. Standard & Poor's credit ratings are determined by rating committees. The views expressed herein have not been determined by a rating committee and do not constitute a rating or an indication of any potential Standard & Poor's rating on an independent sovereign Scotland or on Scotland-domiciled banks after independence. Standard & Poor's takes no position in the debate on the pros and cons of Scottish independence. Overview In an independent Scotland, the choice of monetary regime would be crucial. In our view, it has implications for important decisions relevant to the banking sector, including the existence and role of the central bank, the regulatory regime, and deposit insurance arrangements. The Scottish government's access to funding from wholesale markets would likely influence that of the Scottish banking sector. We currently factor systemic support into the ratings on systemic U.K. banks, although policymakers and regulators are now making strides to try to remove the implicit taxpayer subsidy for systemic banks. However, the willingness and ability of the Scottish government to support its banking sector appears challenging. The creation of a new banking market would create additional costs for Scottish and remaining U.K. banks alike, in reconfiguring operating models (systems, staff, and legal entity structures) and products.

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Key Considerations For Rating Banks In An Independent Scotland

The Six Aspects That Would Determine Bank Creditworthiness Post Independence
Although there is still considerable uncertainty around whether Scottish voters will back the independence proposal, there are important considerations and uncertainties relevant to our view of the creditworthiness of banks domiciled in an independent Scotland. These cover: The role and existence of the central bank. The lender of last resort (LOLR) function is critical to banks as highly leveraged, confidence-sensitive institutions. The credit strength of the Scottish state itself and its access to funding markets. This is relevant because the terms and depth of sovereign access to wholesale markets tend to influence the market access of banks and other corporates domiciled in that country. The existence and credibility of deposit insurance arrangements, which serve to underpin depositor confidence. The ability and willingness of the Scottish government to provide extraordinary support to systemically important banks under stress. Our ratings on banks in the U.K. currently assume such support, although we see policymakers and regulators making strides to try to remove the implicit taxpayer subsidy for systemic banks. The willingness and ability of a future Scottish government to support its banking system appears challenging to us at this point, not least because system assets could be over 1,000% of (10x) Scottish GDP. The intended regulatory regime, including whether regulatory policy would diverge significantly from that of the current U.K. regulators, the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). For Scotland- and remaining U.K.-domiciled banks alike, the potential additional costs and associated operational risks of reconfiguring operating models (systems, staff, and legal entity structures). These would likely be further accentuated if Scotland did not use the British pound sterling. Rating implications aside, there is also a broader question about whether, through choice or operation of law, all Scotland-headquartered banks will necessarily remain such. While this is uncertain, the European Directive on prudential supervision (95/26/EC) could conceivably require banks to align their head office with their registered office in the country where they have the bulk of their activities. Currently, Lloyds and RBS have their registered offices in Edinburgh but their head offices in London. And reflecting the relative size of the Scottish and remaining U.K. economies, their business activities are weighted toward the latter. However, our base assumption is that the decision for any affected bank would be one of choice rather than legal requirement. If Scotland votes for independence in September, we expect that the Scottish and remaining U.K. governments (and the European Commission) would enter a period of negotiation to agree a multitude of crucial details, ahead of independence taking effect. We anticipate that banks, Scottish or otherwise, could need considerable time to adjust. However, U.K.-domiciled banks have a lot of restructuring/reorganization to complete already due to ongoing regulatory changes, and they could find the Scottish government's March 2016 target for independence to be a challenge. A swift negotiation on issues such as monetary policy and regulation would help to reduce uncertainty for banks and allow them time to make the necessary changes.

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Key Considerations For Rating Banks In An Independent Scotland

Strong Banking Systems Are Usually Underpinned By A Strong Central Bank

The BICRA is the starting point for our assessment of a bank's creditworthiness. Within it, we consider economic and industry factors that affect any bank domiciled in a country. Within the industry risk assessment, we assess three factors: the institutional framework, competitive dynamics, and systemwide funding. The latter considers the structural funding position of the banking sector, the depth of the capital markets, and access to contingent funding. The role of the central bank as LOLR is an important part of this assessment, and to our view of the creditworthiness of banks as confidence-sensitive, highly leveraged institutions. Whether Scotland would have its own central bank will depend on the eventual monetary policy, notably the decision on which currency to use: sterling, the euro, or a new currency. If Scotland uses sterling through a formal currency union, then the Bank of England (BoE) would likely remain available as LOLR to domestically active banks domiciled in Scotland. This is an option that the Scottish government favors, but about which the U.K. government and the BoE itself have expressed strong reservations. Similarly, if Scotland were to join the eurozone (European Economic and Monetary Union), Scottish banks would have access to LOLR liquidity from the European Central Bank (ECB). If Scotland adopted its own currency, we assume it would set up a central bank to operate monetary policy and presumably provide the LOLR function to domestic banks. However, in a stress scenario, internationally active Scottish banks would likely have substantial liquidity needs in sterling, and this may be unavailable from a Scottish central bank unless it had high foreign currency reserves or a negotiated swap line with the BoE. By contrast, if Scotland uses sterling unofficially, then it would likely have no central bank. Scotland-domiciled banks would very likely have a right of access to BoE liquidity through any remaining U.K. subsidiaries, although the right of access of their U.K. branches could be more constrained. In our view, this could be a clear point of weakness for a Scottish banking system compared with most banking systems worldwide. A few banking systems do operate successfully without a LOLR function: In Bermuda, for example, the Bermudian dollar is pegged to the U.S. dollar. However, due to the lack of a liquidity backstop, the Bermuda Monetary Authority requires the banks to maintain notably high liquidity (and capital) buffers. Confidence sensitivity is also somewhat mitigated by the fact that Bermudan banks tend to have relatively few foreign currency requirements or obligations.

Independence Could Affect Banks' Access To Funding Markets

As we note above, within our BICRA assessment of systemwide funding, we consider the system's need for, and access to, wholesale funding and cross-border funding. The need for such funding is determined by the system's structural funding position, notably the extent to which local lending is not financed by local deposits. Our view of access to wholesale markets considers the depth of the local market, which is generally the most reliable. It also takes into account the sovereign's access to funding markets, because the terms and depth of sovereign access to wholesale markets tends to influence the market access of banks (and other corporates) domiciled in that country. If a Scottish banking system was created through independence, we would need to assess the extent to which the

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system's structural funding position differed from that of the U.K. banking system today. We currently regard the U.K. banking system as having relatively low net external funding needs, and a material but reduced reliance on wholesale funding in financing the domestic loan book. The system also benefits from deep debt capital markets and a government that has a strong role and a stabilizing influence.

Deposit Insurance Would Be An Essential Component

We assess the quality and behaviour of a bank's deposit base (and broader funding profile) within our assessment of a bank's funding and liquidity. In our view, deposit insurance plays a vital role in providing confidence to retail and small and midsize enterprise depositors, aiding deposit stickiness (that is, a high retention level). Currently, eligible deposits in U.K.-domiciled banks (and the U.K. branches of non-European Economic Area [EEA] banks) are insured by the U.K. Financial Services Compensation Scheme (FSCS). In the past five years, the FSCS has proved effective at ensuring that eligible depositors do not lose out when U.K. banks fail. However, because it is not a pre-funded scheme, the FSCS relies in part on loans from HM Treasury in order to make timely payments to depositors. The banking sector is subsequently levied to make good any FSCS losses. In our view, even under current arrangements, the default of a large U.K. deposit taker could strain FSCS resources, operationally and financially, and leave a potentially sizable liability for the rest of the banking sector. Not every functioning banking system has deposit insurance: a few banking systems outside Europe and the U.S. operate without it--Panama, for example. But Scottish and U.K. depositors would be readily able to deposit their funds in the remaining U.K. or with Scottish branches of remaining U.K. banks if they wanted FSCS insurance coverage (as is the case for Irish residents), or else demand a premium to make an uninsured deposit with a Scottish bank. More importantly, if it became an EU member, Scotland would be required under EU law to establish and maintain an effective deposit insurance scheme. In our view, credible deposit insurance arrangements would be essential in helping to underpin the quality and price-effectiveness of Scottish banks' deposit bases, and, in a stress scenario, to mitigate the risk of deposit flight over the border. If an independent Scotland were to join a currency union with the remaining U.K., we assume that regulation would remain under the BoE and that FSCS coverage would be unchanged. Alternatively, Scotland would very likely be required to set up its own deposit insurance arrangements if it adopted the euro. However, these arrangements would likely be unfunded, leaving the comparatively very sizable deposit bases of the largest Scottish banks backed with an implicit guarantee by the Scottish government. We note a possible parallel here with Iceland, where in 2008 the national deposit insurance scheme could not honour claims when the country's outsized banking system failed.

The Level Of Systemic Support Is Unclear

With the exception of Iceland, we currently classify all Western European governments as "supportive" of their systemically important banks--that is, we believe that there is a strong likelihood that the governments would support a failing bank to the benefit of senior creditors. Experience of bank bail-outs through the global financial crisis of 2007-2009 certainly bears out this view, although policymakers and regulators are now making strides to try to remove

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Key Considerations For Rating Banks In An Independent Scotland

this implicit taxpayer subsidy for systemically important banks and mitigate the consequences for financial stability of allowing a systemic bank to fail (see "Standard & Poor's To Review Government Support In European Bank Ratings," published March 4, 2014). This "supportive" assessment typically leads us to factor in one-to-two notches of uplift for potential extraordinary support into the ratings on systemic banks, depending on how systemic they are and the relativities between the sovereign rating and the banks' SACPs, our view of their intrinsic creditworthiness. Under our bank methodology, the assessment of whether a government is supportive examines the ability and willingness of a government to support its systemically important banks. In our view, the willingness and ability of a future Scottish government to support its banking system is challenging at this point, not least because, according to HM Treasury's paper "Scotland analysis: Financial services and banking" (see note), the Scottish banking system's assets are currently a high 1,254% of Scottish GDP, which compares with an already high 492% of GDP for the U.K., and 880% for Iceland in 2007 just before the banking system collapsed. An alternative classification of a government as "support uncertain," as we now view Iceland, leads to us factor in no notches of uplift for potential extraordinary government support into domestic bank ratings.

Monetary Policy Will Determine The Regulatory Regime

We consider the quality of banking regulation and supervision and the track record of regulators within the institutional framework in our BICRA industry risk assessment. The influence of the regulatory environment can also be a factor. We have a nuanced view of U.K. bank regulation: manifest failings were exposed by the financial crisis, but there have since been a number of important measures to strengthen the regulatory regime that now make the U.K. one of the most demanding environments for prudential and conduct of business regulation. In an independent Scotland, the choice of monetary regime will be crucial. If it were to enter a currency union with the remaining U.K., we expect that the current regulatory regime would be kept more or less intact. If Scotland entered the euro, we assume that the most systemic banks would be subject to prudential regulation by the ECB (as the largest eurozone banks will be from late 2014), with the smaller ones being supervised by a national regulator. Independent monetary policy implies the formation of a national regulator with oversight of the entire banking system. If this happened, we would expect to assess the extent to which regulatory policy would be likely to diverge significantly from that of the current U.K. regulators, the PRA and FCA. That said, for prudential regulation at least, most regulatory standards are established by European directive, which acts across the EU and is usually also adopted by peripheral countries in the rest of the EEA. The conduct of business regulation remains a more national preserve, but we see few reasons why there would be a significant divergence from the current regime. We note that if an independent Scotland joined the EU or wider EEA from the outset of independence, remaining U.K. banks could use the EEA "passport" to ensure the continuity of access to the Scottish banking market.

A New Banking Market Would Mean Additional Costs--And Risks

We consider a bank's earnings prospects within our assessment of capital and earnings. This assessment is weighted toward capitalization, but earnings capacity is also important, particularly at the current time in the U.K. when banks

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Key Considerations For Rating Banks In An Independent Scotland

continue to need to build regulatory capital and at the same time absorb sizable, recurrent charges for past compliance failings. The U.K. is currently a single, cohesive banking market serving an adult population of more than 50 million people under a regulatory regime that makes no extra requirement on banks wherever they wish to operate across the territory. This allows banks to exploit efficiencies of scale, where they are sufficiently well organized to do so. In a sustained low growth, low interest rate environment, cost efficiency has become a key earnings driver for U.K. banks and is set to remain so, even amid the challenges posed by rising compliance costs and recurrent phases of restructuring costs. For Scotland- and remaining U.K.-domiciled banks alike, the creation of a new banking market would likely create potential additional costs, and some associated operational risks, in reconfiguring operating models (systems, staff, and legal entity structures) and products. However, the extent to which an independent Scotland would create a separate banking market largely depends on the separateness of regulation and currency, as discussed above. These additional costs would likely be accentuated for all banks operating in Scotland if Scotland did not use sterling, and for any individual banks that sought to change their legal entity structure or domicile. However, given the prominence of capitalization (versus earnings) to our assessment, extra costs in themselves would appear likely to be a second order rating consideration.

Other Sovereign And Country Risk Considerations Could Come Into Play
We make no assumption about the potential sovereign rating on an independent Scotland. However, our criteria on rating nonsovereign entities above the sovereign would be relevant to any highly rated Scottish or remaining U.K. bank that has material exposure (that is, more than 25% of assets) to Scotland, if Scotland was rated lower than that bank's potential issuer credit rating. (Most large U.K. banks are currently rated in the 'A' category, including extraordinary government support.) Where exposure is less than 25% and/or the sovereign is rated above 'A+', the institution would generally not be subject to any sovereign cap unless we see it as particularly sensitive to a sovereign default. Where exposure is greater than 25%, we apply a stress test to determine the bank's resilience to a theoretical sovereign default scenario. If the bank fails the stress test, then we would cap its rating at the sovereign rating. If it passes the stress test, we could rate a bank up to two notches above the sovereign. We see these criteria as potentially less relevant, not least because we expect that no Scottish-domiciled rated bank would have exposure of more than 25% to Scotland based on their existing structures. As for the potential impact of replacing a U.K. BICRA with a Scottish BICRA for Scottish-domiciled banks, we consider the economic risk assessment of the Scottish banking system as being relatively less likely to affect bank ratings than the industry risk factors noted above. This is because the economic risk constituent that determines a bank's anchor and SACP reflects the blended economic risk of the countries to which the bank is exposed, rather than just the economic risk of its country of domicile. It also reflects, to some extent, our observation that the current indebtedness of household and corporate borrowers in Scotland is not materially dissimilar to that of the U.K. in general. Even in the hypothetical scenario that we judge the banking system of an independent Scotland to have higher economic risk than that of the current U.K. banking system, the weight of Scottish exposures to most rated U.K. banks is relatively modest,

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reflecting their usual U.K.-wide focus and the modest size of the Scottish economy compared with that of the broader U.K.

Note
Scotland analysis: Financial services and banking (HM Treasury, May 2013). For more details, see

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/200491/scotland_analysis_financial_services_an

Related Criteria And Research

Related criteria:
Group Rating Methodology, Nov. 19, 2013 Ratings Above The Sovereign--Corporate And Government Ratings: Methodology And Assumptions, Nov. 19, 2013 Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related research:
Major U.K. Banks Shift Focus From Repairs To Returns, March 13, 2014 Standard & Poor's To Review Government Support In European Bank Ratings, March 4, 2014 Key Considerations For Rating An Independent Scotland, Feb. 27, 2014 Banking Industry Country Risk Assessment: United Kingdom, Sept. 25, 2013

Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
Additional Contact: Financial Institutions Ratings Europe; [email protected]

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