Written before the referendum took place

The Scottish independence referendum on Thursday September 18 draws near, and it looks set to be a close vote. The consensus of forecasts is still for a narrow No majority. Although a Yes vote is the less likely outcome, its effects would be so far reaching that the asset finance industry may need to anticipate the possibility.

Here is Asset Finance International's Legal and regulatory editor, Andy Thompson's low-down, on the likely impact of a "YES" outcome from today's vote.

 The timetable

Q: How soon could Scottish independence take effect?

The time scale for independence in the event of a Yes vote would be determined by subsequent UK legislation. It could not come into effect before the beginning of 2016, and might take longer.

Although the vote would be binding, many issues would need to be negotiated between the UK government and the current devolved Scottish government (SG) before an orderly transition could be completed. These would include a number of divisions of assets and liabilities between the future independent Scottish state (ISS) and the remaining UK (RUK) constituting England, Wales and Northern Ireland.  

Immediate financial market effects

Q: What might be the first reaction of the markets to a Yes vote?

In the first instance a substantial fall in the sterling exchange rate would be likely. This has already started to occur as the date of the vote approaches, and as earlier expectations of a very substantial No majority receded. A Yes vote could take this trend much further.

Q: How would a sharp drop in sterling affect asset finance?

UK finance companies themselves would not be among the most directly exposed commercial sectors, and may be hedged to a large degree against any direct exchange rate risk that they could face, e.g. in lease funding markets in the case of some international manufacturer captive groups.

However, credit risk among existing asset finance customers and new credit applicants could be affected, in very divergent ways from one commercial sector to another. Those lessees most exposed to international competition, such as in some manufacturing sectors, could actually benefit from a lower pound. Those with foreign suppliers, not easily able to pass on increased costs in their own product markets, would be disadvantaged. 

Q: How might market interest rates be affected, and how would that impinge on asset finance?

A falling pound could be accompanied by a sharply rising yield curve in the sterling bond markets, with falls in prices of medium and long dated gilt-edged sovereign bonds and also corporate bonds. That may have some impact on lease rate quotations for fixed rate contracts.

However, short rates will remain much more important, both for rental terms in new quotations and outstanding variable rate agreements. The Bank of England's key policy rate is unlikely to change for the next few weeks. Beyond that, the outlook would be uncertain and could be affected not just by the exchange rate but by the possible impact of a Yes decision on other indicators monitored by the Bank's Monetary Policy Committee (MPC).

If there are signs of weakness in the trends of UK output and employment, base lending rate is  likely to stay at its present low level for the foreseeable future. However, in other circumstances if a major downward exchange rate shift is sustained or even continued, the MPC could increase interest rates appreciably, and sooner than has been recently expected, in order to counteract the inflationary risk. 

 Q: Could there be more localized immediate effects in Scotland?

This is possible. The major immediate risks, although their effects should be largely averted, concern possible movements of funds, principally retail deposits, out of Scottish based banks. Some Scottish bank customers are reported to have already opened new accounts south of the border in the past 10 days since opinion polls started to indicate a close vote.

Such fund movements could be based on two fears. Both would be substantively misplaced in the immediate context, though this does not necessarily prevent a panic. One is fear of the pound in Scotland somehow being devalued, whereas in fact no public authority would acquire any power to introduce a new devalued Scottish currency before the possible advent of separation in 2016.

The other fear appears to be based on the precedent of last year's banking crisis in Cyprus, when “bail-in” losses were imposed on all major depositors and fund transfers out of the country were heavily restricted. However, all UK banks have been subject to much more effective solvency regulation compared with the position in Cyprus up to 2013.

Outflows of deposits could have only limited immediate effects on any bank's solvency ratios; and the lender of last resort (LLR) facility available to all solvent banking institutions from the Bank of England would address the more substantial liquidity effects of possible panic moves on those deposit takers largely based in Scotland.

Q: How soon will the referendum result be known, and when could markets start reacting to a Yes majority?

The voting closes at 22.00 UK time (21.00 GMT) on Thursday. There should be a good indication of the outcome quite soon afterwards, when only Far East financial markets will be open. Live news media will carry reports of reasonably reliable exit polls within minutes of the close of voting, and indicative reports from vote counting centres from some two hours later.

The votes will be counted on an area basis. Most area totals for Yes and No will be officially declared overnight, though some areas will count later. If the vote were extremely close, the outcome might not be known until the total count is complete, which could possibly take until Saturday.

Q: If the vote is very close, could the outcome be unresolved for a week or more as in the US presidential election of 2000 (Bush v Gore), with market uncertainty continuing as a result?

That is very unlikely. In the UK public votes are subject to a full manual count in the first instance, so resources are readily available for a timely recount where a close outcome requires it. The closest conceivable outcome, with serial recounts, would probably not delay a final uncontested result beyond the early part of next week.

The European relationship

Q: Would ISS become a European Union member state?

It would not do so from the date of independence. After that, the position becomes more complex. The Yes campaign is strongly supportive of EU membership, and indeed it argues that ISS would have a better chance of remaining in the EU than an undivided UK, given current plans of UK   Ministers for “renegotiation” of the UK's EU relationship, to be followed by an  UK in/out referendum on EU membership during the prospective term of the 2015-2020 UK Parliament. 

However, there is no precedent for secessions from existing EU member states. All European law specialists seem to agree that in the case of Scottish separation RUK would inherit the UK's membership, being the major part of the country; and ISS would have to apply for acceptance as a new member state. Like all membership applications this would require unanimous agreement from existing members.

Another obstacle is the fact that since the launch of the euro currency in 1998, EU law has required that new member states should commit to ultimate euro accession in principle; and, more importantly, has implied that applicant states will commence with independent national currencies that will lend themselves to economic convergence tests before euro accession is permitted. The Yes campaign, however, envisages that ISS would continue to use the UK sterling currency for the foreseeable future.

While it might be possible to circumvent the complication of prospective eurozone membership, unanimous agreement among the member states on accepting ISS membership at an early date could be problematic in the likely circumstances. Scotland's First Minister Alex Salmond has suggested that ISS might not agree to assume its proportionate share of UK sovereign debt unless pre-independence negotiations on future monetary union with RUK had a satisfactory outcome.

By implication, any such threat could perhaps extend to other subjects of those negotiations, such as the division of public sector assets and liabilities. Many EU member states would resist admitting a seceded state that had not accepted its due share of sovereign date, not least because of the sensitivity of sovereign debt issues in relation to regional secessionist pressures in other member states.

Q: If Scotland seceded from the UK before having itself become an EU state, where would it stand in relation to the European single market?

There would seem to be no likelihood of Scotland being excluded at any stage from the scope of the single market, nor of the relevant regulations being dis-applied in Scotland; nor probably of ISS domiciled enterprises and individuals losing access to single market rights elsewhere in the EU following secession.

It is likely that under EU law some expedient could be found for treating ISS as an EU associated territory within the European Economic Area, pending the final resolution of the full membership issue.   

The currency question

Q:  Why is there uncertainty about the currency that ISS would use?

Due to the pressures experienced within the eurozone since 2010, the Yes campaign has not proposed that ISS would seek euro accession at any foreseeable time. Instead they propose continued use of the pound sterling indefinitely.

However, in the pre-secession negotiations the two sides would start very far apart as to any arrangement for monetary union between RUK and ISS after they become separate states. The SG and the Yes campaign argue that the two states should have equal standing in relation to control of the union, implying that ISS and RUK would each have a mutual veto in any governmental decisions affecting the Bank of England, such as are presently exercised by the UK Treasury. None of the UK political parties feels that this would be politically acceptable to RUK: all feel that post-secession the Bank would have to come solely under RUK government oversight.

A compromise agreement for some form of jointly agreed monetary union cannot be ruled out, but in this case ISS would be very much the junior partner. Failing that, ISS would be left with the option of unilateral adherence to sterling with no mutual agreement, or “sterlingization” as it is currently being termed.

Q: What would be the downside risk of unilateral sterlingization for ISS?

ISS would be using a foreign currency. While it could establish a central bank of its own, this would not have the currency issuing powers of a normal central bank. While it would inherit its due share of the Bank of England's non-sterling currency reserves, the absence of issuing powers in its domestic currency would severely inhibit its ability to exercise the standard functions of a central bank including the LLR role.

Although the UK and other EU countries are seeking to move away from the “implicit guarantee” of possible state bailouts for major banks in the event of failure, placing more emphasis on creditor bail-ins and other solutions, wholesale bank funders to a degree still perceive the home states of major banks as standing behind their senior debt liabilities.

Because of this factor as well as the absence of a likely substantial LLR central bank role in ISS, it is likely that major banks currently headquartered in Scotland but trading mostly elsewhere in the UK would move their UK HQs out of Scotland in response to a Yes vote. Two of the largest UK banking groups (Royal Bank of Scotland and Lloyds Banking Group) are in this position, and have already indicated that they would make such moves.

ISS would in any event have to establish its own deposit guarantee scheme – i.e. the explicit guarantee of deposit liabilities up to a capped level per individual depositor. This would cover deposit liabilities taken in Scotland, which are presently covered by the UK Financial Services Compensation Scheme. The maintenance of this cover would be essential to financial confidence, and the operation of such schemes is in any case a requirement of European law for member states.

While the cost of deposit guarantees is in principle covered by the premiums charged to the guaranteed institutions, the schemes operate generally on a “pay as you go” basis without a large accrued reserve fund; and the absence of a strongly resourced central bank in the guaranteeing state could undermine the perceived value of the guarantees to depositors.

Q: Could RUK prevent sterlingization by ISS?

The UK government and the Scottish No campaign have sometimes implied that it could and would be prevented. However, this seems unlikely. Several small countries (e.g. Ecuador, Panama, Montenegro and Zimbabwe) unilaterally use the currencies of much larger ones.

In nearly all such cases this came about only following a virtual collapse of previous national currencies, and they represent strange precedents for the purposeful choice for Scotland advocated by the Yes side; but these transitions did not require the agreement of the currency issuers.

The narrow core substance of a currency is formed of the notes and coin in circulation. These   are debt liabilities of the issuing state (or union of states in the case of the euro). In the absence of systematic exchange controls of the type long discarded in the EU, the issuer cannot exercise a veto over the currency's places of circulation; nor would it necessarily have a motive to do so.

The issuer benefits from the “seigniorage” value of the note issue (i.e. the fact that this part of its sovereign debt is interest-free). Extra-territorial use adds to the issuer's seigniorage benefit; although it also adds somewhat to the operational challenges of its monetary policy operations (and in Scotland central bank seigniorage is worth relatively less than almost anywhere else because a private commercial bank note circulation partially displaces the role of official legal tender notes).

Essentially the answer would seem to be that although unilateral sterlingization would seem a surprising aspiration for a state seceding from the UK, RUK could not in practice prevent it.

Q: If the plan is for continued use of sterling in Scotland, why should there be a threat of financial instability?

As noted above, any immediate currency panic would not be well founded. However, after the inception of ISS it is possible that the initial currency plans could change.

There are two distinct possible circumstances in which ISS could abandon its adherence to the UK pound sterling at some point after the effective date of secession. A relatively orderly break could come from a later decision by ISS to adopt the euro.

As noted above, this would seem to require first the establishment of a Scottish national currency, most probably a Scots pound de-linked from the RUK pound sterling but initially with the same parity. Then this currency could adhere to the European exchange rate mechanism (ERM) like the Danish kronor at present, so that its sterling parity would move in either direction in line with £:€ rate fluctuations.

This alternative would be comparable with the break between the Irish and UK pounds in 1979 when the Irish Republic joined the ERM (as a broad pre-euro currency bloc) while the UK remained outside it. However, in one respect (of critical importance to the contract conversion aspect) the Irish break of 1979 was different from the hypothetical future ISS avenue to euro convergence. For the Irish pound had been a legally separate currency from the UK pound, albeit with a constant 1:1 parity, for over 50 years before 1979.

The other alternative would be a less orderly break. It is possible that in the precarious position of external adherence to a foreign currency, ISS could be forced to create a devalued Scottish pound as a new currency at a time of financial crisis. The main possible intention might be to devalue ISS's sovereign debt liabilities at the time; but the move would have the economic attributes of a devaluation of an existing currency, improving the international competitive position of ISS at the expense of its terms of trade.

Asset finance and funding after a Yes vote

Q: In what respects would the asset finance markets diverge as between ISS and RUK?

Within leasing companies the marketing of products, and at times their pricing, would be likely to diverge to a much greater extent than they do now as between Scotland and RUK. In the early transition period to secession, Scotland would continue to be treated as within UK financial markets for most commercial purposes. However, it is possible that the credit ratings of some or all Scottish based SMEs could be downgraded because of the general uncertainties for the Scottish economy in the aftermath of a Yes vote.

Ultimately ISS and RUK would be separate markets, with possibly different leasing rates being quoted at all times by finance companies.

The sovereign credit risk rating for ISS would have some effect on the costs of finance for larger Scottish based lessees, since “blue chip” companies in any national market tend to be accorded a credit rating below that of the local sovereign.

Q: So how might ISS stand in terms of sovereign credit rating?

Lacking its own currency, it would certainly stand substantially lower than the UK today, or RUK at the time. Currently the UK is rated in either the top (AAA) or second notch among the the main rating agencies, but the UK rating itself could well be downgraded a notch following a Yes vote in Scotland.

Under the fiscal arrangements to date for Scottish devolution, the SG has not itself borrowed. However, some enhanced transfers of power under the Scotland Act 2012 included provision for the SG to borrow to finance capital expenditure. There are currently plans for it to borrow in the market during 2015 for the first time; and if that goes ahead it will require SG to obtain a bond rating.

Following a Yes vote, however, the prospective rating of SG would certainly be adversely affected by the economic uncertainties, in spite of SG in those circumstances being in transition from sub-sovereign to full sovereign status. 

ISS's heritage sovereign debt (i.e. its share of pre-existing UK national debt) would initially be inter-governmental debt owed to RUK. However, there are some expectations that RUK could unload those assets through market sales, to investors who would have recourse to ISS and not to RUK. This in effect would be a sovereign debt securitization, possibly testing the credit standing of ISS.

Q: If sterlingization were not a success and ISS did at a later stage break with the pound sterling, how would outstanding finance contracts with Scottish based customers be affected?

This could be subject to great uncertainty. When a country changes its currency, contract conversion laws need to be enacted in order to translate all types of running contract. Normally all contracts will be translated at a common conversion rate.

When countries have joined the eurozone to date, due to the workings of ERM their previous national currencies had been at stable rates against the euro (and against one another in the case of the first adopters in 1998). Contract conversion laws in those conditions gave rise to no particular inequities.                 

As noted above, however, there are two distinct possible scenarios for ISS in future to break with sterling, one being an orderly adoption of a Scottish pound (probably preparatory to later euro accession) with an exchange rate that could move either way against sterling. In these circumstances converting running contracts into the new currency at parity might appear an equitable solution, whether or not it were enforceable in respect of all agreements in the light of their contractual terms. 

Contract conversion would be much more problematic for the possible case of an effective devaluation of a new Scottish pound. Conversion at parity (i.e. in this case devaluing the contractual amounts) could be seen as equitable for both parties where both were based in ISS, and thus earning their income and incurring any associated costs principally in the devalued currency. For cross-border contracts, however, there would appear to be no mutually equitable solution. Conversion to the new currency at parity would be seen as inequitable for a non-ISS resident creditor or lessor; while continuation of the contract in RUK sterling would be onerous for the debtor or lessee.

There are few if any precedents in the modern world for a territory to withdraw from a stable currency area to adopt an effectively devalued new currency. This was widely expected to occur in Greece on its threatened exit from the eurozone during 2011-12, but the threat was averted (at the cost of a substantial sovereign debt default).

Q: So how might UK-wide lessors with Scottish customers anticipate such risks?

It is possible that some finance companies in these circumstances would make English law the forum of jurisdiction under the contract, to a greater extent than at present. They may then be better placed in ensuring that rental and instalment debits remain enforceable in sterling throughout the contract term, notwithstanding the terms of hypothetical ISS contract conversion legislation.

Some large and middle ticket deals in these circumstances are already made subject to English law, as a consequence of its global reach as a forum of jurisdiction. However, comparable contracts with Scottish SME customers and personal consumers are at present more often documented as subject to Scots law. The latter position could change for some new contracts in the case of perceived currency risk.  

Financial regulation

Q: How would Scottish independence affect business conduct regulation, as presently exercised UK-wide by the Financial Conduct Authority (FCA)?

It seems that by the time of secession ISS would have to have in place a new national regulator covering all current FCA functions, and (as a starting point) to adopt the existing UK legislation empowering the executive regulation (i.e. the Financial Services and Markets Act (FSMA) 2000 and Consumer Credit Act (CCA) 1974, both as amended by subsequent UK legislation to date) as ISS statute law.

Replicating the FCA in this way would be an inevitable consequence of separation, rather than having been a particular aspiration of the separatists. Thus it is not at all clear how the substantive rules might diverge in the future as between ISS and RUK; but in the long run they would be sure to diverge in some degree as a result of the complete territorial split in the legislative review processes.

Business-to business (B2B) contracts are, with some exceptions at the very small ticket end, not heavily regulated under the CCA. Lessors and brokers involved in the small ticket market nevertheless always need to be FCA-licensed because of the existence of regulated business within the scope of their target markets.

There is no particular reason to assume that B2B agreements would necessarily become more highly regulated within a new ISS jurisdiction; but equally, no guarantee that they would not. What is clear is that UK-wide operations subject to CCA licensing would need dual RUK and ISS licences in future. Annual costs of licences could well be doubled as a result, which could affect brokers proportionately more heavily than principal lenders and lessors (though at the outset it is possible that interim ISS credit licences could be granted to current FCA licence holders at limited additional cost).

In the long run, all UK-wide players would face additional regulatory costs, through the impact of having to cope with progressively diverging regulatory requirements as well as duplicated licensing.

Q: What about prudential regulation?

Again it would seem that ISS would have to replicate the UK jurisdiction of the Prudential Regulation Authority (PRA) division of the Bank of England. A new regulator to oversee banking capital in Scotland – possibly combining the prudential and business conduct jurisdictions in a single agency, perhaps including also a central bank of sorts (see above).

The fact that most UK-wide banking groups would end up headquartered in RUK, as noted above, would to some extent limit the ambit of an ISS prudential regulator. It is nevertheless likely that those banks would undertake their Scottish business through separate ISS domiciled subsidiaries (rather than using the alternative cross-border approach of the “branch basis”).

Those subsidiaries would have to be supervised by the ISS regulator, while also being captured within consolidated supervision of their UK parents by the PRA. The ISS regulator would of course also assume prudential oversight of purely Scottish based deposit takers, including some banks but mainly building societies.

In terms of substantive rules, prudential regulators have much less national discretion than the conduct regulators due to the extent of international convergence under Basel rules and EU Directives. Possible divergences might nevertheless be seen in some areas – for example in the regulation of bonus remuneration, where the UK authorities sought to resist recent EU restrictions, and where the PRA's oversight practice has differed sharply from that of other member states in that it has not sought to curtail some arrangements that might be seen as circumventing the EU rules.

Taxation and accounting

Q: How could corporation tax (CT) be affected?

The ISS and RUK tax systems would become completely separate with very few international constraints on future divergence. Initially ISS would start out with the existing UK system, but would acquire freedom to change both the rates and all details of the assessment basis for taxable profit.

The UK CT rate is due to fall to 20% from April 2015. The SG has expressed an aspiration, though not a firm promise, that ISS would aim to reduce its CT rate further to 18%.

A reduced rate by itself would of course increase the attraction of doing business in Scotland. On the other hand the costs of having to file separate returns for ISS and RUK, having to allocate taxable income territorially between the two jurisdictions, and (in the longer term) probably facing increasingly divergent computation rules, would substantially increase the tax compliance costs for all companies that operate both in Scotland and elsewhere in the UK. 

Q: Are capital allowance (CA) rates likely to diverge? 

This is of course possible, but it is perhaps not an area where early change in ISS would be particularly likely. The main current UK CA rate applicable to lessors, at 18% per year on the “reducing balance” basis (as opposed to the capped 100% up-front write-offs under the annual investment allowance, which mainly benefit SMEs who are not using pure leasing finance) falls increasingly short of the average true depreciation cycle of equipment, as technological change tends to accelerate; and it is distinctly low compared with equivalent write-off rates in other countries. .

It would therefore seem unlikely for the main CA rate to be reduced any further in ISS; while at the same time an increase may not be a priority, given the emphasis on reducing the tax rate.

Q: Is it likely that the VAT systems would diverge, and how might that affect asset finance? 

The scope for divergence in VAT is more limited, due to the extent of EU harmonization rules. The operation of VAT in the existing UK would nevertheless be separated into two completely different systems, with a number of resulting increased compliance costs for all companies with customers both in Scotland and elsewhere.

Following separation the standard rate of VAT could diverge at any time as between ISS and RUK, though there is no particular reason to expect this in the foreseeable future.

One aspect of the VAT system of potential interest to lessors which is not harmonized throughout the EU and varies considerably from one country to another is that of the input VAT recovery rules for leased cars. In this respect, future divergence between ISS and RUK is always possible, but perhaps not likely since the existing UK rules have now been in operation for nearly 20 years and work reasonably well.

Q: Could the lease accounting rules be affected by Scottish separation?

That is one aspect that would probably not be affected. Listed companies throughout the EU are required to comply with international financial reporting standards (IFRS). Although the current IFRS lease accounting standard IAS 17 is under review, and likely to change fundamentally with lessees to be required to capitalize the currently off-balance-sheet operating leases, that will affect the entire EU simultaneously.

For unlisted UK companies, the accounting rules are overseen by the statutory Financial Reporting Council (FRC) and its subordinate standard setting body the Accounting Council. In UK national GAAP (i.e. “generally accepted accounting principles”) the current leasing standard SSAP 21 is generally in line with IAS 17; and is likely to be brought into line with the planned change in the IFRS rules soon after those take effect, which could be in 2018. Ultimately UK GAAP across all subject areas is likely to come into line with IFRS, although that may take many years yet.

Although in principle an ISS could replicate the FRC and allow distinct Scottish GAAP rules to develop in some areas, that seems most unlikely in practice. ISS would be much more likely to follow the recent example of the Irish Republic, and allow RUK's national GAAP to serve also as Scottish GAAP for the remaining period for which this national GAAP remains distinct from IFRS. 

General overview

Q: What other regulatory effects of Scottish separation could arise for asset finance companies?

Outside of the asset finance contracts themselves, like all major UK companies the players in this market could face a huge array of regulatory implications from Scottish separation, depending partly on their corporate groups' business models (e.g. as banks, manufacturers or independents).

To take just one example banks, including their asset finance arms, represent one of the few remaining parts of the UK private sector where defined benefit (or “final salary”) pension schemes are still common for staff at most levels. For such employers operating throughout the UK, the funding requirements for these schemes would become significantly more onerous through Scottish separation, as a result of European rules requiring ring fenced funding for each national jurisdiction in the EU.

Q: How has the project got to this stage with so many key unresolved issues, uncertainties and major implications that do not seem to have been sufficiently discussed?

The short (but not very reassuring) answer is that splitting a modern country into two is an enormously complicated project, and that there are a only a limited number of subject areas within the wide ranging implications on which political debate can effectively focus.

It should be stressed, however, that for all the time that the UK has existed Scotland has remained for many purposes a distinct nation within it. For example Scotland has an essentially separate legal system; and some contract law aspects of asset finance have always diverged as between Scotland and the other UK jurisdictions.

Given an evident rising trend of separatist feeling within Scotland over the past 40 years, influenced though it has been in part by the fiscal revenues accruing from North Sea oilfields that are mainly in the Scottish parts of UK waters, the idea of allowing Scottish voters to determine Scotland's future in or out of the UK at this time was to a large extent accepted across the UK.