OVER the last few weeks our articles have been focusing on the role our pension funds can have in providing investment to help develop Scotland’s productive capacity so we can produce all the things we need to live well and in harmony with nature. Better use of their assets is key to a rapid transition to a zero-carbon economy as well.

In this article we want to turn our attention back to the role of our banks and the necessity for reform of banking regulation.

We believe there are three important elements to banking regulation and for the design of a post-independence banking system:

1) Banking resilience. This is about ensuring our banks are safe and not at any risk of failure

2) Bank lending. Bank lending needs to be channelled towards productive lending to businesses to support their development and growth, especially in the SME sector. This needs to be matched by less mortgage lending by commercial banks and the restoration of building societies as the primary source of mortgage lending

3) Security and accessibility of banking services. This includes payment systems, the safety of customers’ deposits and savings, and ease of access to banking services for all citizens regardless of where they live, including affordability of banking charges.

In the rest of this article, and in ones to follow, we will outline the kind of measures that need to feature in Scotland’s banking regulation regime. These proposals are not offered as dogmatic ideas but are intended to start an important conversation we need to have about the future of Scottish banking. There may be a variety of practical ways to deliver the three objectives we have proposed but a conversation has to start somewhere.

The Scottish central bank will be responsible for granting commercial bank licenses and will supervise commercial bank activity, including ensuring they remain resilient to stress. The bedrock of banking resilience is to be found in two critical metrics – “capital adequacy” and “liquidity adequacy” requirements.

Capital adequacy is a measure of how much bank lending can be permitted as a multiple of a bank’s own capital (equity). A capital adequacy ratio (CAR) expresses the relationship between capital and lending.

For example a CAR of 10% means that a bank can lend up to 10 times the value of its equity capital. This is a simplification to explain the basics, but a bank with £50 billion in equity capital, for example, can lend up to a maximum of £500bn if the CAR is 10% or £250bn if it is 20%.

The liquidity adequacy ratio (LAR) is a measure of how much immediately available cash or easily sold assets is required relative to the size of the total deposits a bank holds.

Liquidity is important because a bank has an obligation (a “liability”) to pay customers immediately when they demand their money which they have deposited with a bank. A bank which cannot meet such demands (ie the bank has run out of cash) is a failed bank. A number of banks ran out of cash during the 2008 financial crisis, such as Northern Rock.

UK banking regulation after the 2008 financial crisis was strengthened so that banks are now required to hold more capital and maintain higher liquidity levels than before. These strengthened capital and liquidity requirements applicable in the UK may well be appropriate for Scotland after independence but there should be a discussion about whether to strengthen them further.

Other matters to consider include the level of support to be provided by a Scottish central bank to commercial banks when capital and liquidity levels fall to a critical level. If a bank is unable to raise additional capital the government may have to step in and provide equity and thereby become a shareholder (as happened with RBS and Halifax-Bank of Scotland in 2008).

A central bank is able to offer various means to provide additional liquidity to commercial banks; quantitative easing (QE) is one of them, but there are other ways for a central bank to provide emergency funding.

It is important to take regulatory measures to avoid the need for emergency funding in the event of a banking crisis. Prevention is better than cure and since trust in banks is critical to the economy the regulatory regime should seek to prevent crises from occurring in the first place. Robust regulation is needed; light touch regulation must remain a thing of the past.

In our next article we will turn our attention to the importance of regulating the behaviour of both banks and the bankers who work for them, in order to prevent reckless lending and other practices by setting enforceable professional standards of conduct as the basis for a scheme for licensing banks as well as individuals who work for them.