The Looming Threat to Royal Bank of Scotland Group plc and Lloyds Banking Group PLC

The referendum on Scottish independence could cause volatility in the shares of Scottish-domiciled Royal Bank of Scotland Group plc (LON:RBS) and Lloyds Banking Group PLC (LON:LLOY).

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Surprisingly little has been said about the impact of the Scottish independence referendum on RBS (LSE: RBS) (NYSE: RBS.US) and Lloyds Banking (LSE: LLOY) (NYSE: LYG.US), both of which are incorporated in Scotland. Yet the vote is only 10 months away and speculation over the outcome will intensify.

Uncertainties

There are big uncertainties that could have profound effects on both banks. The Scottish Government wants to retain Sterling and the Bank of England as lender of last resort, though it’s far from clear the UK Government would agree. The Spanish Prime Minister, fearful of encouraging separatist sentiment, says Scotland would have to apply for EU membership from outside the union. That suggests Scotland would have to join the Euro, too.

The impact of independence on the financial system was looked at by Professor Brian Quinn of Glasgow University, himself a former Head of Supervision at the Bank of England, in a paper for the Hume Institute last August. Correctly anticipating that a Scottish Government would seek to retain Sterling and the Bank of England, his conclusion was that “the concept of a shared system of supervision and crisis management is seriously – perhaps fundamentally – flawed.”

Riskier

The implications for RBS and Lloyds are severe. He states: “it seems very likely that the Bank of England would judge Scottish financial institutions – notably its banks – to have become riskier and apply higher regulatory requirements.” That’s more capital and lower profits, then.

Professor Quinn points out that it’s not clear which country’s taxpayers would foot the bill in the event of a crisis.  The RBS rescue in 2008 cost £320bn, twice Scotland’s GDP. Post independence, the Scottish financial sector’s liabilities as proportion of GDP could be something like 1000%, compared to Iceland’s 800% and Cyprus’s 700%. Bond-holders and inter-bank lenders will perceive higher default risk.

Location, location, location

Professor Quinn (diplomatically) says it wouldn’t be surprising if Scottish financial institutions “reconsidered their group structures and main domicile”. RBS and Lloyds could relocate to rump-UK or separately capitalise their Scottish and UK businesses. But apart from the cost, there would be a massive political rumpus.

Bottom line for the banks: independence would increase their costs, increase the capital they have to hold, and weaken protection for bond-holders and depositors. More importantly, stock markets and bond markets hate uncertainty. As the referendum vote approaches, the shares could be in for a volatile time.

Fundamentals

The fundamentals for both banks are still generally positive. Long-term investors might need to steel themselves, while the volatility could provide interesting entry points.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

> Tony does not own any shares mentioned in this article.

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