Classification and capitalisation of the Bank
The issues of classification and capitalisation are linked. The Bank’s classification status in the National Accounts, a decision formally made by the Office for National Statistics, is determined by the level and form of control exercised by Ministers. This has implications for the Bank’s operational arrangements, initial and future capitalisation, funding requirements and treatment in the National Accounts.
Structure of the Bank
In developing the recommendation for the structure of the Bank, the following issues were explored:
- Ownership – establishing the Bank as a public or private sector institution
- Regulation – specifically the need to apply for a banking licence
- Form – the appropriate corporate structure for the Bank.
There are a wide variety of potential structures for the Bank. While there are some examples of private sector institutions that work in partnership with governments to meet policy objectives, such as the Business Growth Fund in the UK, the expectations of return and types of risk that the private sector is prepared to take are a barrier to a private sector body being able to carry out the range of investments envisioned for the Bank. Given this the Bank should be part of the public sector, though part of its remit should be to leverage in private capital at the level of investments or funds.
Many of the investments that the Bank will make will be through equity, or equity-like instruments. This means that it will not be a bank in the traditional sense of a financial institution that loans money and manages the credit risk on those loans. As well as credit risk, banks manage the maturity risk between the money they lend and their funding; for this reason they are regulated in terms of the equity (regulatory capital) and the liquidity risk they bear. This structure would therefore not suit the remit of the Bank as it seeks to be as flexible as possible in the nature of its financing support, and nor would it aim to take deposits. The Bank would act across different types of investment and therefore an asset management structure would be appropriate. As such, it was concluded that the Bank would not require a banking licence.
In order to establish a corporate body to manage assets, SG could set-up a statutory non-departmental public body. However, this process and structure could be complex, would not be an ideal fit for a financial institution, and would not add anything to what could be achieved through a company structure. Therefore, the proposition is that the Bank should be formed as a limited company owned by Scottish Ministers. For the Bank to operate in the way envisaged and set out in this report, it must have a separate legal personality and the ability to establish subsidiaries with specific purposes for investment and fund management in order to meet regulatory obligations.
To ensure the sustained alignment of the Bank to national economic policy, Scottish Ministers will need to set the strategic direction of the Bank. This means that, as discussed above, the Bank will be classified as a public body. In order for the Bank to have the desired impact it will also require:
- Administrative and operational independence. This will provide assurance to external stakeholders and other investors that it will operate on a commercial basis in those areas that align with SG’s strategic direction
- The flexibility to mix products to be offered and operate in different market areas, adapting to changing market conditions as necessary
- The ability to attract staff through appropriate terms and conditions with the right mix of skills and experience for successful delivery of the Bank’s mandate (including personnel with banking and investment backgrounds).
As a supplier of patient capital with an investment horizon of 10-15 years, the Bank will require public capital and budget support from SG for upwards of 10 years, both to run the Bank and meet its operating costs, as well as capital for making investments. This means the timeline for any recycling of capital would be longer than most other private investments.
In time, the aim for the Bank should be to make a positive financial return and become self-sustaining. However, it will require capitalisation from SG to commence activities. An early commitment to this has been made by SG in the 2018-19 Draft Budget with an undertaking to provide initial capital of £340m over 2019-20 and 2020-21.
The Draft Budget also announced establishing a new £150m Building Scotland Fund (£80m in 2018-19 and £70m 2019-20) to increase housebuilding, commercial property and R&D. It is proposed that any investments entered into by this Fund and any pipeline investments and remaining balance on the Fund transfers to the Bank for its shadow year of operation in 2019-20.
The proposed target level of initial public capital for the Bank from SG is a minimum of £1bn over the first 5 years. A further £1bn target should be set for public capital in years 6-10. This scale of public capital is deemed to be of a level that will make a material difference to the supply of capital to the Scottish economy, balancing the need to capital with the availability of resources that SG can allocate.
It is also consistent with other NIBs. Review of international comparators indicates the level of public capitalisation typically ranges between 0.5% and 1.5% of GDP. In a Scottish context, £2bn broadly equates to 1.3% of GDP.
Non-Government sources of finance
A key objective of the Bank will be to bring in other sources of capital to supplement the activities of the Bank. Most successful NIBs area able to leverage initial public capital by issuing bonds – thereby increasing the amount of funds available for investment in the economy. The ability to leverage relatively small amounts of public capital into a significant source of strategic and long-term finance is a key source of strength for NIBs around the world.
Over the longer term the Bank should also look to leverage its initial capital base, further strengthening its investment capability. However, in its early years this option will not be immediately available to the Bank, as it will take time to develop an investment portfolio and the track record that is necessary to issue its own bonds. But this should be an objective to provide the Bank with the full range of financing powers and flexibility that is required to play a major role in the economy in perpetuity. It is recognised that dispensation from HM Treasury would be required for the Bank to raise its own finance.
From the outset, however, the Bank should bring in private capital to advance its objectives at the level of particular interventions where the investment criteria and expected returns are clear. This has been achieved successfully elsewhere, including in Scotland via SIB, which has leveraged significant private capital.
The Bank should seek to reinvest its financial returns, both capital and interest, to create a lasting, self-sustaining institution with increasing influence on the Scottish economy. To achieve this, there are some key milestone objectives:
- To secure a dispensation from HM Treasury to have the flexibility to manage, retain and carry-forward cash balances over financial year-ends
- To become self-funding over the medium-term that is; the Bank covers its operating costs from investment returns
- To be able to raise capital in its own right and no longer be reliant on capital advances from SG to fund its investments.
Initial HM Treasury dispensation
Each year, SG must operate within the budget limits set for capital and revenue by the Scottish Parliament. The money available for this comprises the budget settlement provided by the UK Government and the taxes raised within Scotland. This annuality of approach means that money must be spent in year; capital receipts, for example, have to be re-cycled into other projects in the same year.
Under the Fiscal Framework there is some limited flexibility at SG level to carry forward capital and revenue balances from one financial year to another through the Scotland Reserve. At present, the Reserve is capped in aggregate at £700m and the maximum which can be drawn down during the financial year is limited to £350m, of which capital is limited to £100m.
SG should request dispensation from HM Treasury for the Bank to hold reserves and carry these over between financial years, out with the existing limits set for SG.
Securing a different approach to management of year-end balances is not without precedent. HM Treasury agreed a different approach to the Green Investment Bank (prior to its recent privatisation) and to BBB, which has an on-going dispensation over and above BEIS’ existing budget to invest public capital into SMEs. A similar arrangement is in place for Scottish housing associations, on a temporary basis, which are currently classified to the public sector whilst legislation is passed to reduce public sector control over these bodies and return them to a private classification. Without such dispensation the Bank would be unable to deliver the scale and ambition which is set out for it here, including through the adoption of a long-term, patient investment strategy.
At this early stage, it is not possible to give a fully accurate assessment of the running costs of the Bank. Much of this will depend on the precise nature and timing of the investment activity of the Bank, and its operating model, and how it is able to work with third parties. However, an exercise was undertaken to look at comparable organisations and also built up potential costs based on the activities set out in this plan. Costs would include staff, corporate administration resources and systems for financial management and investment and risk management.
The potential running costs for the Bank when fully established are estimated to be between £20m and £30m per annum. This would allow for an organisation that would have circa. 100 to 150 people working for it and engaging in a full range of investment activities. This will allow the Bank to have the scale of effect on the Scottish economy that is desired.
The Bank should be set up as efficiently as possible, with many resources re-deployed into the Bank where possible. In the first three years of the Bank’s operation, the costs would be lower as the Bank expanded its activities and brings current finance activity on board.
The initial capitalisation of the Bank will be from SG, and given the timescales that are required to invest ‘patient’ capital (whether debt or equity), support from the government will be required for a number of years.
The Bank will be classified to the public sector (central government) when it is set up, although it will have operational independence from government. This means that in order for the Bank to retain funds over the long term and reinvest in the Scottish economy, some dispensation from HM Treasury will be required to enable flexibility in the carry forward of cash balances over financial year-ends.
A key objective will be for the Bank to leverage its initial capital base and raise its own bonds. It is recognised that dispensation from HM Treasury will be required for the bank to raise its own finance.
Recommendation 11: The Bank should be established as a public body to ensure a continued focus on the Scottish economic strategy and alignment with a mission-based approach to investment. The form of public body should ensure maximum flexibility in how the Bank invests.
Recommendation 12: Long term, mission-orientated investment requires a long-term capitalisation and funding commitment by the Scottish Government. The target level of initial capitalisation is £1bn for new activity, provided over the first five years followed by a further £1bn over years 6-10.
Recommendation 13: Three essential milestones should be set for implementation and successful operation of the Bank at the scale envisaged:
- To be set-up with the flexibility to manage, retain and carry-forward cash balances over financial year-ends
- To become self-funding over the medium term that is; the Bank covers its operating costs from investment returns
- To be able to raise capital in its own right and no longer be reliant on capital advances from the Scottish Government to fund its investments