Financial and business services key sector report

OVERVIEW

This paper sets out a current description of Scotland's Financial and Business Services Key Sector, identifies challenges faced as well as potential opportunities and then describes the public sector interactions with the Key Sector and assesses the effectiveness of those to date.

As can be seen, from the Public Sector Interaction section at this stage the majority of public sector activity has concentrated on the financial services element of the Key Sector in Scotland. The Assessment of the Effectiveness of Interactions section includes details of future actions to be taken to address the public sector interaction with the business services industry.

It is also important to set out the context in which this assessment of the Key Sector has been made and the following paragraphs provide a brief overview of recent events.

Context: Current Issues

The global financial services industry is in a period of major change and the outcome of these changes present both challenges and opportunities for the industry here in Scotland.

Background

Following intensification of the market turbulence that began in autumn 2007, September and October 2008 saw a re-escalation of the international financial crisis, against a backdrop of an increasingly pronounced economic slowdown, a housing market downturn, and in the banking sector, weakened balance sheets. Rapidly deteriorating investor confidence led to bankruptcies, unexpected private-sector takeovers of financial institutions, and government interventions to restore stability to markets and contain overspill to the real economy.

On 8 October 2008, the UK Government announced a package of interventions to shore up the banking sector. It would guarantee up to £250bn of new inter-institution lending to reduce counterparty risk and build confidence in the interbank lending market. The Bank of England's Special Liquidity Scheme (initially launched in April 2008), whereby banks may swap high quality mortgage-backed assets and other securities for Treasury Gilts, was expanded. The Scheme closed for new business on 30 January 2009, although existing swaps of asset-backed securities from UK Treasury Bills may stay in place for 3 years. At least £50bn in capital was made available to purchase shares in UK banks, whereby balance sheets could be shored up in exchange for partial nationalisation and accompanying conditions. On 13 October 2008, the UK Government announced capital injections of up to £37bn, which would potentially leave it owning 60% of RBS, and 43.5% of the proposed Lloyds TSB/ HBOS merged group. Following the UK announcement, part-nationalisation through capital injection was widely adopted in Europe and the US.

On 19 January 2009 the UK Government then announced a new package of measures designed to both support the industry and to increase lending by banks. This included the Asset Protection Scheme aimed at addressing losses from "toxic" assets held by financial institutions. On 3 November 2009, RBS announced agreement on terms for entry to the Asset Protection Scheme and as a result, HM Treasury's ordinary shareholding remains at 70.3% (voting share cap of 75%) while the economic interest (the value of the government investment as a proportion of the value of all investment) rises to 84.4%. Lloyds Banking Group will not participate in the Scheme and will instead raise additional private sector capital - HM Treasury shareholdings will therefore remain at 43.5%.

Scotland

The impact on the structure of Scotland's financial services industry has been felt mainly in the banking sector with the merger of HBOS and Lloyds TSB (becoming the new Lloyds Banking Group) aided by the UK Government waiving competition rules in the public interest, leaving concerns about the long term competitiveness of the sector in Scotland. On 30 March 2009, Dunfermline Building Society's wholesale and retail deposits, branches, head office and originated residential mortgages (other than social housing and related deposits) were transferred to the Nationwide Building Society under the terms of the Banking Act 2009. Subsequently, Nationwide successfully bid for Dunfermline's social housing portfolio which had been held in a bridge bank wholly owned by the Bank of England.

However, it will be some time before we know what the long-term impacts will be on the size, shape and focus of Scotland's financial and business services sector going forward and how this will affect performance. It is not yet fully apparent how the divestments required under EU State Aid provisions (see Page 7) may impact on the restructuring proposals (and any potential associated job losses) previously announced by RBS and Lloyds Banking Group (see Page 6). In the medium term, the shape of the banking sector in Scotland could look quite different - we have already seen some "new entrants" like Tesco Bank and Virgin in Scotland and the need for divestments provides an opportunity to increase the players in Scotland in both banking and insurance. The manner in which such "new players" deliver their products to customers may be quite different from current models. In the long term, UK Financial Investments Ltd ( UKFI) will be looking to ensure that the UK Government's interests in banks are returned to the private sector - and at a rate of return which protects the taxpayer as far as possible. How this is undertaken e.g. in respect of RBS may well have an impact on the banking sector in Scotland.

The following section illustrates the significant growth and contribution of the sector in recent years.

Description of Scope and Performance of the Sector

The financial and business services ¹ key sector comprises a diverse range of activities that can be broadly categorised into the following sub-sectors:

Financial Services banking life and pensions general insurance asset management financial intermediation

Business Services legal activities accountancy, auditing and tax management consultancy architectural and engineering activities technical testing and analysis advertising recruitment security activities industrial cleaning

Financial and Business Services

• In 2008, financial and business services accounted for just under 359,000 employee jobs, or 15% of all employment in Scotland ² .
• The latest Scottish Quarterly GDP Index ³ (for 2009 Q3) shows that GDP in the sector is around 72% higher in real terms than at the start of 1998.
• It is also a major export sector, accounting for over a fifth of Scotland's total exports (rest of UK and rest of world, 2008) ⁴ .
• In 2009, 96% of registered enterprises in the sector were small (0-49 employees), only 2% were large (250+ employees); 97% of registered enterprises were Scottish owned, 2% UK owned, with 1% under foreign ownership.
• Almost half of all employment in both financial and business services is based in Glasgow and Edinburgh, with Aberdeen the next largest base for financial and business services employment in Scotland.

Notes:

1. Shaded cells denote that financial data is not available for Financial Services, as the Annual Business Inquiry ( ABI/2) does not cover the sector.

2. GVA is another term for GDP at basic prices.

3. Exports are derived from Scotland's Global Connections Survey ( GCS), published in March 2009. Exports to the rest of UK are currently classified as "in development" and therefore should be treated with caution. The figures for key sectors are derived by aggregating estimates based at a low standard industrial classification ( SIC) level. The GCS is not designed to collect data at this level of accuracy, therefore these results should be treated as indicative.

4. Employment data is sourced from the Annual Business Inquiry and is based on SIC 2003 classification of industries.

Financial Services

• Scotland is internationally recognised as the most important UK financial centre outside London and the South East, with a breadth of services including global custody, asset servicing, banking, investment management, corporate finance, general / life assurance and pensions.
• Although Scotland's banking sector, like banks across the globe, has experienced significant difficulties this does not reflect the industry-wide picture and recent announcements of expansion and investment plans by financial services companies have buoyed prospects for the future. These have included over 800 new jobs for Glasgow announced by Tesco Bank, which is in addition to the 200 new posts already announced for Edinburgh and the 500 new jobs being created in Glasgow by Esure. This has been supported by significant assistance from Scottish Enterprise ( SE) and Scottish Development International ( SDI).
• Employment stood at 95,500 in 2008 ⁵ , which represents 4% of the total Scottish workforce, as well as 9% of all financial services employment in Great Britain. Almost two thirds of jobs in financial services are based in Edinburgh and Glasgow, but there are also significant financial services companies in Aberdeen, Perth and Dundee.
• Employment in financial services covers employment across a range of sub-sectors, further detail about which is given in Annex 1. The share of employment in financial services across GB varies across the sub-sectors. Life and Pensions in particular stands out in Scotland, with over a fifth of all employment in that sector across GB in 2008.
• In 2009, small businesses (0-49 employees) accounted for 87% of enterprises, but only 6.5% of employment in the sector. Conversely, medium (50-249 employees) and large (250+ employees) enterprises accounted for just 13% of businesses, but 93.5% of employment.
• Scotland has a long standing legacy of indigenous financial services institutions sitting alongside a range of international firms. In 2009, 86% of registered businesses were Scottish, accounting for 56% of employment. Just 6% of enterprises were under foreign ownership, but accounted for 20% of employment.
• The latest Scottish Quarterly GDP Index for Scotland shows that in 2009 Q3, output in Scotland's financial services industry, was 69% higher in real terms than at the start of 1998. Output in the Scottish economy as a whole was 18% greater in real terms, while output in UK financial services as a whole was 74% greater.

Business Services

• Output in Scotland's business services, as measured by the Scottish Quarterly GDP Index, was 75% higher in real terms in 2009 Q3 than at the start of 1998, compared to 55% across UK business services as a whole.
• The latest Annual Business Inquiry data show that business services contributed just under £10.1 billion in GVA to the Scottish economy in 2007. The legal and accounting activities sub-sector makes the largest contribution (£2.8 billion), followed by architectural, engineering and related technical consulting (£2.7 billion) and recruitment (£1.8 billion).
• The sector accounted for employment of 263,400 in 2008 ⁶ , around 11% of all employment in Scotland. Just over half of all business services jobs were based in Glasgow (24%), Edinburgh (16%) and Aberdeen (13%).
• The sector exports a substantial amount both to the rest of the UK and the rest of the world, with total export earnings increasing by a total of 41% over 2002-2008 in real terms ⁷ . The latest available data show that in 2008, business services exports to the rest of the UK stood at just under £1.9 billion, while exports to the rest of the world were around £0.7 billion.
• In 2009, small businesses (0-49 employees) accounted for 97% of enterprises but only 36% of employment in the sector. Conversely, large businesses (250+ employees) made up just 1% of enterprises but accounted for 47% of employment in the sector.
• Indigenous firms are prevalent in the Scottish business services sector, accounting for 97% of enterprises and 68% of employment in 2009. In contrast, just 1% of firms were under foreign ownership, accounting for 15% of employment in the sector.

Rationale for Key Sector Status

The Government Economic Strategy ( GES) identifies that Scotland's businesses are the primary driver of sustainable economic growth, and that Scotland's national competitiveness depends critically on the competitiveness of our individual businesses. Some sectors and firms offer the potential for high levels of growth, and the opportunity to strengthen Scotland's areas of international comparative advantage, through achieving critical mass and boosting productivity. Sectors have the potential to make a significant contribution to increasing Scotland's growth where:

• Scotland has distinctive capabilities and businesses with the potential to be internationally successful in areas of global demand;
• they currently account for a significant part of the Scottish economy and reflect the contribution of all areas of Scotland; and
• government intervention can make a significant difference to future success by facilitating or accelerating development in areas where the market alone cannot deliver the best outcome.

Financial Services - notwithstanding the current turmoil in international financial markets, Section 1 demonstrated the key role of financial services through:

• Scotland's long standing international reputation for success in financial services;
• the crucial role that the sector plays in the Scottish economy; and
• the fact that the economic performance of financial services has been strong for a prolonged period.

Business Services - business services is also a crucial sector for Scotland, having grown rapidly in recent years to comprise a large and diverse range of professional services. There is scope for Scotland to build on this success and better leverage the linkages that exist with the financial services industry, particularly in areas such as legal services and accountancy. Not only are these sub-sectors likely to be key customers of each other, a combined approach will potentially present Scotland's capabilities across the range of professional services and demonstrate critical mass on an international scale.

Targeted government intervention - alongside economy wide action to create a supportive business environment, and developing the underlying sources of competitiveness strength in Scotland - on areas of importance to both sectors notably in skills, education and infrastructure can drive future success where the market alone cannot deliver the best outcome. Moreover, the nature of the current environment highlights still further the need for supportive government policy in both the short and long term.