Scottish National Investment Bank: implementation plan

Executive summary

Introduction

The Scottish Government's 2017-18 Programme for Government ^[1] committed to establishing a Scottish National Investment Bank to boost Scotland's competitiveness and realise the Scottish Government's ambitions for the economy by providing patient capital to finance growth. This commitment was made on strong international evidence that national investment banks of scale can lead to a strong, positive impact on investment, innovation and long-term economic growth.

Such investment banks have played a key role in the economic development of many countries, and continue to do so around the world today. The roles performed by National Investment Banks (" NIBs") have evolved over time in line with country-specific developments and challenges. While the traditional functions of NIBs were in infrastructure investment and broad capital development, their activities have evolved over the course of the 20th century ^[2] . Through acting in concert with their governments and other public sector institutions, many NIBs are steering the path of investment towards specific ‘missions' and are actively creating and shaping new markets. By making strategic investments and nurturing new industrial landscapes, they also focus on solving important societal challenges, and have helped other countries to rebalance domestic economies and reinvigorate their industrial base. This requires patient, long-term, committed finance – typically over a 10-15 year return horizon which is beyond the investment horizon for conventional bank lending.

If structured effectively, and with the appropriate attitude to risk and return, a Scottish National Investment Bank can also play a leading role driving growth and innovation, helping to transform Scotland's economy ^[3] .

A new cornerstone institution in Scotland's economic landscape

The Programme for Government ^[4] builds on the 2015 Scotland's Economic Strategy ^[5] and sets out a clear economic approach which has at its heart a determination to establish an inclusive, fair, prosperous, innovative country, ready and willing to embrace the future. It acknowledges that the successful economies of the future will be resource efficient, low carbon and harness the power of technology, and illustrates a bold and forward-looking vision of a future-proofed, high-tech, low carbon Scottish economy.

It is apparent that we are now at a critical juncture, with a once in a generation opportunity for Scotland to grasp the potential that comes from technical advancement. To unlock such potential, the new Scottish National Investment Bank ("the Bank") will be a cornerstone institution in Scotland's economic architecture to help realise these possibilities. The Bank will need to be an innovative and forward looking institution and, as comparator institutions internationally have shown, have the ability to adapt to local market conditions and needs. Drawing from this strategic direction, the Bank should adopt the following vision:

"The Scottish National Investment Bank will provide finance and act to catalyse private investment to achieve a step change in growth for the Scottish economy by powering innovation and accelerating the move to a low carbon, high-tech, connected, globally competitive and inclusive economy."

The plans for the Bank must be bold, ambitious and based on financial innovation and market leadership. The Bank should be a catalyst for businesses with growth ambitions, supporting the acceleration and scaling up of the commercial deployment of innovation, technology advances and R&D, and investing in cross-sectoral projects and initiatives that will help transform Scotland's local, regional and national economies. Where it identifies need, it will invest and lend on commercial terms, but with a different risk appetite to other financiers where required and appropriate, taking a longer term view on returns. The Bank will be an early investor in new and emerging market opportunities seeking to crowd-in investors and funders to help establish new financing markets aligned with the Scottish Government's priorities for the economy.

A vision for the Bank aligned to Scottish economic policy

The Bank should be an enduring institution, set-up as a public sector institution in perpetuity that aligns with the Scottish Government and its agencies to provide financing leadership. Close alignment between the Bank and government policy – both economic and social – should help create a powerful connection between policy, regulation and financing which can be co-ordinated for maximum impact.

The direction of policy, together with the activity and support of the Bank, will create confidence in the private sector to invest where previously they would not have done. This will enhance the effectiveness of the Scottish Government's interventions and allow a longer term view to be taken by business, investor and the Scottish Government itself ^[6] .

Focus of activities

The Bank should develop financial products to help realise growth opportunities across the economy, with a particular focus on innovative and productive sectors. It should have the capability to provide capital across all stages of the business growth lifecycle and ensure that, where there are gaps or opportunities, it can address these through a range of financial products. Critically, it should focus activities on areas which can contribute most to the policy-driven missions identified by the Scottish Government.

Because innovation is highly uncertain and has long lead times, achieving smart, innovation-led growth requires not just any type of finance, but patient finance. The Bank should, therefore, provide access to long-term patient finance where need exists.

To build on the success of existing operations and the clear alignment with the Bank's agenda, the financing activities undertaken by and on behalf of the Scottish Government, such as Scottish Enterprise's Scottish Investment Bank and the provision of funding for loan and equity finance schemes (for example, under the SME Holding Fund and the Scottish Growth Scheme) should sit within the Bank allowing the Bank to utilise the strengths and skills already developed and build on the positive foundations laid by the work of the Scottish Government and its agencies.

This consolidation will ensure a greater coherence for those firms looking for finance by simplifying the existing public sector landscape. Issues affecting the demand for finance, such as reluctance to take on equity funding or lack of knowledge on the funding options can be an inhibitor to growth, and the coherence of the public sector offer is an important part of addressing this. It will also ensure the efficiency of public sector activity in this area through enabling the Bank to best direct its capital across the existing financing activity and new activities, utilising existing channels to market and investor relationships. The full details of the integration and alignment should feature as an explicit strand of the plan to progress the Bank's set-up.

Existing business advice and support provided on behalf of Ministers by the enterprise agencies and infrastructure advice via Scottish Futures Trust should also be co-ordinated with the Bank's activity, so that the whole ecosystem works effectively together to achieve the mission-led objectives set by Scottish Ministers enabling businesses and the economy to flourish.

The Bank's activities should also be aligned with non-Scottish Government financing activity in Scotland, including that of the British Business Bank, to ensure that access and opportunities for financing, investment and economic growth are complementary and maximised. The Bank should seek to lead the development of a co-ordinated strategy to achieve this.

Building on the existing supply of finance, the immediate areas of additional activity required for the Bank to deliver most impact are expected to be:

• Growth Capital: Supporting companies' growth ambitions, including those businesses which are driven by knowledge and ideas rather than operating with a strong base of fixed and tangible assets. The Bank should do this by providing access to long-term patient finance necessary for ambitious firms to invest in order to grow and turn their ideas into revenues, and also seek to address recognised gaps in the current market for lending to SMEs whose need for finance may be over a short to medium-term horizon.

• Financing projects that will transform the economy: To achieve this transformative mission-based remit of the Bank, there will be a need for investment in projects that will help Scotland exploit and accelerate new innovation – these are the ‘big ideas' for the economy such as the transition to a low carbon economy. Such projects may require the Bank to play a catalytic role in infrastructure investment (across transport, low carbon, housing, real estate, etc.) providing finance that addresses the reasons why the private sector is not investing.

The initial financial product range that the Bank should focus on is:

• Provide SMEs with access to micro loan finance of up to £100k by the continuation of the existing activities enabled by the Scottish Government's SME Holding Fund
• Expand the offerings of loan finance to SMEs by providing short to medium-term loan finance (senior and mezzanine debt) in the range between £100K and up to £1m-£2m for which there is currently unsatisfied demand
• Consider the potential to deliver targeted debt support through the creation of specific loan funds such as the recently launched Brexit Loan Fund being established by the Strategic Banking Corporation of Ireland
• Provide early stage risk capital equity up to £2m currently provided by the Scottish Investment Bank via its co-investment funds
• Provide other targeted equity and mezzanine investment models for amounts up to £2m, whilst also providing scale-up investment finance by way of equity and loans up to £10m, and above, where opportunities are identified
• Mission-based finance could be both debt and equity depending on the analysis of the gap or market opportunity, but focused on the transformative change agenda set by the Programme for Government.

It will be for the Bank itself to develop detailed product offerings. There should be a presumption, as with existing activity, that those offerings aim to maximise additionality (measured in financial, economic, social and environmental terms), but within the bounds of the Bank being financially self-sustainable.

Acting commercially, the Bank should target a positive financial return at both an individual investment level and at an investment portfolio level – with the portfolio return target set over the long-term. Investment should be on an ethical basis and to guide this principle the Bank should develop a code of ethics that goes beyond regulatory requirements and adopts a best practice approach.

The Bank should focus on, and give priority to, areas of investment that are additional to the finance already provided by the market and by other providers in Scotland. Through doing so, it will complement rather than crowd-out existing or potential investment. As a Government backed investor the Bank will provide increased confidence to the private sector to co-invest as seen with SIB's existing investment activity.

The Bank will need the capability to make direct investments, especially for larger transformative projects which will take time and effort to develop the opportunities and financing solutions. This is an area where close co-ordination of effort will be required between the Bank, the Scottish Government and other public sector bodies.

Much of the Bank's investment and lending activities with companies, will be through others. This requires fund management capability or the development of its own asset management structures. In order to reach growing firms, the Bank's partnership working with the enterprise agencies in particular and other market participants will be essential.

A clear understanding of the remit of the Bank will be critical to its success, as will a focus on specific areas where it will operate. Several activities are excluded due to an inappropriate fit with the Bank's remit and/or for operational reasons. These include:

• The Bank will not offer traditional banking services such as taking deposits or offering mortgages, and as such it will not require a network of branches
• It will not undertake funding activities, such as the awarding of capital and revenue grants which will remain with the Scottish Government and its agencies.

As the Bank will not be a deposit taking institution it will not require a banking licence. This enables the Bank to have much more flexibility over where and how it invests in the economy by not being bound by banking regulation.

Classification and capitalisation

The Bank should be set up as a limited company, wholly owned by the Scottish Government with an independent Board to oversee operations. This enables the Scottish Government to set up the Bank at arm's length and enables it to act more freely and flexibly in the market than a regulated bank in order to achieve the objectives set for it by Scottish Ministers. The Bank should be a public body, classified to the public sector to ensure direct alignment between the activities of the Bank, the broader economic policy and the Scottish Government's enterprise and skills agencies.

The Bank should be capitalised over time by the Scottish Government. An early commitment to this has been made by the Scottish Government in the 2018-19 Draft Budget with an undertaking to provide initial public capital of £340m for 2019-20 and 2020-21. The Draft Budget also established a new £150m Building Scotland Fund (£80m in 2018-19 and £70m in 2019-20). It is proposed that this fund's remit, and investments made, transfer to the Bank in 2019-20 when it is operating in interim or ‘shadow' form, pre-incorporation.

To achieve a step change in the supply of finance, the target level of public capital for the Bank should be a minimum of £1bn over the first five years and a further £1bn over years 6 to 10 (this excludes the funding of the existing financing activities to be brought under the remit of the Bank). A public capitalisation at the level of £2bn – equating to around 1.3% of Scotland's GDP – is in line with international comparators.

The Bank should reinvest its financial returns, both capital and interest, to create a self-sustaining, lasting institution with increasing influence on the Scottish economy. To achieve this ambition, there are three 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. This is required by the time the Bank is established
• To be self-funding, meaning that the Bank covers its operating costs from investment returns. Given the longer term investment horizon of the proposed investment activities, this objective may not be achieved until the medium-term
• 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. Further dispensation from HM Treasury will also be required for this.

Governance

The Bank's investment mandate should come from the Scottish Government via a Strategic Framework.

The Bank should have a Board, with the Chair of the Bank and Non-Executive Board Members appointed by Scottish Ministers, but it is envisaged that the Executive Management Team appointments will be made by the Board.

The structure of the Bank should enable it to enter into a range of activities to support economic growth in Scotland by providing targeted financing solutions. A ‘Top-co' arrangement with a series of subsidiaries (for example, to enable co-investment funds) would be the most appropriate operating model to maximise the flexibility of the Bank's investment activities and private sector investment.

Given the scale of ambition for the Bank, and the associated scope of activity, the potential running costs for the Bank when fully established are estimated to be between £20m-£30m per annum. This would allow for an organisation that would have circa 100-150 people working for it and engaging in a full range of financing activities.

Importantly, to augment the governance arrangements and ensure that the Bank has appropriate societal representation, the Scottish Government should assess the optimal means of ensuring effective representation with stakeholders and wider civic society. This report recommends establishing an advisory group as one option to achieve this with its purpose to advise the Scottish Government on the Strategic Framework, and with the Chair of this group having a place on the Bank's Board as a Non-Executive Director.

Transition

There are a number of key activities that need to take place in order for the Bank to be a fully operational, independently run, institution, including: passage of a Bill through the Scottish Parliament; agreeing the dispensation from HM Treasury; agreement of the operating model; integration of existing activities and people; and investment in additional people and systems. The Bank should be established as a legal entity and become fully active during 2020 following the legislative process.

To provide strategic direction to the transition process, a shadow Chair should be appointed as soon as possible in 2018 to oversee the project team formed to deliver the transition and establishment of the Bank. With a view to be operating in a shadow form in 2019, a shadow Board and interim Executive Management Team should also be appointed in advance to develop the initial Investment Strategy and Business Plan for 2019-20.

The work to establish the most effective operating model for the Bank should be agreed during 2018. This should include how it will assume responsibility for activities currently provided by others, allowing these skills and knowledge to be available to the Bank. A shadow bank structure should be operational in 2019 overseeing existing financing activities which are relevant to the Bank and managing new funding made available to the Bank as well as implementing its plans to be fully operational during 2020. Being active as a shadow organisation in 2019 will provide a clear sign of progress and momentum.

Summary

The vision set out here for the new Bank is one with the scope and scale to be transformational to the Scottish economy. It will coalesce with the wider economic landscape around a number of critical missions helping Scotland to harness its full economic potential.