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Scotland Independence Could Lead to Cyprus-Style Banking Crisis

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An independent Scotland is at risk of a Cyprus-style banking crisis, as its banking sector would be "exceptionally large" compared to the size of its economy, a U.K. government report has said.

"An independent Scotland would have an exceptionally large banking sector compared to the size of its economy - with banking assets of more than 1250 percent of Scottish [gross domestic product] - making it more vulnerable to financial shocks and the volatility of the sector," the Treasury report said on Monday.

The report pointed out Scotland's banking exposure would dwarf that of Iceland and Cyprus, two countries that faced severe banking collapses in recent years. Iceland's banks, for example, had assets equivalent to 880 per cent of GDP, while Cyprus, which faced a banking crisis in March, had total banking assets of around 700 per cent of GDP.

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"Overall, the experience of financial crises shows that countries with a large banking sector compared to the size of their GDP are significantly more vulnerable," the Treasury report said.

The paper is the third in a series of analysis on Scotland that seek to influence a referendum in September 2014, that will decide whether Scotland stays in the U.K. or leaves to become an independent state.

Banking sector assets for the whole U.K. are around 492 per cent of GDP at present and while this is high relative to other nations, the Treasury said the financial crisis in 2008 demonstrated that the U.K. has the capacity to manage these risks.

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However the same could not be said for Scotland if its banks needed bailing out, posing significant risks to Scottish taxpayers, the report claimed.

"At the end of September 2012, the two largest banks – the Cyprus Popular Bank and Bank of Cyprus – had assets in the region of 210 per cent and 175 per cent of Cyprus's GDP respectively."

"It is worth noting that, if Scotland became independent, its banking sector would be similarly concentrated (with two large players, Bank of Scotland and Royal Bank of Scotland and a number of smaller firms), and that an independent Scotland's domestic banking sector would be likely to be significantly larger than that of Cyprus (assuming no change to firms' domicile arrangements)."

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The Treasury also argues that an independent Scotland would lack the U.K.'s track record and credibility with the international financial markets.

"When markets perceive weaknesses in the credibility of the sovereign, this negatively impacts the credibility of domestic banks, with a consequent increase in the cost of funding."

Scotland's Finance Secretary John Swinney said that the document was a "feeble attempt to undermine confidence in Scotland's ability to be a successful independent country."

"The Treasury, true to form, will outline what is in its own best interests, not what is in the best economic interests of the people of Scotland," said Swinney.

"Assertions and claims about Scotland's financial sector are entirely misleading - in terms of share of GDP, in fact, financial services are actually smaller for Scotland at 8.3% than the UK at 9.6%.

"So if the argument is about risk, then the risk is with the U.K."

By CNBC.com's Jenny Cosgrave; Follow her on Twitter @jenny_cosgrave

Contact Europe: Economy

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