Local authority investments - Communities and Local Government Committee Contents

6  Credit rating agencies

72. The role of credit rating agencies (CRAs) was discussed in much of our evidence, both written and oral. The Government's statutory guidance on local government investments describes the need for specified investments to be invested with the Government, a local authority, a parish council or community council or "with a body or in an investment scheme which has been awarded a high credit rating".[90] It also explains that local authorities' Annual Investment Strategies should state:

a)  how high credit rating is to be defined for the categories of investments which the local authority intends to use in the financial year;

b)  how and how frequently credit ratings are to be monitored and what action is to be taken when ratings change.[91]

There is nothing in either the Government guidance or in the CIPFA Codes that advises local authorities on the way in which credit ratings are to be interpreted.

73. Local authorities use the information provided by the three credit ratings companies, Fitch, Moody's, and Standard & Poor's. We invited all three to submit written evidence, receiving responses from Fitch and Moody's. These agencies assess the risk of financial and other institutions. Moody's written evidence describes the way in which bonds (defined as bonds and other type of financial instrument rated by Moody's)[92] are rated:

In the most basic sense, all bonds perform in a binary manner: they either pay on time, or they default. If the future could be known, we would need only two ratings for bonds: "Default" or "Won't Default". Because the future cannot be known, credit analysis resides in the realm of opinion. Therefore, rather than being simple "default/won't default" statements, our ratings are opinions about the risk of outcomes in the future with degrees of uncertainty.[93]

74. Moody's memorandum goes on to describe what credit ratings can and cannot do, and quotes its Code of Conduct:

Credit ratings are Moody's current opinions of the relative future credit risk of entities, credit commitments, or debt or debt-like securities […] Credit Ratings do not address any other risk, including but not limited to: liquidity risk, market value risk, or price volatility. Credit Ratings are not statement of current or historical fact. Credit Ratings do not constitute investment or financial advice, and Credit Ratings are not recommendations to purchase, sell, or hold particular securities.[94]

Therefore, according to Moody's memorandum, credit ratings are a matter of opinion rather than fact; and do not, in themselves, constitute advice, though they may be cited to justify or support advice. Fitch also outlines what is defined as a rating:

Ratings are based on information obtained directly from issuers, other obligators, underwriters, their experts, and other sources Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of such information, and has undertaken no obligation to so audit or verify such information or to perform any other kind of investigative diligence into the accuracy or completeness of such information. If any such information should turn out to contain misrepresentations or to be otherwise misleading, the rating associated with that information may not be appropriate and Fitch assumes no responsibility for this risk. [95]

75. Mr Weaver described the fallibility of credit rating agencies:

The information they provide is part of the whole picture. It is not the whole picture. Credit rating agencies are not regulators, they are not auditors. They are fallible. Their pronouncements need to be studied and understood but not slavishly followed and it is important that the treasury management team in a council is taking a wider view than simply relying on a single set of businesses, frankly, not agencies. They are not agencies of government, they are businesses selling information and they are fallible; they are not infallible.[96]

We would add to those limitations the fact that credit ratings can be slow to change and lag financial and economic developments.[97]

76. The evidence from the Society of Local Authority Chief Executives and Senior Managers (SOLACE) shows how the fallibility described by Mr Weaver came to affect local authorities' investments in Icelandic banks:

Icelandic Banks passed all the tests and had reasonable credit ratings. The real problem is that neither the Banks nor Credit Rating Agencies had adequate information on the liabilities explicit or implicit in derivative instruments such as collateral debt obligations or credit default swaps.[98]

77. Mr Horsfield of Arlingclose suggested that an over-reliance on credit ratings left some people and institutions unaware of the real risks. Commenting on the fact that Moody's credit rating of the Icelandic banks rose to AAA, the top rating, he said that that resulted in Arlingclose being wary of the credit rating system and being wary of Iceland:

From our perspective, that [the Moody's re-rating] influenced our decision on the reliance on ratings because it seemed to us to be so out of kilter with what other indicators in the market on those institutions in Iceland were telling us. You could not reconcile the two.

Arlingclose's written evidence makes a more damning, general case against an over-reliance on credit ratings:

We believe that the blind reliance on credit ratings supplied on an incremental and mechanistic basis is the main reason why local authorities have money at risk with Icelandic institutions. There was ample and readily available information that presented, at the very least, a requirement to adopt a cautionary stance. Unfortunately, this was at best—and quite remarkably in our opinion—unavailable and, at worst, it was ignored.[99]

This argument finds some support in the conclusions of the Audit Commission's report "Risk and Return", which notes that some evidence suggests that those local authorities that used a narrower range of information—credit ratings alone—rather than using a wider source of information, such as reading around the subject and studying the market intelligence from a "a range of sources and broker information", were more likely to invest in the Icelandic financial institutions.[100]

78. The evidence and argument above should not, however, be taken as an indication that we consider the credit ratings themselves to be the main reason for local authorities' potential losses in the Icelandic banks. As the Audit Commission's report "Risk and Return" points out, there was a general wariness about Icelandic banks during 2008 and

Confidence in the creditworthiness of some of the Icelandic banks changed relatively rapidly and between January and September 2008, a number of credit rating downgrades were announced, which should have prompted treasury managers to review the creditworthiness of the Icelandic banks.[101]

79. Neither do we conclude that local authority treasury managers should disregard credit ratings altogether. CIPFA states in its written evidence that

[…] whilst local authorities will continue to use other sources of information they have available, an approach encouraged by CIPFA itself, and despite recent criticism about the agencies' response to changing financial climates, it should be recognised that the ratings agencies remain a key accepted view of an organisations' financial standing and it is unlikely that local authorities themselves would have the resources or knowledge to carry out their own detailed credit analysis.[102]

80. Rather, we consider that there is room for further guidance to local authorities on the appropriate place of credit ratings in decisions about investments. Indeed, CIPFA has already recognised as much. CIPFA's Treasury Management Panel recently (March 2009) published a bulletin, "Treasury Management in Local Authorities—Post Icelandic Banks Collapse", which explains the way in which credit ratings should be used by local authorities:

There has been much debate about the role of credit ratings and their use by local authorities. Credit ratings remain a key source of information but it is important to recognise that they do have limitations. Authorities are advised to have regard to the ratings issued by all three main agencies […] and to make their decisions on the basis of the lowest rating. Ratings should be kept under regular review and 'ratings watch' notices acted upon.[103]

One of the reasons why the problems which led to money being placed at risk in the Icelandic banks arose was because of the over-reliance placed on the ratings awarded by the credit rating agencies, which is the only measure of "investment quality" mentioned in the informal commentary to the Government guidance.

81. The lack of information about the appropriate use of credit ratings in the Government guidance and in the CIPFA Codes is an omission. Some local authorities have relied too heavily on credit ratings, without appreciating that they should be viewed within the context of other financial and economic information and advice. We welcome the new guidance from the CIPFA Treasury Management Panel, but believe that there is room to go further. We recommend that the Government revise the informal commentary on its statutory guidance, to include information about the appropriate use of credit ratings. We also recommend that the CIPFA Codes include guidance to local authorities on the nature of credit ratings, highlighting the risks of over-reliance on them. Credit ratings should not be used in isolation as a justification for the soundness of an investment and local authorities should be made aware of the fact that credit ratings should be viewed within the context of wider financial and economic information and advice.

90   Local Government Investments, Guidance under section 15(1)(a) of the Local Government Act 2003, paragraph 12. Back

91   Ibid, paragraph 13. Back

92   Ev 143 Back

93   Ibid Back

94   Ibid Back

95   Ev 153 Back

96   Q 88 Back

97   The Treasury Select Committee, Banking Crisis: reforming corporate governance and pay in the City, Ninth Report of the Session 2008-09, HC 519, para 189. Back

98   Ev 56 Back

99   Ev 53 Back

100   Audit Commission, Risk and return: English local authorities and Icelandic banks, Cross-cutting National report, March 2009 and Ev 134. Back

101   Audit Commission, risk and return: English local authorities and Icelandic banks, Cross-cutting National report, March 2009, p 21. Back

102   Ev 64 Back

103   CIPFA, Treasury Management Panel, "Treasury Management in Local Authorities - Post Icelandic Banks Collapse, March 2009, p 3. Back

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