Local authority investments - Communities and Local Government Committee Contents


8  The Audit Commission

What is the Audit Commission's role in relation to local authorities?

122. The Audit Commission appoints the external auditors who are responsible for auditing all local authorities. The Audit Commission's written evidence states that these auditors:

have a responsibility to satisfy themselves that the audited body has put in place proper arrangements to secure economy, efficiency and effectiveness in its use of resources, in accordance with criteria specified by the Commission. These arrangements are defined by the statutory Code of Audit Practice to include the audited body's arrangements for managing its financial and other resources, including arrangements to safeguard the financial standing of the audited body.[149]

123. As the Audit Commission's supplementary evidence points out, its work is necessarily retrospective, because the auditors focus on a local authority's annual accounts, and the financial management system and processes that were used during that year.[150] The appointed auditors cannot and do not advise on a local authority's treasury management strategy or policies "as they may subsequently have to review the effects of their implementation."[151] Additionally, auditors are "mindful of the need to adopt a proportionate approach and to target audit work on the areas where the risks that something might go wrong are highest."[152] This chapter explores whether the Audit Commission targeted work on treasury management sufficiently during 2007 to 2008, at a time when the banking world was subject to increased volatility, which consequently made treasury management an area of, arguably, greater risk.

Auditing practice

RISK OF TREASURY MANAGEMENT

124. The Chief Executive of the Audit Commission, Mr Bundred, told us in oral evidence:

Before the Icelandic banking collapse […] we did not regard local authority treasury management as an area that was poorly managed or at great risk.[153]

Mr Evans, the Managing Director of the Audit Commission, reiterated this point:

When auditors were planning their audits for 2007-08, frankly treasury management as an issue was not on their risk radar. Post-BCCI and the development of the CIPFA Treasury Management Code, it was generally thought that treasury management was a function that was well managed. The specific issues around Iceland did not feature until spring 2008.[154]

125. In similar vein, the Audit Commission's supplementary evidence makes the following remarks about their lack of concern about Icelandic investments:

When auditors were planning their audits in 2007, they had no reason to consider treasury management to be a significant risk. Only a few experts in investments were drawing attention to the potential weakness of the Icelandic banks before the spring of 2008, and many not until the autumn.[155]

126. The Audit Commission's case, therefore, is that there is nothing which it could reasonably have been expected to do which might have prevented, or restricted, the potential losses of local authorities in the Icelandic banks. We agree to this extent: there is an array of organisations, including the Treasury, the Department for Communities and Local Government, the Financial Services Authority, the Chartered Institute for Public Finance and Accountancy, rating agencies and treasury management advisers, which had varying responsibilities to regulate, warn, advise, give information or audit and which, to a greater or lesser degree, failed to warn local authorities of the risks involved in investing in Icelandic banks. However, the question is not whether the Audit Commission could or should have foreseen the failure of the Icelandic banks, but whether it should have been more aware of risks to treasury management generally, and acted accordingly.

The Audit Commission's own investments in Iceland

127. Evidence of the Audit Commission's complacency in respect of treasury management can be seen most clearly in the management of its own funds. The Commission has £10 million invested in Icelandic financial institutions: it has £5 million invested in Landsbanki, which was due to mature on 29 April 2009, and £5 million invested with its subsidiary, Heritable, due to mature on 29 June 2009. An internal audit review and a review by independent treasury experts at KPMG were commissioned by the Audit Commission to study the circumstances surrounding its own investments. The internal review drew the following conclusions:

  • the Audit Commission made a deposit with one bank (Heritable)—a subsidiary of Landsbanki—without taking account of the increased risk created by that bank's reliance on a guarantee from Landsbanki;
  • the Audit Commission relied on short-term credit ratings issued by Fitch to support investment decisions, without considering the long-term negative outlook warnings in respect of other Icelandic banks or other sources of information, including press speculation at the time;
  • the process of investment had become too routine and was not scrutinised at a senior level.[156]

128. These conclusions are remarkably similar to some of those reached by the Audit Commission itself in the review of local authority treasury management practice referred to earlier in this Report, Risk and Return. For example:

  • […] The risks associated with seemingly different institutions may be highly correlated because they are in the same group, sector or country. These are not acknowledged […] [157]
  • […] Credit ratings are a useful indicator of likely performance and, therefore, a credible means of judging and managing risks. However, while ratings are an important piece of information, they do not give the whole picture. Their use should be supplemented with other information […][158]
  • […] While officers from the best local authorities tend to be proactive in seeking feedback on treasury management policy and compliance, the governance and scrutiny of treasury management arrangements is generally poor […] .[159]

129. The Audit Commission's belief that treasury management was a low-risk, well-managed function has therefore been shown to have been misguided. Measures could and should have been taken both by the Commission and by local authorities themselves to ensure that their own treasury management was being properly run. The Commission's responsibilities, however, go wider than merely the management of their own funds. Its defence that only a few experts were drawing attention to weaknesses in the Icelandic banks before spring 2008 misses the point, which is that the financial climate generally had become far more volatile and that the risk inherent in investment had therefore become greater.[160] Local authorities, with their £30 billion and more of investments, were exposed to that additional risk, and the Audit Commission—which claims that its "primary focus will always be safeguarding the interests of taxpayers"[161]—should have recognised as much.

What could the Commission have done?

130. The question remains of the extent to which the Audit Commission—even had it not considered treasury management to be low-risk—could and should have taken steps which might have minimised the risks which local authorities were running. The Audit Commission maintains that it audits retrospectively and cannot advise local authorities specifically on their treasury management policies. Mr Bundred, the Commission's Chief Executive, told us "it is not the role of the Audit Commission to give advice to local authorities about their investment decisions."[162] In its supplementary written evidence, the Commission explains why it would be inappropriate to give such advice:

Auditors cannot comment or advise on an authority's treasury management strategy or policies, as they may subsequently have to review the effects of their implementation. Neither can they substitute their judgement on risk or second guess specific investment decisions by managers, as these are properly the responsibility of management.[163]

The supplementary evidence also argues that:

The focus of auditors' work is a local authority's annual accounts and the financial management systems and processes that underpin them. Their work is therefore essentially retrospective.[164]

131. We accept that it would be inappropriate for auditors to attempt to advise local authorities directly on their investment decisions. However, the Commission's contention that the nature of audit, being a retrospective judgement, meant that it could not have done anything to alert local authorities to the greater risks of treasury management is undermined by guidance it issued to its appointed auditors following the Icelandic banking collapse. In its supplementary evidence, the Audit Commission explained that the vast majority of local authority audits for 2007/8 were completed before the Icelandic banking collapse: of those local authorities with Icelandic deposits, only nine audits were outstanding at 7 October 2008.[165] However, subsequent to the news of the collapse of the Icelandic banks, the Audit Commission issued guidance to the auditors of those nine local authorities "on the implications [of the fact that they had money at risk] for their opinion on the accounts."[166] This seven-page document guides the auditor through the questions that should be asked about any investments that the local authorities might have made, and concludes with the following questions that auditors should ask when evaluating local authorities' investment arrangements:

Were all the deposits made in 2007-08 in compliance with the council's investment policy?

When were the deposits made? Was appropriate action taken as information became available and in the light of appropriate professional advice?

Is the investment policy consistent with a performing strongly score? E.g. was it subject to effective scrutiny and review, by those with appropriate skills and understanding? Is a limit set for investing in all institutions on the counterparties list (including subsidiaries, and so recognising the interdependence between Heritable and parent company Landsbanki)? Do the limits relate to the council's cash basis? Is there a clear assessment of risk to prevent over concentration of investment in a single bank? Who has responsibility for authorising deposits—does the officer have sufficient seniority and a relevant qualification? Does the strategy require consideration of long term credit ratings in addition to short term credit ratings? Credit ratings should be applied appropriately, accompanied by judgment/horizon scanning/independent advice. Is there evidence of this, e.g. was the risk associated with the higher returns for these deposits assessed?

Are decisions subject to effective scrutiny and are investments monitored on a regular basis?[167]

132. Notwithstanding the Audit Commission's disclaimers about what auditors can and cannot do, the guidance issued after the Icelandic banking collapse shows that there were questions that auditors could properly have asked to ensure that local authorities were following agreed treasury management procedures. If the Audit Commission's auditors had followed this guidance as normal practice before the Icelandic banking collapse, local authorities might have been alerted to some of the failures in treasury management procedure which, in some cases, led to funds being put at risk.

133. This conclusion is supported by consideration of the position of one of the seven local authorities named in Risk and Return. Bridgnorth District Council invested £1 million in Iceland on 2 October 2008. Bridgnorth maintains that it was working within its delegated power and that its independent auditors, appointed by the Audit Commission to audit the council, confirmed that the investment had been appropriately made and that there was nothing untoward.[168] Council leader Elizabeth Yeomans made these comments, following publication of the Audit Commission's report:

I am very concerned that the Audit Commission has criticised the council in a national report, when its own auditors have satisfied themselves that we acted reasonably.[169]

134. Our point is not to question the Audit Commission's view of the manner in which Bridgnorth acted on 2 October 2008. Our point is to demonstrate that the auditing practice was not adequate for the prevailing financial climate: auditors could and should have been required to satisfy themselves that authorities had suitable treasury management policies in place and that they were being followed correctly. As Risk and Return has subsequently demonstrated, this was clearly not the case in Bridgnorth, despite the clean bill of health given that authority by its auditor.

Conclusion

135. The Audit Commission took it for granted that treasury management was a well-managed function, and, consequently, was not an area of concern for auditors. Even if it could not reasonably have been expected to foresee the collapse of a country's entire banking system, the Audit Commission should have been aware of the greater risk to treasury management as a result of the prevailing financial climate and should have adjusted its practice accordingly. The Audit Commission failed to realise that treasury management was becoming an increasingly risky area and, in that respect, it must share some of the blame for the potential loss of funds in the Icelandic banks. If it had viewed treasury management within the increasingly volatile economic context, it would have put treasury management higher in its auditing procedures, and if it had done that, it is possible that less public money would now be at risk. We recommend that the Audit Commission review its own auditing procedure and prioritisation of the areas of local authority activity it chooses to audit, in order to ensure that such complacency does not happen in future.


149   Ev 133 Back

150   Ev 135 Back

151   Ibid Back

152   Ibid Back

153   Q314 Back

154   Q302 Back

155   Ev 137 Back

156   Audit Commission, Internal audit review: investments in Icelandic banks, 2008, p 1. Back

157   Audit Commission, Risk and Return: English local authorities and Icelandic banks, Cross-cutting National report, March 2009, p 31. Back

158   Ibid Back

159   Ibid, p 44. Back

160   For some discussion of the changes in the financial climate, see the Seventh Report of the Treasury Committee, Session 2008-09, Banking Crisis: dealing with the failure of the UK banks (HC 416), paras 14-17. Back

161   Audit Commission website, http://www.audit-commission.gov.uk/aboutus/.  Back

162   Q288 Back

163   Ev 135 Back

164   Ibid Back

165   Ev 137 Back

166   Ev 139 Back

167   Audit Commission, extracts from weekly auditor communication (WAC) 41/2008, Guidance to auditors on treasury management and Icelandic deposits, 2008, p 6. Back

168   http://news.bbc.co.uk/1/hi/england/shropshire/7965124.stm  Back

169   Ibid Back


 
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Prepared 11 June 2009