Memorandum by Guildford Borough Council
(LAI 06)
1. Annual Investment Strategy: how has it affected
performance given recent potential losses experienced by local
authorities?
1.1 The Annual Investment Strategy (AIS)
is a requirement of the Prudential Investment Guidance and a professional
requirement of CIPFA's Code of Practice on Treasury Management.
It is a document that outlines the basis of investment activity
for the local authority framed against the core principles of
the Guidance. Those principles are that security and liquidity
of capital must come before yield considerations. What this means
in practice is that the strategy requires the local authority
to invest in such a way as to ensure that the preservation of
capital is the prime consideration.
1.2 The vast majority of local authorities
employ treasury management advisers to provide advice and assistance
on a wide range of treasury management issues including investment
strategy and ongoing advice.
1.3 To the extent that over 100 local
authorities now have capital at risk after making investments
in Icelandic banks, it would seem reasonable to question the effectiveness
of the AIS document as well as wider aspects of local authority
treasury management advice.
2. Prudential Investment Guidance and the AIS
2.1 The Guidance (and by implication the
AIS that is a requirement of it) is part of a larger prudential
framework applying to local authority capital finance introduced
in April 2004. It generally allows local authorities to make local
decisions about the financing and ongoing affordability of capital
assets. The Investment Guidance replaced the highly prescriptive
Approved Investment Regulations and was a welcome and long overdue
development. Without exception all strategies have as their primary
objective—the preservation of capital.
2.2 We do not consider that the Guidance
or the AIS are responsible for the potential losses experienced
by local authorities and we would counsel against any return to
a more limited and prescriptive list of investment activities.
In our view there has been a fundamental misinterpretation of
risk and a wholly inappropriate response to the sharply deteriorating
credit conditions since the onset of the so-called credit crisis.
2.3 This is illustrated in a number of ways:
(i) That over 100 public sector organisations,
with capital preservation of funds as the primary objective, had
almost £1 billion invested with Icelandic banks and their
subsidiaries;
(ii) That this investment exposure included many
investments initially made for periods in excess of one year;
(iii) Investments were made right up until the
end of September 2008; and,
(iv) That clear warning signals were ignored.
2.4 The vast majority of AIS documents simply
concentrate on establishing parameters for the investment of funds
based around credit ratings. The credit ratings themselves are
often provided on an automated basis by some of the advisory companies.
Thus a downwards movement in a rating of an individual institutions
will typically result in a single warning action against that
specific institution. This is, in our view, dangerous because
financial markets are global by nature and if one institution
is downgraded it must prompt wider questions and concerns. In
Iceland this was critical since all its banks had cross holdings
in the others. If there was a concern about one of its banks then
that had to raise questions about wider concerns in the other
Icelandic banks and the banking sector in general regardless of
what the rating agencies were providing. This was happening in
a credit crisis that started in the spring and early summer of
2007 not during 2008. The decision to continue lending into
Iceland, even after warning signals from some of the rating agencies,
let alone the many other significant and available signs of concerns,
must raise serious questions about the way and the basis that
advice about risk is provided and interpreted.
2.5 We believe that the blind reliance on
credit ratings supplied on an incremental and mechanistic basis
sits behind 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, unappreciated, and,
at worst, it was ignored.
2.6 What were the clear signals?
— Widespread newspaper articles (going
right back to early 2006) of potential problems with the Icelandic
economy.
— An analysis of the Icelandic economy
from 2006 onwards indicated that it was an economy under
stress. The value of its currency was deteriorating, inflation
was sharply higher and its official interest rates were in double
digits and rising. As an economy its growth had been fuelled almost
entirely from the expansionary activities of its banks and their
liabilities now dwarfed its economic output and the value, therefore,
of any potential government guarantee.
— Numerous research released by investment
banks signalling potential problems with Iceland and its banks.
This research kept on coming and its outlook took on increasingly
pessimistic tones.
— One of the credit rating agencies introduced,
in early 2007, a new ratings methodology that inexplicably resulted
in the Icelandic banks being given the highest available rating.
This brought widespread derision from the financial markets to
the extent that the methodology was revised and the ratings downgraded
shortly thereafter. This again raised sharp questions about the
reliance on credit ratings as a sole barometer of risk.
— Credit default swaps (CDS) are a market
tool that provides investors with insurance against a corporate
or sovereign failure. CDS priced Iceland and its banks at levels
that significantly contradicted the credit ratings. Even though
local authorities are unable to use CDS within their treasury
activity, their implied warning of failure should have been heeded.
2.7 Taking these points together resulted
in our Treasury Management Consultants, Arlingclose, having concerns
about Iceland and its institutions. Arlingclose take its responsibility
to its local authority clients very seriously and when they have
concerns that they cannot resolve then they adopt a prudent and
cautious stance. That stance was to advise clients not to lend
to Iceland's banks or their subsidiaries wherever domiciled.
2.8 Icelandic banks went into administration/receivership
in early October 2008. The credibility of credit rating agencies
had been widely questioned since the onset of the so-called credit
crisis in the early summer of 2007. If we accept there is a crisis
in credit and financial markets then the continued sole reliance
on credit ratings—whose role in it were under widespread
scrutiny—would appear to us to be a significant failing
in the assessment of risk. This is not the fault of the AIS but
the interpretation and means of assessing risk.
2.9 The annual nature of strategies is a
concern since the unravelling of the financial markets did not
lead to widespread changes to a strategy prepared on an annual
basis. Once again, Arlingclose had been advising its clients to
respond to the emerging crisisby investing only with higher rated
institutions and the Debt Management Agency Deposit Account Facility
(DMADF) ie a UK Government backed deposit facility. It was important
that local authorities received advice and responded to the clear
emergence of a crisisrather than to carry on regardless.
2.10 It is 17 years since the last
significant failure of a bank that resulted in local authorities
having capital at risk. In 1991, the Bank of Credit and Commerce
International (BCCI) collapsed and left some local authorities
with significant capital losses. BCCI was on the Bank of England's
list of deposit taking institutions and this was misinterpreted
as reflecting a degree of confidence in the bank by investors
despite the telling absence of any credit rating. The other key
issue, that has also been forgotten, was the interest rates offered
by the borrowing bank. BCCI was offering above market rates as
were the Icelandic institutions. This should always be treated
with a degree of caution.
3. Benchmarking
3.1 The AIS also typically include a benchmark
against which performance is measured. Local government finance
officers often report that they have outperformed this benchmark
and, in some instances, professional fund managers. This should
in itself be a warning sign that risk and returns are potentially
going beyond prudent levels. Is it honestly realistic to believe
that local authority treasury managers—often spending only
limited time and resources on the management of cash investments—can
repeatedly outperform the efforts of full?time investment professionals?
They may do but it is not without risk and this
is an important feature in this debate ie the lack of appreciation
of the risk being taken. In some cases this has been with the
support of their treasury advisers and reflects a potentially
far muddier area where advisers may have links to companies and/or
affiliations with organisations that earn commissions from the
borrowing/investment activity of the local authorities. This gives
rise to potential conflicts of interest.
4. In the light of recent events, are there any
changes needed to the framework for the scale, spread and risk
of local government reserves?
4.1 In our opinion there are no significant
changes to the framework required but there is a fundamental need
for local authorities and some advisers to move away from using
credit rating agencies as the sole source of assessing credit
risk.
4.2 One technical change would be appropriate
and despite efforts by Arlingclose to encourage the Department
for Communities and Local Government (DCLG) to do so, we have
been disappointed in its response at a time of such heightened
risk and concern for local authority treasury management.
4.3 We believe, along with Arlingclose,
that the bonds currently being issued by the UK banks and building
societies included in the Government's Guarantee Scheme provide
local authorities with an appropriate investment opportunity to
secure a medium term return with a AAA HM Treasury guarantee.
DCLG regulations currently classify the acquisition of these bonds
as an investment of a capital nature. A modest change in the regulations
would classify the bonds as investments of a revenue nature and
would enable a much wider range of local authorities to acquire
the bonds.
5. Should local authority money be invested in
Government stock, with lower risk, but with a low return? What
effect would this have on UK banks and on council taxes?
5.1 Local authorities can and do invest
in Government stock (treasury bills and gilts) and have done for
many years. The price of gilts fluctuates on a real time basis
and whilst they offer the highest level of credit protection (AAA
rating), indicating that the risk of getting the capital value
back is viewed as very low, the day-to-day fluctuation in price
has implications for the valuation of any holding in local authority
accounts.
5.2 This volatility would stop local authorities
from making widespread investments in Government stock because
of the risk associated with an adjustment in the value of the
holdings and its impact on the investment return.
5.3 Yields on gilts are at historically
low levels (two year gilts as at 21 November 2008 yield
less than 2%) whilst the majority of local authorities are currently
budgeting for investment returns in 2008-09 and 2009-10 at
substantially higher levels. This is creating significant and
additional financial pressures on local authorities that are exacerbated
by those authorities with money at risk in Icelandic banks.
5.4 Local authorities have access to the
DMADF facility mentioned in paragraph 2.10 that essentially
allows investment in a government backed money market account.
5.5 The wholesale investment in government
stock by local authorities would not have a significant impact
on UK bank operations in our view but it would—in the absence
of changes in the accounting treatment of investments and the
change outlined in 4.3 above—lead to increased volatility
in investment returns at a time when some stability is required.
5.6 Any change to investments offering a
lower return would, of course, affect the income to the local
authority and therefore either the level of Council Tax or the
level of savings required to achieve a given level of tax. Given
the current pressures on local authority budgets they will obviously
try to maximise the return and it is the balance between return
and security that is the key. The creation of benchmarking "league
tables" where a lower rate is automatically assumed to show
a poorer performance does not help this culture. Therefore, particularly
for small authorities, it is vital that there is access to impartial
professional advice that looks further than just the credit ratings
but feed in intelligence that can only be obtained by working
full time within the financial markets.
6. What is the role of central government in
providing financial advice and guidance to local authorities?
Should any other bodies have a role?
6.1 We believe that the role of central
government is to provide a fair and appropriate financial framework
for local authorities. We believe that the Prudential Code for
Capital Finance does just that and was introduced after widespread
consultation and development with local authorities to replace
a prescriptive and centrally controlled system viewed as out?of?date.
6.2 Local authority treasury management
is captured within that Code but over time the advice local authorities
have received and the acceptance of investment returns without
due consideration of the potential risks has decreased and increased
respectively. What has happened in Iceland has been, if nothing
else, a sharp reminder about the relationship between risk and
return. Some treasury advisers and many local authorities have
perceived that policy towards credit risk should be set and monitored
solely by reference to credit ratings. The Guidance issued by
central government does not imply that but it has been interpreted
as such.
6.3 The Chartered Institute of Finance and
Accountancy (CIPFA) issues a Code of Practice on Treasury Management
that is adopted by all local authorities. It has a role in ensuring
that its Code is relevant and up?to?date and it has largely done
this well. It provides training to local authority investment
staff. Its links with treasury advisers are less well established
and the membership of its Treasury Management Panel is too insular
and should be urgently reviewed.
6.4 Treasury advisers should provide demonstrably
independent advice without potential or real conflicts of interest.
They must clearly decide and communicate what advice they are
providing clients and it should be consistent.
7. Should the Government protect local authorities'
investments in the same way that it is protecting personal assets?
What consequence does this have for the relationship between local
and central government?
7.1 No, the Government should not protect
local authorities' investments in the same way that it is protecting
personal assets. If local authorities wanted that then they already
have access to it in the DMADF. Local authorities have chosen—in
the pursuit of higher returns—to ignore the lower returns
and the lowest credit risk that the DMADF provides even during
the last few months of extreme stress in financial markets.
7.2 Those local authorities with money at
risk in Iceland are waiting to hear from central government on
what assistance it can provide them to mitigate the impact of
the potential losses of investment income and, potentially, capital.
Central government has a number of options available and it must
communicate these to the local authorities concerned clearly and
quickly since local authorities are now setting 2009-10 budgets
and Council Tax levels. Any lingering prospects of protecting
the assets of local authorities' investments in the same way as
is the case with personal assets should be clarified sooner rather
than later. It is uncertainty that creates tension between central
and local government.
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