Memorandum by Arlingclose (LAI 09)
SUMMARY
1. Established in 1993 and developing
its Treasury Advisory Services in 2004, Arlingclose is an independent,
unbiased financial advisory company to the public sector, providing
advice on debt and investment management compliant with the relevant
regulations.
2. This memorandum is based on our experience
as a leading financial adviser to 10% of the UK's local authorities
and is informed by our decision to advise our clients to refrain
from investing in Icelandic institutions from early 2006. Specifically
we focus on:
(a) the fundamental misinterpretation of risk
and an inappropriate response to the sharply deteriorating credit
conditions despite clear warning signs;
(b) the need for local authorities to move away
from using credit rating agencies as the sole source of credit
risk;
(c) the requirement for a technical amendment
to the appropriate Statutory Instrument (SI:534 2004) regarding
classification of bonds issued by UK banks in the Government's
Guarantee Scheme; and
(d) the necessity for treasury advisers to provide
truly independent advice which is clearly communicated and consistent
without potential or real conflicts of interest.
3. What are the present arrangements for local
authorities' Treasury Management—and in particular the requirement
to produce Annual Investment Strategies—and how have these
affected the performance of local authorities, both as service
providers and employers, given recent potential losses experienced
by many local authorities?
3.1 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.
3.2 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 local authorities' strategies require them
to invest in such a way as to ensure that the preservation of
capital is the prime consideration.
3.3 Considering that over one hundred local
authorities now have capital at risk after making investments
in Icelandic banks, it would seem reasonable to question the effectiveness
of the AIS as well as wider aspects of local authority treasury
management advice.
PRUDENTIAL INVESTMENT
GUIDANCE AND
THE AIS
3.4 Introduced in April 2004, the Prudential
Investment Guidance (and by implication the AIS) is part of a
larger prudential framework applying to local authority capital
finance. They generally allow local authorities to make local
decisions about the financing and ongoing affordability of capital
assets so that they can pursue their primary strategic objective—the
preservation of capital. The Investment Guidance replaced the
highly prescriptive Approved Investment Regulations and was a
welcome and long overdue development.
3.5 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.
So if the Guidance and AIS are not responsible, then what is?
3.6 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.
3.7 This is illustrated in a number of ways:
— over one hundred public sector organisations,
with capital preservation of funds as the primary objective, had
almost £1 billion invested with Icelandic banks and their
subsidiaries;
— investment exposure included many investments
initially made for periods in excess of one year;
— concentration risk was ignored with over
exposures to specific sectors or economies without regard to their
relative size.
— investments were made right up until
the end of September 2008; and,
— clear warning signals were ignored.
3.8 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 institution
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 concern about one of its banks then
that had to raise questions about wider concerns in other Icelandic
banks and the banking sector in general regardless of what the
rating agencies were providing. This requires a human, subjective
overlay which in many cases appears to have been absent from automated
processes.
3.9 Local authorities were investing in
Icelandic institutions despite Arlingclose's concerns, often for
lengthy periods before, and less excusably, after the credit crisis
which developed from the spring and early summer of 2007. The
decision to continue lending into Iceland, even after warning
signals from some of the rating agencies, and other significant
concerning signs, must raise serious questions about the way and
basis that risk is assessed, interpreted and managed.
3.10 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.
3.11 What were the concerning signals?
— Widespread newspaper articles (going
right back to early 2006) of potential problems with the Icelandic
economy.[1]
— 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 largely
from the expansionary activities of its banks which resulted in
liabilities dwarfing economic output and the value, therefore,
of any potential government guarantee.
— Numerous pieces of research released
by investment banks signalling potential problems with Iceland
and its banks. This research kept on coming and its outlook took
on an increasingly pessimistic tone.[2]
— 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 and the ratings were removed shortly
thereafter. This again raised sharp questions about the reliance
on credit ratings as a sole barometer of risk.
— Direct communication with the specific
institutions about which we had concerns did not allay Arlingclose
fears
— The credit default swap (CDS) market
provides investors with the ability to insure against a corporate
or sovereign failure. CDS priced Iceland and its banks at levels
that contradicted the credit ratings.
3.12 Taking these points together resulted
in Arlingclose having concerns about Iceland and its institutions.
Arlingclose takes its responsibilities to its local authority
clients very seriously and when we have concerns that we cannot
resolve, we adopt a prudent and cautious stance. That stance
was to advise clients not to lend to Iceland's banks or their
subsidiaries wherever domiciled since early 2006. We appear
to have been the only company offering Treasury Advisory Services
to do so.
3.13 Icelandic banks went into administration
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 is 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.
3.14 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, we have been advising our clients to respond
to the emerging crisis by 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 crisis rather than to carry on regardless.
BENCHMARKING
3.15 The AIS also typically includes 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. We are not convinced that it is 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.
3.16 An important feature in this debate
is the apparent lack of appreciation of the risk being taken.
In some cases this has been with the support of treasury advisers
and reflects a potentially far murkier area where advisers may
not be delivering truly independent advice due to pecuniary links
to companies and/or affiliations with organisations that earn
commissions from the borrowing and lending activities of the local
authorities. This gives rise to potential conflicts of interest.
3.17 The AIS and benchmarking, including
Cipfa Statistics, focus attention too narrowly on performance
within discrete financial years. This is unhelpful and may prompt
inappropriate investment strategies which seek to maximise short
term yield, potentially at the expense of security. We believe
that a move towards longer term investment strategies and performance
monitoring and benchmarking which value security and liquidity
over yield could foster the development of a framework where local
authorities naturally reduce aggregate levels of risk, increasing
the utilisation of highly secure government guaranteed debt instruments
such as Gilts.
4. In the light of recent events, are any
changes needed to the framework for the scale, spread and risk
of local government reserves?
4.1 In our opinion no significant changes
to the framework are required but there is a fundamental need
for local authorities and some advisers to move away from using
credit rating agencies as the sole indicator of credit risk.
4.2 One technical change would be appropriate
and despite our efforts 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 that specific bonds currently
being issued by the UK banks 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 expenditure nature.
A modest change, the insertion of just two words, in the regulations
(SI:534 2004) would classify the bonds as investments of
a revenue nature and would enable a much wider range of local
authorities to participate in this opportunity.
4.4 Whilst we appreciate that the situation
for Scotland's local authorities falls under the Scottish Government
we cannot ignore that there is a total lack of investment guidance
in Scotland. This is an unacceptable position that has persisted
for many years.
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, to a
limited extent, invest in Government stock (treasury bills and
gilts) and have done so for many years. The price of gilts fluctuates
in real time 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 and is an additional dissuading factor
in their increased utilisation.
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 currently stand at historically
low levels (two year gilts as at 21 November 2008 yield
less than 2%) whilst the majority of local authorities have budgeted
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 for those
authorities with money at risk in Icelandic banks.
5.4 Local authorities have access to the
DMADF facility mentioned in paragraph 3.14 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 could—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.
Although this volatility does not negatively affect the revenue
position of investing authorities who elect to "buy and hold"
to maturity, the impact on Council Tax would be related to the
actual investment decisions of each individual local authority.
However investment in Government guaranteed assets at yields which
exceed current projected paths for interest rates would have a
positive effect on local authorities' revenue positions and therefore
could alleviate inflationary pressures on Council Tax.
5.6 As mentioned in 4.3 we believe
that there remain inappropriate barriers to investment in certain
forms of Government guaranteed stock and we have suggested an
amendment to the appropriate Statutory Instrument (SI:534 2004).
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 passionately 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. It 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 this 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 in our opinion 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. It may be appropriate
for the FSA to require that providers of financial services to
Local Government or other public bodies provide absolute information
on their direct or indirect commissions or fees derived from financial
institutions each and every time a transaction is to be undertaken
in order to improve transparency.
6.5 In the United Kingdom the Financial
Services Authority (FSA) provides a regulatory framework for financial
services firms to work within.
6.6 Arlingclose does not think that there
is a need for additional bodies to be involved in the regulatory
framework as it relates to local authority finance, and the provision
of advice to local authorities. In a free market we have confidence
that local authorities will learn from experience and exercise
their right to seek credible financial advice from appropriate
independent sources.
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 In our opinion the classification of
"Professional Client" under current FSA definitions
is appropriate.
7.2 Should local authorities require additional
security then they already have access to it through the Government's
Guarantee Scheme identified in paragraph 4.3, the DMADF, Gilts,
Treasury Bills or other UK local authorities.
7.3 Those local authorities with money at
risk in Iceland are waiting to hear from central government on
what assistance it can provide them. In our opinion definitive
explicit advice delivered in a timely fashion will allow authorities
the best opportunity to mitigate the impact of the potential losses
of investment income and, potentially, capital.
7.4 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.
7.5 The "credit crunch", banking
crisis and economic slowdown have all contributed to an environment
where local authorities may have to endure a lower yield environment
for a significant period of time. Action and appropriate advice
is needed quickly if authorities are to manage their positions
to deal with the risks and challenges that now face them.
1 25 March 2006, The Times, Icelandic banks
refused extensions on loans
2 April 2006, The Sunday Times, British firms face
chill as Iceland crumbles
12 August 2007, The Sunday Telegraph, Is the Viking
invasion over?
24-25 November 2007, The Financial Times-Weekend, Iceland
feels heat after years of growth
18 January 2008, The Daily Telegraph, UBS issues warning
over Icelandic stocks
5 March 2008, The Financial Times, Moody's poised
to downgrade Iceland Back
2
13 March 2006, Merrill Lynch, Nordic Business Report
January 2008, UBS client note
March 2008, Moody's Investor Services. Back
| 
