Memorandum by Butlers (LAI 18)
EXECUTIVE SUMMARY
Butlers have been consultants to local authorities
on treasury management activity since 1991 and currently work
with over 140 local authority clients. We provide advice on strategic
treasury management activity, regulatory and procedural issues
and information on investment counterparty credit worthiness which
we purchase from three credit rating agencies.
1. Present arrangements for treasury management/effects
on performance
1.1 The treasury management framework provides
a well regulated environment with a clear strategy and controls
approved by Councils in advance.
1.2 It is too early to say whether the potential
losses resulting from deposits in Icelandic banks will have any
significant adverse effect on services and jobs. With risk avoidance
replacing risk management, at least in the short term, there is
now even more emphasis on security. If this is coupled with lower
interest rates in the market, there will inevitably be a reduction
in investment returns which could have an impact on services and
jobs.
2. Are changes needed to the framework?
2.1 It is felt that the current framework
is adequate to deal with the scale, spread and risk of local authority
reserves. Changes to a predominantly sound system may inhibit
the freedoms and flexibilities which local authorities need.
2.2 The present difficulties stem from world-wide
turmoil, not an inefficient framework of risk management. We see
little merit in placing further restrictions on the Annual Investment
Strategies of local authorities.
2.3 The performance of local authorities
could be improved if relations with the Debt Management Office
were to change.
3. Gilt-Edged Investment
3.1 Investment in gilts does hold a number
of advantages (low risk, high liquidity) that could be of benefit
to councils, notably in times of financial dislocation.
3.2 Nevertheless, investment in gilts is
not a risk free exercise and there are a number of disadvantages
(capital losses, price volatility) that need to be taken into
account.
3.3 Wholesale investment in gilts could
have an impact upon small banks and building societies but in
normal market conditions, the net impact upon the overall banking
sector's ability to function efficiently should be small.
3.4 The lower net yield that would be earned
from large-scale investment in gilts would impact upon revenue
earnings. Any shortfall might have to be recouped via increases
in tax rates, or a reduction in the scale of services provided.
4. Central Government Financial Advice
4.1 Central government should not provide
financial advice—the advice should be provided by organisations
that are experts within relevant fields.
4.2 Central government should provide guidance
that allows local authorities to tailor their own strategy to
their individual attitude to risk.
4.3 Local authorities themselves and market
practitioners should have a say in how the investment guidance
is set up.
5. Government Protection of Local Authority
Investments
5.1 In order to provide complete protection
to local authority deposits, the Investment Guidance would need
to be so restrictive to protect the investment that there would
be no potential for performance to support the Revenue Account.
5.2 Were guarantees to be given without
restrictions, it may promote an unhealthy attitude to risk and
investments by local authorities.
5.3 In the case of unforeseen widespread
banking failure there needs to be appropriate Governmental support
to maintain the market's status quo.
THE EVIDENCE
1. What are the present arrangements for local
authorities' Treasury Management and how have these affected their
performance, both as service providers and employers, given recent
potential losses experienced by many local authorities?
Treasury Management Arrangements
1.1 We set out below a summary of the present
arrangements for Treasury Management. We anticipate that others
will provide a more detailed commentary.
1.2 The Chartered Institute of Public Finance
and Accountancy (CIPFA) issued a Treasury Management Code of Practice
and a Prudential Code for Capital Finance in Local Authorities.
In 2004, the Office of the Deputy Prime Minister and the Welsh
Assembly Government produced statutory guidance on local government
investments. Guidance for Scotland is currently being drafted.
1.3 The Treasury Management Code requires
approval by Council members of the treasury management strategy
and the policy and practices adopted for implementation of that
strategy. Detailed implementation within the agreed strategy and
parameters is delegated to the Chief Financial Officer. Regular
monitoring reports and an annual stewardship report are presented
for Council member approval.
1.4 The Prudential Code provides a framework
by which local authorities can demonstrate that capital investment
plans are affordable, prudent and sustainable. This is achieved
through the production of Prudential Indicators, some of which
set parameters for controlling the length of investments and the
mix between fixed and variable rate investments.
1.5 The Guidance on Local Government Investments
requires local authorities to set an Annual Investment Strategy
distinguishing between specified investments and non-specified
investments. The Guidance also, in conjunction with the Prudential
Code, determines the maximum period for which funds may be prudently
committed. Specified investments are for up to one year and made
with a body which has a high credit rating from one of the three
designated credit rating agencies, and would include also local
authorities, money market funds etc.
1.6 This Annual Investment Strategy also
requires approval by the full Council at each local authority
and is recommended to be incorporated in the wider Treasury Management
Strategy Report required by the Treasury Management Code.
Nature of Reserves and Balances
1.7 A key duty on all local authorities
(as part of the Treasury Management process) is the duty to ensure
that the authority has sufficient reserves and balances to enable
it not only to maintain its financial standing but also to ensure
that it can realise its service provision expectations.
1.8 When reviewing their medium term financial
plan (MTFP) Treasury Management Strategy and annual budgets, authorities
should consider the establishment and maintenance of reserves.
Reserves can be held for three main purposes:
1.8.1 a working balance to help cushion the impact
of uneven cash flows and avoid unnecessary temporary borrowing—this
forms part of the General Reserve;
1.8.2 a contingency to cushion the impact of unexpected
events or emergencies -this also forms part of the General Reserve;
and
1.8.3 a means of building up funds to meet known
or predicted liabilities—this is often referred to as earmarked
reserves.
1.9 The existing legislation requires authorities
to have regard to the level of reserves needed for meeting estimated
future expenditure when calculating the budget requirement. It
is the responsibility of the Chief Financial Officer to advise
the authority about the level of reserves it should hold and to
ensure that there are clear protocols for their establishment
and use. The protocols should set out:
1.9.1 the reason for/purpose of the reserve;
1.9.2 how and when the reserves can be used;
1.9.3 procedures for the reserves' management and
control; and
1.9.4 a process and timescale for review of the reserve
to ensure continuing relevance and adequacy.
1.10 Although the Chartered Institute of
Public Finance & Accountancy (CIPFA) and the Local Authority
Accounting Panel in guidance issued in November 2008 states that
the Institute "does not accept that a case for introducing
a generally applicable minimum level of reserves can be made"
it does confirm that "authorities, on the advice of their
chief finance officers, should make their own judgements on such
matters taking into account all relevant local circumstances".
Legislative and Regulatory Framework
1.11 Sections 32 and 43 Local Government
Finance Act 1992 require authorities to have regard to the level
of their reserves to meet future expenditure when calculating
the budget requirement.
1.12 In addition there are a number of safeguards
to prevent authorities from over committing themselves, namely:
1.12.1the balanced budget requirement;
1.12.2section 114 requirements under LGF Act 1988
(unlawful/unbalanced budget);
1.12.3external auditor's responsibilities to ensure
that authority's finances are soundly based; and
1.12.4the Prudential system of capital control is
built on the premise of the affordability, prudence and sustainability
of the Council's capital plans to include the availability of
resources to meet these plans.
Opportunity Cost of Holding Reserves
1.13 The authority in holding reserves will
invest them pending application. Therefore in measuring any opportunity
cost of holding these reserves account needs to be taken of investment
income. The opportunity cost of holding these reserves therefore
is a judgement as to whether the expenditure foregone is worth
more than the income generated. This obviously is an objective
as well as a subjective judgement and will require a decision
based on a number of factors.
Effects on local authority performance
1.14 It is too early to say whether the
potential losses resulting from deposits in Icelandic banks will
have any significant adverse effect on services and jobs. There
may obviously be adverse effects on services and jobs for any
local authority which loses all or part of its deposits with Icelandic
banks. In addition, there may be a more general effect on all
local authorities caused by the increasing concentration on security
of investments. Local authorities will continue to manage their
investment portfolios in accordance with the following objectives
(in descending order of priority): security, liquidity and yield.
With risk avoidance replacing risk management, at least in the
short term, there is now even more emphasis on security. If this
is coupled with the reduction in the number of banks taking deposits
and lower interest rates in the market, there will inevitably
be a reduction in investment returns which could in future have
an impact on services and jobs.
1.15 We wish to note that the effects, if
any, on local authority services have been caused by extreme and
sudden market events and not by the treasury management arrangements
themselves. The changes introduced in 2004 had a positive effect
on local authority treasury management. In particular, local authorities
were given greater investment flexibility which was coupled with
increased requirement, to report to Council members.
1.16 The current Investment Guidance, by
discouraging investment in some negotiable securities (in particular
corporate loan and debt instruments), has caused the emphasis
in investment to be upon fixed-term instruments which are illiquid
and increase vulnerability to counterparty failure.
1.17 For those with sums at risk the potential
loss on the amount invested will need to be accounted for on the
expectation of the likely return in the present financial year.
However, the recent ministerial announcement to introduce regulations
has delayed the ultimate revenue impact until 2010-11. Loss of
interest will impact on the level of reserves and balances and
reduce spending opportunities in the future. For some, there will
be a need for a capitalisation direction from the government to
allow the impact to be spread over a period of years; this would
be essential if the potential loss is significant.
2. In the light of recent events, are any
changes needed to the framework for the scale, spread and risk
of local government reserves?
2.1 We have set out above in paragraphs
1.9-1.11 details of the framework relating to the management and
scale of local authority reserves. The remainder of section 2
deals with the spread and risk of investment of those reserves.
2.2 We believe that the current framework
for the management of the spread and risk of reserves is basically
sound and does not require substantial amendment.
2.3 In relation to counterparty selection,
the framework requires local authorities to invest in institutions
with "high credit ratings". The information that the
credit rating agencies gave on the risk of default on highly rated
counterparties—based upon extensive historic data (see table
below)—provided strong support for using ratings as the
mainstay of lending decisions. What could not be factored-in was
the near-collapse of the financial system and the rapidity with
which this took place.
AVERAGE CUMULATIVE CREDIT LOSS RATES BY LETTER
RATING, 1982-20071
Rating
| Year 1 | Year 2
| Year 3 | Year 4
| Year 5 |
| Aaa | 0.000 | 0.000
| 0,000 | 0.001 | 0.034
|
| Aa | 0.000 | 0.008
| 0.033 | 0.050 | 0.107
|
| A | 0.012 | 0.046
| 0.119 | 0.195 | 0.263
|
| Baa | 0.103 | 0.289
| 0.514 | 0.844 | 1.099
|
| Ba | 0.677 | 1.928
| 3.519 | 4.856 | 6.305
|
| B | 2.908 | 6.460
| 9.424 | 11.664 | 13.274
|
| Caa-C | 11.145 | 17.666
| 22.753 | 26.050 | 32.346
|
| Investment Grade | 0.037 |
0.106 | 0.211 | 0.338
| 0.462 |
| Speculative Grade | 2.775 |
5.605 | 8.092 | 9.885
| 11.468 |
| All Rated | 0.971 | 1.923
| 2.749 | 3.365 | 3.887
|
1 Data are in percent based on issuer-weighted average default rate and on issuer-weighted average senior
unsecured bond recovery rates.
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Source: Moody's |
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2.4 The cause of the potential losses now faced by some
local authorities in relation to Icelandic investments is the
sudden onset of the recent global financial turmoil. This was
an extreme once in a century event that hit the world's financial
markets in mid-September following the collapse of US investment
bank, Lehman Brothers. It should be noted that exposure was not
an exclusively UK or local authority issue.
2.5 The present arrangements are basically robust and
the failure is not in the framework, but in the speed of the deterioration
of the financial crisis (which led to the Icelandic banks rapidly
losing liquidity), and resulted in sudden revisions to credit
ratings by the rating agencies.
2.6 We would be concerned by any change to the framework
which eroded the responsibility of local authorities to set their
own investment criteria. One of the strengths of the new prudential
system introduced in 2004, with the advent of the Prudential Code
and the implementation of the Local Government Act 2003, was the
concept of self-regulation.
2.7 The precise investment criteria used by any given
local authority is and should be a matter for local decision.
Different authorities with differing levels of investments and
cash flow have different investment requirements.
2.8 Different authorities will need specific investment
criteria to cater for their particular requirements. Not all investment
strategies will be similar. Some local authorities developed investment
strategies which included Icelandic banks, others excluded them.
Some investments with Icelandic banks matured prior to the collapse,
others were still outstanding. At the point of investment, sometimes
one to three years earlier, the banks had a high credit rating,
covering both short, long, and individual and support ratings.
Earlier action by the rating agencies would have reduced the national
exposure, but would not have eliminated it, as deposits were contracted
for a fixed period.
2.9 It is felt that the current framework is adequate
to deal with the spread and risk of local authority reserves.
Changes to a predominantly sound system may inhibit the freedoms
and flexibilities which local authorities need. The present difficulties
stem from world-wide turmoil, not an inefficient system of risk
management. We see little merit in placing further restrictions
on the Annual Investment Strategies of local authorities.
2.10 The performance of local authorities could be improved
if relations with the Debt Management Office were to change. A
change to the debt management arrangements by the Public Works
Loans Board in November 2007 made it more difficult for local
authorities to repay debt early; the penalty for early repayment
was increased. This left local authorities with more money to
invest, and to compound their problem the Debt Management Office
is now offering comparatively poor returns on monies local authorities
wish to place with them; the ultimate in secure investments. We
suggest the interest arrangements with regard to the premature
repayment of PWLB debt are reviewed with the aim of removing the
disincentive to repay debt.
3. Should local authority money be invested in Government
stock, with lower risk, but with lower return? What effect would
this have on UK banks and on council taxes?
3.1 The gilt-edged market is a highly specialised area
of investment management that is not devoid of risk. Successful
management of a gilt portfolio requires an intimate knowledge
of the individual stocks outstanding and a thorough understanding
of the mathematical intricacies of bond behaviour. This latter
consideration is particularly relevant in the case of the sensitivity
of the price of individual issues and different areas of the yield
curve to changes in the level of interest rates (the concept of
modified duration).
3.2 Local authorities can currently invest in gilt-edged
stocks either directly or through the employment of an external
fund manager.
3.3 Investment in gilts does hold a number of advantages
that could be of benefit to councils, notably in times of financial
dislocation:
3.3.1Low risk—as obligations of the UK central government,
gilts offer very high investment counterparty certainty. Their
AAA sovereign rating represents the lowest level of risk assigned
to market instruments by credit rating agencies.
3.3.2High liquidity—the gilt-edged market comprises a wide
selection of marketable securities issued by Her Majesty's Government.
It has remained a very liquid area of investment, although it
did experience disruption at the height of the "credit crunch".
The main stocks traded in the market place (benchmark issues)
are highly capitalised (typically in excess of £10 billion)
and the system operated under the jurisdiction of the Debt Management
Office ensures marketability in the vast majority of circumstances.
Buying and selling stock tends to be trouble free.
3.3.3 Income certainty—interest on gilt holdings accrues
on a daily basis and is paid to holders at six-monthly intervals.
This is an obligation of the UK Government which has never been
in default.
3.3.4 Wide choice—the different maturity dates of individual
stocks, coupon structures and interest payment dates means there
are investments to meet most investors' requirements. In addition,
the wide selection of index-linked stocks in issue offers inflation
protection, if required.
3.4 Nevertheless, investment in gilts is not a risk free
exercise and there are a number of disadvantages that need to
be taken into account.
3.4.1 Capital risk—gilts do offer counterparty certainty
but this does not mean that investors are protected from risks
of capital loss. As marketable securities, the prices of gilts
will rise and fall in response to changing interest rate levels.
The value of a portfolio of gilts will fall when interest rates
rise, an event that will reduce the overall level of returns on
a council's investment portfolio.
3.4.2 In addition to this, the price structure currently prevailing
in the gilt market (a result of the generally low level of interest
rates) means that the price of a majority of issues that would
be of interest to councils are above their redemption value. Consequently,
stocks that are purchased with the intention of being held until
redemption will experience a capital loss over their remaining
life.
3.4.3 Price volatility—as marketable securities the value
of gilt-edged stocks will be influenced by the movement in interest
rates and expectations about the future prospects for rates. Prices
can be very volatile—this was particularly evident in the
period following the collapse of US bank Lehman Brothers (in mid-September)
and the resulting surge in market uncertainties. Overall values
can vary widely over short and long periods and this could raise
valuation and accounting issues for councils.
3.4.4 Additional costs—gilt-edged securities are held in
custody accounts. This service used to be provided by the Bank
of England for a small nominal charge but was terminated a number
of years ago. Fees charged for custody services by specialist
custodians can cost investors as much as £20,000 per annum,
a sum that will reduce yet further the net return from this source
of investment.
3.5 The effect of council investment upon banks—local
authority lending to the banking sector represents a comparatively
small source of total funds for the latter. But it is a more important
source of finance for building societies. Wholesale investment
in gilts could have an impact upon the liquidity of this particular
market sector. However, given the fact that in normal, less uncertain
market conditions, council investment in gilts would be discouraged
by the lower yield available relative to money market deposits,
the net impact upon the overall banking sector's ability to function
efficiently should be small.
3.6 The effect upon Council Tax—the lower net yield
that would be earned from large-scale investment in gilts compared
with market deposits with banks and building societies or via
holdings of alternative negotiable instruments would impact upon
revenue earnings. Any shortfall might potentially have to be recouped
via increases in tax rates, or a reduction in the scale of services
provided.
4. What is the role of central government in providing
financial advice and guidance to local authorities?
4.1 The role of central government is to set out the
parameters within which local authorities should operate. Government
has fulfilled this role by providing the Investment Guidance.
4.2 The Investment Guidance in its current format provides
a comprehensive and flexible approach to management of surplus
funds.
4.3 It is the role of the local authority to determine
its attitude and approach to managing risk, within the parameters
contained within the Investment Guidance. This can be achieved
by seeking advice from relevant experts if the local authority
deems this necessary.
4.4 Financial advice should be provided by those organisations
that are experts in the relevant fields, for example provision
of credit ratings. This is not a role that central government
should adopt.
4.5 central government does have a role in assisting
local authorities, but this should be confined to general assistance
rather than specific financial advice.
4.6 Should any other bodies have a role?
4.6.1 Local authorities themselves should have a say in how the
investment guidance is set up—this can be (and normally
is) achieved through consultation on draft guidance.
4.6.2 When consulting on changes to the Investment Guidance central
government should seek the views of experts and practitioners
(eg fund managers) in the field of investment management. This
would ensure that the changes being proposed are workable in practice.
4.6.3 In addition to seeking the views of experts/practitioners,
other bodies should also be involved in the consultation process,
such as:
4.6.3.1 CIPFA;
4.6.3.2 audit bodies such as the Audit Commission and appointed
private sector auditors;
4.6.3.3 LGA; and
4.6.3.4 Local government consultants—eg Butlers.
5. 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?
5.1 In order to provide complete protection for local
authority deposits, the Investment Guidance would need to be so
restrictive that there would be no potential for performance to
support the Revenue Account. Clearly security is paramount but
the freedoms embodied in the Prudential Code do allow some latitude
to meet service objectives.
5.2 Were guarantees to be given without restrictions,
it may promote an unhealthy attitude to risk and investments by
local authorities. There would be no effective deterrent against
unnecessary risks being taken. By guaranteeing investment security
does this perversely increase risks in the types of instruments
which would be used? Whilst most would maintain a sensible approach,
there may be those that would push the guarantee to its limit.
5.3 The two points are not mutually exclusive—protection
could only come with highly restrictive controls.
5.4 There is also an assumption implicit in the NIPS
Code that local authorities are sufficiently knowledgeable to
deal in the markets. Therefore, in the event of error or careless
practice on a single local authority's account this should be
the local authority's responsibility. However in the case of unforeseen
widespread banking failure, or an unforeseen breakdown of market
information, there needs to be appropriate Governmental support
to maintain the market's status quo.
5.5 There is a need to allow sufficient flexibility in
the local authority investment decisions to relate to each local
authority's individual circumstances.
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