Joint memorandum by CIPFA Scottish Directors
of Finance Section and CIPFA Scottish Treasury Management Forum
(LAI 22)
1.0 Summary
1.1 It is considered that:
— Recent events in relation to major financial
institutions across Europe and the US are unprecedented;
— While there are lessons to be learned,
and it has to be recognised that treasury management activity
always carries an element of risk, the current approach to spreading
risk has worked reasonably well to mitigate the effects of recent
events;
— Investing in Government Stock is an important
tool for local authorities but should not be the only one;
— The Government should not regulate to
define which individual investments local authorities may or may
not invest in; and
— There are specific circumstances where
it might be appropriate to offer a Government Guarantee for local
authority deposits.
2.0 Background to the Submission
2.1 The issues covered by the Inquiry are
wholly devolved matters and as such the Inquiry's remit does not
extend to Scottish local authorities. However, it was considered
that some observations on Scottish local authority investment
would be helpful to the Committee's background understanding.
2.2 The CIPFA Scottish Directors of Finance
Section is a forum for local authorities' Finance Directors to
meet and discuss finance issues. Directors of Finance are generally
the Proper Officers responsible for the proper administration
of local authorities' financial affairs under section 95 of
the Local Government (Scotland) Act 1973. In a Treasury Management
context, Directors of Finance have ultimate responsibility for
the implementation of the Treasury Policy approved by their Council.
2.3 The CIPFA Scottish Treasury Management
Forum (TMF) is a practitioner's forum of the officers who carry
out the day to day Treasury Management activities on behalf of
local authorities. Its membership includes all local authorities
in Scotland.
3.0 Present Arrangements for Local Authority
Investment
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 statutory basis for the investment
of local authority surplus funds is not as well founded as that
in England & Wales. There is currently no formal Investment
Guidance in the form that England & Wales have, and as best
practice, authorities have adopted the English Authorised Investments
list in 2001. It means that Scottish Councils have fewer investment
options, and most surplus funds are deposited with Banks, Building
Societies and other Local Authorities. It has also led to doubt
over the use of Money Market funds, and lending to the Government
in the form of the Debt Management Agency Deposit Facility (DMADF)
provided by the Debt Management Office (DMO), since these were
added to the English Authorised Investments list in 2002. The
regulatory framework in Scotland is the same with Councils all
adopting and adhering to the CIPFA Code for Treasury Management
in the Public Sector. We refer the Committee to the response from
CIPFA for a more detailed background on the regulatory framework
and Code of Practice.
3.2 It is not considered that, in the short
term, the recent events will have a direct effect either on the
services provided by Scottish Councils or on their role as employers.
Should there be no recovery of the funds from the Icelandic Banks
this situation will be different due to the additional financing
costs.
4.0 Framework for Local Authority Investment
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 The last time local authorities were
subject to a significant counterparty default was in 1991 with
the failure of the Bank of Credit and Commerce International (BCCI).
We consider that the report by the Treasury and Civil Service
Committee of the House of Commons on the BCCI closure is still
pertinent. This stated that:
"In balancing risk against return, local
authorities should be more concerned to avoid risks than to maximise
returns." Paragraph 58, Second Report, December 1991
Scottish local authorities still pay due regard
to this statement and investments are managed with regard to security,
liquidity and return explicitly in that order. While authorities
are not completely risk averse, they are certainly risk aware
and it is a key role in Treasury Management for Elected Members,
and Officers on their behalf, to understand and manage the many
risks in Treasury Management activities.
4.2 The recent events in the money markets
have been unprecedented—not just in relation to Iceland,
but the nationalisation, part-nationalisation and wholesale re-capitalisation
of some of the biggest banks in Europe and the US. Before Northern
Rock, the willingness of the UK Government to step in and guarantee
an institution was unproven.
4.3 Although there is obviously a significant
amount of money at risk following recent events, it represents
a relatively small proportion of local authority investments in
Scotland. Authorities had their investments spread with a range
of institutions, including banks, building societies and other
local authorities. While local authorities can ill-afford any
money at risk, the spread of risk with different counterparties
proved effective in managing the overall exposure to recent events.
4.4 Local authorities have used credit ratings
as a basis for assessing counterparty risk for many years. However,
over the last year, many local authorities have been reviewing
their investment approaches by strengthening the use of credit
rating agencies and maximum levels of investment, and will continue
to do so to ensure that any lessons from recent events are learned.
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?
4.5 If it is UK Government Gilts that is
being referred to by "Government Stock", local authorities
have generally not invested in these since there is a potential
for capital loss by virtue of the price movement unless held to
maturity. Before mid-2007 when the potential effects of the
sub-prime crisis became apparent, this potential loss of capital
was in contrast to deposits with financial institutions with a
high credit rating where there was no capital loss unless the
counterparty defaulted. Liquidity requirements mean that local
authorities generally have a fairly short maturity on most of
their investments, so holding Gilts to maturity is not a realistic
option. Treasury Bills are an option, but there are some liquidity
issues, as well as transaction and custody costs. The introduction
of the DMADF addressed these issues, but the facility was not
adopted in Scotland at the time, pending the introduction of the
anticipated Scottish Investment Regulations. Given that the regulations
were still not in place, and in light of market condition towards
the end of September, a number of Scottish Authorities have recently
placed deposits with the DMADF to reduce the risk profile of their
investments. However, the interest rate on the facility is exceptionally
low. It is obviously appropriate that the interest rate offered
on deposits with the DMADF reflects the low risk and is therefore
significantly lower than that offered by banks and building societies
in current market conditions. While security is paramount in the
current climate, some authorities have already expressed concern
over the effect on their budget of the reduced interest return.
4.6 In a Treasury Management context, it
is also worth noting that in November 2007 the Public Works
Loan Board, part of the DMO, introduced a separate interest rate
for the premature repayment of debt. In practice, this has meant
that the opportunities which local authorities formerly had to
achieve debt management savings through debt restructuring are
no longer available, putting further pressure on local authority
budgets. Previously, authorities could have used pro-active debt
management to manage the effect of the lost interest, but this
is much less the case now.
4.7 There are other options which local
authorities are considering in the short term. For example, Certificates
of Deposit (CDs) with an explicit Government Guarantee issued
by banks as part of the recent guarantee scheme are yielding over
one percent more than the DMADF for the same period. However,
local government cash flows tend to be "lumpy", with
significant mismatches in the timing and value of income and expenditure.
Further, other public sector initiatives, for example responding
to the current economic pressures and reviewing payment terms,
also impact on a Council's cash flow management. To take account
of these variances in cash flow, local authority investments have
to be kept reasonably liquid, and this would create issues with
using CDs and Government Stock. As such we consider that these
types of investments should only be used for "core longer
term cash" which makes up a relatively small proportion of
a Council's investments. Therefore, while "Government Stock"
has a significant role to play in the mitigation of risk in local
authority investment, it should not be mandated as the only option.
If it is, there is going to be a substantial long term shortfall
in investment income with an inevitable consequence for Council
Tax levels.
4.8 Local Authority temporary deposits have
provided a significant source of liquidity to banks and other
financial institutions. Although the deposits are a relatively
small part of the overall money market, in recent years they have
provided significant liquidity to smaller financial institutions
such as the Building Societies. In the current environment, lending
to these institutions by local authorities has reduced substantially
and this funding will have to be replaced by other sources in
the market. There is also significant lending between authorities
as part of authorities' normal short term cash flow management
and it is important that this be allowed to continue.
5.0 The Role of Government
What is the role of central government in providing
financial advice and guidance to local authorities? Should any
other bodies have a role?
5.1 The Government's role should be to set
the legislative and regulatory framework for local authority investment,
and to ensure a robust reporting standard within local authorities
so that the risk being incurred is identified in advance to Elected
Members. The Government's role should not, however, extend to
the identification of what individual specific investments a local
authority should or should not undertake.
5.2 We consider that CIPFA, and in particular
CIPFA's Treasury Management Panel are best placed to consider
the lessons to be learned from recent events and to continue to
disseminate best practice and build professional standards.
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?
5.3 There are a number of valid reasons
for believing that local authority investments should be subject
to a Government Guarantee, in specific circumstances. For example,
most of the CDs issued by banks under the Government's Guarantee
Scheme are issued in very large denominations. Therefore while
large institutions can invest covered by the Government Guarantee,
local authorities, which have a smaller amount to invest at a
time, have difficulty in doing so. While the purpose of the scheme
is to provide the banks covered by the scheme with liquidity,
it still gives a guarantee to larger lenders not available to
local authorities. This leaves local authorities somewhere in
the middle—larger institutions can invest in the Government
guaranteed CDs, retail investors have an explicit guarantee, and
in the middle are local authorities.
5.4 However, under the Market in Financial
Instruments Directive (MiFID), local authorities as generally
categorised as Professional Clients not as Retail Clients. This
is indicative of the greater level of understanding of the money
markets which local authorities should have, and their greater
resources to retain the services of professional advisors where
appropriate. Local Authorities should therefore be in a position
to make value judgements on the risk incurred in their investments.
If all local authority deposits were to be guaranteed by the Government,
there would be no penalty for taking undue risk. While we believe
that Scottish local authorities have managed their risk to date,
a blanket guarantee in the future might encourage excessive risk
taking. It is therefore considered that the Government should
not, as a rule, protect local authority investments in the same
way that it protects personal assets. The guarantee would therefore
depend on circumstances where due to the nature of investments
in Icelandic Banks it is considered that a guarantee would apply.
5.5 There are, however, two circumstances
in which a Government guarantee for local authority deposits may
be appropriate. Firstly, since local authorities have less access
to the guaranteed CDs/Bonds issued by the institutions in the
Guarantee Scheme, a limited guarantee covering local authority
deposits in those institutions for the same period as the Guarantee
Scheme might be appropriate. This would put local authorities
on an equitable footing with larger financial institutions. Secondly,
as noted above in paragraph 4.8, many smaller financial institutions
previously received significant funding from local authorities.
A combination of the current market conditions and some credit
ratings downgrades has meant that there is a lot less lending
by local authorities to these institutions. If further substantial
consolidation is to be avoided, it may be that a guarantee to
local authorities investing, within well defined treasury management
policies, in these institutions would be helpful.
| 
