Local authority investments - Communities and Local Government Committee Contents


Memorandum by the Local Government Association (LAI 23)

  Thank you for your call for evidence in respect of local authority investments, the LGA is pleased to respond to your request. We are also grateful, in the light of recent Government announcements in this area, for your extended deadline of Friday 5 December.

  We contend the principles underpinning local authority Treasury Management are sound, having been carefully developed over a number of years. No authority reports that it faces immediate financial difficulties and there is no evidence of recklessness by authorities in their management of this area. Local authority deposits at risk with Icelandic banks represent 3.7% of total funds they had placed in the market at 31 March 2007.

  We do not support the proposal that local authority funds should be invested in Government stock, not least as the interest losses would be substantial. Authorities may however wish to invest some of their surplus cash with the Government as part of a balanced risk strategy, as they do now

  The recent government announcement to defer the impact of impairments for a year is very welcome, and will help authorities plan ahead. However it is not a permanent solution and we believe the Government should support local authorities so they can in turn maximize the support they can provide for local people and communities in these difficult times. Such a package would not be costly and would include:

    — A guarantee that local authorities can spread any losses from deposits with the four Icelandic banks over a period of up to 20 years.

    — Targeted support for authorities that depend heavily on interest income to fund current budgets, in the same way that the Government already compensation exceptional costs such as those related to flooding.

  We would be delighted to explore the issues in our submission in more detail with the Committee.

  1.  The Local Government Association (LGA) represents 466 authorities in England and Wales, together these councils speak for over 50 million people and spend £113 billion a year delivering services on their behalf.

Context

  2.  The past six months have seen a period of substantial turmoil in global financial markets. The origins of this crisis are likely to be debated for some time, but the impact on major international banking institutions has been severe.

  3.  At 31 March 2007 English Local Councils and related authorities had some £24.7 billion of funds on deposit.[4] On 9 October 2008 £926 million (or 3.7% of the March 2007 holdings) was held with affected Icelandic banks as below:

Table 1

TOTAL DEPOSITS WITH ICELANDIC BANKS


English Councils£788m
Plus Fire, Park, Police, Passenger and Waste Authorities £138m
Equals Total English council and related authority deposits £926m
Plus Welsh and Scottish Authorities£111m
Equals Total deposits£1,037m




Source: LGA


  4.  Since 9 October the LGA has been working with:

    a. All affected councils to ensure the extent of liabilities is understood and recovery of money is pursued in an efficient and well co-ordinated manner.

    b. Administrators (in the case of Heritable and Kaupthing Singer Friedlander) and Resolution Committees (in the case of Landsbanki and Glitnir banks) to ensure maximum sums are recovered.

    c. The Improvement and Development Agency (IDEA) and Communities and Local Government (CLG) to ensure individual authorities were properly supported.

    d. HM Treasury to ensure UK creditors' interests are appropriately represented.

Key Messages

  5.  In spite of the unprecedented financial turmoil, no council is reporting that it faces immediate financial difficulties and there is no evidence of recklessness by authorities in their management of this area. The LGA contends the principles underpinning the approach to Treasury Management are sound, having been carefully developed over a number of years. In the months since the Icelandic bank failures affected authorities have:

    a. Continued to make payments to creditors in good time,

    b. Been developing contingency plans in case some of the deposits are not recovered.

    c. Been open in setting out their deposits in Icelandic institutions.

    d. Established active creditors' committees to press their case for recovery.

Select Committee Question 1

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?

Background to Treasury Management

  6.  Local authorities follow the Chartered Institute of Public Finance and Accountancy (CIPFA) Treasury Management Code. This code sets out the procedures local authorities should follow in the organization of their treasury management functions.

  7.  The Treasury Management code is given legislative weight by the 2003 Local Government Act. This is supplemented by guidance on investments issued the Office of the Deputy Prime Minister in March 2004.

  8.  The original CIPFA Treasury Management code was developed in the light of the BCCI collapse in July 1991 and CIPFA have just updated their guidance in this area.

  9.  The heart of the treasury management code is that authorities should adopt a diversified investment strategy spreading deposits across different institutions in order to ensure that:

    a. Their deposits are secure.

    b. They have sufficient liquidity to meet day to day demands.

    c. They achieve the highest available yield commensurate with the first two factors.

Implication of having diversified deposits

  10.  The benefit of a diversified investment strategy is that, in the event of an unexpected institutional failure, an authority is unlikely to lose all of its deposits. However a further consequence of the same approach is that at a time of substantial financial turmoil at least some authorities may find some of their funds have been deposited with an institution that finds itself in difficulties.

  11.  The available evidence is that authorities have adopted diversified treasury strategies. Councils have placed surplus cash[5] deposits in banks and financial instruments that have had high financial ratings.

Table 2

SUMMARY OF ENGLISH INVESTMENTS[6] AT 31 MARCH 2007


InstitutionAmount on deposit at
31 March 2007


Banks£14.9bn
Building Societies£6.8bn
Other£3.0bn
Total£24.7bn




Source: CIPFA Capital Expenditure and Treasury Management Statistics 2006-07 Table 9.

Annual investment strategies


  12.  Local authority investment strategies are key documents and should be adopted by a meeting of full Council. They become part of an authority's financial framework, and can only be varied by further resolution of full council. This sends a signal that the strategy is a key document to be considered carefully before being adopted.

Credit ratings and counterparty lists

  13.  The heart of a council's investment strategy is the decision about which institutions an authority will deposit money with. Authorities should only deposit funds with financial institutions that are of a sufficient financial strength to be included on a "counterparty list".

  14.  Counterparty lists are informed by an independent assessment of the financial stability of the institutions, the normal source of which is the rating given by one or more of the three main rating agencies. The agencies all give short and long-term ratings for financial institutions. Some give further information—for example about countries. The investment strategy sets out the minimum acceptable rating that an institution must achieve to be included on the counterparty list. The LGA has carried out research, this shows that whilst there are minor variations between individual counterparty lists—the general principle of placing deposits with highly rated institutions is a common feature.

  15.  Counterparty lists will vary:

    a. Not all financial institutions are rated by rating agencies, smaller UK building societies are typically not rated. Some authorities will still include these, recognising the extent of FSA regulation of this sector, but will lend them less money and only for shorter periods (eg 180 days).

    b. Authorities that have larger cash holdings will have higher amounts they will deposit with individual institutions.

    c. Some authorities will have money that is not needed in the near future, and they may decide to deposit some of that for longer periods, meaning they may place a greater emphasis on long as well as short-term ratings.

    d. Some authorities may choose to have slightly wider range of institutions to place deposits with, others may choose to only list institutions that have the very highest ratings.

    e. The number of institutions available is reducing as a result of mergers and takeovers of banks.

  16.  Authorities can sometimes face practical difficulties in placing deposits. Not all counterparties will want to accept local authority deposits at a time that they are available.

  17.  Treasury strategies and counterparty lists are normally agreed at about the same time as the council budget. The budget will also make an assumption of income generated from interest on deposits. The counterparty list will be regularly updated as individual institutions' ratings change. Authorities can and do also update their strategies in the year in response to changes in the economy.

Local authority budgets

  18.  Local authorities face a challenging 2009-10 budget:

    a. The three-year settlement means finding savings is a key to delivering a balanced budget.

    b. In 2006-07 Councils generated £11.5 billion of income from fees and charges (in comparison with £22.5 billion from council tax.[7] The economic slowdown is affecting authorities as they face sharply lower income from fees and charges, creating unexpected pressures in the current year—as well as the coming one.

    c. In 2006-07 English Authorities generated £1.4 billion interest on their deposits representing a return in that year of about 4.8%. The recent falls in interest rates mean the percentage return on deposits will be very substantially lower in the 2009-10 financial year.

Impact of deposits and income on council budgets

  19.  Individual councils can face quite different financial circumstances. Some councils have substantial borrowings whilst others are debt free, some authorities have significant cash holdings that they hold on deposit—whilst others have much less money to lend.

  20.  The impact of lending also varies. Unitary Authorities and County Councils may also have large cash holdings. Their reasons for holding cash will vary, they may be holding funds on behalf of schools or social services clients, they may be planning a major redevelopment project and their holdings are needed to finance that project. As authorities with substantial budgets they will need to maintain a higher minimum level of reserves as part of prudent financial management. The value of individual and groups of deposits is often a relatively small proportion of larger authorities' budgets. Having adopted diversified investment strategies the extent of loss is to some extent manageable.

  21.  In contrast district councils typically have smaller budgets but may also have significant cash holdings because:

    a. They have built up capital receipts, either from years of sales of individual council houses or a one-off disposal of housing stock or other assets. Under current rules, right to buy receipts can't be used to finance new spending.

    b. They have collected business rates and council tax for upper tier authorities that they subsequently pass on in line with an agreed payment schedule. This may mean some small authorities may temporarily hold significant funds from major business ratepayers in their area—eg airports and power-stations.

  22.  Local authorities can be highly geared entities. This means the income they raise from council tax is a comparatively small percentage of their total spending, and small changes in budgets are amplified into larger differences in amount to be raised by local tax. Authorities already facing significant budget pressures, will find the impact of any losses particularly hard to manage. They will have to plan for significant impairment pressures whilst retaining adequate levels of reserves—as required by their external auditors.

Short-term impact

  23.  The LGA has been in contact with a series of authorities that have deposits with Icelandic banks. None of the authorities we contacted face short-term financial difficulties.

  24.  The evidence is authorities had been drawing up contingency plans for the coming 2009-10 budget. These plans varied between authorities but in individual severely affected authorities included slowing or stopping all but the most essential spending.

  25.  We may not know the percentage of deposits that are eventually recovered for several years, because recoveries may come in part from realisation of long term assets of the various banks. In managing the recovery of creditors' money, Administrators may decide that it is in the best interests of creditors to continue to run operations that are performing well, rather than to attempt an immediate sale of these businesses.

Information from Administrators and Icelandic 'Resolution Committees'

  26.  The LGA has been in contact with the Heritable and Kaputhing Singer & Friedlander (KSF) UK administrators. KSF administrators have not been able to provide an estimate of what percentage of deposits will be recovered or over what timetable they may be paid. Heritable Administrators have indicated that there will be a material dividend payable to unsecured creditors in due course, but that it is too early to provide a realistic estimate of quantum or timing.

  27.  Heritable creditors appear to have the benefit of a parent company guarantee from Landsbanki in Iceland, although the terms and effect of this are presently uncertain.

  28.  The Icelandic creditor arrangement for Landsbanki and Glitnir is also complex, and is being managed by 'Resolution Committees'. The Resolution Committees are not insolvency practitioners but are groups of individuals who now have the responsibility for the management of the non-domestic businesses of the Icelandic banks. The local domestic businesses have been transferred to new banks and this separation has been made under Icelandic law. The arrangements for communication by the Resolution Committees are, therefore, not backed by insolvency law and it is not clear when they will be able to give an estimate of what amounts might be recovered.

  29.  Glitnir is the subject of a moratorium, further restricting the actions which may be taken by creditors.

  30.  The LGA is seeking clarification on a number of important matters concerning Landsbanki and Glitnir including: whether local government deposits have been transferred to the new, state-owned banks and, if so, the effect this has on those deposits; how local government deposits rank in the order of payment to creditors.

Accounting for losses

  31.  Several factors will determine the medium term effect on authorities:

    a. The proportion of deposits that are not recovered.

    b. The length of time over which councils eventually have to make up lost deposits.

  32.  CIPFA is the professional institute for public sector accounting, they recently published their technical guidance on this issue. CIPFA concluded that potential losses on deposits in affected banks are revenue "impairments" and as such councils should budget to write them off in their income and expenditure accounts. In practice this would have meant that estimated losses would have to be financed in the 2009-10 financial year.

  33.  CIPFA further noted that this was not just an issue of self regulation. The 2003 Local Government Act does not allow impairments to be regarded as capital and therefore they cannot be financed by capital receipts.

Secretary of State announcement

  34.  On 26 November 2008 the Minister of State announced he intends to make a regulation under section 21(1) of the Local Government Act 2003 which will have the effect of deferring the impact of impairments for local authorities' Icelandic banks investments ("relevant investments") until the 2010-11 financial year.

  35.  Local Authorities will still have to make an estimate of impairments as part of the 2009-10 budget process, but they will then be able to charge a credit to their accounts to equal the impairment.

Preparing 2009-10 budgets

  36.  Local Authority Treasurers must draw up robust and prudent budgets, with final decisions made by mid February 2009.

    a. A prudent budget means that the assumptions in it must be justifiable. A budget must take account of potential losses. In the absence of information from Administrators, a reasonable estimate of impairments must be made.

    b. The budget must ensure the authority still maintains a reasonable level of reserves, particularly given the uncertainties in the coming 12 months.

    c. A robust budget means the savings proposals should be deliverable, this means ensuring there are plans to deliver all savings in the budget.

  37.  In practice decisions will have to be made some time in advance of the February deadline. Authorities have to consult on budgets with business ratepayers, and many authorities now consult widely on their budget proposals.

  38.  Specific consultation is needed where significant service changes are proposed, particularly if they involve changes to an agreed three year budget or business plan. Such consultation will typically include:

    a. Service users where it is proposed to close or mothball an activity eg a leisure centre.

    b. Staff who might be made redundant or redeployed under such a proposal.

    c. Businesses or service users—where it was proposed to raise fees and charges.

  39.  The Secretary of State's announcement is welcome as it helps Local Authorities plan their budgets and gives everyone more time to make a reasonable estimate of eventual impairments. Authorities can decide, in the absence of any other support, if they need to apply for capitalisation in 2009.

Capitalisation

  40.  The 2003 Local Government Act allows for revenue spending to be treated as capital if a capitalisation direction has been received.

  41.  Capitalisation would allow local authorities to either:

    a. Charge estimated losses against capital reserves—for example capital receipts.

    b. Fund the loss over up to 20 years. In effect making a payment each year from the revenue to pay off the capitalised sum.

Delivering the 2009-10 and 2010-11 budgets

  42.  Planning and consulting on budgets is only the first step. Delivering a resulting budget that includes significant service changes will require significant elected Member and senior management focus. The Secretary of State's announcement allows for better forward planning.

  43.  The more affected authorities face a considerable medium-term budget challenge. They must resolve this issue over the coming 12 months without losing the capacity to manage other important agendas.

  44.  In order to plan ahead local authorities need an early decision about any capitalisation requests—ideally as soon as a clearer picture emerges about likely levels of losses, probably in spring 2009.

In summary

  45.  The effects on local authorities will vary significantly:

    a. Most authorities had no exposure to Icelandic banks at the point of their collapse, and the evidence is a number of authorities were reducing their exposure to Icelandic banks as deposits matured over summer 2008. However these authorities still face other pressures because of the economic slowdown.

    b. Some authorities with more substantial deposits at risk will face significant difficulties. They will need to plan and consult on potentially significant service changes. Users and employees may be directly affected. Early indication of capitalisation will allow those authorities to plan three-year budgets effectively and reduce disruption in their local economies.

Select Committee Question 2

In the light of recent events, are any changes needed to the framework for the scale, spread and risk of local government reserves?

An unprecedented event

  46.  Before considering any proposed changes it is important to recognise this was an extremely unusual event. It was unlike previous financial episodes that affected local government treasury management. This was a case of an entire banking system of a highly developed European country unexpectedly collapsing.

  47.  Local authorities find themselves in the same position as many other "sophisticated" creditors including; international banks and bondholders, UK banks and building societies, charities, universities and housing associations.

  48.  Total English local authority deposits at 9 October represented 3.5% of total deposits outstanding at 31 March 2007 (though in a number of cases the individual authority exposure was significantly higher). There is not yet complete information on this issue but the LGA has seen evidence that several authorities were in the process of reducing their exposure to Icelandic banks.

  49.  However a significant number of the deposits were longer-term ones that could not be prematurely withdrawn without the agreement of the Icelandic banks. These deposits were made when the international financial environment was quite different.

Areas for change

  50.  The LGA believes there may be potential improvements to the treasury management framework, but like other risk management decisions these should be:

    a. Evidence based.

    b. Proportionate.

    c. Made with a full understanding of the likely consequences (given that the annual interest on cash deposits is equivalent to 6.3% of council tax income overall[8] and, for some councils very much more than that).

  51.  The existing arrangements are highly decentralised. Authorities have different investment strategies and within these make local choices on when and where to invest their funds. This means whilst individual authorities made deposits that are now at risk, many did not.

  52.  There are areas where changes might be made:

    a. Clarifying the responsibilities of professional advisors and credit referencing agencies.

    b. Building country credit ratings into decision making

    c. Establishing systems making it easier for authorities to work together to get the best terms when making deposits.

    d. Looking at the perverse incentives that discourage authorities from repaying PWLB debts early.

  53.  Some issues for further exploration include training for Members to help them in their oversight role and for treasury managers—along the lines of CIPFA's new treasury qualification.

Select Committee Question 3

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?

  54.  The LGA does not agree with the proposal to require local authorities to deposit funds in Government stock. Authorities may however wish to invest some of their surplus cash with the Government as part of a balanced risk spread strategy, as they do now

  55.  UK banks and building societies offer higher interest rates than those offered by central government through the Debt Management Office. If authorities place deposits in the DMO they will currently earn 1.6% on those balances. This compares unfavourably with the three-month London Interbank Bid Rate which stands at 3.9%.[9]

  56.  With council tax currently generating £22 billion year the additional cost of depositing only in DMO products is equivalent to an additional 2.5% on top of existing levels council tax—assuming rates remain at their current level.

  57.  In practice the effects on individual budgets will vary. The impact on larger authorities might be less significant, but smaller more highly geared authorities will be greater.

  58.  Any comparison with other countries needs to look at to totality of local authority funding, including the extent to which those authorities in other countries have access to other sources of finance.

  59.  The LGA is concerned that the locally determined income is already at comparatively low levels, this proposal would reduce it further.

Effects on UK banks

  60.  It is difficult to draw direct comparisons between local authority cash holdings and UK bank holdings. LGA has collected the following data—but Information from the British bankers association is at October 2008 and includes Northern Ireland

Table 3

UK TOTAL BANK HOLDINGS AT OCTOBER 2008


Deposit typeValue at October 2008


Personal deposits£660bn
Sole traders£88bn
Other businesses (includes UK local authority bank deposits) £103bn
Building society holdings (includes UK local authority building society deposits) £228bn
Total£1,079bn




Source: British Bankers Association

Table 4

GREAT BRITAIN LOCAL AUTHORITY INVESTMENTS AT 31 MARCH 2007


All Authorities England£24.6bn
Plus Welsh Authorities£1.4bn
Plus Scottish Authorities£1.8bn
Equals all authorities Great Britain£27.8bn
Of which:
Bank deposits£16.6bn
Building society deposits£7.4bn
Other deposits£3.8bn
Total deposits£27.8bn




Source: CIPFA Capital Expenditure and Treasury Management Statistics 2006-07.

Select Committee Question 4

What is the role of central government in providing financial advice and guidance to local authorities? Should any other bodies have a role?

  61.  Central government has established the framework for local authority capital accounting and investment management. Within this framework CIPFA then provide more detailed technical advice, drawing on advice from expert practitioners from within local government when doing this.

  62.  Elected Members in each authority are responsible for setting the local investment strategies on advice from the Finance Director, who is also responsible for ensuring the day to day management of treasury services follows the agreed strategy.

  63.  Authorities draw on professional advice from specialist advisors, but the responsibility for final decisions lies with the local authorities themselves. The advantages of the system are that it is flexible, and able to accommodate the quite different financial circumstances in different authorities. It also provides a very clear incentive for high quality financial management, because full responsibility rests locally and skilful management can make a significant difference to the authority's performance.

  64.  If central Government were to take a more prescriptive role in providing financial advice and/or guidance some fundamental issues would need to be considered:

    a. As any advice would necessarily be public, that might have a significant effect on the financial markets.

    b. The Government would expose itself to liability if its guidance proved incorrect.

    c. The Government would be placed in the position of having to defend its advice against the judgements of market professionals and others.

    d. If the Government required prescriptive advice to be followed, it would need to accept consequential liability if its advice failed to warn about a subsequent event leading to loss.

  65.  The LGA believes it is not likely to be practical for Government to provide advice or guidance in this area, beyond the existing approach of establishing a framework within which authorities operate.

Select Committee Question 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?

  66.  Local and central government have a series of shared objectives in these uncertain times:

    a. The stability of the UK financial system.

    b. The economic prosperity of local areas and the UK as a whole.

    c. Ensuring appropriate action is in place to support struggling communities and businesses.

    d. Providing high quality services at minimum cost to the taxpayer.

  67.  The LGA proposes timely, but targeted support for those authorities facing an unprecedented financial challenge. The key is that any support is identified and in place in time for authorities to prudently plan for the 2010-11 budget.

  68.  The alternative is that, because of the capping regime in place, more highly geared councils will be obliged to make budget reductions affecting local businesses and services and undercutting those shared objectives.

  69.  The key features of LGA proposals are:

    a. To allow authorities to capitalise significant losses, so the sums are paid off over a number of years.

    b. To fund some of the interest losses where the loss is above a given threshold, perhaps set as a percentage of the council budget. The benefit of this is the sums are comparatively small—perhaps around £45 million or less than 0.04% of the annual local authority budget.

  70.  The approach is similar to the Bellwin scheme that was used to provide assistance with recovery from last year's floods—providing targeted help at a time of unprecedented financial turmoil.

  71.  Local Government is not looking for substantial financial assistance. The key in our proposal in local government should finance the bulk of any losses in a way that minimises the short-term financial impact on local communities at a time of great economic uncertainty.











4   This information is drawn from CIPFA Capital Expenditure and Treasury Management Statistics 2006-07 Table 9. The £24.9 billion includes joint passenger transport, fire and civil defence, waste disposal and police authorities. Back

5   These figures represent surplus cash, not useable revenue reserves. Part of the cash surplus will relate to revenue reserves, part will be capital reserves, but much of it will be temporarily surplus cashflows or the proceeds of borrowing raised in advance of capital spending, which has been invested until needed. Back

6   Investments include joint passenger transport, joint fire and civil defence joint waste disposal and joint police authorities. Back

7   Source CLG Local Government Finance Statistics No 18 (2008) Table 2.5a Back

8   Interest on balances = £1.46 billion in 2006-07, council tax income was £22.9 billion in the same year. Back

9   At 27 November 2008. Back


 
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