Memorandum by the Department for Communities
and Local Government (LAI 27)
SUMMARY
1. This evidence is from Communities and
Local Government (CLG).
2. It covers the following topics:
— Policy background (paragraph 6).
— Why authorities need to invest (paragraph
9).
— The former "approved investments"
regime (paragraph 12).
— The structure of the present framework
(paragraph 16).
— The current CLG investments guidance
(paragraph 17).
— The secondary legislation on investments
(paragraph 22).
— Debt Management Account Deposit Facility
(paragraph 25).
— Monitoring of investment activity (paragraph
27).
INTRODUCTION
3. Communities and Local Government has
policy responsibility in Government for local government, empowerment,
planning, housing, economic development and regeneration, community
cohesion and fire and resilience. In relation to local authorities,
it is responsible for, among other matters, the legal and administrative
arrangements relating to revenue and capital finance in England,
including investment functions.
4. The evidence below sets out the history
of, and rationale for, the present framework for local government
investments. It remains the Department's view that the system
is broadly fit-for-purpose. The policy is that local authority
investment decisions should be made by authorities themselves,
subject to general prudential principles recommended by the Government.
The system appears to achieve that objective. However, in the
light of recent events, the Department is, of course, examining
whether any changes may be needed. The Department therefore welcomes
the Committee's inquiry and looks forward to considering its recommendations
in due course.
5. We separately provided a briefing note
to the Committee, on 24 November, on the impact of the Icelandic
bank failures on local government in England, and the support
that we have offered to the affected authorities.
Policy Background
6. In this evidence, "investment"
means the placing of temporarily surplus local authority money
in the hands of a bank or other body, so that it remains available
for spending by the authority when such a need arises in future.
The present framework for local authorities' investments was radically
revised in 2004 in parallel with the introduction of the
Prudential regime for local government borrowing. The Prudential
system itself was foreshadowed in the 2001 White Paper Strong
Local Leadership—Quality Public Services. It was a main
item in the wide-ranging package of measures aimed at giving local
authorities far greater local discretion—and, in parallel,
more local responsibility.
7. Prudential borrowing was brought in by
the Local Government Act 2003 ("the 2003 Act")
and the same legislation achieved analogous improvements in relation
to investments. The frameworks for both borrowing and investment
are now structured similarly and have the following key features:
— Flexible codes of guidance replace the
former complex legislation.
— The codes are based on the concept of
prudence (affordability of borrowing, security of investments).
— Borrowing and investment strategies are
determined annually by the full Council and kept under review.
— The decisions on how much to borrow and
how and where to invest are made locally, not by central Government.
8. The Prudential system encourages investment
in the capital assets that local government needs to improve services
and relies on modern accounting concepts, plus professional and
self-regulation. It allows local authorities to raise finance
for capital expenditure—without Government consent—where
they can afford to service the debt without extra Government support.
Why Authorities Need to Invest
9. The financial transactions and decisions
of an authority routinely generate a surplus or deficit of cash
which the authority then decides how to handle through its treasury
management strategy.
10. Capital receipts, revenue reserves and
temporary cash balances will increase the cash available. These
are defined in more detail below. The cash surplus (or deficit)
will then be reflected in some combination of borrowings, investments
and bank deposits (or overdrafts). An important point to note
is that the cash position of the authority is dealt with as a
whole, and a particular investment cannot be said to consist of
a particular reserve or capital receipt.
11. Cash surpluses must either be kept in
bank current accounts or placed in some form of longer term investment.
Such surpluses invested by local authorities will broadly come
under one or more of the following headings:
(a) Temporary cash balances, which arise when
there is an imbalance between cash flowing into the authority
and cash flowing out. These balances may exist for very short
periods—sometimes only a day—but may be substantial
(for example, a large authority often has tens of millions of
pounds to invest in the overnight market). Most authorities will
look to earn interest on this money by transferring it from their
current bank accounts to short-term deposits, either in the money
market or, if they wish to minimise risk, in the Debt Management
Office's Debt Management Account Deposit Facility (see paragraph
25 below).
(b) Capital receipts, which arise when property
is sold. The money raised may not be needed for immediate spending
and will be invested, sometimes for long periods. Pooling arrangements
(compulsory payments of part of the receipt to central Government)
apply to housing capital receipts: 75% in the case of Right to
Buy sales and 50% for housing land sales. Sales of non-housing
assets, such as land with development potential or commercial
assets—such as shopping centres—can generate very
large receipts, which are not subject to a pooling requirement.
Capital receipts may be used for capital spending (but not for
revenue spending). They thus reduce the need to borrow for capital
projects. Local authorities are expected to make a significant
contribution to the achievement of the Government's target for
public sector asset disposal, which will generate capital receipts.
(c) Revenue reserves, which contain both a working
balance to help cushion the impact of any uneven cash flows, and
money put aside to meet unforeseen and exceptional circumstances.
This is prudent financial management, and the requirement for
financial reserves is acknowledged in statute; sections 32 and
43 of the Local Government Finance Act 1992 require billing
and precepting authorities in England and Wales to have regard
to the level of reserves needed for meeting estimated future expenditure
when calculating the budget requirement. The investments made
from revenue reserves will be of a longer-term nature than those
made from temporary cash balances.
(d) In addition, a fourth category is money borrowed
in anticipation of capital spending needs and temporarily invested.
Authorities often find it impracticable to link borrowing precisely
to the spending profiles of major capital schemes and it is standard
practice to borrow some time ahead of the spending deadline; this
is particularly attractive at times of low interest rates when
rises seem imminent. It is generally accepted that it would be
unlawful to borrow with the sole purpose of investing at a profit
and without any spending objective, and there is no evidence of
such practice. Authorities with large cash surpluses often take
the opposite course and pay for capital schemes out of those cash
holdings on an interim basis, thus postponing the borrowing and
reducing their investments.
The Former "Approved Investments" Regime
12. The Committee may find it helpful to
have a brief description of the investments system which preceded
the present one. That system operated from 1990 under powers
in the Local Government and Housing Act 1989, as part of the overall
capital finance system implemented by that legislation. The whole
1989 Act system, including the investments regime, was replaced
in 2004 when the Prudential system was introduced.
13. Based on complex regulations, the system
of approved investments limited authorities to investing primarily
in institutions authorised by the Bank of England, plus some other
prescribed options considered highly secure. In addition, investments
could not normally exceed one year in duration.
14. Authorities were not prohibited from
placing funds in non-approved investments, but if they did, they
were treated as having incurred capital expenditure, which meant
that the transaction counted against the authority's capital resources
and reduced its capacity for spending on future capital projects.
In addition, when a non-approved investment was cashed in, at
least 50% of the money had to be "set aside"—ie
it could only be used for debt-redemption, not for spending. So
there was a powerful incentive to use only approved investments.
15. The system was inflexible and unpopular
with authorities—and it did not achieve its objective of
ensuring the safety of local authority funds. In the early and
mid 1990s, numerous authorities lost money invested in BCCI (Bank
of Credit and Commerce International) and other failed banks—all
of which were on the Bank of England's list of authorised deposit
takers and hence counted as "approved investments".
The Structure of the Present Framework
16. The components of the framework are
as follows:
(a) Primary legislation. The absence of
an explicit investment power was one of the deficiencies of the
previous system and the Local Government Act 2003 (section 12)
now confers a clear power to invest in the following terms: "A
local authority may invest (a) for any purpose relevant to its
functions under any enactment, or (b) for the purposes of the
prudent management of its financial affairs."
(b) Secondary legislation. The Local Authorities
(Capital Finance and Accounting) (England) Regulations 2003 [SI
3146 as amended] ("the 2003 Regulations")
contain a regulation (25) which is relevant to investments. The
effect of this is set out below (paragraph 22).
(c) CLG Statutory guidance. The Secretary
of State has issued guidance on investments, as described below
(paragraph 17), under section 15 of the Local Government
Act 2003, which reads as follows: "In carrying out its functions
under this Chapter, a local authority shall have regard (a) to
such guidance as the Secretary of State may issue, and (b) to
such other guidance as the Secretary of State may by regulations
specify for the purposes of this provision."
(d) CIPFA Treasury Management Code. Regulation
24 of the 2003 Regulations (made under section 15 of
the 2003 Act—see above) requires authorities to have
regard to the CIPFA code on Treasury Management in the Public
Services, which includes some broad guidance on investments, among
other matters.
The Current CLG Investments Guidance
17. By contrast with the code on Prudential
borrowing, which was published by CIPFA, the main guidance on
investments is issued by CLG itself. In both cases, however, the
2003 Act requires authorities to "have regard"
to the guidance. The CLG investments guidance was developed in
close liaison with the local authority associations, CIPFA and
the Audit Commission and was the subject of consultation with
all local authorities in England. The CLG document is online at:
http://www.local.communities.gov.uk/finance/capital/data/lginvest2.pdf
18. The basic requirement in the guidance
is for officers to put an Annual Investment Strategy to the full
Council. This is to set out the policies for giving priority to
achieving security and liquidity and the procedures for risk assessment
and management.
19. The guidance then identifies a category
of Specified Investments, which is meant to cover options with
relatively low risks. These include short-term sterling deposits
with central/local Government or with commercial bodies having
high credit ratings. The Annual Investment Strategy needs to say
very little about such options. If the authority proposes to use
any Non-Specified Investments (ie anything else), the Annual Investment
Strategy needs to give more details, setting out the procedures
for selecting those investments, the types of such investments
selected and the proposed upper limits on the amounts that are
to be invested in each type. But the system allows elected Members
to decide just how much detailed scrutiny they wish to undertake.
20. The guidance document is presented in
two parts. One is the formal statutory guidance to which
authorities are required by law to have regard. The other is a
purely informal commentary and this has no statutory backing.
The advantage of this structure is that the formal guidance can
be kept concise, while the informal commentary can provide explanatory
material and additional suggestions in more user-friendly terms.
21. There have been no indications that
the guidance is deficient. Contrary to recent statements in the
media, the guidance definitely does not encourage authorities
to maximise the return from their investments. It makes clear
that authorities' overall aim should be to safeguard the funds
they hold in trust for their communities and ensure the money
can be accessed readily whenever needed. The informal commentary
(though not the statutory guidance itself) then adds that when
these objectives have been properly addressed, authorities may
reasonably turn their attention to the yield from their investments.
Secondary Legislation on Investments
22. Although most regulations on investments
have been superseded by the statutory guidance, one such provision
does still exist. This is part of regulation 25 in the Local
Authorities (Capital Finance and Accounting) (England) Regulations
2003. Its aim is to discourage the acquisition of the shares
and bonds of individual companies, since this is clearly
at the riskier end of the investment spectrum and can give rise
to highly speculative activity.
23. The regulation achieves that disincentive
by defining such transactions as capital expenditure, which means
they would count against the authority's capital resources and
reduce its capacity for spending on future capital projects.
24. There is however an exemption from that
rule if the shares and bonds are in collective investment schemes
(such as unit trusts), since then the risk is more acceptably
spread across a portfolio of options.
Debt Management Account Deposit Facility
25. The Debt Management Office (DMO) is
an Executive Agency of the Treasury. Its responsibilities include
debt and cash management for the Government. It incorporates the
Public Works Loan Board (PWLB), which has long been the main lender
to local authorities for capital spending.
26. Since 2002, the DMO has also operated
the Debt Management Account Deposit Facility (DMADF). This facility
offers local authorities an alternative to using the money markets
to place surplus cash for short periods (between one day and six
months). All deposits are guaranteed by the Government and therefore
benefit from a sovereign triple-A credit rating.
Monitoring of Investment Activity
27. The principle of delegation inherent
in the current system means the Government does not undertake
detailed monitoring of individual authorities' investment practices.
CLG maintains regular liaison with the local authority associations,
CIPFA and the Audit Commission on a wide range of financial issues.
Through this route it is able to form a view as to how the system
is working. As indicated at the outset, CLG considers that it
is operating broadly as intended.
28. However, information is regularly collected
on investments:
(a) by type of institution (eg bank deposits,
building society deposits, Debt Management Account Deposit Facility)
using monthly samples and quarterly top-up to full coverage (the
statistics produced form part of the Office for National Statistic's
monitoring of the public sector finances and are published annually
in Chapter 5 of Local Government Financial Statistics England);
(b) in aggregate on an annual basis in local
authorities' Capital Expenditure returns to CLG, as part of the
Department's monitoring of the prudential system (see also Chapter
5 of Local Government Financial Statistics England).
29. The aggregate level of investments by
local authorities in England was £29 billion at 31 March
2008.
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