Local authority investments - Communities and Local Government Committee Contents


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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