Memorandum by Sector (LAI 29)
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?
There are over 450 local authorities. Each is
responsible for annual expenditure, expressed in capital and revenue
budgets, of many millions of pounds and in the case of the larger
authorities, these amounts increase are in the many billions of
pounds region. The cash flow implications of these large businesses
are very large and complex to manage.
The Cipfa Prudential Code, which is statutorily
recognised by the Local Government Act 2003, sets out the framework
within which local authorities are required to manage the treasury
management implications of their expenditure and income plans,
both past and future. Included in this framework and set out in
the Investment Guidance Note, issued by the CLG, is the recognition
and separation of investments into two categories: Specified and
Non-Specified.
Under the Specified category, investments are
made with high credit rated organisations, as measured by credit
ratings issued by the credit rating agencies: Fitch, Moodys and
Standard and Poors. The Guidance then lists the types of investments,
with this low risk over-ride, that fall within this category.
Non-Specified are considered to be higher risk investments and
the Guidance states that the additional risk needs to be recognised,
evaluated and quantified in the context of the Authority's attitude
to risk and reward and there needs to be a plan of action for
managing this risk.
In relation to performance, there has always
been an over riding acceptance that the security of capital was
the primary objective and the return was a secondary consideration.
This tone is prevalent in the Cipfa Code. Within an acceptable
level of risk, authorities are required to deliver best value
and in turn support their revenue budgets expectation as expressed
in each authority's Medium Term Financial Plan. Accordingly, once
they have satisfied themselves that credit, interest rate and
liquidity risk has been managed appropriately, they are encouraged
to get the best returns available.
Cash deposits placed with Icelandic Banks are
not lost at the time of writing but it is accepted that the repayment
of capital and interest is suspended for the foreseeable future.
These investments were placed with Icelandic Banks which had a
high credit rating (Short-term F1), under the definition of the
Investment Guidance Note referred to above, and in a cash instrument
which is included in the Specified Investment category.
2. In the light of recent events, are any
changes needed to the framework for the scale, spread and risk
of local government reserves?
When the Framework is examined on an objective
basis, it is clear that it covers all of the aspects of good practice
without being too prescriptive. However, it doesn't give authorities
the full scope to fully manage all of their risks. In order to
do this, it would be necessary to expand the Framework to include
the use of derivatives. The Committee may wish to consider this
in the context of Housing Associations (Registered Social Landlords)
which have comparable less financial risk than local authorities
but are allowed to use derivatives within certain restrictions,
but local authorities are not allowed to use them at all.
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?
A local authority that doesn't drive high returns
after first considering credit, interest rate and liquidity risk
could be said to not be delivering best value for the council
tax payers. An investment approach of only investing in UK Government
Gilts would deliver low credit risk and is an extreme approach
given that the return trade-off is very low returns. There could
also be said to be a potential liquidity mismatch between gilt
maturity dates and preferred investment periods to suit the local
authorities' cash flow forecasts with any buying and selling (trading)
of Gilts before their natural maturity date to compensate for
this mismatch introducing additional interest rate risk into the
equation. The local authority would also be required to appoint
a custodian, which would increase the cost of managing the treasury
function. The net effect of this approach would be higher Council
Tax with less flexibility.
The other, as important, consideration would
be the effect on the sterling money markets. Local authorities
are responsible for placing £10 billion of cash investments
into the market, increasing liquidity and enabling a large number
of financial institutions to benefit from boosting their balance
sheets through the wholesale money market route. Any reduction
in this activity would have a negative effect on the financial
markets.
The are many alternative AAA credit rated vehicles
that local authorities could use to achieve the same level of
risk but with greater return. Many local authorities have now
tightened their lending criteria to only lend to financial organisations
that have a minimum long-term rating of AA. The returns are materially
greater following this approach despite the slight reduction in
credit quality, and flexibility is maintained.
4. What is the role of central government
in providing financial advice and guidance to local authorities?
Should any other bodies have a role?
Through the CLG, as the issuing body of Regulations,
and the Debt Management Office of The Treasury, as the lender
of long-term loans to local authorities, the Government is instrumental
in controlling the statutory framework for treasury activities
and the method by which the Government, through the Public Works
Loans Board, are prepared to lend to local authorities. The provision
of financial advice is best left to those organisations that are
experienced in this field and do not have potential conflicts
of interests with other Government Departments.
Cipfa, as the professional accountancy body
for public sector accountants, do take their professional training
role seriously and have a Treasury Management Panel set up to
provide advice and guidance to local authorities. The only criticism
I would have of their approach is that they only have local authority
practitioners on this Panel and have excluded advisors, who is
some circumstances have a greater experience and knowledge of
treasury management and the financial markets than those on the
Panel. Sometimes the guidance that flows from the Panel does lack
pragmatism.
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?
I think that the Government and the Bank of
England needs to recognise the effect that local authority dealing
behaviour can have on the financial markets. For example, many
building societies that now have a credit rating that falls blow
the minimum required by some local authorities have experienced
large cash outflows as a result and a severe deterioration in
their deposit base.
However, whilst guaranteeing local authority
deposits would encourage greater liquidity flows in a financial
market which is desperate for this to happen, an outright guarantee
could encourage risk to be ignored. So there is a balance to be
struck here which possibly suggests that a guarantee should be
considered during periods of exceptional market conditions, to
organisations that were highly credit rated at the time the dealing
transaction was executed.
This should be seen as a very positive step
and demonstrate that when required there is a joined up approach
between central and local government in tackling difficult issues
which arise from time to time and are beyond the control of central
and/or local government.
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