Local authority investments - Communities and Local Government Committee Contents


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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