Local authority investments - Communities and Local Government Committee Contents


Memorandum by Howard Knight following Evidence Session 19 January 2009 (LAI 32)

  Following the Session on 19 January, Lynda McMullan of Kent County Council has `expressed concern that the evidence I gave—with specific reference to Kent County Council—is incorrect and misleading.

  I certainly had no intention of either misleading the Committee or of misrepresenting the evidence relating to Kent CC and I have no hesitation in apologising if my evidence appeared to so do.

  Ms McMullan has raised concerns about two aspects of my evidence, as follows:

(1)  SPECIALIST TREASURY MANAGEMENT STAFF

EVIDENCE GIVEN:

Q7 Sir Paul Beresford: Have you had any indication of whether the officers have had any training in this area?

  Mr Knight: It is clear that in some authorities they do have specialist treasury management officers. Certainly when I was chair of finance of a metropolitan authority we did have specialist staff. If you read the PriceWaterhouseCoopers' report on Kent, for instance, at the moment, it actually says that that authority which has one of largest investment portfolios, does not have any of its own specialist treasury management staff—have to say I was pretty astonished by that.

  Ms McMullan advises:

    KCC have an Investment and Treasury team of circ five people. These people are very experienced but clearly we do not employ them to do the specialist role that external advisers were contracted to do. In addition a professionally qualified manager supervises this team and met regularly with the external advisers to discuss the operation.

    Elsewhere in his evidence Mr Knight talks about councils working together to ensure specialist skills are available collectively—this in effect was exactly the role such advisers took. The issue is whether councils had arrangements in place to provide specialist market advice, not how it was procured. We believe this statement misrepresents or reflects a misunderstanding of the situation based upon second hand information.

  Howard Knight's response:

  I have no hesitation in accepting Ms McMullan's statement that KCC has an Investment and Treasury Team of five people with a professionally qualified supervisor.

  However, it will be for Kent CC's own investigations, through its Overview and Scrutiny Committee and otherwise, to determine whether Kent CC had in place a team with the specialist knowledge, capacity and skills, and with the right attitude, understanding and responsibilities towards being efficient, effective and pro-active client's representatives on behalf of the ultimate client—Kent CC and its elected members, on behalf of the people of Kent.

  Members of the CLG SC will have the opportunity to read the PWC report for themselves and draw their own conclusions. My evidence reflected a summary of the PWC review as reported in The Independent on 19 January 2009 (the day of the Evidence Session) "PWC said Kent did not employ specialist treasury staff and relied on the expertise of Butlers."

  A key issue for all local authorities to consider is whether they do have the capacity to be an effective client or whether, de facto, they have in effect outsourced important aspects of their client role and responsibilities to their specialist advisers. This is an issue which relates to all functions, not just treasury management.

  Academic research suggests that, within three years of "outsourcing a function" (and it doesn't matter whether this is in the private or public sectors or whether the function is engineering or financial services or ….), the outsourcer will have lost the skills, knowledge and capacity to be a good and effective client.

  It is for this reason—as well as to address the development of cartels and oligopolies—that, in the USA, the consistent advice of the Managers of Towns and Cities has been that, whatever the function, the authority itself should retain a significant portion of that function under direct management.

  It is clear from the statements of a large number of local authorities with funds at risk that they had placed enormous reliance on their treasury management advisers—and this is reinforced by statements made by leading elected members in response to my survey—to the extent to suggest that, whilst authorities had retained the client's administrative treasury management functions, they had effectively ceded their highly informed, high-skilled, strategic client adviser functions to their treasury management advisers. Of course, this may not be reflected in the actual contractual relationship between local authorities and their treasury management advisers.

  Further, I simply do not accept Ms McMullan's proposition that, in response to my comments about the need for local authorities to work together to be sufficiently knowledgeable—both about the market and about particular financial instruments—"this in effect was exactly the role such advisers took." The proposition is itself an indication that, because treasury management advisers are themselves knowledgeable, it doesn't require the local authority itself to have that capacity. For the reasons I have set out above, I disagree.

  In addition, the evidence given by Butlers (Kent CC's treasury management advisers) to the CLG SC on 26 January 2009 simply does not support Ms MacMullan's perception about the extent and nature of the role and responsibilities of treasury management advisers generally and Butlers specifically. It is, of course, possible that these differences of perception—and conditioned by the exact nature of their contractual relationship—will be tested in litigation. For the moment, I am content to point to those clearly stated differences as a further indication that local authorities need to assure themselves that they have sufficient capacity and knowledge in their own treasury management team to be an effective client.

(2)  Reliance on Credit Ratings

Evidence given:

Q23 Mr Betts: Let us move on to the issue of market information, if you like, and what might be available. Clearly there is information from the credit ratings agencies, and some information to us is that some of the "advisers" who have been external advisers to authorities have done little more that pass credit rating agency information to councils and do not seem to have done very much more than that. Is there anything more that could be done to get appropriate and up-to-date information to both council officers, whether they are specialists or generalists, and to members?

  Mr Knight: "… However, I think it is fair to say that there was a huge over-reliance on the information provided by credit rating agencies in a market that was rapidly changing. If you compare authorities—this maybe unfair but I'll do it—if you looked at say Kent, it was relying on info only from one CRA, whereas if you look at Essex, which doesn't have funds at risk, it was very clear about having information from three credit rating agencies and only relying on the lowest or worst scenario from each of those agencies when taking information into account in terms of the way it moved forward."

  Ms McMullan advises:

    This is simply factually untrue. KCC uses all three credit ratings agencies. We cannot understand how Mr Knight came to this conclusion as there is nothing to even suggest this to be the case in any of our documentation.

  Howard Knight's response:

  I accept that my statement was factually inaccurate—Kent CC did use all three credit rating agencies—and, therefore, as I indicated, it was unfair. I apologise to the CLG SC and Kent CC for this. I am happy for this to be corrected.

  My evidence inaccurately conflated three issues. It is, therefore, important to set them out here:

    — If you contrast the investment policies and criteria of Essex CC and Kent CC, you will find that Essex's policies and criteria did not allow investment in Icelandic Banks because they did not meet Essex CC's stringent treasury management standards, whereas Kent CC's policies and criteria did allow such investments

    — Certain financial instruments and investments being offered in the market are only rated by one Credit Rating Agency. [It needs to be remembered that the banks themselves commission, and pay fees to, the credit rating agencies to provide that rating. In defending their decisions to assign AAA ratings to collateralised debt obligations and other securities which, subsequently, were found to be unjustified, the agencies have argued that "they did their best with the information available".]

    — My reading of Essex CC's policies and criteria is that it did not allow investment in such securities, but that Kent CC's policies and criteria did allow such investment.

27 January 2009



Supplementary memorandum by Howard Knight (LAI 32A)

  At the Select Committee meeting on 19 January 2009, I was asked to provide:

    — additional information from the survey I had conducted with elected members holding particular positions of special responsibility (Leader, Cabinet Member for Resources, Chair of Audit Committee, Chair of Resources Overview and Scrutiny Committee) in c 50 local authorities of all types (Shire County and District, Metropolitan and Unitary, London Borough) in England, and

    — any additional comments on local authority treasury management issues generally.

  My written evidence has already included:

    — Treasure your assets—a guide to local authority financial investments, published by The Centre for Public Scrutiny, December 2008

    — A preliminary note on responses to my survey

    — A response to concerns expressed by Kent CC about my reference to that authority in my oral evidence on 19 January 2009.

  This submission contains:

    — conclusions from the survey

    — additional comments

Question
Nature of Response

Finance background and training
Do the leading elected members (councillors—Leader, Cabinet Member for Resources, Chair of the Audit Committee, Chair of Overview & Scrutiny Committee) with key responsibilities for Treasury Management
(1)  have an economic or finance academic or professional background? A minority have; the majority don't have any relevant academic or professional background.
(2)  receive any specialist training in local government finance generally, and treasury management specifically? (1)  Every councillor has had access to some basic training on local government finance.

(2) Many councils also offer in-house workshops on eg budgeting, performance management etc.

(3)  Basic Treasury Management is likely to be covered in those sessions.

(4)  Only a minority of the leading members have undertaken additional training and development on Treasury Management. Occasionally, this has involved input from the authority's external "treasury management advisers".

(5)  The Improvement and Development Agency's (IDeA) Leadership Programme, for existing and aspiring Leaders, used to include a Finance Module, but that was dropped from the core programme. Discussions are now taking place about its re-instatement.
Should these leading members be required to undertake specialist training in Treasury Management? Overwhelmingly, respondents believed that there should be an expectation that elected members with particular responsibilities in this area should have the opportunity to secure development and training. Only a minority thought this should be compulsory. A majority thought that the authority should have a responsibility to provide the opportunity if requested.

Comment:

  (1)  To the best of my knowledge, there is no research evidence that easily demonstrates a clear correlation between elected member development and authority outcomes. However, there is considerable evidence to demonstrate that elected members who have undertaken development and training feel better equipped to be effective leaders and scrutineers.

  (2)  All authorities have some elected member development programme. It is still only a minority that have an accredited programme (eg Charter for Elected Member Development)

  (3)  Although there is a clear logic to support the view that, as with any job, elected members should undertake appropriate development and training to enable them to best undertake their responsibilities, there are many reasons why such training might not be offered or taken up.
  (4)  However, it is worth noting that Councillors are now required to undertake specialist training before they can be members of Planning and Licensing Committees.

  (5)  In my experience of member development on local government finance, in-authority programmes can be very good for developing an understanding of the issues. However, the most valuable sessions in giving elected members the confidence, knowledge and skills to ask the awkward and challenging questions have been those provided by an external agent eg by CIPFA or Local Government Futures

  (6)  I would have reservations about making development and training in local government finance generally, or treasury management specifically, a legal requirement even for those members with special responsibilities.

I think it would be better to incorporate the expectation of appropriate member development and training into CIPFA's Treasury Management Code Of Practice to which all local authorities have to have regard and allow monitoring of that performance by each authority's Audit Committee.
Treasury management policies
Is there any evidence to suggest that councillors have pressed officers to adopt "more risky" treasury management policies? I have found little evidence, from tracking through from officer reports on recommendations on TM strategy and policy to the minutes of the decisions of Council Cabinets, to suggest that councillors have pressed officers to adopt "more risky" TM policies. However, such tracking will not reflect any informal influences that may have been brought to bear by elected members in the formulation of those officer reports.
Responses to my survey also provide little evidence to suggest that councillor pressure has led to riskier investment policies than being recommended by officers. Only one authority admitted that members had pressed for riskier policies—referring to the returns being achieved by others—but had quickly adopted a more cautious policy early in 2007 with the first real indications of concern.

I also have clear evidence from one authority where it was the Cabinet Member for Resources (with professional banking experience) who initiated changes to adopt more cautious investment policies at an early date.

In the vast majority of authorities, the decisions taken by elected members on TM strategy and policy directly reflected the recommendations of the officers.
Is there any evidence to suggest that councillors have undertaken detailed scrutiny of Treasury Management policies proposed by officers or of TM performance? I have found little evidence of TM policies and performance being subjected to the same degree of scrutiny as other council services or functions.

In most authorities, TM strategy and policy papers have received what I would describe as relatively perfunctory scrutiny. That was one of the reasons for producing Treasure your assets.

In most councils (and the Audit Commission) it appears that TM was treated rather mundanely, with the legislative requirement to approve the TM strategy and policy seen as a necessary hurdle to be leaped rather than an opportunity for significant challenge. The perception is that this approach was also reflected in the "3-stage routine" followed by officers:

  (1)  qualify institutions and investment vehicles as "acceptable" by reference to their credit ratings

  (2)  identify the opportunities for investment in those qualified institutions by reference to the size and term requirements

  (3)  choose the investment that maximises the return.

Although most reports on TM strategy and policy included reference to the wider market and economic conditions and prospects, there is little reference to the market being dynamic with the potential for significant change (although the recent experience is unprecedented) nor to the potential for using other relevant market data, such as credit spreads, to inform investment decisions during the period that the policies apply.

At a time when all the market information suggested that investors should become more risk averse—and when at least one treasury management adviser was strongly advising against investments in institutions in particular sovereign states—it appears that many authorities simply ploughed on regardless. There is little evidence to suggest that the changing market triggered a renewal of either adopted policy or scrutiny.

With many councils having investments at risk, there is certainly now an incentive for councils to undertake more detailed scrutiny—either about historic performance or future policies. Treasure your assets gives detailed advice about how they might undertake such scrutiny.
So, what does distinguish those authorities who now have investments at risk from those which don't? It isn't political control.

It isn't size.

It is:

  (1)  the minimum credit rating and approved institution criteria which were agreed in their TM policies and used to determine which counter-parties were included on their lending lists.

  (2)  the speed with which council's responded to both formal and informal changes in market intelligence in changing their investment strategies. It is clear that in a number of authorities, and in the light of market intelligence, the Section 151 Officer applied more strict investment policies—in relation to minimum lending criteria, the size of any particular investment, and approved institutions—than the officially agreed policies required. This was usually done in consultation with the Cabinet Member for Resources, but was not necessarily formally reported to the Council at the time.

  (3)  The scale, timing and period of particular investments. Some authorities seem to have made some of their riskier investments for longer-terms at the time when market intelligence would have suggested otherwise.
  (4)  The specific relationship—including the roles, responsibilities and information/advice provided by the authority's external treasury management advisers (see below).

  (5)  It now appears that none of the authorities whose external treasury management advisers state that they provided advice as well as specialist information have funds at risk in Icelandic Banks and that all of the authorities which do have funds at risk had external treasury management advisers who state that their service is limited to the provision of specialist and tailored information. (CLG SC 26 January 2009.)

Comment:

On the face of it, some authorities also seem to have contravened one or more of three basic rules:

  (1)  never put all your eggs in one basket

  (2)  if an offer looks too good to be true, it probably is

  (3)  always be very suspicious of financial institutions that consistently offer or report better terms or returns than the rest of the market.
The role of TMAdvisers?
Do you have any comments on the roles of TMAs?   (1)  Most local authorities have appointed external treasury management advisers.

  (2)  The survey responses suggest that most elected members with some form of special responsibility for TM have never met their treasury management advisers.

  (3)  Only rarely had a representative from an authority's treasury management advisers been present at any relevant meeting (Cabinet, Audit, Scrutiny) when TM strategy, policy or performance was under consideration.
  (4)  All members believed that their authority had appointed external treasury management advisers to provide specialist advice as well as information.

  (5)  Elected members in all authorities with investments at risk made particular reference to their belief that their authority had been paying for and receiving specialist treasury management advice. This view has certainly been re-inforced by officer reports, even since October 2008, which imply that all treasury management advisers have actually been providing advice as well as information.

In both my initial written submission and oral evidence on 19 January 2009, I drew attention to what, at the least, might be described as the discontinuity between the perceptions of some authorities (members and officers) and some treasury management advisers on the issue of whether external advisers had been contracted to provide advice and/or information.
This issue—and the implications for authorities in assessing whether they have the capacity to be a good client for treasury management, as well as the historic decision-making and outcomes for particular authorities—was well explored at the CLG SC on 26 January 2009. Suffice it to say that the evidence given by Sector and Butlers as to the limited contractual nature and obligations of the TM service they provided to authorities came as a considerable surprise to the vast majority of elected members in those authorities to whom they provided a service.
Comment:

(1)  I am not in any position to make any comment about the particular contractual relationships between authorities and their external treasury management advisers.

(2)  It is clear that the vast majority of elected members with special responsibilities for TM believed that their authorities had appointed external treasury management advisers who would provide advice as well as information. The extent to which officers have, unwittingly or otherwise, mislead their members—and perhaps themselves—is an issue for individual authorities to explore.
The role of Credit Rating Agencies?
Do you have any comments on the roles of CRAs? The survey responses show that elected members—as well as officers, TMAs and Brokers—have historically placed enormous reliance on the published ratings of Fitch, Moody's and S&P and, in particular, on any changes in those ratings.

CRAs' actual performance over the last three years is, quite properly, the subject of some questioning. Even though it is clear that the banks themselves didn't understand the nature and scale of the risk associated with particular securitisation and OCDs, there was clearly on over-reliance by potential investors on the expectation that the CRAs would understand them.

Comment:

I have not found any evidence that authorities went beyond reliance on published ratings—and changes in those ratings—in assessing the risks of particular investments.

Given the market intelligence and speculation from early 2006 onwards about the security of some institutions and institutions based in certain sovereign states, it is perhaps a little surprising that some councils made large and lengthy investments relying totally on published CRAs and without having commissioned more research eg commissioning inter-active credit ratings.
The role of Government
Should the Government guarantee council investments in the same way as it does for individual investors? Unsurprisingly, a majority of survey respondents from authorities with investments at risk did think that there ought to be a government guarantee on those investments! Only a minority of respondents from authorities without funds at risk supported that view.
Comment:

It seems to me to be counter-intuitive for councils, on the one hand, to be arguing for increased local discretion and flexibility and, on the other hand, to suggest that the Government should guarantee whatever decisions they then make.

Obviously, both the legislative framework and CIPFA's TM Code should be continually kept under review and updated where appropriate.


Additional Comments:

  The existing CIPFA TM Code of Practice (CIPFA 2001 Section 4) sets out 4 key recommendations for the adoption of policies and practices to secure best value in treasury management by public bodies.

  Implicitly, by addressing those recommendations and requirements, a public body should be addressing explicitly the issue of whether it has in place the ability and capacity to be an efficient, effective and responsive client for treasury management.

  There are many ways of building sufficient and appropriate capacity. It is clear that many authorities looked to their treasury management advisers to "fill the gap" in relation to the lack of specialist, continually updated, knowledge and intelligence about the market which are pre-conditions for fulfilling the requirement to successfully identify, monitor and control risk and to secure optimum performance consistent with those risks.

  However, evidence given by some treasury management advisers to the CLG SC made it abundantly clear that those advisers neither saw nor believed they were contractually committed to undertake that role.

  In that context, it is difficult to believe that many authorities actually had in place sufficient or appropriate capacity to properly fulfil their effective client role. [I addressed this in more detail in my supplementary submission in relation to Kent CC.]

  In reviewing the CIPFA TM Code of Practice, I do think there is merit in considering explicit guidance—including bench-marks and checklists—in relation to the necessity of securing sufficient client capacity.

  Further, I believe that such explicit guidance would inevitably question the ability of some bodies—even with the commission of external advice and other resources—to efficiently provide the capacity to offer a comprehensive "professional and officer client role" to their elected members or boards.

  Therefore, in parallel with the review of the Code, I believe that the LGA, CIPFA and the Audit Commission should investigate the merits or otherwise of the "professional and officer client role" being provided on a county, regional or even national basis. Such a role could be played under the auspices of a lead authority (eg a county council for all public bodies in the county) or a joint authority (eg some metropolitan areas already have a joint authority which has responsibility for pension funds and investments, which has many common skills and knowledge requirements.)

  Such an arrangement would still enable each individual authority or other public body to remain responsible and accountable for the adoption of its own strategy and policy and for performance.

17 February 2009



Memorandum by Martin Hickman, Consumer Affairs Correspondent, The Independent (LAI 34)

UK LOCAL AUTHORITY INVESTMENTS IN ICELAND*

  *Collapsed Icelandic banks Kaupthing, Glitnir, Landsbanki and their UK subsidiaries

  Total number of UK councils: 468

  Total UK council investments in Icelandic banks: £885.3 million

  The Independent's figures include UK district, borough, metropolitan, unitary and county councils. They exclude fire, police, and transport authorities

Butlers
Claims to advise 144 UK councils: 31% of total

Number with investments in Icelandic banks: 51

Proportion of total UK council exposure to Iceland: 53%

Scotland £22.5 million, Wales £0, England £447 million
TOTAL:
£469.5m
Sector Treasury Services Claims to advise 250 UK councils: 53% of total

Number with investments in Icelandic banks: 46

Percentage of total UK council exposure to Iceland: 35%

Scotland £23 million, Wales £49.7 million, England £240.4 million
TOTAL
£313.5m
Sterling Consultancy Services Will not disclose number of UK councils it advises

Number with investments in Icelandic banks: 3

Percentage of total UK council exposure to Iceland: 2%

Scotland £3.7 million, Wales £0, England £13.5 million
TOTAL:
£17.2m
No external advisorNumber of UK councils without advisors: at least 16

Number with investments in Icelandic banks: 16

Percentage of total UK council exposure to Iceland: 1%

Scotland £0, Wales £0, England £13 million
TOTAL:
£13m
ArlingcloseClaims to advise 40 (now 50 after Icelandic collapse) UK councils: 9%

Percentage of total UK council exposure to Iceland: 0

Number with investments in Icelandic banks: 0**
TOTAL:
£0


Notes:

**Arlingclose has taken on several local authorities with Icelandic investments; none of these investments was made while it was advisor

Rhondda Cynon Taff (£3) and Doncaster (£3 million) failed to respond

Top 10 Council Investors in Icelandic Banks

Council (Political control)
Investments AdvisorBroker(s)

1. Kent (Con)
£50.3m ButlersICAP, Martins, Tullett Prebon, Garban
2. Nottingham (Lab)£41.6m ButlersCity Deposit, Martins, Sterling
3. Haringey (Lab)£37m SectorMartins, Tullett Prebon, Sterling
4. Norfolk (Con)£32.5m ButlersICAP, Sterling
5. Dorset (Con)£28.1m ButlersICAP, Tullett Prebon, Tradition
6. Hertfordshire (Con)£28m ButlersICAP, Martins, Tullett Prebon, Sterling, Tradition
7. Barnet (Con)£27.4m ButlersICAP
8. Somerset
(No overall control)
£25m No advisorICAP, Sterling, Tradition, Tullett Prebon
9. Northumberland
(No overall control)
£23mSectorICAP, Martins, Tullett Prebon
10 Surrey (Con)£20m ButlersMartins, Stirling, Tradition, Tullett Prebon


List of Councils (51) Advised by Butlers

Council
Investments AdvisorBrokers

1. Barnet
£27.4m ButlersICAP
2. Bassetlaw£8m ButlersFidelity, Sterling, Tullett Prebon
3. Bolsover£3m ButlersSterling
4. Bolton£6mButlers Martins, Tradition, Sterling
5. Bracknell Forest£5m ButlersICAP
6. Braintree£5m ButlersSterling, Tullett Prebon
7. Breckland£12m ButlersICAP, Tradition, Tullett Prebon,
8. Brent£15mButlers Declined to disclose
9. Bristol£8mButlers Declined to disclose
10. Bromley£5m ButlersDeclined to disclose
11. Cambridge£9m ButlersMartins, Tullett Prebon
12. Cherwell£6.5m ButlersICAP
13. Derwentside£7m ButlersTradition, Tullett Prebon
14. Dorset£28.1 ButlersICAP, Tradition, Tullett Prebon
15. East Ayrshire£5m ButlersDeclined to disclose
16. Epping Forest£2.5m ButlersICAP
17. Gloucester£2m ButlersMartins
18. Great Yarmouth£2m ButlersTradition
19. Hertfordshire£28m ButlersICAP, Martins, Tradition, Tullett Prebon, Sterling
20. High Peak£2m ButlersMartins
21. Ipswich£5m ButlersNo brokers used
22. Kent£50.3m ButlersICAP, Martins, Tullett Prebon, Garban
23. Lancaster£6m ButlersPrebon Yamane
24. Newcastle-under-Lyme£2.5m ButlersTradition
25. Norfolk£32.5 ButlersICAP, Sterling
26. North East Lincolnshire£7m ButlersICAP, Sterling
27. Nottingham£41.6m ButlersCity Deposit, Martins, Sterling
28. Oxford£4.5m ButlersMartins, Sterling, Tradition
29. Purbeck£2m ButlersPrebon
30. Reigate & Banstead£15.5m ButlersLCB, Tradition
31. Rotherham£4m ButlersPrebon
32. Rugby£3mButlers Martins, Prebon
33. Rushmoor£2m ButlersPrebon
34. Rutland£1m ButlersMartins, Tradition
35. Scottish Borders£10m ButlersDeclined to disclose
36. Solihull£3m ButlersMartins, Tullett Prebon
37. South Lanarkshire£7.5 m ButlersDeclined to disclose
38. South Oxfordshire£2.5m ButlersTradition
39. South Ribble£5m ButlersMartins
40. Surrey£20m ButlersMartins, Sterling, Tradition,Tullett Prebon
41. Surrey Heath£4m ButlersDeclined to disclose
42. Tamworth£7.5m ButlersICAP, Prebon, Tradition
43. Uttlesford£2.2m ButlersICAP, Sterling, Tullett Prebon
44. Vale of White Horse£1m ButlersTradition
45. Wakefield£9m ButlersDeclined to disclose
46. West Oxfordshire£9m ButlersTradition, Tullett Prebon
47. West Sussex£12.9m ButlersICAP, Martins, Sterling, Tullett Prebon, Tradition
48. Winchester£1m ButlersICAP, Sterling, Tradition, Tullett Prebon
49. Wokingham£5m ButlersTradition, Tullett Prebon
50. Wynchavon£2.5m ButlersTradition
51. Wyre Forest£9m ButlersICAP


January 2009



Supplementary Memorandum submitted by Martin Hickman, Consumer Affairs Correspondent, The Independent (LAI 34A)

Local Authority Treasury Management

  I am a reporter at The Independent newspaper. A story I wrote comparing the differing records of local authority investment advisers regarding Icelandic banks appeared on the front page of the Independent on Monday 19 January.

  Following publication of the story, I was contacted by an individual claiming to work at a senior level in the City of London who indicated he had information about the behaviour of local authority advisers and brokers.

  After agreeing to respect their anonymity, I met this individual in the City of London in January. We discussed local authority investments in general, rather than specifically investments in Iceland. During our meeting, this individual made a series of claims about the conduct of local authority finance officers, advisers and brokers.

  This individual claimed:

    That local authority investment officers placing tens of millions of pounds of investments in banks were poorly trained and motivated.

    That some local authority officers placing investments had enjoyed extensive hospitality provided by companies profiting directly from those investments.

    That brokers actively touted for business, dealing directly with local authority finance officers to discuss the placement of funds.

    That brokers received from banks substantial commission (sometimes running into hundreds of thousands of pounds) for placing local authority funds with those banks.

    That brokers share this commission with advisers; unbeknownst to local authority clients.

    That advisers actively advise local authority clients to place funds with particular institutions in order that they would receive a share of this broking commission.

    That together advisers and brokers hold conference calls with local authority finance officers in which they (advisers and brokers) act in concert to give such advice.

  During our conversation, this individual named specific companies, individuals within those companies and individual transactions. I have not passed on these details because I feel it would be a breach of natural justice to those organisations and individuals to do so.

  For professional reasons, I have not sought to investigate these claims. I must stress that as such I consider them to be unsubstantiated. However I was satisfied that this individual was employed at a senior level in a financial company in the City of London. It was also my belief that their views were sincerely-held and honestly expressed.

  I hope this information is of use to the Committee.

April 2009



Memorandum by the Audit Commission (Revised LAI 37)

  The Commission's core statutory function in relation to audit is to appoint auditors to approximately 900 principal local government and NHS bodies. The Commission also undertakes national studies on a wide range of topics to examine the economy, efficiency and effectiveness of local public services. We carry out research and provide independent analysis to give insight into complex social problems and best practice in tackling them. We make practical recommendations for policymakers and for people delivering public services. This often includes recommendations to central government relating to its interaction with the bodies that provide local public services. This memorandum draws on evidence and information from the work of appointed auditors and from our ongoing research into local authority treasury management.

Summary

  1.  The Audit Commission is pleased to submit evidence to the Communities and Local Government Select Committee investigation into local authority investments.

  2.  This memorandum summarises the information we have obtained from appointed auditors and the early stages of a research project we are undertaking into treasury management in local public bodies.

  3.  Although we have not finalised our conclusions, we have identified a number of themes:

    (a) we have identified 124 local government bodies with potential losses of deposits in Icelandic banks totalling £950.1 million. District councils have experienced proportionately greater losses than other authorities;

    (b) treasury management has generated a useful revenue stream for local authorities;

    (c) there is evidence of variability in how local authorities use information before making deposits, with some authorities using only information from ratings agencies and others using a wide range of information sources;

    (d) the quality of governance and scrutiny of the treasury function is variable but there are some authorities in which scrutiny has been limited with little effective challenge; and

    (e) public bodies are not always clear about the risks they are prepared to take with their financial assets and there may be an inconsistency between their appetite for risk and the way their treasury function operates.

  4.  We expect to publish our report in March 2009.

Introduction

  5.  Since the default of the Icelandic banks, the Commission has been working to ensure that the extent of the exposure of local public bodies is understood and that the lessons that can be learnt from the situation are captured. The Commission currently has two main streams of work.

  6.  First, through its appointed auditors, the Commission has collected information from public bodies identifying those that had deposits in Icelandic banks and their subsidiaries and the value of deposits held. Individual auditors have also reviewed their assessments of the financial standing of those authorities with Icelandic deposits as part of the use of resources judgements.

  7.  Secondly, the Commission has also started a major research project to examine local authorities' arrangements for handling their cash reserves held on deposit. This project has three elements:

    (a) the collection of data from a wide range of local public bodies on their deposits on 7 October 2008 in all institutions and any deposits in Icelandic banks since November 2007;

    (b) more detailed work, including site visits, to a sample of some 40 local authorities to examine treasury management. The sample has been selected to include a range of bodies including: those that had deposits in Icelandic banks on 7 October 2008, those that had never held Icelandic deposits and those that had previously held Icelandic deposits; and

    (c) a review of the nationally available guidance.

  8.  The Commission intends to publish its final report in March 2009.

  9.  We have completed our collection of data from the vast majority of local public bodies. We have also carried out the first set of detailed visits to local authorities and examined national guidance. It is, however, too early to come to authoritative conclusions. Nevertheless, we hope it will be helpful to the Committee if we identify some of the emerging themes. It is, of course, possible that some of these will not be fully substantiated by further research.

  10.  This submission draws on some of the early findings of the research and of our appointed auditors.

Exposure

  11.  In October 2008 the Commission asked its appointed auditors to identify which public bodies held deposits with Icelandic banks that were at risk. This exercise identified 124 bodies that were exposed, including local councils, police authorities, passenger transport authorities and fire and rescue authorities. The total exposure reported was £950.1 million. In cash terms, the largest single exposure was £50.35 million. However, the Commission has compared the potential loss to the gross revenue expenditure (GRE)—a broad measure of spending—of the bodies to adjust for the different sizes of the organisations with potential losses. In one case, the potential loss represented over 25% of GRE and in 13 cases over 10%. Of the 30 authorities where potential loss exceeds 5% of GRE, 27 are district councils, 1 is a police authority and 2 are transport bodies.

Use of resources

  12.  Auditors have a responsibility to satisfy themselves that the audited body has put in place proper arrangements to secure economy, efficiency and effectiveness in its use of resources, in accordance with criteria specified by the Commission. These arrangements are defined by the statutory Code of Audit Practice to include the audited body's arrangements for managing its financial and other resources, including arrangements to safeguard the financial standing of the audited body.

  13.  In reviewing an audited body's arrangements for its use of resources, it is not part of auditors' functions to question the merit of the policies of the audited body, but auditors may examine the arrangements by which policy decisions are reached and consider the effects of the implementation of policy.

  14.  Appointed auditors consider the financial standing of local authorities as part of the annual use of resources assessment, which forms part of the Commission's Comprehensive Performance Assessment of local authorities. Treasury management arrangements are considered in the context of financial standing, which looks at how well the council manages its spending within the available resources. In particular, auditors have to consider the authority's arrangements to keep its treasury management strategy under review and to monitor performance against it, and for ensuring that the strategy reflects the requirements of the CIPFA Code of Practice for Treasury Management in Public Services.

  15.  Although appointed auditors have advised us of isolated cases of breaches of bodies' treasury management policies, there is not yet any evidence that these were widespread. Breaches of which we are aware include deposits apparently being made without appropriate authorisation and individual counterparty limits being exceeded.

Deposits and interest receipts

  16.  Local public bodies hold large sums of public money with around £29 billion of deposits in banks and building societies. Authorities draw an income from these deposits. In recent periods, treasury management has been a source of additional income for local authorities. In its research on the impact of the economic downturn on local authorities, Crunch Time? [Ref 1], the Commission noted that 40% of chief finance officers had reported increases in interest receipts in 2007-08. Although we have not compiled an average yield on cash deposits, using a typical figure of 5.5% for 2007-08 would imply that councils' interest receipts exceeded £1.5 billion.

  17.  Local public bodies deposit money in a very wide range of institutions. Over 130 different counterparties have so far been identified. Predominantly these are UK owned financial institutions, but there are also UK subsidiaries of foreign banks and UK branches of foreign banks. From an examination of the returns, it is clear that there is a wide range of behaviour: some organisations have very conservative approaches while others have used a wider range of counterparties. Having a wide range of counterparties typically leads to a higher rate of return, although it potentially also increases the risk of losing the deposit.

  18.  In addition to the authorities that had exposure to Icelandic banks on the day of default, a number of authorities had previously held Icelandic deposits.

Use of credit ratings and other information

  19.  We have identified a range of behaviour among bodies in how they use information to assess the appropriateness of counterparties. In some cases, almost the only information used before placing a deposit is a single credit rating from a commercial ratings agency. In other cases, they use a much wider range of information, including reading around the subject, looking at market intelligence from a range of sources and broker information. Additionally, the culture of the treasury management functions vary between local authorities, with some staff adopting a sceptical approach to information, while others are more trusting of that which they receive. There is some evidence from our early fieldwork that those with Icelandic deposits were using a narrower range of information than those that either had never deposited or had stopped depositing.

  20.  Most authorities have contracts with treasury management advisers and brokers. However, in many cases the advice is fairly limited, for example they are used only to access the latest credit ratings. Brokers may add value but some authorities may achieve better results by approaching counterparties directly rather than through an intermediary.

Governance and Scrutiny

  21.  Given the large sums of public money involved, it is important that local authorities have in place arrangements for appropriate scrutiny and governance of the treasury management function. Our early fieldwork has identified some cases where this function is well developed, with appropriate systems in place to enable monitoring of the function, together with active engagement and challenge from both top management and elected members. However, in other cases the governance and scrutiny functions are ineffective: treasury management policies have been adopted by councils with minimal review and there is little challenge to the way the treasury function has been carried out.

Risk appetite and assessment

  22.  Effective treasury management policies require a good understanding of the risk that the organisation is prepared to bear. However, as yet, we have found little evidence that local authorities have systematically assessed their risk appetite.

  23.  There is some evidence that, in managing their cash deposits, authorities have not had an appropriate balance between maintaining security and liquidity on one side, and receiving a yield on the other. Because of the historically high returns that were available in 2008, it may be that yield considerations were given too much weight and that security was neglected.

  24.  We have identified some shortcomings in the way that deposit limits have been set. For example, some limits do not take account of the increased risk of default of lower rated institutions. Limits could be expected to be lower for lower rated institutions. Additionally, authorities have generally not considered the country risk, where there may be an adverse economic situation that affects more than one institution. This was highlighted by the collapse of the Icelandic banking system. But there are other countries where there is considerable exposure, with potential seriously to damage a council's financial position.

Conclusion

  25.  At this stage it is too early to draw any firm conclusions. However, treasury management has been a useful source of additional income for local authorities where, over the past year, interest receipts have exceeded budget forecasts. We have identified examples of strong treasury management in some organisations with informed decision making and high standards of governance, scrutiny and accountability. However, we have also identified some weaknesses in the way the treasury function operates in some bodies with insufficient use of information, poor governance and a failure to appreciate the risks in the decisions being taken.

  26.  Going forward, local public bodies will need to ensure that they are managing their cash deposits appropriately. This includes understanding their appetite for risk and an appropriate structure for managing their deposits in line with this risk appetite. Authorities need to ensure that they are either not taking any risk with their deposits by leaving them with the government's Debt Management Office (DMO) or that they have a relatively sophisticated and well-resourced treasury management function.

Reference

  Ref. 1: Crunch time? The impact of the economic downturn on local government finances. Audit Commission, 2008



Supplementary memorandum by the Audit Commission the role of auditors (LAI 37B)

Background

  The Audit Commission submitted a memorandum of evidence to the Select Committee in January and Steve Bundred, its Chief Executive, and Martin Evans, its Managing Director, Audit gave oral evidence to the Committee at its hearing on 9 February.

  We have subsequently been asked to produce a short note on the work of appointed auditors in relation to finance, as part of the regular Corporate Assessment of local authorities, to provide some context for what the Committee says in its report in relation to treasury management.

Summary

  1.  Public audit is an essential element in the process of accountability for public money. The Audit Commission's appointed auditors' provide independent assurance on whether public money has been properly safeguarded and accounted for, and how well it has been used in the delivery of services. They are an important safeguard where taxpayers' money is raised by compulsory levy and the normal commercial disciplines of the market do not apply.

  2.  The focus of auditors' work is a local authority's annual accounts and the financial management systems and processes that underpin them. Their work is therefore essentially retrospective.

  3.  It is a fundamental principle that public auditors should be independent of those who are responsible for the stewardship and use of public money. The Audit Commission's primary statutory function is to appoint auditors on behalf of the taxpayer and preserve their independence. This is essential if taxpayers, on whose behalf public auditors work, are to trust auditors' judgements and conclusions.

  4.  Auditors cannot comment or advise on an authority's treasury management strategy or policies, as they may subsequently have to review the effects of their implementation. Neither can they substitute their judgement on risk or second guess specific investment decisions by managers, as these are properly the responsibility of management.

  5.  Both appointed auditors, in planning the audit to meet their statutory and professional responsibilities, and the Commission, when mandating elements of the annual audit programme, are mindful of the need to adopt a proportionate approach and to target audit work on the areas where the risks that something might go wrong are highest. This risk based approach also serves to reduce the cost and burden of audit for audited bodies.

  6.  Following the development of the CIPFA Code of Practice on Treasury Management (the CIPFA Code) in light of the events surrounding the collapse of BCCI in the early 1990s, neither the Commission nor appointed auditors perceived treasury management to be a significant risk. Indeed the view was that this was generally a well managed function.

  7.  Few experts in investment were drawing attention to risks with Icelandic investments until the spring of 2008, and many not until the autumn. In carrying out their audits of the 2007-08 accounts, auditors would not have had cause to draw attention to potential risks relating to investments in Iceland, and neither the opportunity nor the powers to intervene. They can only intervene in extreme circumstances, primarily if they believe unlawful acts are imminent.

  8.  In giving their annual value for money conclusions and use of resources assessments, auditors reviewed the treasury management arrangements put in place by an authority. This involved the auditor satisfying him or herself that an authority had put in place arrangements to comply with the CIPFA Code. The CIPFA Code was considered the appropriate standard, as it not only represents generally accepted best practice in this area but is defined in regulations as a "proper practice" to which authorities should have regard. It is only the recent extraordinary events that have exposed its limitations.

  9.  They are, however, now in a strong position to assess, separately for every individual local authority, whether things have gone wrong and, if so, why. Combined with our national report on these issues, this will ensure that the appropriate lessons are learned by all authorities, whether they had investments in Iceland or not.

Introduction

  10.  Public audit is an essential element in the process of accountability for public money. The Audit Commission's appointed auditors' provide independent assurance on whether public money has been properly safeguarded and accounted for, and how well it has been used in the delivery of services. They are an important safeguard where taxpayers' money is raised by compulsory levy and the normal commercial disciplines of the market do not apply.

  11.  Auditors have two core responsibilities that touch on treasury management.

    a. Their primary responsibility is to give assurance (in the form of an opinion) that the financial statements of the authority present fairly (ie do not materially misstate) the financial performance and position of the authority.

    b. Reflecting the wider scope of audit in the public sector, auditors have a duty, as part of their audit of the accounts, to satisfy themselves that the audited body has put in place proper arrangements to secure economy, efficiency and effectiveness (ie value for money) in its use of resources.

  12.  In meeting these responsibilities, the focus of auditors' work is a local authority's annual accounts and the financial management systems and processes that underpin them. Their work is therefore essentially retrospective.

  13.  In the context of their value for money responsibilities, appointed auditors also consider the financial standing of local authorities as part of the annual use of resources assessment, which forms part of the Commission's Comprehensive Performance Assessment of local authorities (and from 2009 will form part of the new Comprehensive Area Assessment). Treasury management arrangements are considered in this context.

  14.  This supplementary note focuses on auditors' responsibilities in relation to value for money and their related use of resources assessments. However, for completeness, it briefly outlines the work auditors do in relation to local authority investments in giving their opinion on the financial statements.

  15.  First, however, it outlines considerations relating to auditors' independence and summarises the annual audit cycle, both of which impact on auditors' role in relation to local authority investments.

The Independence of Auditors

  16.  It is a fundamental principle that public auditors should be independent of those who are responsible for the stewardship and use of public money. The Audit Commission's primary statutory function is to appoint auditors on behalf of the taxpayer and preserve their independence. This is essential if taxpayers, on whose behalf public auditors work, are to trust auditors' judgements and conclusions.

  17.  The independence of the Commission's appointed auditors—whether District Auditors from the Commission's own staff or private sector accountancy firms—is enshrined in statute. They are legal entities in their own right with separate statutory duties and powers.

  18.  While the Commission can give guidance and advice to auditors and can mandate elements of their annual work programme, it cannot:

    a. interfere with an appointed auditor's exercise of his or her professional skill and judgement in performing his or her statutory functions;

    b. substitute its own judgements for those of an appointed auditor in the exercise of those functions; or

    c. direct an appointed auditor to act or to review his or her decisions, as only the courts have the powers to do so.

  19.  The Commission's Code of Audit Practice, which is approved by Parliament and with which auditors have a statutory duty to comply, requires appointed auditors to exercise their professional judgement and act independently of both the Commission and the audited body. It also requires them to comply with the Ethical Standards issued by the independent Auditing Practices Board (APB).

  20.  Ethical Standards (ES) contain basic principles and mandatory procedures to be followed, together with related guidance, on the integrity, objectivity and independence of auditors. They identify a number of potential threats to auditors' independence and integrity, including the self review and management threats.

  21.  To avoid these specific threats the Code of Audit Practice states "it is not part of auditors' functions to question the merits of the policies of the audited body, but auditors may examine the arrangements by which policy decisions are reached and consider the effects of the implementation of policy. … In making any recommendations, auditors should avoid any perception that they have any role in the decision-making arrangements of the audited body".

  22.  Therefore, appointed auditors cannot comment or advise on an authority's treasury management strategy or policies, as they may subsequently have to review the effects of their implementation. Neither can they substitute their judgement on risk or second guess specific investment decisions by managers, as these are properly the responsibility of management.

  23.  Auditors can only intervene in extreme circumstances, primarily if they believe unlawful acts are imminent.

The Audit Cycle

  24.  Initial planning for the audit of the 2007-08 accounts took place in spring 2007 and these initial plans were firmed up in the autumn. Work on the opinion audit began in earnest at the beginning of 2008, with the bulk of the work taking place in summer 2008 when draft accounts had been prepared and approved by the authority.

  25.  Both appointed auditors, in planning the audit to meet their statutory and professional responsibilities, and the Commission, when mandating elements of the annual audit programme, are mindful of the need to adopt a proportionate approach and to target audit work on the areas where the risks that something might go wrong are highest. This risk based approach also serves to reduce the cost and burden of audit for audited bodies.

  26.  Following the development of the CIPFA Code in light of the events surrounding the collapse of BCCI in the early 1990s, neither the Commission nor appointed auditors perceived treasury management to be a significant risk. Indeed the view was that this was generally a well managed function.

  27.  When auditors were planning their audits in 2007, they had no reason to consider treasury management to be a significant risk. Only a few experts in investment were drawing attention to the potential weakness of the Icelandic banks before the spring of 2008, and many not until the autumn.

  28.  When carrying out and reporting on their audits of the 2007-08 accounts, auditors would not have had cause to draw attention to potential risks relating to investments in Iceland. Whilst there were some warnings in the early summer 2008, this is not something auditors could reasonably be expected to have had regard to. Auditors do not monitor credit rating agencies' or treasury management advisers' bulletins nor, given the nature of their role, is there any reason for them to do so.

  29.  The vast majority of local authority audits for 2007-08 were completed (and the reports to those charged with governance summarising the key findings of the audit had been prepared and issued) before the collapse of the Icelandic banks. Of the bodies with Icelandic deposits, only nine audits were outstanding at 7 October 2008.

Value for Money Conclusion

  30.  It is one of the principles of public audit that the scope of the audit is wider than in the private sector and covers issues of probity and propriety and value for money.

  31.  The Commission's appointed auditors have a statutory responsibility, as part of their audit of the accounts, to satisfy themselves that an audited body has put in place proper arrangements to secure economy, efficiency and effectiveness (ie value for money) in its use of resources. Under the Code of Audit Practice they are required to give a positive conclusion as to the adequacy of those arrangements. In doing so, they must have regard to criteria specified by the Audit Commission.

  32.  These arrangements are defined by the Code of Audit Practice to include an audited body's arrangements for managing its financial and other resources, including arrangements to safeguard its financial standing.

  33.  The statutory focus of auditors' work in relation to the value for money conclusion is the arrangements put in place by an authority. In the case of treasury management, this involves the auditor satisfying him or herself that an authority had put in place arrangements to comply with the CIPFA Code.

  34.  The CIPFA Code was considered the appropriate standard, as it not only represents generally accepted best practice in this area but is defined in regulations as a "proper practice" to which authorities should have regard. It is only the recent extraordinary events that have exposed its limitations.

  35.  As such, auditors would not:

    a. review individual investment decisions;

    b. review the portfolio of investments;

    c. provide assurance on the operation of the authority's treasury management arrangements.

  36.  These are properly matters for an authority's management. An authority's treasury management system is part of its wider system of internal control. Regulation 4(2) of the Accounts and Audit Regulations 2003, as amended by the Accounts and Audit (Amendment) (England) Regulations 2006 requires authorities to "conduct a review at least once in a year of the effectiveness of its system of internal control" and to prepare a statement on internal control. This is a basic management function and is implicit in the CIPFA Code.

  Use of resources assessments

  37.  In the context of their value for money responsibilities, appointed auditors also consider the financial standing of local authorities as part of the annual use of resources assessment, which forms part of the Commission's Comprehensive Performance Assessment of local authorities (and from 2009 will form part of the new Comprehensive Area Assessment). Treasury management arrangements are considered in this context.

  38.  Auditors are required to review a wide range of corporate financial and performance management systems and processes, by applying a series of Key Lines of Enquiry (KLOE), and "score" their effectiveness against criteria specified by the Commission on a four-point scale:

    1: Below minimum requirements—inadequate performance.

    2: Only at minimum requirements—adequate performance.

    3: Consistently above minimum requirements—performing well.

    4: Well above minimum requirements—performing strongly.

  39.  KLOE 3.1 for the 2008 use of resources assessment considers how well "the council manages its spending within the available resources". The criteria for level 2 performance in this area required auditors to consider the authority's arrangements for keeping its treasury management strategy under review and monitoring performance against it, and for ensuring that the strategy reflects the requirements of the CIPFA Code.

  40.  For 2009, KLOE 1.1 asks auditors to consider whether the authority plans its finances effectively to deliver its strategic priorities and secure sound financial health.

  41.  The Commission has provided guidance to auditors on level 2 performance in treasury management as follows:

    "The council's treasury management ensures it has sufficient cash to meet its needs, balancing achieving VFM with the security of its investments (ie achieving a balance between liquidity, security, and yield). Performance is monitored against its treasury management strategy and outcomes match benchmarks set out in the strategy. The council meets any tax and prompt payment legislation (Late Payment of Commercial Debt (Interest) Act 1998). The council has 'had regard to' the Code of Practice for Treasury Management and the CIPFA Prudential Code, as per regulations issued under the Local Government Act 2003."

Audit of the Financial Statements

  42.  In carrying out their audit of the financial statements, auditors comply with the same professional auditing standards that apply in the private sector.

  43.  Auditors are concerned to satisfy themselves that:

    a. an authority does actually own the investments it is claiming to have in its balance sheet; and

    b. the assets have been appropriately valued in the accounts.

  44.  To get the assurance they need to be able to give an opinion on a set of financial statements, auditors will carry out third party verification tests—where the auditor writes to those listed as holders of an entity's investments asking that they confirm that they have these investments.

  45.  Normally, valuation of deposits with banks is not problematic. Clearly, however, in the light of the Icelandic banking crisis this will be an issue when auditors audit the 2008-09 financial statements. Where authorities have reliable evidence about any reduction in value, they will need to reduce (write down or impair) the value of the investment in the balance sheet and charge the amount of the write down to the income and expenditure account. Where they do not have reliable information, they will have to disclose in a note to the accounts that they may not recover the full amount when the investment falls due for redemption.

Actions taken since 7 October 2008

  46.  Once the news of the collapse of the Icelandic banks broke, the Commission immediately issued guidance to those auditors who had yet to complete their audits of the 2007-08 accounts on the implications for their opinion on the accounts.

  47.  We also asked all auditors to review their use of resources assessments in relation to financial standing and, in a number of cases, auditors chose to revise their assessments on the basis of the new evidence available to them.

  48.  We have also asked auditors to obtain more detailed information about authorities' treasury management arrangements to inform our study of treasury management in local government.

  49.  Auditors will also be monitoring the situation locally. Many of the authorities that have money at risk in the Icelandic banks have already commissioned independent reviews of their practice, which have made recommendations. Auditors will consider whether the authorities' responses are appropriate and whether they need to take any action themselves, for example in terms of public reporting.

  50.  We will also ask all auditors to follow up the findings from this study at the local level over the coming year, whether an authority had investments in Iceland or not, to ensure that the appropriate lessons are learned by all authorities. This work will inform auditors' work on their value for money conclusions and use of resources assessments for 2008-09, which will be issued in September 2009.

Conclusion

  51.  The Audit Commission's appointed auditors' provide independent assurance on whether public money has been properly safeguarded and accounted for, and how well it has been used in the delivery of services.

  52.  In order to maintain the independence, which is critical to their role, auditors cannot comment or advise on an authority's treasury management strategy or policies, as they may subsequently have to review the effects of their implementation. Neither can they substitute their judgement on risk or second guess specific investment decisions by managers, as these are properly the responsibility of management.

  53.  Historically, neither the Commission nor its appointed auditors perceived treasury management to be a significant risk. Indeed the view was that this was generally a well managed function. In giving their annual value for money conclusions and use of resources assessments, auditors reviewed the arrangements that an authority had put in place to comply with the CIPFA Code, which was considered the appropriate standard of best professional practice in this area.

  54.  Few experts in investment were drawing attention to risks with Icelandic investments until the spring of 2008, and many not until the autumn. In planning and carrying out their audits of the 2007-08 accounts, auditors would not have had cause to draw attention to potential risks relating to investments in Iceland, and had neither the opportunity nor the powers to intervene.

  55.  They are, however, now in a strong position to assess, separately for every individual local authority, whether things have gone wrong and, if so, why. They will follow up our national report on these issues to ensure that the appropriate lessons are learned by all authorities, whether they had investments in Iceland or not.



Memorandum by the Investment Management Association (IMA) (LAI 38)

Summary

    — The necessary framework is in place to guide the administration and investment of cash by local authorities.

    — Good governance could be improved by the employment of outside advisers and managers in all but the largest authorities.

    — There may some merit in amending the rules on limiting investment to say a maximum of 5% with any one entity and addressing the length of the term of investment.

    — Given the current economic climate any tightening of the rules to limit counterparty exposure might only enhance the liquidity problems in the money markets.

    — Pooled investment vehicles offer many advantages and are likely to be used increasingly.

Who we are

  1.  The IMA represents the asset management industry operating in the UK. Our members include independent fund managers, and the asset management subsidiaries of banks and life insurers, as well as managers of occupational pension schemes.

  2.  They are responsible for the management of over £3 trillion of assets, which are invested on behalf of clients globally. These include authorised investment funds, institutional funds (eg pensions and life funds), private client accounts and a wide range of pooled investment vehicles. We estimate over £200 billion of those assets are held for local authorities; predominantly as pension scheme assets. This evidence does not address pension scheme issues, but only cash management, or Treasury, operations.

  3.  Member firms, which are regulated by the FSA, manage significant sterling cash portfolios for clients, including within segregated cash portfolios for local authority clients. We would expect any firm to have a disciplined approach to managing such portfolios and undertake rigorous analysis of institutions and others who offer cash instruments for investment. This includes a consideration of rating agency opinions; though importantly credit ratings should not be used as a replacement for adequate credit risk management.

  4.  In this regard and given comments on the over-reliance of credit ratings below and elsewhere, the Committee may wish to note that we published in December 2008, with EFAMA and the ESF, Guidelines on the Over-reliance of credit ratings by asset managers. These are attached for ease of reference in case some of the principles might assist the Committee's considerations.

Present Arrangements

  5.  Whilst others will no doubt give similar evidence, as we are asked about the adequacy of the current framework we have set out a brief summary of how we see it.

  6.  We understand local authorities currently to manage their cash on a day-to-day basis. Like any organisation receiving and disbursing money, cash flows are uneven and, therefore, it would be prudent to invest such daily surpluses over periods of time related to the known cash requirements of the organisation. Furthermore, government restrictions on the use of capital receipts from, for instance the transfer of local authority housing stock to a housing association, generates funds that can be invested for a considerable period of time. It is, therefore, in the interest of the local council taxpayer to secure a market return in interest payments; though obviously this seeking after yield should not be at any cost. This was a lesson from a bank failure long pre-dating the current crisis.

  7.  Certain constraints had been placed on the investment of such cash by regulation following investment in BCCI, a bank offering exceptional short term returns, which failed. Those regulations limited the duration of investment and allow investment in certain instruments only without losing flexibility of future use of the cash when returned to the local authority eg certificates of deposit, short gilts and supranational bonds.

  8.  The advent of the regulations saw the birth of advisers to local authorities, now including Sector Treasury Services, Butlers, Arlingclose and Sterling International. These advisers help local authorities in the drawing up of an authority's Annual Investment Strategy, recommending on how to invest cash, reviewing the instruments in which to invest and as appropriate advising on the selection of professional managers who are typically given a mandate to manage the cash for a period of three years against an appropriate benchmark. A number of our larger members have significant cash management activities for local authorities.

  9.  The Chartered Institute of Public Finance and Accountancy (CIPFA) also created a panel to examine and recommend on best practice and publish a document (and regular updates) which makes recommendations on treasury management practice which is, by and large, followed by local authority treasury managers. This advocates prudent investment and advises local authorities to diversify their investments across a range of investments and institutions.

  10.  The production of the Annual Investment strategy has had the effect of focusing on what is done each year, looking to the future and helping local authority directors of finance form a view of potential income to support the rate and reduce the burden of the local council taxpayer. However, the perception is that this has not always led to the strengthening of an authority's treasury management team. Responsibility for such investments is frequently undertaken as part of a wider-ranging job. The advisers referred to above do however help to fill this gap in expertise.

Change and the Future

  11.  Given the regulations currently in place, sound advice on Treasury Management promulgated by CIPFA, input from several well-regarded investment advisers together with a number of well-established investment managers in the field, there is a robust framework already in place. The key is to make the structure work better.

  12.  We address (some themes overlap):

    — external assistance in identifying the right investments;

    — the ability to react to change; and

    — the risk of over-reaction.

External assistance

  13.  Local authorities produce annual investment strategies for their cash investments; merely to do so more frequently could be counter productive. The strategy reviews investments and cash flows and tries to predict income to support the rate. In normal times, this can be quite significant depending on the cash resources currently held by the authority. The income projections are often calculated with help from the advisers and based on predictions of professional cash managers if employed.

  14.  It has been suggested to us that less than half of the local authorities in the UK use advisers and significantly less than half use professional cash managers. It being said that this figure was much higher but lack of volatility in markets between 1997 and 2007 after the establishment of the MPC and early warning of Base Rate changes meant that many local authorities took managing their money back "in-house".

  15.  Our members' experiences are that many local authorities have a Treasury investment policy with a stated lending list, which for some has been quite complex, but has now become very conservative. Without the depth of resources, experience and expertise to use all available instruments, there is a fear that the policy has limitations driven as much by name recognition as by quality.

  16.  In our view, the primary aims for local Authorities' cash investments should be:

    — Preservation of capital.

    — Diversification of credit risk.

    — Liquidity.

  17.  Local Authorities' requirement for yield and investment income should always be secondary to the above aims. Whilst acknowledging that yield is an important consideration, the priority of Local Authorities' Treasury Management departments must always be the preservation of council tax payers and pension funds' capital. These aims are set out in CIPFA's Code.

  18.  The Icelandic bank failures have attracted much attention. Despite the sums that some local authorities invested in Iceland were large they were usually less than 10% of total cash funds invested by that authority in the market and it could be argued that that is not inconsistent with a reasonable diversification. Furthermore, criticism may not always fully reflect the fact that some of the funds had been invested for long periods eg three years with no recourse to recall, so it was difficult to do anything as the credit ratings of the Icelandic banks grew steadily worse. Nevertheless there remains an issue as to more recent investment despite warning signs. It was not unknown for Icelandic banks to have been excluded from lists by some professionals about two years ago.

  19.  Having noted the above qualifications, with over 100 Local Authorities suffering capital losses through investment in Icelandic banks, serious questions remain about the pressure felt by many authorities to achieve the greatest returns possible and the extent to which external advisers can assist internal treasury staff to balance that pressure.

  20.  A proposal for the future might be to limit the maximum amount of cash placed by a local authority with any entity to, say, 5% of the total available for investment, with the exception of cash placed for management by professional managers or upon external advice.

  21.  Aside from Icelandic banks still being on lists seen by firms last year, other comments have highlighted the prevalence of errors in identifying the ultimate ownership of banks. This is an issue not limited to local authorities; evidence given to the Treasury Select Committee on deposit protection has noted the difficulty of identifying even which banks are in the same group. Work could be done here to assist local authorities.

Reacting to change

  22.  The permitted investments are already controlled by regulation so freedom of action is already limited. It is the ability to react to changes in circumstance within these permitted investments that may need to be reviewed. For example, should investments be limited to a maximum of say 18 months; this might not eliminate all losses similar to those experienced in Iceland but it might have reduced.

  23.  In the absence of assistance from advisers, authorities may be slow to pick up news on counterparties/institutions, particularly downgrades. We are not in a position to identify the factors behind this and the extent of cost this may bring to authorities that do not use external consultants.

  24.  The framework for effective and efficient management of local authority cash is already in place. Despite the risk of it being seen as self-serving we do think it could be prudent for all authorities to consider the use of advisers such as Sector, Butlers et al and professional investment managers as a matter of course because they are experts and spend all their working time reviewing investments. Given the resources they deploy they are inevitably more able to react to adverse market events. Authorities will wish to consider having robust arrangements to consider conflicts of interests that arise from using fee-based advisers; recent guidance from the Pension Regulator on the use of external consultants and conflicts may provide useful pointers for local authorities. IMA strongly supported this more detailed and robust guidance; and we have issued case studies on conflicts to assist pension trustees.

The risk of over-reaction (and dealing with the Committee question about investment in Government stock)

  25.  Should limitation of access to receipt of interest cease, or be too severely limited, the effect on local authority budgets could be critical in balancing budgets. The current febrile state of the market will, at sometime in the future, return to a more predictable normality. Local authorities have already adapted and have reviewed where they are placing their money eg with DMO. Because of the banking crisis lending is being kept very short and risk minimised, but this action only exacerbates the current problem. There is at present a 1% yield pick up between one week and one year on the UK yield curve; lending very short means authorities cannot access this.

  26.  If local authorities were required to invest only with the government it would limit liquidity available to the banks in normal times and it would increase dependence on the government. We are not best placed to comment on the effect on council taxes, but poor or sub-optimal returns ultimately must have a negative impact for the council.

  27.  There is a risk that the losses from this crisis will push local authorities to lower/zero risk assets, which may allow them to confirm that the assets are safe, but is not necessarily in their best interests. Holding Government Stock is a sensible option for Local Authorities, and some currently invest in both gilts and treasury bills. Unfortunately the day to day price fluctuations in Gilts are not conducive to the valuation and reporting requirements of Local Authorities. Member firms consider that new skills would have to be learned to trade a gilts book. This reinforces the need for external assistance but also leads to a consideration of pooled vehicles below.

Central Government's Role

  28.  Central Government's role in providing financial advice and guidance is achieved through the Prudential Code for Capital Finance. We believe that this provides an appropriate financial framework for Local Authorities.

Protection of Investments

  29.  It should not be necessary for the Government to protect local authorities in the same way it protects individuals. Local Authorities are currently classified as "Professional Clients" under current FSA definitions. We believe that this is appropriate, and that they should not receive further protection from the Government. The framework is in place for local government to protect itself. To do otherwise would risk incentivising decisions not to seek external assistance.

Other Comments—Pooled Vehicles

  30.  Local authorities can now invest in Government Stock via pooled, unitised investment vehicles providing liquidity, appropriate yield and ease of administration whilst meeting their reporting and valuation requirements. It is our expectation that Local Authorities' use of such funds will grow over the coming year, in response to a tightening up of their treasury management practices to meet their primary capital preservation requirements, and we understand firms to have received much direct feedback to that effect.

  31.  Legislation was passed in 2002 to allow local authorities in England and Wales to invest in money market funds (SI 2002 No. 451 and 2002 No. 885). Similar legislation has not been passed in Scotland (although we did understand that it was on the agenda for 2008).

  32.  Whilst a matter for the Scottish office we think this legislation should be passed. Money market funds offer the benefit of diversification which is provided by a pooled investment (and is a key differentiator when compared with a deposit account), they provide professional cash management and independent credit analysis (eg our information is that no UK-managed MMF was invested in Icelandic banks). This should in theory be an ideal type of vehicle which local authorities should use for short-term cash management.

  33.  Consideration could be given to the establishment of longer term pooled funds which would give a better rate of return for local authority cash and which would minimise losses to individual authorities if an entity were to fail.

  34.  Member firm's experience in relation to corporates is that they are now much more likely to use pooled vehicles like money market funds (either variable or constant net asset value funds) than attempt to make these decisions themselves.

  35.  This range of products run along the risk/return spectrum offering the flexibility that Local Authorities may require, whilst offering realistic market yields. Some funds will offer higher yields in exchange for reduced liquidity and some will offer higher yields for increased credit risk.





 
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