Memorandum by Sterling Consultancy Services
(LAI 42)
Summary
— The current framework for local government
investments, based on credit ratings, is basically sound, but
there is scope for some improvement.
— Local authorities have substantial investment
balances, and prudent diversification of these investments across
highly credit rated banks has led to many authorities having a
small percentage of their portfolio at risk of default in Iceland.
— It can be argued that the recent high
market interest rates have already compensated many authorities
for their potential losses in Icelandic banks.
— A smaller number of local authorities
did not diversify their investments as widely, and have a relatively
larger proportion at risk.
— There is a clear need for better training
of elected members, finance officers and auditors in the field
of treasury risk management.
Current Framework for Local Authority Investments
1. The current framework stems from the
Local Government Act 2003 and associated secondary legislation.
The former Office of the Deputy Prime Minister (ODPM) and the
Welsh Assembly Government issued statutory guidance in 2004 covering
England and Wales only, introducing the concepts of specified
(lower risk) and non-specified (higher risk) investments, and
the Annual Investment Strategy.
2. The Chartered Institute of Public Finance
and Accountancy (CIPFA) has published codes of practice on "Treasury
Management in the Public Services" and "The Prudential
Code for Capital Finance in Local Authorities". Secondary
legislation requires local authorities to have regard to these
codes of practice.
3. Both the Government guidance and the
CIPFA codes of practice emphasise that local authorities should
look to the security and liquidity of their investments before
seeking the highest rate of return. However, in the words of the
ODPM Guidance, "it will be appropriate to seek the highest
rate of return consistent with the proper levels of security and
liquidity".
4. In the current climate of low grant settlements,
efficiency savings and capping, the recent benign interest rate
environment has led to treasury management being a welcome source
of additional income that has alleviated spending pressures elsewhere
in some local authorities.
5. The requirement for local authorities
to produce an Annual Investment Strategy, approved by the full
Council, is an important part of the framework for local government
investments in England and Wales. This clearly places the responsibility
on each Council's elected members to approve the parameters under
which officers can invest the Council's surplus cash.
6. However, the Annual Investment Strategy
is only one of a growing number of financial matters to be approved
by the Council before the start of each financial year, and it
is often relegated to an appendix of the report which sets the
budget and Council Tax for the coming year. Elected members are
naturally more interested in budget allocations and Council Tax,
arguably leading to a rather more limited scrutiny of matters
such as the Annual Investment Strategy. This area is clearly likely
to receive additional attention and debate this year, and a number
of Councils have now promoted the Annual Investment Strategy to
a report of its own.
Credit Ratings
7. The Annual Investment Strategy requires
local authorities to take account of the credit ratings issued
by at least one of three named rating agencies. It is not unique
in this respect; for example, the Bank for International Settlements
has based the Basel II capital adequacy regime on these credit
ratings.
8. The credit rating agencies have access
to information that is not in the public domain, including information
restricted under stock market listing requirements. They should
therefore be among the best placed to give an informed opinion
on the creditworthiness of the bodies they rate.
9. One credit rating agency awarded the
three Icelandic banks its highest "Aaa" long-term rating
in February 2007, placing them on a par with the UK Government.
A number of local authorities placed a degree of reliance on this
opinion and made fixed-term deposits for several years at this
time, and these deposits form part of the amount currently invested
in Iceland.
10. The same agency also retained one Icelandic
bank on its highest short-term credit rating until 8 October
2008, several days after the Icelandic government took control
of the country's banks.
11. There are valid questions to be asked
of the three agencies about the accuracy of the credit ratings,
and about the timeliness of rating changes.
Why Local Authorities make Investments
12. Local Authorities tend to have extensive
cash balances, which they invest to reduce the risk of holding
it all in one bank current account, and to earn interest income.
There are four main components to local authority cash balances:
13. Reserves—including amounts required
to be set aside by statute, such as unspent schools' balances
(which can only be spent on schools) and receipts from the sale
of capital assets (which can only be spent on new capital assets);
amounts voluntarily put aside for a specific purposes such as
planned future expenditure or self insurance; and general reserves
to cover unexpected expenditure.
14. Income received in advance of expenditure.
There is typically a substantial time lag between the receipt
of income and the payment of expenditure in a local authority,
leading to a positive working cash flow. For example, substantially
all of an authority's Council Tax for a financial year will be
received by the first week in January, but employees will not
be fully paid until the end of March, and invoices for some of
the goods and services bought during the year will be paid as
late as the summer months.
15. Amounts borrowed in advance of need.
CIPFA's Prudential Code explicitly allows local authorities to
borrow for planned capital expenditure in the current and next
two financial years, and many councils have taken advantage of
low long-term rates to borrow several years in advance. This cash
is then invested until spent.
16. Sums invested on behalf of others. It
is common practice for local authority pension funds, police and
fire authorities and local charities to deposit cash with the
local authority, either for ease of administration, or to earn
interest at higher rates than they would be able to achieve themselves.
Why Local Authorities have both Investments and Borrowing
17. Nearly every upper tier local authority
holds substantial portfolios of both debt and investments, resulting
in an increased exposure to both the risk of default and movements
in interest rates.
18. This is one consequence of the local
government finance regime, requiring capital and revenue budgets
to be kept separately. Local authority capital accounts are generally
cash poor, funded by long-term borrowing, while revenue accounts
tend to be cash rich, for the reasons mentioned above.
19. There is a collective memory of the
double digit interest rates of the 1980s, which tends to suggest
that today's long-term borrowing rates of around 4.5% are historically
low. This encourages authorities to borrow long-term at fixed
rates.
20. The Public Works Loan Board (PWLB) allows
local authorities to borrow long-term at interest rates close
to the cost of government borrowing, while the London money market
gives authorities the option to lend short-term at market rates,
which are often higher. At the start of the credit crunch, local
authorities were able to borrow at around 4.5% and invest above
7%, generating a substantial amount of additional income. This
places local authorities in an opposite, but mutually advantageous
position to banks which tend to lend long-term but borrow short-term
on the market.
21. Most local authorities in this position
are happy to accept the additional risks in return for the additional
income, although a few do not fully understand the risks involved,
or believe they must borrow externally if capital expenditure
is not otherwise financed, even if they have substantial cash
balances.
22. In November 2007, the PWLB changed the
arrangements for repaying long-term borrowing to the Board. Loans
are now discounted at an interest rate below the gilt yield, which
has made repayments more expensive and hence deterred local authorities
from reducing their debt portfolios.
Why Local Authorities Invested in Iceland
23. The 2004 ODPM guidance allows authorities
to invest in banks with "high" credit ratings, with
"minimal procedural formalities", although it is for
each authority to define what constitutes a "high" credit
rating.
24. According to the criteria adopted by
many local authorities, the three Icelandic banks held high credit
ratings until May 2008, and one held a high rating until the end
of September 2008.
25. The Icelandic banks were among a relatively
small number of banks willing to accept deposits of the same size
that local authorities wish to make, often between £1 and
£5 million. Many highly rated banks only accept deposits
exceeding £25 million, which is too large for most local
authorities. Most UK building societies, by contrast, accept £1 million
as a deposit.
26. However, a number of local authorities
had been advised to be wary of lending to building societies,
especially those without credit ratings. This was despite the
provisions of the Building Societies Act 1986, as amended, which
currently gives wholesale depositors, including local authorities,
priority in the event of liquidation. This advice increased the
amount of cash being lent to the small number of banks in the
market for £1 million plus deposits, including the Icelandic
banks.
27. The Icelandic banks paid high, but not
exceptional, rates of interest on deposits. Local authorities
typically lend their cash to whichever approved counterparty is
paying the highest rate of interest, subject to an internal limit
per counterparty. The guidance from both ODPM and CIPFA make it
clear that it is sensible to seek the highest rate of return,
once security and liquidity concerns have been met.
Why the Investments are not being Repaid
28. The majority of local authority investments
are fixed-term, fixed-rate deposits with banks and building societies.
The fixed term of these investments typically varies between one
day and five years, although there is no statutory maximum in
the current framework. The fixed nature of the investment gives
the local authority certainty of the level of investment income
that will be received, and provides protection against the risk
of falling interest rates.
29. However, the downside of making a fixed
long-term investment is that the local authority cannot demand
repayment before the contractual maturity date, although it may
be possible to negotiate early repayment. Our experience indicates
that requests from local authorities for early repayment from
Icelandic banks in the summer of 2008 were refused.
30. In early October 2008, following well
publicised concerns over the banks' funding positions, the Icelandic
government took control of the country's banks and gave them temporary
protection from the payment of debts as they became due. Since
that time, no maturing investments have been repaid to UK local
authorities.
31. There is around £1 billion
of local authority cash tied up in Icelandic banks, representing
approximately 3% of all local authority investments. It is interesting
to note that since market interest rates have been substantially
higher than yields on low-risk government bonds for the past two
years, local authorities will, in aggregate, have received in
the region of £1 billion additional investment income
over this period by investing on the money market.
32. It can therefore be argued that individual
local authorities who have 3% or less of their total investments
tied up in Icelandic banks have not lost out financially from
the episode, even if the eventual amounts recovered are low. It
follows that those authorities who have a substantially greater
proportion invested in Iceland (and in some cases this is more
than 10%) have lost out. This is as a direct result of the failure
to diversify their investment portfolios adequately.
Knowledge of Officers and Members
33. Although many finance staff in local
authorities are qualified accountants, investment management is
not a core part of accountancy training, and few accountants will
be fully conversant with the details of treasury risk management.
34. In certain authorities, daily investment
decisions can be seen as routine and are left to be made by junior
staff. More senior officers may "authorise" the investment,
but in many cases this will be a case of rubber-stamping after
the deal has been struck.
35. In addition, some authorities have a
poor framework for turning the high-level strategy approved by
Council in the Annual Investment Strategy into a coherent daily
decision making process. Indeed, a small number of dealing staff
are unaware of the contents of their council's Annual Investment
Strategy.
36. Elected members and internal and external
auditors also lack specialist knowledge of investment management,
resulting in poor scrutiny of decision making and of compliance
with the approved strategy, statutory guidance and codes of practice.
The Role of Treasury Consultants
37. There is some confusion in the media
about the role of local authorities' treasury consultants. Their
role includes:
a. helping authorities to meet their obligations
under the legislation and codes of practice, including the production
of an Annual Investment Strategy,
b. keeping authorities up to date with changes
to relevant public credit ratings,
c. explaining how the Bank of England, PWLB and
money market work,
d. providing information on the pros and cons
of various investment and borrowing options,
e. assisting with the use of risk management
techniques,
f. helping authorities to account for investment
and borrowing decisions, and
g. training officers and members on the above.
38. Consultants do not:
a. pass on unfounded rumours about market participants,
which would be in contravention of the Financial Services and
Markets Act 2000, or
b. tell authorities which investments they should
or should not make.
39. Local authorities that do wish to outsource
their investment decision making process employ the services of
a cash fund manager in addition to those of a treasury consultant.
40. A small number of authorities do not
pay for any external assistance, and rely on information being
passed to them by brokers. They should understand that the broker's
only role is to execute the trade, and not to give advice on the
suitability or otherwise of the investment.
Going Forward
41. There is clearly a need for better risk
management training of treasury officers, chief financial officers,
internal and external auditors, and elected members. The plans
by CIPFA and the Association of Corporate Treasurers to produce
a professional qualification in local authority treasury management
are a positive step forward. Treasury consultants also have their
part to play in this field.
42. The regulatory framework is basically
sound, although there are some elements of good practice that
local authorities should be required to include in the Annual
Investment Strategy:
a. a maximum amount to be invested with any one
counterparty, and
b. a maximum amount to be invested in any one
foreign country.
43. The wording of the former ODPM and Welsh
guidance implies that an investment remains in the specified or
non-specified category appropriate at the time the investment
was made, despite any later changes. So a long-term investment
will be reported as non-specified (higher risk) even when it is
due to mature shortly, and a highly rated short-term investment
which is subsequently downgraded remains specified (lower risk).
Many Icelandic deposits therefore remain classified as specified
investments in authorities' monitoring reports. The wording of
the guidance could be changed, requiring investments to be moved
between the categories as their position changes, enabling better
monitoring of the portfolio's risk position.
44. There are a couple of investment types
that are currently classed as capital expenditure to deter their
use by local authorities, but could sensibly be used for risk
management purposes. The restriction should arguably be removed
for:
a. corporate bonds issued as part of the Government's
Credit Guarantee Scheme, and
b. collective investment schemes, such as money
market funds, which are still classed as capital expenditure in
Wales, despite restrictions having been lifted in England in 2002.
45. The PWLB should remove the disincentive
for local authorities to repay long-term debt, by discounting
loans at the gilt yield, rather than at a margin below it.
46. There is no clear legislative position
on the use of derivatives by local authorities, and the current
regulatory framework is silent on the issue. The 1991 judgement
against the London Borough of Hammersmith & Fulham, under
the previous regulatory regime, has deterred local authorities
from using two types of derivative that could form part of prudent
treasury risk management, and the government should consider issuing
guidance on their use:
a. interest rate swaps, to protect against movements
in interest rates, and
b. credit default swaps, as insurance against
counterparty default.
47. Gilts should remain available for local
authority investments as part of a balanced risk management strategy,
but they should not be prescribed as the only option. Gilts are
not suitable in all cases due to the risk of capital losses if
interest rates rise, the additional cost of custody, and the limited
maturity date structure.
48. A blanket government guarantee for local
authority investments would not be appropriate, as this would
remove the onus from individual local authorities to manage their
risk position. However, with the Icelandic bank failures, the
government noted that this was an exceptional event and reimbursed
retail investors in full, despite the Financial Services Compensation
Scheme only applying to the first £50,000 per person.
The government might consider doing the same for local authorities
as a one-off measure in this instance, to prevent the cost falling
on the Council Tax payer.
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