Memorandum from Reading Council (LAI 17)

 

In connection with your Committee's enquiry I submit some comments in response to each of the questions raised, together with some wider comments, as the questions raised seemed to be mainly about the investment side of treasury management (TM), but an understanding of the borrowing side is important, as TM has to be looked at as a whole.

 

Reading BC did not have investments with Icelandic banks, nor have we ever had such investments, and indeed those banks have not appeared on our list as eligible counterparties, and it is from this perspective that I submit comments.

What are the present arrangements for local authorities' Treasury Management - and in particular the requirement to produce Annual Investment Strategies - and how have these affected the performance of local authorities, both as service providers and employers, given recent potential losses experienced by many local authorities?

1. The present arrangements have become fairly well established and at a strategic level involve approving a Treasury Management Strategy Statement (TMSS) and Annual Investment Strategy (AIS) before the start of each year, and reporting the outturn in a Treasury Outturn Report (TOR). Like many authorities we fulfil the first of these requirements by including the TMSS & AIS as part of the Council's budget package, and the TOR is reported to Council in parallel with the final accounts. The relevant documents are available on our website for public inspection (by following budget or statement of accounts links at http://www.reading.gov.uk/councilanddemocracy/councilfinances/ ).

2. In practice, in Reading, as in many authorities, these documents are prepared based on templates provided by our treasury advisor. Anyone looking at a large number of statements would find some similarity of style according to advisor. This carries some risks that authorities don't sufficiently "personalise" the template and own their strategy, placing too much reliance on the advisor. We have always taken the view that whilst it is the role of advisors to guide and help, ultimately the authority must control and own the process. Ultimately treasury activity is carried out by a small team within the finance function with the staff handling day to day transactions having clear guidance on what can be done on a day to day basis. More senior officers in the team take responsibility for long term borrowing decisions (mainly from the Public Works Loans Board (PWLB)), and medium term (1 month-3/5 year lending).

3. In recent years treasury management has made a positive contribution to many authorities financial position; it had until about a year ago been possible to restructure debt on favourable terms with the PWLB, and it has been recognised that since the advent of the Prudential System it is acceptable to borrow ahead of need, if interest rates appear advantageous. In this context in recent years with an inverse yield curve it has been possible to borrow long term at attractive interest rates, lending out the money until it is needed usually at a higher rate. We, like most unitary authorities had a substantial underspend on our treasury budget in 2007/08, and indeed an underspend is forecast in the current year. We would suggest active treasury management has contributed positively to local authorities financial position, and indirectly to improved service delivery.

In the light of recent events, are any changes needed to the framework for the scale, spread and risk of local government reserves?

4. Our view is that whilst the broad structure of the guidance does the correct things, recent events have emphasised the need to consider the risks, both financial and reputational of treasury activity. Historically, in the pre prudential controlled system we had modest sums to invest and could usually place them with a range of high street banks and building societies. Money was often needed within a relatively short period, so investments were short term. More recently when we began to have larger sums to invest (in some cases borrowed to help fund the Council's ambitious capital programme), initially we were placing larger sums with the same small group of banks, usually revising our lending limits upwards to do so. In discussion with our advisor and broker we developed a more substantial lending list, based on credit ratings, but not using them as the only criteria. We included some higher rated foreign banks, though with lower limits than equivalent rated UK banks, and a greater range of building societies (top 10, rather than top 2/3). During 2007, in March we arranged a loan with the Northern Rock for 1 year from September 2007. Whilst one of the lower rated institutions on our list, part of our judgment for including them was that as a significant "high street" institution it was unlikely the government and banking community as a whole would allow total failure. The subsequent difficulties faced by Northern Rock were a salutary lesson, and caused us to review, tighten and affirm a more strict adherence to our lending list. We suggest that all authorities should have re-evaluated risk in the autumn of 2007, given CIPFA guidance that capital preservation should be seen more significantly than pursuing enhanced returns.

5. Inasmuch as so many authorities have had investments in Icelandic Banks, clearly a wide range of authorities, and indeed the Audit Commission, have come to a different risk judgment to ourselves. Clearly market have undergone substantial stress in 2008 with the government now having to support a range of UK financial institutions. At the current time these are the only non public sector organisations we are placing money with (other than our own bank (Co-Operative)).

Should local authority money be invested in Government stock, with lower risk, but with a low return?  What effect would this have on UK banks and on council taxes?

6. We do not take the view that the purchase of Government Stock should be the only investment permitted for local authorities. Such investments are not really suitable for "cash flow" investments (i.e. the largest amounts of money come into the authority on 1^st (local tax) 15^th (DWP HB grant) but expenditure occurs daily, with the largest regular item being salaries, towards the end of the month; authorities that have covered their long term borrowing requirements need to make short term investments between the two. As a general principle AAA money market funds and call accounts with reputable banks provide the most suitable investment vehicle for this purpose, in normal times.

7. It does however appear to us that some authorities may have relied excessively on credit ratings or their advisors interpretation of them and given insufficient thought to the possibility and consequences of investments in foreign banks being unlikely to get the same sort of support in severely stressed times, and in particular to the risks associated with the banks in a relatively small island economy.

What is the role of central government in providing financial advice and guidance to local authorities?  Should any other bodies have a role?

8. It is the role of central government through legislation, and high level guidance to set the broad framework within which authorities operate. That framework specifically, and appropriately recognises guidance issued by CIPFA. Central government should not have a role in advising authorities should or should not invest with particular institutions, save the strategic level one, and the basic advice that lending should be done with capital preservation as the key objective.

Should the Government protect local authorities' investments in the same way that it is protecting personal assets?  What consequence does this have for the relationship between local and central government?

9. Local authorities are generally regarded as professional counterparties in the market place, and employ professionally trained and qualified staff in senior finance roles, and in most cases purchase professional advice about their treasury activities from professionally qualified advisors with substantial market experience. The position of authorities is very different from that of individuals, and therefore an unconditional government guarantee of LA investments would not be appropriate.

 

10. Having said this it should be recognised that local authorities are removed from the London centred market and have to rely on advisors and brokers to keep them up to date of market developments. Recent years have seen the emergence of lending products from banks, often at interest rates below those offered by PWLB, in some cases with a low starting interest rate (LOBO loans). Some authorities have made significant use of these LOBO products, though it does not seem to have been recognised that the lenders option would be most likely to be exercised at a time when borrowing rates were disadvantageous. In the light of events there is a need for guidance to re-emphasise the need for risk management in relation to treasury activity.

 

11. In addition, as indicated above the government (DMO) run PWLB substantially worsened its lending terms about a year ago. Until the November 1, 2007 changes the PWLB had permitted the repayment of most loans, with any discount or premium calculated at the present interest rate for a loan of the remaining period of the loan being repaid. At that time a set of repayment rates 25-46bps less were introduced for repayments, although at some points on the yield curve the rate at which authorities could borrow was marginally improved. For authorities that had borrowed ahead, and in the changed economic circumstances now faced, one response would be to prematurely repay some of the borrowing, to reduce treasury risk. The action of the PWLB last year has (until very recently) made this almost unaffordable, and in some ways has increased treasury risk faced by authorities. Whilst we understand (having visited them) that the PWLB no longer wished to be considered the sole or main lender to local government, and we can accept the need for some margin between borrowing and repayment rates we think those introduced by the PWLB were excessive, and a 10-20bps margin would have been equally as effective in normal times. Assuming the committee intends to consider local authority treasury management as a whole, we think there is a case for an exploration of this issue in its work.

 

We would be happy to clarify, or provide more detail about any of the issues raised in this letter if it would assist the committee in its deliberations.

 

December 2008