Memorandum from Butlers (LAI 18)

 

Butlers have been consultants to local authorities on treasury management activity since 1991 and currently work with over 140 local authority clients. We provide advice on strategic treasury management activity, regulatory and procedural issues and information on investment counterparty credit worthiness which we purchase from three credit rating agencies.

 

1 Present arrangements for treasury management/effects on performance.

 

1.1 The treasury management framework provides a well regulated environment with a clear strategy and controls approved by Councils in advance.

 

1.2 It is too early to say whether the potential losses resulting from deposits in Icelandic banks will have any significant adverse effect on services and jobs. With risk avoidance replacing risk management, at least in the short term, there is now even more emphasis on security. If this is coupled with lower interest rates in the market, there will inevitably be a reduction in investment returns which could have an impact on services and jobs.

 

2 Are changes needed to the framework?

 

2.1 It is felt that the current framework is adequate to deal with the scale, spread and risk of local authority reserves. Changes to a predominantly sound system may inhibit the freedoms and flexibilities which local authorities need.

 

2.2 The present difficulties stem from world-wide turmoil, not an inefficient framework of risk management. We see little merit in placing further restrictions on the Annual Investment Strategies of local authorities.

 

2.3 The performance of local authorities could be improved if relations with the Debt Management Office were to change.

 

3 Gilt-Edged Investment

 

3.1 Investment in gilts does hold a number of advantages (low risk, high liquidity) that could be of benefit to councils, notably in times of financial dislocation.

 

3.2 Nevertheless, investment in gilts is not a risk free exercise and there are a number of disadvantages (capital losses, price volatility) that need to be taken into account.

 

3.3 Wholesale investment in gilts could have an impact upon small banks and building societies but in normal market conditions, the net impact upon the overall banking sector's ability to function efficiently should be small.

 

3.4 The lower net yield that would be earned from large-scale investment in gilts would impact upon revenue earnings. Any shortfall might have to be recouped via increases in tax rates, or a reduction in the scale of services provided.

 

4 Central Government Financial Advice

 

4.1 Central government should not provide financial advice - the advice should be provided by organisations that are experts within relevant fields.

 

4.2 Central government should provide guidance that allows local authorities to tailor their own strategy to their individual attitude to risk.

 

4.3 Local authorities themselves and market practitioners should have a say in how the investment guidance is set up.

 

5 Government Protection of Local Authority Investments

 

5.1 In order to provide complete protection to local authority deposits, the Investment Guidance would need to be so restrictive to protect the investment that there would be no potential for performance to support the Revenue Account.

 

5.2 Were guarantees to be given without restrictions, it may promote an unhealthy attitude to risk and investments by local authorities.

 

5.3 In the case of unforeseen widespread banking failure there needs to be appropriate Governmental support to maintain the market's status quo.

 

The Evidence

 

1 What are the present arrangements for local authorities' Treasury Management and how have these affected their performance, both as service providers and employers, given recent potential losses experienced by many local authorities?

 

Treasury Management Arrangements

 

1.1 We set out below a summary of the present arrangements for Treasury Management. We anticipate that others will provide a more detailed commentary.

 

1.2 The Chartered Institute of Public Finance and Accountancy (CIPFA) issued a Treasury Management Code of Practice and a Prudential Code for Capital Finance in Local Authorities. In 2004, the Office of the Deputy Prime Minister and the Welsh Assembly Government produced statutory guidance on local government investments. Guidance for Scotland is currently being drafted.

1.3 The Treasury Management Code requires approval by Council members of the treasury management strategy and the policy and practices adopted for implementation of that strategy. Detailed implementation within the agreed strategy and parameters is delegated to the Chief Financial Officer. Regular monitoring reports and an annual stewardship report are presented for Council member approval.

 

1.4 The Prudential Code provides a framework by which local authorities can demonstrate that capital investment plans are affordable, prudent and sustainable. This is achieved through the production of Prudential Indicators, some of which set parameters for controlling the length of investments and the mix between fixed and variable rate investments.

 

1.5 The Guidance on Local Government Investments requires local authorities to set an Annual Investment Strategy distinguishing between specified investments and non-specified investments. The Guidance also, in conjunction with the Prudential Code, determines the maximum period for which funds may be prudently committed. Specified investments are for up to one year and made with a body which has a high credit rating from one of the three designated credit rating agencies, and would include also local authorities, money market funds etc.

 

1.6 This Annual Investment Strategy also requires approval by the full Council at each local authority and is recommended to be incorporated in the wider Treasury Management Strategy Report required by the Treasury Management Code.

 

Nature of Reserves and Balances

1.7 A key duty on all local authorities (as part of the Treasury Management process) is the duty to ensure that the authority has sufficient reserves and balances to enable it not only to maintain its financial standing but also to ensure that it can realise its service provision expectations.

 

1.8 When reviewing their medium term financial plan (MTFP) Treasury Management Strategy and annual budgets, authorities should consider the establishment and maintenance of reserves. Reserves can be held for three main purposes:

 

1.8.1 A working balance to help cushion the impact of uneven cash flows and avoid unnecessary temporary borrowing - this forms part of the General Reserve;

 

1.8.2 A contingency to cushion the impact of unexpected events or emergencies -this also forms part of the General Reserve; and

 

1.8.3 A means of building up funds to meet known or predicted liabilities - this is often referred to as earmarked reserves.

 

1.9 The existing legislation requires authorities to have regard to the level of reserves needed for meeting estimated future expenditure when calculating the budget requirement. It is the responsibility of the Chief Financial Officer to advise the authority about the level of reserves it should hold and to ensure that there are clear protocols for their establishment and use. The protocols should set out:

 

1.9.1 The reason for /purpose of the reserve;

 

1.9.2 How and when the reserves can be used;

 

1.9.3 Procedures for the reserves' management and control; and

 

1.9.4 A process and timescale for review of the reserve to ensure continuing relevance and adequacy.

 

1.10 Although the Chartered Institute of Public Finance & Accountancy (CIPFA) and the Local Authority Accounting Panel in guidance issued in November 2008 states that the Institute "does not accept that a case for introducing a generally applicable minimum level of reserves can be made" it does confirm that "authorities, on the advice of their chief finance officers, should make their own judgements on such matters taking into account all relevant local circumstances".

 

Legislative and Regulatory Framework

 

1.11 Section 32 & 43 Local Government Finance Act 1992 require authorities to have regard to the level of their reserves to meet future expenditure when calculating the budget requirement.

 

1.12 In addition there are a number of safeguards to prevent authorities from over committing themselves, namely:

 

1.12.1 the balanced budget requirement;

 

1.12.2 S114 requirements under LGF Act 1988 (unlawful/unbalanced budget);

 

1.12.3 External auditor's responsibilities to ensure that authority's finances are soundly based; and

 

1.12.4 The Prudential system of capital control is built on the premise of the affordability, prudence and sustainability of the Council's capital plans to include the availability of resources to meet these plans.

 

Opportunity Cost of Holding Reserves

 

1.13 The authority in holding reserves will invest them pending application. Therefore in measuring any opportunity cost of holding these reserves account needs to be taken of investment income. The opportunity cost of holding these reserves therefore is a judgement as to whether the expenditure foregone is worth more than the income generated. This obviously is an objective as well as a subjective judgement and will require a decision based on a number of factors.

 

 

 

Effects on local authority performance

 

1.14 It is too early to say whether the potential losses resulting from deposits in Icelandic banks will have any significant adverse effect on services and jobs. There may obviously be adverse effects on services and jobs for any local authority which loses all or part of its deposits with Icelandic banks. In addition, there may be a more general effect on all local authorities caused by the increasing concentration on security of investments. Local authorities will continue to manage their investment portfolios in accordance with the following objectives (in descending order of priority): security, liquidity and yield. With risk avoidance replacing risk management, at least in the short term, there is now even more emphasis on security. If this is coupled with the reduction in the number of banks taking deposits and lower interest rates in the market, there will inevitably be a reduction in investment returns which could in future have an impact on services and jobs.

 

1.15 We wish to note that the effects, if any, on local authority services have been caused by extreme and sudden market events and not by the treasury management arrangements themselves. The changes introduced in 2004 had a positive effect on local authority treasury management. In particular, local authorities were given greater investment flexibility which was coupled with increased requirement, to report to Council members.

 

1.16 The current Investment Guidance, by discouraging investment in some negotiable securities (in particular corporate loan and debt instruments), has caused the emphasis in investment to be upon fixed-term instruments which are illiquid and increase vulnerability to counterparty failure.

 

1.17 For those with sums at risk the potential loss on the amount invested will need to be accounted for on the expectation of the likely return in the present financial year. However, the recent ministerial announcement to introduce regulations has delayed the ultimate revenue impact until 2010/11. Loss of interest will impact on the level of reserves and balances and reduce spending opportunities in the future. For some, there will be a need for a capitalisation direction from the government to allow the impact to be spread over a period of years; this would be essential if the potential loss is significant.

 

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

 

2.1 We have set out above in paragraphs 1.9-1.11 details of the framework relating to the management and scale of local authority reserves. The remainder of section 2 deals with the spread and risk of investment of those reserves.

 

2.2 We believe that the current framework for the management of the spread and risk of reserves is basically sound and does not require substantial amendment.

 

2.3 In relation to counterparty selection, the framework requires local authorities to invest in institutions with 'high credit ratings'. The information that the credit rating agencies gave on the risk of default on highly rated counterparties - based upon extensive historic data (see table below) - provided strong support for using ratings as the mainstay of lending decisions. What could not be factored-in was the near-collapse of the financial system and the rapidity with which this took place.

 

Source: Moody's

 

2.4 The cause of the potential losses now faced by some local authorities in relation to Icelandic investments is the sudden onset of the recent global financial turmoil. This was an extreme once in a century event that hit the world's financial markets in Mid-September following the collapse of US investment bank, Lehman Brothers. It should be noted that exposure was not an exclusively UK or local authority issue.

 

2.5 The present arrangements are basically robust and the failure is not in the framework, but in the speed of the deterioration of the financial crisis (which led to the Icelandic banks rapidly losing liquidity), and resulted in sudden revisions to credit ratings by the rating agencies.

 

2.6 We would be concerned by any change to the framework which eroded the responsibility of local authorities to set their own investment criteria. One of the strengths of the new prudential system introduced in 2004, with the advent of the Prudential Code and the implementation of the Local Government Act 2003, was the concept of self-regulation.

 

2.7 The precise investment criteria used by any given local authority is and should be a matter for local decision. Different authorities with differing levels of investments and cash flow have different investment requirements.

 

2.8 Different authorities will need specific investment criteria to cater for their particular requirements. Not all investment strategies will be similar. Some local authorities developed investment strategies which included Icelandic banks, others excluded them. Some investments with Icelandic banks matured prior to the collapse, others were still outstanding. At the point of investment, sometimes 1 to 3 years earlier, the banks had a high credit rating, covering both short, long, and individual and support ratings. Earlier action by the rating agencies would have reduced the national exposure, but would not have eliminated it, as deposits were contracted for a fixed period.

 

2.9 It is felt that the current framework is adequate to deal with the spread and risk of local authority reserves. Changes to a predominantly sound system may inhibit the freedoms and flexibilities which local authorities need. The present difficulties stem from world-wide turmoil, not an inefficient system of risk management. We see little merit in placing further restrictions on the Annual Investment Strategies of local authorities.

 

2.10 The performance of local authorities could be improved if relations with the Debt Management Office were to change. A change to the debt management arrangements by the Public Works Loans Board in November 2007 made it more difficult for local authorities to repay debt early; the penalty for early repayment was increased. This left local authorities with more money to invest, and to compound their problem the Debt Management Office is now offering comparatively poor returns on monies local authorities wish to place with them; the ultimate in secure investments. We suggest the interest arrangements with regard to the premature repayment of PWLB debt are reviewed with the aim of removing the disincentive to repay debt.

 

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

 

3.1 The gilt-edged market is a highly specialised area of investment management that is not devoid of risk. Successful management of a gilt portfolio requires an intimate knowledge of the individual stocks outstanding and a thorough understanding of the mathematical intricacies of bond behaviour. This latter consideration is particularly relevant in the case of the sensitivity of the price of individual issues and different areas of the yield curve to changes in the level of interest rates (the concept of modified duration).

 

3.2 Local authorities can currently invest in gilt-edged stocks either directly or through the employment of an external fund manager.

 

3.3 Investment in gilts does hold a number of advantages that could be of benefit to councils, notably in times of financial dislocation:

 

3.3.1 Low risk - as obligations of the UK central government, gilts offer very high investment counterparty certainty. Their AAA sovereign rating represents the lowest level of risk assigned to market instruments by credit rating agencies.

 

3.3.2 High liquidity - the gilt-edged market comprises a wide selection of marketable securities issued by Her Majesty's Government. It has remained a very liquid area of investment, although it did experience disruption at the height of the "credit crunch". The main stocks traded in the market place (benchmark issues) are highly capitalised (typically in excess of £10 billion) and the system operated under the jurisdiction of the Debt Management Office ensures marketability in the vast majority of circumstances. Buying and selling stock tends to be trouble free.

 

3.3.3 Income certainty - interest on gilt holdings accrues on a daily basis and is paid to holders at six-monthly intervals. This is an obligation of the UK Government which has never been in default.

 

3.3.4 Wide choice - the different maturity dates of individual stocks, coupon structures and interest payment dates means there are investments to meet most investors' requirements. In addition, the wide selection of index-linked stocks in issue offers inflation protection, if required.

 

3.4 Nevertheless, investment in gilts is not a risk free exercise and there are a number of disadvantages that need to be taken into account.

 

3.4.1 Capital risk - gilts do offer counterparty certainty but this does not mean that investors are protected from risks of capital loss. As marketable securities, the prices of gilts will rise and fall in response to changing interest rate levels. The value of a portfolio of gilts will fall when interest rates rise, an event that will reduce the overall level of returns on a council's investment portfolio.

 

3.4.2 In addition to this, the price structure currently prevailing in the gilt market (a result of the generally low level of interest rates) means that the price of a majority of issues that would be of interest to councils are above their redemption value. Consequently, stocks that are purchased with the intention of being held until redemption will experience a capital loss over their remaining life.

 

3.4.3 Price volatility - as marketable securities the value of gilt-edged stocks will be influenced by the movement in interest rates and expectations about the future prospects for rates. Prices can be very volatile - this was particularly evident in the period following the collapse of US bank Lehman Brothers (in mid-September) and the resulting surge in market uncertainties. Overall values can vary widely over short and long periods and this could raise valuation and accounting issues for councils.

 

3.4.4 Additional costs - gilt-edged securities are held in custody accounts. This service used to be provided by the Bank of England for a small nominal charge but was terminated a number of years ago. Fees charged for custody services by specialist custodians can cost investors as much as £20,000 per annum, a sum that will reduce yet further the net return from this source of investment.

 

3.5 The effect of council investment upon banks - local authority lending to the banking sector represents a comparatively small source of total funds for the latter. But it is a more important source of finance for building societies. Wholesale investment in gilts could have an impact upon the liquidity of this particular market sector. However, given the fact that in normal, less uncertain market conditions, council investment in gilts would be discouraged by the lower yield available relative to money market deposits, the net impact upon the overall banking sector's ability to function efficiently should be small.

 

3.6 The effect upon Council Tax - the lower net yield that would be earned from large-scale investment in gilts compared with market deposits with banks and building societies or via holdings of alternative negotiable instruments would impact upon revenue earnings. Any shortfall might potentially have to be recouped via increases in tax rates, or a reduction in the scale of services provided.

 

4 What is the role of central government in providing financial advice and guidance to local authorities?

 

4.1 The role of central government is to set out the parameters within which local authorities should operate. Government has fulfilled this role by providing the Investment Guidance.

 

4.2 The Investment Guidance in its current format provides a comprehensive and flexible approach to management of surplus funds.

 

4.3 It is the role of the local authority to determine its attitude and approach to managing risk, within the parameters contained within the Investment Guidance. This can be achieved by seeking advice from relevant experts if the local authority deems this necessary.

 

4.4 Financial advice should be provided by those organisations that are experts in the relevant fields, for example provision of credit ratings. This is not a role that central government should adopt.

 

4.5 Central government does have a role in assisting local authorities, but this should be confined to general assistance rather than specific financial advice.

 

4.6 Should any other bodies have a role?

 

4.6.1 Local authorities themselves should have a say in how the investment guidance is set up - this can be (and normally is) achieved through consultation on draft guidance.

 

4.6.2 When consulting on changes to the Investment Guidance central government should seek the views of experts and practitioners (e.g. fund managers) in the field of investment management. This would ensure that the changes being proposed are workable in practice.

 

4.6.3 In addition to seeking the views of experts / practitioners, other bodies should also be involved in the consultation process, such as:

 

4.6.3.1 CIPFA;

 

4.6.3.2 Audit bodies such as the Audit Commission and appointed private sector auditors;

 

4.6.3.3 LGA; and

 

4.6.3.4 Local government consultants - e.g. Butlers.

 

 

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

 

5.1 In order to provide complete protection for local authority deposits, the Investment Guidance would need to be so restrictive that there would be no potential for performance to support the Revenue Account.  Clearly security is paramount but the freedoms embodied in the Prudential Code do allow some latitude to meet service objectives.

 

5.2 Were guarantees to be given without restrictions, it may promote an unhealthy attitude to risk and investments by local authorities. There would be no effective deterrent against unnecessary risks being taken. By guaranteeing investment security does this perversely increase risks in the types of instruments which would be used? Whilst most would maintain a sensible approach, there may be those that would push the guarantee to its limit.

 

5.3 The two points are not mutually exclusive - protection could only come with highly restrictive controls.

 

5.4 There is also an assumption implicit in the NIPS Code that local authorities are sufficiently knowledgeable to deal in the markets.  Therefore, in the event of error or careless practice on a single local authority's account this should be the local authority's responsibility.  However in the case of unforeseen widespread banking failure, or an unforeseen breakdown of market information, there needs to be appropriate Governmental support to maintain the market's status quo.

 

5.5 There is a need to allow sufficient flexibility in the local authority investment decisions to relate to each local authority's individual circumstances.  

 

 

December 2008