Memorandum from CIPFA Scottish Directors of Finance Section and CIPFA Scottish Treasury Management Forum (LAI 22)

 

1.0 Summary

 

1.1 It is considered that:

 

· Recent events in relation to major financial institutions across Europe and the US are unprecedented;

· While there are lessons to be learned, and it has to be recognised that treasury management activity always carries an element of risk, the current approach to spreading risk has worked reasonably well to mitigate the effects of recent events;

· Investing in Government Stock is an important tool for local authorities but should not be the only one;

· The Government should not regulate to define which individual investments local authorities may or may not invest in; and

· There are specific circumstances where it might be appropriate to offer a Government Guarantee for local authority deposits.

 

2.0 Background to the Submission

 

2.1 The issues covered by the Inquiry are wholly devolved matters and as such the Inquiry's remit does not extend to Scottish local authorities. However, it was considered that some observations on Scottish local authority investment would be helpful to the Committee's background understanding.

 

2.2 The CIPFA Scottish Directors of Finance Section is a forum for local authorities' Finance Directors to meet and discuss finance issues. Directors of Finance are generally the Proper Officers responsible for the proper administration of local authorities' financial affairs under section 95 of the Local Government (Scotland) Act 1973. In a Treasury Management context, Directors of Finance have ultimate responsibility for the implementation of the Treasury Policy approved by their Council.

 

2.3 The CIPFA Scottish Treasury Management Forum (TMF) is a practitioner's forum of the officers who carry out the day to day Treasury Management activities on behalf of local authorities. Its membership includes all local authorities in Scotland.

 

3.0 Present Arrangements for Local Authority Investment

 

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?I

 

3.1 The statutory basis for the investment of local authority surplus funds is not as well founded as that in England & Wales. There is currently no formal Investment Guidance in the form that England & Wales have, and as best practice, authorities have adopted the English Authorised Investments list in 2001. It means that Scottish Councils have fewer investment options, and most surplus funds are deposited with Banks, Building Societies and other Local Authorities. It has also led to doubt over the use of Money Market funds, and lending to the Government in the form of the Debt Management Agency Deposit Facility (DMADF) provided by the Debt Management Office (DMO), since these were added to the English Authorised Investments list in 2002. The regulatory framework in Scotland is the same with Councils all adopting and adhering to the CIPFA Code for Treasury Management in the Public Sector. We refer the Committee to the response from CIPFA for a more detailed background on the regulatory framework and Code of Practice

 

3.2 It is not considered that, in the short term, the recent events will have a direct effect either on the services provided by Scottish Councils or on their role as employers. Should there be no recovery of the funds from the Icelandic Banks this situation will be different due to the additional financing costs.

 

4.0 Framework for Local Authority Investment

 

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

 

4.1 The last time local authorities were subject to a significant counterparty default was in 1991 with the failure of the Bank of Credit and Commerce International (BCCI). We consider that the report by the Treasury and Civil Service Committee of the House of Commons on the BCCI closure is still pertinent. This stated that:

 

"In balancing risk against return, local authorities should be more concerned to avoid risks than to maximise returns." Paragraph 58, Second Report, December 1991

 

Scottish local authorities still pay due regard to this statement and investments are managed with regard to security, liquidity and return explicitly in that order. While authorities are not completely risk averse, they are certainly risk aware and it is a key role in Treasury Management for Elected Members, and Officers on their behalf, to understand and manage the many risks in Treasury Management activities.

 

4.2 The recent events in the money markets have been unprecedented - not just in relation to Iceland, but the nationalisation, part-nationalisation and wholesale re-capitalisation of some of the biggest banks in Europe and the US. Before Northern Rock, the willingness of the UK Government to step in and guarantee an institution was unproven.

 

4.3 Although there is obviously a significant amount of money at risk following recent events, it represents a relatively small proportion of local authority investments in Scotland. Authorities had their investments spread with a range of institutions, including banks, building societies and other local authorities. While local authorities can ill-afford any money at risk, the spread of risk with different counterparties proved effective in managing the overall exposure to recent events.

 

4.4 Local authorities have used credit ratings as a basis for assessing counterparty risk for many years. However, over the last year, many local authorities have been reviewing their investment approaches by strengthening the use of credit rating agencies and maximum levels of investment, and will continue to do so to ensure that any lessons from recent events are learned.

 

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?

 

4.5 If it is UK Government Gilts that is being referred to by 'Government Stock', local authorities have generally not invested in these since there is a potential for capital loss by virtue of the price movement unless held to maturity. Before mid-2007 when the potential effects of the sub-prime crisis became apparent, this potential loss of capital was in contrast to deposits with financial institutions with a high credit rating where there was no capital loss unless the counterparty defaulted. Liquidity requirements mean that local authorities generally have a fairly short maturity on most of their investments, so holding Gilts to maturity is not a realistic option. Treasury Bills are an option, but there are some liquidity issues, as well as transaction and custody costs. The introduction of the DMADF addressed these issues, but the facility was not adopted in Scotland at the time, pending the introduction of the anticipated Scottish Investment Regulations. Given that the regulations were still not in place, and in light of market condition towards the end of September, a number of Scottish Authorities have recently placed deposits with the DMADF to reduce the risk profile of their investments. However, the interest rate on the facility is exceptionally low. It is obviously appropriate that the interest rate offered on deposits with the DMADF reflects the low risk and is therefore significantly lower than that offered by banks and building societies in current market conditions. While security is paramount in the current climate, some authorities have already expressed concern over the effect on their budget of the reduced interest return.

 

4.6 In a Treasury Management context, it is also worth noting that in November 2007 the Public Works Loan Board, part of the DMO, introduced a separate interest rate for the premature repayment of debt. In practice, this has meant that the opportunities which local authorities formerly had to achieve debt management savings through debt restructuring are no longer available, putting further pressure on local authority budgets. Previously, authorities could have used pro-active debt management to manage the effect of the lost interest, but this is much less the case now.

4.7 There are other options which local authorities are considering in the short term. For example, Certificates of Deposit (CDs) with an explicit Government Guarantee issued by banks as part of the recent guarantee scheme are yielding over one percent more than the DMADF for the same period. However, local government cash flows tend to be 'lumpy', with significant mismatches in the timing and value of income and expenditure.  Further, other public sector initiatives, for example responding to the current economic pressures and reviewing payment terms, also impact on a Council's cash flow management.  To take account of these variances in cash flow, local authority investments have to be kept reasonably liquid, and this would create issues with using CDs and Government Stock. As such we consider that these types of investments should only be used for 'core longer term cash' which makes up a relatively small proportion of a Council's investments. Therefore, while 'Government Stock' has a significant role to play in the mitigation of risk in local authority investment, it should not be mandated as the only option. If it is, there is going to be a substantial long term shortfall in investment income with an inevitable consequence for Council Tax levels.

 

4.8 Local Authority temporary deposits have provided a significant source of liquidity to banks and other financial institutions. Although the deposits are a relatively small part of the overall money market, in recent years they have provided significant liquidity to smaller financial institutions such as the Building Societies. In the current environment, lending to these institutions by local authorities has reduced substantially and this funding will have to be replaced by other sources in the market. There is also significant lending between authorities as part of authorities' normal short term cash flow management and it is important that this be allowed to continue.

 

5.0 The Role of Government

 

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

 

5.1 The Government's role should be to set the legislative and regulatory framework for local authority investment, and to ensure a robust reporting standard within local authorities so that the risk being incurred is identified in advance to Elected Members. The Government's role should not, however, extend to the identification of what individual specific investments a local authority should or should not undertake.

 

5.2 We consider that CIPFA, and in particular CIPFA's Treasury Management Panel are best placed to consider the lessons to be learned from recent events and to continue to disseminate best practice and build professional standards.

 

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?

5.3 There are a number of valid reasons for believing that local authority investments should be subject to a Government Guarantee, in specific circumstances. For example, most of the CDs issued by banks under the Government's Guarantee Scheme are issued in very large denominations. Therefore while large institutions can invest covered by the Government Guarantee, local authorities, which have a smaller amount to invest at a time, have difficulty in doing so. While the purpose of the scheme is to provide the banks covered by the scheme with liquidity, it still gives a guarantee to larger lenders not available to local authorities. This leaves local authorities somewhere in the middle - larger institutions can invest in the Government guaranteed CDs, retail investors have an explicit guarantee, and in the middle are local authorities.

 

5.4 However, under the Market in Financial Instruments Directive (MiFID), local authorities as generally categorised as Professional Clients not as Retail Clients. This is indicative of the greater level of understanding of the money markets which local authorities should have, and their greater resources to retain the services of professional advisors where appropriate. Local Authorities should therefore be in a position to make value judgements on the risk incurred in their investments. If all local authority deposits were to be guaranteed by the Government, there would be no penalty for taking undue risk. While we believe that Scottish local authorities have managed their risk to date, a blanket guarantee in the future might encourage excessive risk taking. It is therefore considered that the Government should not, as a rule, protect local authority investments in the same way that it protects personal assets. The guarantee would therefore depend on circumstances where due to the nature of investments in Icelandic Banks it is considered that a guarantee would apply.

 

5.5 There are, however, two circumstances in which a Government guarantee for local authority deposits may be appropriate. Firstly, since local authorities have less access to the guaranteed CDs / Bonds issued by the institutions in the Guarantee Scheme, a limited guarantee covering local authority deposits in those institutions for the same period as the Guarantee Scheme might be appropriate. This would put local authorities on an equitable footing with larger financial institutions. Secondly, as noted above in paragraph 4.8, many smaller financial institutions previously received significant funding from local authorities. A combination of the current market conditions and some credit ratings downgrades has meant that there is a lot less lending by local authorities to these institutions. If further substantial consolidation is to be avoided, it may be that a guarantee to local authorities investing, within well defined treasury management policies, in these institutions would be helpful.

 

December 2008