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

Summary

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

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

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

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

l 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 (e.g. 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 e.g. 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

� 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:

l Preservation of capital;

l Diversification of credit risk;

l 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 ten percent 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 e.g. 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, five percent 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 eighteen 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 e.g. 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 1 week and 1 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 (e.g. 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.

 

January 2009