Strengthening local authority investment

Local authority treasury management is big business in the UK. At the end of March 2009 English local authorities had £53.6bn of long term borrowing and £26.8bn of investments. Of the outstanding borrowing 98 per cent was longer term and of this 76 per cent was with the Public Works Loans Board (PWLB).

Prior to the fall in interest rates external interest was an important source of income for many authorities, with £1.9bn being received in 2008/09. That said, the regulatory guidance has always stressed that security and liquidity of funds should be considered prior to yield.
 
Collapse of the Icelandic banks
Local authorities were placed in the spotlight following the collapse of the Icelandic banks, with 127 English local authorities having £954m invested. The Risk and Return report from the Audit Commission and also the report on Local Authority Investments from the Communities and Local Government Select Committee both reviewed the framework in place at the time. Neither report identified significant difficulties with the existing regulatory framework, but did identify areas which could be strengthened.

A key element of the regulatory framework is the CIPFA Treasury Management Code (the Code). A revised Code was published in November 2009 incorporating those elements highlighted in the reviews as areas requiring strengthening. One key element related to the role of those charged with governance, namely elected members in local authorities. The Code makes it clear that responsibility for treasury management cannot be placed outside the organisation. For operational reasons the function can be delegated to an officer, typically the responsible finance officer, however, ultimately members must be fully aware of the risks that they are exposed to. The Code also highlighted a requirement that an authority’s treasury management strategies receive appropriate scrutiny and requires the body responsible for the scrutiny of treasury management to be named.

The right skills
An essential element of the Code is that those responsible for treasury management have the necessary skills and experience in order to undertake their roles. The revised Code also covers the requirement that those charged with governance have access to appropriate training in order for them to effectively undertake their responsibilities. The CIPFA Treasury Management Panel produce regular newsletters and Bulletins and the December 2009 Bulletin identified the key skills requirements for those responsible for treasury management. These included elected members, those responsible for scrutiny, the responsible finance officer, treasury manager and treasury officer and detailed the skills expectations for each.

Questions were asked in the reviews about why local authorities had such large investments at the same time as large borrowings. Local authorities are legally able to borrow to finance their capital programme in advance of when the funds are actually required called “borrowing in advance of need”.

They are not, however, allowed to borrow to invest. There are instances where this approach best fits local circumstances. Following its recent review of the Prudential Code (the framework for financing capital expenditure) the Chartered Institute of Public Finance and Accountancy (CIPFA) now requires local authorities that wish to borrow in advance to be explicit about this in their annual strategy. They are also required to consider carefully whether they can demonstrate value for money in borrowing in advance of need and can ensure the security of such funds.

Considering security
The Department for Communities and Local Government also took the opportunity to review their guidance on local authority investments. They strengthened the existing requirement for local authorities to consider security ahead of liquidity and yield. A local authority’s initial investment strategy (which must be approved by full council before the start of the financial year) should now also state the following:
• how credit ratings are to be used and monitored and what other information is also to be used
• the use made of treasury management advisors and how the quality of that service is maintained
• how officers’ training needs are to be met.

In order to assist with enhancing the knowledge and expertise of local authority treasury officers, CIPFA, in conjunction with the Association of Corporate Treasurers, have launched a treasury management qualification aimed at the public sector. The course, which is web based with optional tuition and revision sessions runs every six months, and covers the main areas of corporate treasury. Whilst some of the topics may not be familiar or appear directly relevant to those who work the public sector treasury management, a knowledge of them helps to put the public finance aspects of the course into context and enhance understanding of treasury in the public finance world.

The Select Committee criticised the role of the Treasury Management Advisors and that of the Financial Services Authority (FSA). The TM Panel Bulletin issued in March 2010 clarified the regulatory regime covering TMAs and provided a list of typical services provided by them.

The current situation
The strengthening of the guidance and regulations have reinforced the need for local authorities to be clear about how they manage their treasury management risk. They are required to explicitly state their appetite for risk, that elected members are fully aware of this and its implications and that it is subject to appropriate scrutiny.

In order to support local authorities in this the CIPFA Treasury Management Network in association with the Treasury Management Panel are undertaking a risk study which will measure the quantum of treasury risk being faced by individual local authorities and also reveal for the first time the broader picture across local government in England and Wales.

By completing a short questionnaire, all respondents will get a risk report on their specific treasury portfolios which will be presented against the national average, to provide further context. Using market analytics, the outputs of the study will highlight the following risks:
• counter party default risk
• volatility of future investment returns
• debt refinancing risk
• volatility of net interest income on the general fund.

To complement the Risk Management Study a Risk Management Toolkit publication is being developed by the Treasury Management Panel in conjunction with the Treasury Management Network. The publication will provide a Toolkit of techniques and reports that local authorities can use to identify, benchmark and manage their
treasury risks.

The Toolkit proposes the following risk management methodology for treasury decision making:
1. establish the organisation’s risk appetite
2. establish quantified risk benchmarks which represent the agreed risk appetite, against which to measure the level of risk in the portfolio
3. take treasury decisions and manage the portfolio, relative to the agreed risk benchmarks
4. review outcomes and performance relative to the risk benchmarks.

Debt Management Office
In the immediate aftermath of the Icelandic bank collapse many local authorities made a flight to safety in the approach to the amount of credit risk that they were willing to accept on investments. This meant that some authorities only invested in the Debt Management Office (DMO). Being part of government the security of investment was of the highest quality, however, this was at the expense of yield, a price that many authorities were prepared to pay.

Prior to 2008-09 local authorities in England made very minor use of the DMO. By the end of March 2009 11 per cent or £2.9bn was invested with them and investments in banks and building societies reduced by £6.3bn. Overall in 2008-09 investments dropped by £3.3bn. This was coupled with a reduction in the amount of new borrowing in the year.

Hence 2008-09 saw the largest reduction in net borrowing for over five years. The credit risk concerns, coupled with lower yields than previously received meant that many authorities were delaying their long term borrowings and borrowing internally. Whilst this reduced credit risk through lower investments it does lead to an interest rate exposure where interest rates may have increased when it is time to borrow.

The Treasury Management Panel December 2009 newsletter gave authorities more information on the type of information that is available in the market place to support a local authority’s assessment of a counterparty’s credit worthiness. This was so that local authorities would not solely rely on credit ratings in assessing their
credit worthiness.

Local authorities have also been working hard to ensure that those responsible for treasury management possess the required skills and knowledge. Of the 83 who took the joint CIPFA/ACT qualification 65 people passed, giving a pass rate of 78 per cent. Authorities are also running training sessions for elected members.

Moving Forward
So where do local authorities go from here? It is essential that the key elements of the regulations are adhered to, especially the security, liquidity and then yield consideration. The enhanced focus on credit worthiness and fall out from the credit crunch have meant that counter party lists have been shrinking, reducing a local authority’s ability to diversify.

In any market situation such as this the market will respond by bringing out new products which it perceives meets market requirements. For example a money market fund that has a high credit rating, may provide immediate diversification for a local authority and a yield comparable to the market.

Local authorities should consider new products in the light of their treasury management strategy and their appetite for risk. Where a product fits with this appetite  an authority should consider investing in accordance with their investment strategy.

In conclusion, the framework for local authority investments was reviewed post Iceland and certain elements were strengthened. The need for those responsible for treasury management within local authorities to have the knowledge and skills required to be informed investors in a complex and changing market place is
greater than ever.

For more information
Web: www.cipfa.org.uk