Treasury management can be a risky business as the collapse of the Icelandic banks showed. A recent study shows the pitfalls to watch out for
Treasury management risks came into sharp focus following the collapse of the Icelandic banks in 2008. That experience reinforced the main principles of treasury investment: security (getting back the initial amount you invested); liquidity (having access to funds when needed); and yield (the return received). As a result, many authorities fled to the safety of the Debt Management Office, which met the first two criteria.
CIPFA’s Treasury Management Code has always stressed the importance of organisations not only being risk aware but including how they manage risks in their treasury management strategy.
However, the full range of potential risks has never been identified. CIPFA’s Treasury Management Network, backed by the Treasury Management Panel, decided to address this. It embarked on a study covering 206 English local authorities (53% of the total), with total borrowing of £32bn and investments of £12bn.
The research showed that authorities were investing the majority of their funds on a short-term basis. While this approach brings a low risk of default and low liquidity risk, it does run interest rate risks when the investment matures.
Borrowing was shown to be increasingly important, as the graph shows. But much of it is long term and at fixed rates. This means that the costs are known, providing comfort for the section 151 officer when budget-setting.
A large number of authorities had not borrowed up to their Capital Financing Requirement, ie, their underlying requirement to borrow. Post-Iceland, the government was concerned that councils were borrowing significant sums before they needed the finance and investing them in the meantime, increasing credit risks. The study shows that this is not currently the case, more the opposite, meaning that internal resources are being used initially to finance capital expenditure.
This approach brings with it a different set of risks. There is a refinancing risk in that there might be insufficient finance available when the authority needs to borrow. There is also interest rate risk – when the authority does come to borrow, interest rates might have risen.
The refinancing risk is reduced by the availability of funding from the Public Works Loan Board, the lender of last resort for local authorities. Historically, PWLB funding has been at competitive rates. However, the October 2010 Comprehensive Spending Review changed this by increasing the PWLB rate and directly exposing authorities to interest rate risk. This meant that authorities that had delayed their borrowing had to pay more than if they had borrowed before the CSR.
The higher PWLB rate has also led to renewed interest in local authority bonds. Their popularity had waned, mainly because of the costs and associated bureaucracy, coupled with the availability of PWLB borrowing at competitive prices. Recent examples include Birmingham City Council’s issue in 2005 for funding the National Exhibition Centre and Transport for London’s bonds to finance its infrastructure costs.
Some authorities have used market loans called Lender Option Borrower Options or Lobos. These give the lender the option to change the interest rate on certain dates. The borrower then has the choice of paying the new rate or repaying the loan. The associated interest rate risks are that the lender will increase the rates when general rates are high, leaving the borrower with either a high interest rate when rates fall, or having to refinance at a time when general interest rates are high. The study showed that there is a relatively small risk of these Lobos being called and that interest rates would have to move significantly for this to be a major risk. This is because the option to change the rate is valuable to the lender.
Overall, the research showed that currently the main risks are associated with borrowing rather than investment. Large loans will be needed over the coming years to finance capital programmes and replace maturing loans. When these are added to the £13.2bn of borrowing needed for the change to a self-financing housing system in April 2012, the risks are significant and should be considered as part of budget-setting processes.
Mandy Bretherton is the technical manager for local government finance at CIPFA
