D-Day for town halls

8 Nov 11
Treasury management has been riding the waves of change in recent months but a bigger development lies ahead. Derivatives might be making a comeback
By Mandy Bretherton | 1 November 2011

Treasury management has been riding the waves of change in recent months but a bigger development lies ahead. Derivatives might be making a comeback

roller coaster

Treasury managers in local government have found life a rollercoaster over recent months as their world has once again been transformed by circumstances outside their control. Unlike the last ride, where the driving force was beyond British waters, the changes this time have come from closer to home.

It all began in October 2010 with the Comprehensive Spending Review and the shock announcement that the government would be increasing the price of borrowing from the Public Works Loan Board with immediate effect. The policy driver for the change was thought to be twofold, first, to encourage councils to explore alternative sources of funding and, secondly, to exert downward pressure on local authority borrowing. The policy certainly had the desired effect in relation to the exploration of alternative markets, sparking a flurry of activity in the previously quiet local authority capital markets. 

One of the issues arising from the use of capital markets is the ability to manage the interest rate risks. Companies can hedge their bets using ‘derivative products’ such as futures, swaps and options, although these can also be used speculatively and carry risks – as Hammersmith & Fulham council discovered to its cost in the late 1980s. Since the infamous ruling that the council’s use of interest rate swaps for trading purposes was ultra vires, local authorities have steered well clear of derivatives.  
The Localism Bill might change this. It includes a General Power of Competence, which will give local authorities the power to do anything individuals can do. Whether or not this will include the use of derivatives will become clearer in due course. While CIPFA is not in a position to give an opinion on whether the power will make the use of derivatives legal, it does see the need for robust framework for their potential use.

To this end, the institute is updating the Treasury Management Code. It will require public sector organisations to be explicit about their use of derivatives in their annual treasury management strategy, which has to be approved by those charged with governance.

The code will confirm that derivatives should be used only for the prudent management of financial affairs, never for speculative purposes. It will also require organisations to seek proper advice and to heed it when entering into arrangements to use derivatives. They should fully understand the products before using them.

The guidance notes to the code will also be updated to include the high-level requirements councils should take into account in any use of derivatives.

The CIPFA Treasury Management Panel then plans to produce more detailed guidance on the use of derivatives. This will build on the high-level principles and provide some practical examples, where derivatives might assist in the management of specific risks.

This new activity around the capital markets, coupled with the looming March 2012 deadline for the shift to Housing Revenue Account self-financing – where £13.2bn is required on the same day – has kept treasury managers busy. For those authorities who need to borrow for the HRA, the rollercoaster took another turn in late September when the government announced that for the HRA transaction only, the PWLB would revert back to pre-CSR levels. While this was welcome news, authorities would have found it even more welcome earlier in their planning processes.

Even with the stability now provided for the HRA transaction, authorities still have to carefully consider their options with the current instability in the market place, its impacts and associated risks. PWLB rates during September fell to low levels reflecting the flight to the safety of UK gilts. 

The CIPFA treasury management network is repeating the risk study it carried out last year, based on data to the end of September. It will compare current risks with those in 2010. The earlier study showed many authorities were using internal resources rather than borrowing externally. Not only did this save on borrowing costs, it also lowered credit risk by reducing the level of investments. This policy is unlikely to be sustainable over the medium term and hence authorities need to consider the timing and source of their borrowing carefully.

It is now hoped that we will return to a period of stability in terms of policy announcements, and that the rollercoaster is on a long, flat and straight course for the foreseeable future. Whether this will be changed by potential turmoil in the wider markets will be seen over time. In the meantime, however, this will enable local authorities to plan their treasury management strategies effectively and prudently manage the risks they face.

Mandy Bretherton is technical manager for local government finance at CIPFA

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