Safety in numbers_2

29 Feb 12
Security is vital for local authority investments and that means managing the range of risks entailed. CIPFA’s recent study shows what councils are doing to protect their funds
By Mandy Bretherton | 1 March 2012

Security is vital for local authority investments and that means managing the range of risks entailed. CIPFA’s recent study shows what councils are doing to protect their funds

Illustration: iStock

Effective treasury management is all about the management of risk.  It involves weighing up the classic three elements of security, liquidity and yield and managing the associated risks.  Local authority treasury management is no different, although the management of public funds places the primary focus on security and liquidity. The security of the principal sum is of paramount importance.

Although treasury risk management has featured highly on the agenda of CIPFA’s Treasury Management Panel in recent years it is difficult to quantify and to manage objectively. In an attempt to quantify the risks faced by English local authorities, the Treasury Management Network carried out a study in 2010. The take-up was fantastic and participating authorities were able to compare their treasury management positions. The exercise has just been repeated and the results are just as interesting.

Not surprisingly, investments are ­typically for relatively short time periods. In 2010, 64% of all deposits were short term, compared with 56% in 2011. In the current financial climate, authorities need liquidity and are also still nervous of counterparties following the collapse of the Iceland banks. 

Keeping the length of investment short is just one of the ways in which authorities have managed to contain credit exposures. The study also measured the average probability of default in ­authorities’ investment portfolios. 

This showed that there were very few councils with much appetite for credit risk. Of the rest, most tend to be those participating in tradeable instruments. Many councils have increased exposure to money market funds, which also improves their credit profile, as well as deposits with the UK government, either through the Debt Management Account Deposit Facility, or in gilts for authorities happy to take a longer view of the longevity of their cash balances.

One trend that has recently emerged is that local authorities are lending more to each other, from 5.5% of all deposits in 2010 to over 8% of deposits in the 2011 study. This helps to address the concern about counterparty risk. However, the trick is to match one authority’s investment requirements with another’s borrowing needs.

In terms of borrowing, much is for relatively long periods and at fixed rates, with the average length 31 years and average rate 4.8%. This means that finance directors have managed the risk that interest rates might rise. In the current financial climate, stability of debt management costs is extremely helpful.

Historically, around 75% of borrowing has been done through the Public Works Loan Board and this trend remains, although some authorities are actively considering other market options ­following the October 2010 PWLB ­interest rate rise. 

Authorities are not generally ­borrowing in advance of need, but are making significant use of internal funds. They are running down cash balances and delaying borrowing. This has the impact of reducing counterparty risk (as investments are reduced).  Historically, this would have increased interest rate risk at the point that external borrowing was undertaken. However, in the current climate, it reduces interest rate risk as there is likely to be a reduced ­borrowing requirement in the future.

Hence, a key element of treasury risk management is to evaluate interest rate risk to help set an appropriate level of external borrowing.

Bond issues are also now being ­considered, although given that the prime amount for a bond issue is typically £150m-£200m, this option is out of the reach of many authorities. Another associated issue in relation to bonds is the management of the interest rate risk associated with lending to the market place on one specific day. Corporates, rather than expose themselves to this risk, will manage it via products such as derivatives. 

For local authorities, a simple gilt lock can help to ensure such risk is effectively managed.  This would enable the price of the bond that is linked to the gilt market to be fixed in advance. But there are a number of legal issues around whether authorities have the power to enter into such products or not. 

The General Power of Competence was introduced as part of the Localism Act 2011 and some argue that this does give the legal power. CIPFA is not in a position to comment on whether this is so. However, it has amended the Treasury Management Code to include high-level principles that should be followed by public sector organisations considering using financial instruments to manage interest rate risk. These include making sure you have the appropriate powers and that you have a good knowledge of any products. The old adage ‘if you don’t understand it – don’t use it’ holds fast.

In the same way, if local authorities are to  manage effectively their risks they will need to understand them. The risk study can provide the basic information, which local authorities can then build on by establishing a benchmark position that can be measured against during the year. Without the definition of an acceptable level of risk in this way, authorities cannot clearly know what level of risk they are trying to manage. 

The biggest risks are liquidity, ­refinancing, interest rate and credit risks. They are of greatest importance to local authorities and need to be managed and understood more clearly. These risks are largely dependent on striking an appropriate balance between the levels of external borrowing and investments as part of managing the authority’s net debt exposure – a key area for consideration in the future.

Historically, investment interest was a helpful element of the revenue budget, but in the current times of austerity, the low rates of interest gained by investments are a significantly smaller element of the budget. So managing treasury management risks is a vital element of managing an authority’s budget position. The risk study and associated guidance will help authorities to identify and manage their risk exposures and to establish benchmarks for their treasury portfolios.

 The initial results of the risk study have given an interesting insight into the risks faced by local authorities. As the outputs are finalised, we await any further messages with interest.

Mandy Bretherton is technical manager, local government finance, at CIPFA. See for more information on the Treasury Management Network Risk Study. The Treasury Management Panel is shortly to publish a Risk Management Toolkit.

This article is published in the March edition of Public Finance magazine

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