31 October 2008
By Tash Shifrin
Financial pressures are a constant for local authorities, but a new and unexpected difficulty has stolen the headlines. In October, scores of councils came down with a nasty case of frostbite after finding themselves overexposed in Iceland.
The Local Government Association states that 104 local authorities had money frozen in the three collapsed Icelandic banks, along with 19 other public bodies. Around a dozen universities also have cash tied up in Iceland. All told, about £1bn is at stake, held in a country with a population of a little over 300,000 – about the same size as the London Borough of Barnet, one of the frostbitten councils that is seeking to recover £27.4m from Iceland.
It has been something of a shock. Even the Audit Commission and such august establishments as Oxford University have been caught in the freeze. But local authorities have been worst hit. There is a general consensus that the councils did nothing improper. The LGA and the government have reiterated that the town halls' investments were carried out in accordance with the guidelines issued by the government in 2004.
Local government minister John Healey sent rapid response teams into three councils – Uttlesford, Tamworth and Wyre Forest – although none had short-term cash flow problems and none requested the visit.
But questions remain. It is not the first time local authorities have been hit by trouble in the financial markets. In the 1980s, the London Borough of Hammersmith and Fulham was one of a number of councils that attempted to play the markets with interest swap deals, which were eventually ruled unlawful and voided.
In 1991, councils with money held in the Bank of Credit and Commerce International were caught out when fraud and corruption at the bank was uncovered.
Should the guidance – which was changed in 2004 when central government rules were relaxed – have been more cautious? It states: 'Under the new system, the government still wishes to encourage authorities to invest prudently, but without burdening authorities with the detailed prescriptive regulation characteristic of the 1989 Act system.'
Healey was at pains to tell the Commons that, under the new guidance, councils were 'not under pressure to maximise their investments'. He added: 'They were required to make investments prudently, and to give the highest priority to the security and liquidity of the investments that they made.' But other areas of the public sector appear to have fared better with more restrictive guidance. The health service, for example, got off virtually scot-free: just two of 107 foundation trusts, with investments amounting to £2m, were caught in the Icelandic meltdown.
In the NHS, while foundation trusts have the freedom to invest in commercial banks as they wish, other bodies face restrictions on commercial investments. In a parliamentary answer, health minister Ben Bradshaw said this meant that 'in practice the large majority' of cash balances for NHS bodies were held in government bank accounts.
Should local authorities be governed by a similar approach? Alison Scott, assistant director for local government at CIPFA, says it is important to avoid 'kneejerk reactions' and sudden changes to guidance. Both the government guidance and CIPFA's Treasury Management Code 'have, until Iceland, withstood the test of time very well', she says.
After the BCCI fiasco, some councils – most notably Western Isles in Scotland – faced huge difficulties because of the scale of their investment. But the Icelandic saga has not left any authority with major short-term problems, Scott says. 'Local authority portfolios are now better diversified and better focused on risk.'
At the LGA, programme director for finance Mark Luntley says that councils hit by the Icelandic crash were behaving prudently and following guidance, 'not making things up as they went along'. Their dealings have been 'transparent – and rightly so', he adds.
Scott notes that local authorities 'do have the facility to invest with the UK Debt Management Office', which issues government bonds, 'but traditionally returns through that are lower' – an important factor because the interest local authorities make on their investments 'does support services and council tax', she says.
The sums involved are not negligible. CIPFA data shows that English local authorities' total short-term investments stood at £21.7bn at the end of March 2007 – a substantial proportion of the £113bn a year spend on services – while interest is estimated at £1.26bn for this financial year.
It is clear that different councils have followed the investment guidance in different ways, however. York City Council – which is still recovering the last of its money from the BCCI scandal – has set a very cautious investment policy, says technical finance manager Louise Branford-White.
York received 'negative ratings alerts', an indication that credit ratings might drop, about the Icelandic banks from its treasury management advisors in April. In line with its policy, it pulled out of Iceland 'without waiting for the credit rating to actually fall', Branford-White says.
Some authorities have changed tack in the wake of the Icelandic freeze. A spokesman for the Debt Management Office says there has been 'some increased take-up' of its facilities by councils since the crash. 'I think people are looking for safe havens for cash,' he says.
Kent County Council, with £50m locked in Iceland, is moving to redirect its investments towards UK banks, although Cabinet member for finance Nick Chard adds: 'We'd like the government to guarantee it was safe.'
Chard says redirecting the cash to British banks would make only a 'relatively marginal' difference to its return on investment.
But the council could not go down the NHS route of investing primarily with the government, he suggests. 'If we deposited it all with the DMO we'd lose £6m worth of interest a year – about 1% on the council tax. That's a substantial amount of money.'
Scott says there would be 'very significant implications' for the banking sector and for government macroeconomic policy if there was a big shift away from commercial banks – local authorities are major wholesale investors.
But Scott adds that the guidelines for local authorities will be reviewed. CIPFA, the government and the Audit Commission will be looking at the new financial landscape and 'whether there are lessons to be learned'. CIPFA will also provide advice on how to treat funds in Iceland in this year's accounts. The Commons communities and local government select committee is also launching an inquiry, looking at both the guidance provided by Whitehall and the potential for greater investment in government stock.
Meanwhile, the LGA is still sifting through the wreckage in Reykjavik. It is pressing the Icelandic banks, the country's ambassador and the UK government in its efforts to recover its members' cash, but Mark Luntley says there is still 'no timetable' for the return of the frozen £1bn.
PFoct2008
