A sophisticated approach to risk

30 Nov 17

Regulatory changes mean councils will need to look at potential gains and losses more prudently, and may mean higher reserves are needed, says CIPFA's Alison Scott.


CIPFA is about to publish its updated Prudential Code for Capital Finance in Local Authorities and Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes.

At the same time, the Department of Communities & Local Government is consulting on its amended investment guidance and minimum revenue provision guidance.

These all require councils to take a more long-term view of sustainability and a more sophisticated approach to risk.

The capital strategy introduced by the updated codes requires local authorities to look at how risks associated with a wide range of investments, capital expenditure, service-related guarantees and financial support to other bodies interact and the overall impact on their long-term financial sustainability.

To ensure best practice, councils will need to consider local circumstances in depth and think about how risk and reward are explained to decision makers so that they are properly aware of potential risk and long-term sustainability.

No two capital strategies will look the same and there can be no simple blueprint as all local authorities are different. 

In recent weeks, there has also been considerable debate over what effects the new financial instrument disclosure rules will have.

The new standard, IFRS9, is specifically designed to increase transparency around risk, requiring gains and losses made on financial instruments to be recognised earlier, which increase volatility on the revenue account.

This standard requires much more explicit distinction between investment vehicles where capital is not a risk, which will be accounted for largely at amortised cost, and those where capital is at risk where fair value measurement will be required.

The standard further distinguishes between investments held largely for service purposes, such as those in airport companies, where gains and losses are recognised only on redemption, and those held for return where gains and losses are recognised at the end of each reporting period.

While much has been made of the downside risk, the biggest challenge to local authorities will be ensuring they take a prudent approach to gains.

Risk will need to be considered across the life of the instrument and a prudent approach would dictate holding back some of those gains to provide a cushion against any future losses. 

CIPFA has argued for statutory mitigation against significant volatility but, even where this is granted, local authorities will still need to consider risk as, if they are to be able to realise the investment when cashflow requirements dictate, at some point any losses will need to be realised. 

Perhaps the biggest challenge for the government and ministers will be to accept that one implication of local authorities acting more “commercially” to make up for funding shortfalls arising from years of reductions in government support will be an increase in the level of reserves held to ensure continued financial sustainability should some of the increased risks local authorities are taking on materialise.

The new prudential code is an important first step in improving the conversation around and the understanding of cumulative risk at individual local authority level.

In addition, perhaps what is also needed is a national conversation about what is meant by “commercialisation” and the overall balance of risk and return that is acceptable to the sector.

As with any development, there will always be outliers that gain media attention and can, on their own, give a distorted view of the sector.

The challenge for all those representing the sector, including CIPFA, is to facilitate meaningful debate and understanding and provide guidance to the silent majority who are trying to bridge resource gaps with a level of risk that is commensurate with public funds and provides for sound future financial sustainability.

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