Magazine article Public Finance

Safety in Numbers

Magazine article Public Finance

Safety in Numbers

Article excerpt

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. …

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