Treasury 5th Report Banking Crisis: The impact of the failure of the Icelandic banks

SandyHood

I am pleased to see more and more students recognise that what we study on AAT is not just a set of facts that will be tested. There is a direct link between the course and what happens in the world around us.
In the current credit crisis, Unit 15 is a case in point.
The following was published this morning and can be read in full on:

Treasury Committee report published 4 April 2009 Banking Crisis: The impact of the failure of the Icelandic banks

ADVISED TO INVEST?

65. On 17 October, the Local Government Association (LGA) reported that 123 authorities had deposited an estimated £919.6m in Icelandic banks and their UK licensed subsidiaries.[125] Deposits were held by councils, fire and rescue, and passenger transport, national parks, pensions and waste authorities. The Audit Commission put the value of deposits as high as £953.53m, a figure which represented a little over 3 per cent of the local authorities' deposits. [126] According to the Audit Commission, 30 organisations had sums at risk that exceeded five % of gross revenue expenditure.[127] Kent County Council had the highest amount deposited with £48.9m held in Icelandic banks.[128] When asked if local authorities were advised to invest public money offshore, Councillor Richard Kemp, Deputy Chairman, LGA, told us that "there was no advice not to".[129]

66. Under the Local Government Act 2003, each local authority must take its own decisions on how and where to invest its funds and must have regard to the Chartered Institute of Public Finance and Accountancy (CIPFA) Prudential Code for Capital Finance in Local Authorities. CIPFA also publishes a Treasury Management Code, which sets out the procedures and policies that each authority should follow.[130] The LGA informed us that local authorities should spread their investment risks with 5% or at the very maximum 10% of total investments invested in one institution or sovereign.

67. Many local authorities employ private sector advisors, who have specialised knowledge and skills in understanding money markets. The main private-sector advisors to local authorities in the United Kingdom (Arlingclose, Butlers and Sector) have recently given evidence to the Communities and Local Government (CLG) Committee. Their evidence offered several accounts of what happened in relation to the advice given on Icelandic banks and we look forward to the CLG Committee's forthcoming report on local authority investments.[131]

RELIANCE ON CREDIT RATING AGENCIES

68. When we asked who was to blame for the loss of local taxpayers' money, Councillor Kemp told us that he believed that there had been "a series of failures within the system". We were told that the LGA had sought investment advice from "ministers, from Parliament, from regulators, from the credit reference agencies, a whole variety of people".[132]

69. Some local authorities apparently continued to invest in the Icelandic banks and their UK subsidiaries as they continued to receive "relatively high ratings" from the credit ratings agencies[133] up until the afternoon of 30 September.[134] Councillor Merrick Cockell, Chairman, London Councils, told the CLG Committee that local councils "have to rely on credit rating agencies". He argued that the purpose of credit rating agencies was to "provide the sort of advice which non-experts, and indeed experts, require, looking … at the detail of financial institutions and working out whether they are safe or less safe bets."[135] The Building Societies Association agreed that ratings were a "useful tool", but cautioned that their track record in enabling investors to avoid credit losses in the banking crisis had been unimpressive.[136] What is very surprising is that after April 2008 the credit rating agencies began downgrading the ratings of Glitnir and Kaupthing and the Fitch ratings agency produced a damning special report on Iceland on 22 May 2008, yet some local authorities persisted in placing new investments in these institutions. Even after a very significant downgrade in September 2008 which extended to Landsbanki, seven local authorities persisted in depositing sums amounting to £32.8m over the next few days, in breach of treasury management policies. [137]

70. We will consider the wider issues of the extent to which the credit rating agencies were implicated in the banking crisis in a future report.

PLEA FOR ASSISTANCE

71. Councillor Kemp told us that the Government had helped local authorities in the short term "by allowing us to withdraw concerns about Iceland from the equivalent of our balance sheet for this financial year so we do not have to take it into account".[138] The LGA was asking for "capitalization of the money because some councils would find it very difficult to pay their sums back in one year, if the crunch came to it". The Government had refused to allow councils to spread the capitalization of their lost assets across a period of years.[139] Councillor Kemp concluded that local authorities had "invested properly on the advice of all those people, including the Chancellor and we should have our money back".[140]

72. We acknowledge that some local authorities will feel hard done by as a consequence of the limitations of Government support for them. Local authorities are required to take their own decisions on the level of prudent, affordable capital investment. They have a duty to the taxpayer diligently to protect the money they are investing on their behalf. Some authorities have shown themselves to be better than others in this regard. Under these circumstances it would seem perverse to reward those authorities who failed to protect their investment with yet more money from the taxpayer.

SandyHood

This is an issue that has been a feature on the TODAY programme this morning, and I fully expect to read about it in the newspaper tomorrow.
Terry Stiasny report on compensating charities (audio)

SandyHood

What does this have to do with Unit 15?

What does this have to do with Unit 15?

Here is my posting last year:
Unit 15 and the recent financial news posted October 11th 2008

Look at this:-
15.2 Manage Cash Balances
Performance criteria – in order to perform this element successfully you need to:
B Invest surplus funds in marketable securities within defined financial authorisation limits.
C Ensure the organisation’s financial regulations and security procedures are observed

Unit 15 Knowledge and Understanding requirements
The business environment
5 Government monetary policies

Accounting techniques
16 Managing risk and exposure

Accounting principles and theory
25 Liquidity management

The organisation
28 An understanding that practice in this area will be determined by an organisation’s specific financial regulations, guidelines and security procedures
29 An understanding that in public sector organisations there are statutory and other regulations relating to the management of cash balances

And the treasury report paragraph:-
66. Under the Local Government Act 2003, each local authority must take its own decisions on how and where to invest its funds and must have regard to the Chartered Institute of Public Finance and Accountancy (CIPFA) Prudential Code for Capital Finance in Local Authorities. CIPFA also publishes a Treasury Management Code, which sets out the procedures and policies that each authority should follow.[130] The LGA informed us that local authorities should spread their investment risks with 5% or at the very maximum 10% of total investments invested in one institution or sovereign.

blobbyh

Fantastic post, Sandy.

SandyHood

Audit Commission, Risk and return - English local authorities and the Icelandic banks March 2009

Local treasury management policy meets national requirements


76 All local authorities have, as required, adopted the CIPFA Code of Practice for Treasury Management in Local Authorities. They use the Code to govern the way that surplus funds are invested. Local authorities also produce an annual investment strategy in accordance with the requirements laid out in the Local Government Act 2003.

77 Most policies refer to the statutory framework and to the need to prioritise security and liquidity above yield. Policies also, rightly, make it clear that investments will be used to generate income. But good policies emphasise local accountability and responsibility, the criteria within which it is appropriate to maximise yield, and also define the rules for determining:

* a high credit rating;
* the maximum periods for which funds may be invested;
* the total principal sums invested with counterparties at any point in time;
* the criteria for choosing investment counterparties with adequate security;
* the types of investment; and
* an appropriate balance between short-term and longer-term deposits.

78 The quality and content of individual policies varies markedly. For example, 21 per cent of treasury management policies do not specify what a high credit rating is. Thirty-two per cent of policies do not outline how frequently ratings should be monitored and 29 per cent do not specify procedures to deal with a rating change that means counterparties no longer meet local thresholds. In some cases, policies have been formulated using a template supplied by treasury advisers. In others, policies contained wording copied verbatim from the CIPFA Code of Practice guidance, with little evidence that due consideration has been given to local policy or priorities.

79 In general, treasury management policies are reviewed and revised as part of an annual process and are not considered in between. But policies tend to be rolled over from year to year and, consequently, most have been unchanged for some years. A small number of policies have been revised in response to the Icelandic banking crisis. But in most cases, policies for 2008/09 have not altered; instead, operational changes have been made, such as revisions to counterparty lists or deposit limits.

80 However, treasury management policies for 2009/10 are being revised. Local authorities intend to include, for example, refined credit rating criteria, such as more clearly defined limits for investing abroad, limits for investing in banking groups, and support ratings. Footnote 1

81 Treasury advisers are consultancy firms that provide information to local authorities. Most local authorities use one or more external firms of treasury advisers to provide expert information and guidance. Treasury advisers play a variety of roles in helping to draw up local treasury management policy and strategy, including:

* assisting an authority to develop its treasury management policy;
* helping an authority to develop approved lending, or counterparty, lists;
* providing information on the creditworthiness of counterparties;
* advising on the criteria to take into account when determining which organisations to include on counterparty lists;
* advising on the investment instruments that should be used;
* advising on the maximum sums that should be invested in each organisation, ratings criteria, investment limits and the duration of deals; and
* advising on borrowing, borrowing limits and when to refinance at lower interest rates.

82 In the best authorities, policy is developed locally and information provided by treasury advisers is used as reference material alongside information gathered from other sources. Few local authorities gather information directly from credit rating agencies and, instead, rely on information provided by their treasury advisers. However, a direct relationship with one or more of the credit rating agencies is not, on its own, an indicator of good performance.

SandyHood

Local authorities specify risk thresholds

83 In line with best professional practice, local authorities manage risk by developing counterparty lists that specify minimum credit ratings and other thresholds. The thresholds vary between local authorities in accordance with local policy and appetite for risk. As a minimum, counterparty lists specify:

* the group of institutions that comprise a counterparty list;
* the minimum credit ratings for each counterparty;
* the length of time that money will be invested; and
* the maximum sums that will be invested with different types of institution.

84 The counterparty lists developed by local authorities with more highly developed arrangements for assessing and managing risk are also likely to specify thresholds for determining an appropriate split between investments in UK and non-UK banks, together with the maximum amounts that can be deposited in banks with the same owner (group limits). These local authorities are also likely to manage counterparty lists actively, in anticipation of bank mergers. The more risk-aware local authorities do not judge risk by relying solely on a single credit rating or a single credit rating agency. Instead, they consider the credit ratings quoted by one agency alongside those quoted by others.

85 The local authorities that managed risk most effectively were those that specified additional measures of risk in conjunction with long and short-term credit ratings. For example, the Icelandic banks met one local authority’s credit rating threshold, but failed to make the counterparty list because they did not meet the support ratings threshold.

86 The best local authorities use a range of knowledge and information to judge risk and set credit rating thresholds before developing counterparty lists. The same local authorities also use a range of information before making investment decisions, including information gathered from treasury advisers, the financial press, and other sources, such as Reuters and Bloomberg. However, just over half of local authorities (51 per cent) relied solely on information provided by treasury advisers.

87 Some local authorities ask treasury advisers to compile and manage counterparty lists on their behalf. Outsourcing arrangements can be beneficial: for example, to small local authorities with limited capacity. However, the role of treasury advisers does not extend to assuring compliance with good practice in treasury management. Hence, such arrangements need appropriate management, oversight and scrutiny. For instance, one local authority failed to adopt a revised counterparty list prepared by its treasury adviser. The revised list did not include the Icelandic banks. Instead, the local authority continued to place deposits in accordance with an outdated counterparty list, which included the Icelandic banks.

88 Local authorities also make use of brokers who act as an intermediary between the authority and the lender. They do not provide advice but enable depositors to access a wide range of banks. Brokers perform a useful role, but authorities may sometimes benefit from a direct relationship with counterparties. And brokers should not be used as a source of advice on individual investments.

Local authorities manage risk by diversifying their investments

89 The pattern of deposits held on 7 October 2008 suggests that local authorities were, in general, making appropriate judgements regarding risk and return:

* Most funds were invested for terms of one year or less, of which £12.6 billion (41 per cent) was deposited on terms of between one day and six months and £12.2 billion (39 per cent) was deposited for more than six months, but less than one year. Less than 20 per cent of deposits (£6.1 billion) were placed for more than one year.
* Most funds (38 per cent) were deposited in AA-rated, very strong grade, institutions; 14 per cent of funds were deposited in A-rated, strong grade institutions; and 2 per cent of funds were deposited in the small number of AAA-rated, extremely strong grade, institutions. The remaining funds were placed in building societies. Most building societies do not have credit ratings. Instead, judgements of creditworthiness are made based on the size of the building society.

90 In general, there is a pay-off between risk rating and yield. The AAA-rated, extremely strong grade institutions offer maximum security for investments in return for lower yield. On the other hand, an A-rated, strong grade institution, offers less security, but higher yield. Local authorities were, therefore, making judgements balancing risk and return.

91 However, the management of risk and return varied between local authorities, and suggests that different authorities were willing to take different amounts of risk. All local authorities held deposits in A-rated, strong grade, institutions; and 97 per cent of local authorities held deposits in AA-rated, very strong grade, institutions. In contrast, 38 per cent of local authorities held deposits in AAA-rated, extremely strong grade institutions.

SandyHood

Local authorities hold most of their deposits in UK banks and building societies

92 On 7 October 2008, local authorities held deposits in 25 different countries. More than £19.4 billion (63 per cent) was deposited in institutions registered in the UK, of which £17.7 billion (57 per cent) was deposited in institutions owned by UK companies. Almost 43 per cent of funds was deposited overseas or in institutions that were not owned by UK-based companies. More than 20 per cent of funds (£6.99 billion) was deposited in banks based in the Republic of Ireland. The remainder was deposited in financial institutions across Europe, the United States, the Middle East, the Far East and Australia (Figure 6).

Link to Figure 6 Most funds are placed in institutions owned and based in the UK by Audit Commission


93 On 7 October 2008, local authorities held 61 per cent of their deposits in banks and just over half of that amount (35 per cent) in building societies. The remainder was invested in money market funds, other local authorities and in other types of account, including instant access call accounts and the Debt Management Deposit Account Facility (DMDAF). The DMDAF is operated by the government’s DMO. It offers local authorities the facility to place deposits in an AAA-rated, extremely strong grade body, but with a significantly reduced yield. The amount deposited in the DMO on 7 October 2008 was £580 million, or 1.9 per cent of the total on deposit that day.

94 Local authorities have tightened their criteria for identifying counterparties since the collapse of the Icelandic banks. They have set higher credit rating thresholds in addition to reducing the maximum sums that will be invested in each institution. Local authorities are finding it increasingly difficult to place deposits within the higher thresholds and many are relying increasingly on the DMDAF. After the collapse of the Icelandic banks, many local authorities wanted to open DMDAF accounts but, for operational reasons within the DMO, account opening often took six weeks or longer.

95 There is no requirement for the DMO to maintain the DMDAF. The operational notice that governs the facility allows the DMO to suspend or terminate it at any time, potentially without notice. However, it would be useful if the DMO were to guarantee the DMDAF as a place of safety and security for local authority funds.

Local authorities consider yield when setting budgets

96 Each local authority makes its own assumptions about investment income and the extent of local authorities’ reliance on interest receipts varies. Where investment targets are set, most local authorities assume income from interest at between 1 and 5 per cent of net budget. However, in two local authorities, budgeted income from interest earned in 2008/09 equated to almost a quarter of annual spend. The spending plans of some local authorities will be materially affected by reduced rates of return from invested funds as a result of interest rate cuts. Indeed, one local authority has already cut services as it overestimated investment returns in 2007/08, during which time interest rates were rising.

97 While there is no direct evidence that local authorities prioritise yield above financial security and liquidity, some treasury teams experience pressures to ensure that investments perform well. For example, local authorities benchmark their treasury management functions. A key indicator is investment returns in comparison with an average interest rate, and treasury teams are encouraged to out-perform the benchmark where possible. Staff in two local authorities considered that they could not afford to use the DMO or to place deposits of less than three months, which generally offer lower rates of return. Staff at a third local authority reported that investments were made in the Icelandic banks in the light of the high interest rates offered and local pressures to maximise revenue.

98 Benchmarking is a useful and beneficial means of assessing performance. However, a focus on benchmarking yield, to the exclusion of other aspects of treasury management such as security and liquidity, may lead to an undesirable concentration on yield. If benchmarking of the treasury management function is required, a broad range of performance indicators, including security and liquidity, should be monitored.

99 Reliance on interest receipts has reduced since the collapse of the Icelandic banks and local authorities have adjusted their income assumptions downwards. There is also evidence of a broader shift in attitude and a reinterpretation of the relationship between security, liquidity and yield. In the past, local authorities were more willing to risk security in return for yield. Current attitudes towards risk management reflect an increasingly cautious approach that focuses on protecting capital, sometimes at the expense of yield.

100 However, extreme caution costs money and it may not be appropriate for all future deposits to be made only with AAA-rated, extremely strong grade institutions. Such decisions are a matter of local choice and local authorities need to set and communicate policy that describes the local risk appetite and the local thresholds for managing the trade off between risk and reward.

SandyHood

Local treasury management practices and staff qualifications vary

101 There are variations in local treasury management arrangements. Some local authorities manage the whole of their investment portfolio; others divide responsibilities and manage simple investments such as bank term deposits and cash funds and outsource other, more complex activities, including managing gilts and certificates of deposit, as well as property portfolios. A small number of local authorities rely almost entirely on external fund managers.

102 Some smaller local authorities have been unable to allocate sufficient resource to treasury management functions, with a consequent failure to understand the markets and counterparties properly. Local authorities are now recognising that safeguarding invested cash requires an adequate level of resource; and many have either allocated extra resource, or are now considering how best to allocate extra resource to this function.

103 In some cases, county councils look after funds for police and fire authorities. This arrangement is potentially a good way of reducing costs. However, if this approach is adopted, there needs to be clear separation of funds, which should be managed in line with the policy of the owner of the deposits rather than the manager.

104 Local authority staff working in treasury management hold a variety of general accountancy qualifications, including CIPFA; Association of Chartered Certified Accountants; the Chartered Institute of Management Accountants; and the Association of Accounting Technicians. Treasury managers from two of the 37 case study sites hold, or are studying for, specific treasury management qualifications, including those awarded by the Association of Corporate Treasurers.

105 There are currently few training and development opportunities specifically designed for local authority treasury management staff. While the best local authorities actively encourage staff to seek further training and to identify and access networking opportunities where possible, the lack of training opportunities means that staff are very dependent on on-the-job learning and development. The quality of such training will vary and may mean that poor or outdated practices persist in some local authorities. General financial awareness is an indicator of good treasury management. Indeed, the most effective staff tend to be those who manage more than one type of investment portfolio, such as pension funds or school reserves, or who work closely with managers responsible for pension funds.

106 Local authorities need to determine the level of resources they need to manage the function in accordance with advice provided by the director of finance or equivalent. In some cases, decisions will be made to outsource some or all responsibilities. Such decisions should take full account of the relative costs and benefits. It is for the local authority to specify the type of support it needs and at what level and, having let a contract, to monitor performance against this specification and satisfy itself that it is getting good value for money from the arrangement. When outsourcing is used, the accountability for public money, however, remains with the authority.

Governance and scrutiny

107 While officers from the best local authorities tend to be proactive in seeking feedback on treasury management policy and compliance, the governance and scrutiny of treasury management arrangements is generally poor.

108 The national framework requires that treasury management arrangements are considered annually at a meeting of the full council, or equivalent. However, such meetings generally afford little time for discussion and debate and the contribution of elected members is weak. Full council meetings are, therefore, unlikely to be the best place for a detailed review of policy and performance. Other bodies, particularly audit committees, should, therefore, play a more prominent role providing an oversight of treasury management policy and practice. In addition, a backward-looking, annual review of policy is not sufficient to ensure that treasury management arrangements are functioning effectively.

109 Few elected members have received training or have backgrounds that enable them to scrutinise or challenge effectively. In some local authorities, this means that officers seek to exclude elected members from discussions. In others, elected members are content to delegate responsibility for treasury management to the officers. Local authorities need to develop a governance framework of reporting and review alongside the annual review process and should work to improve the level of awareness and engagement of all elected members. As a minimum, such arrangements would include:

* an elected member (or equivalent) with responsibility for all aspects of finance, including treasury management;
* regular awareness-raising briefings to other elected members about treasury management, investment strategies and approaches for managing risk;
* inclusion of treasury management in the annual programme of internal audit reviews;
* reporting to the council, cabinet (or equivalent) and audit committee on a regular basis, in addition to the annual review;
* arrangements for producing management information that enables and prompts a user to consider security and liquidity as well as yield; and
* maintenance of a list of all current deposits available for scrutiny at any time.

110 Local authorities also need to ensure that they have in place arrangements to test for compliance that include:

* segregation of duties between staff making deals from those checking them;
* regular (at least monthly) compliance checks; and
* regular spot checks.

Local authorities have different attitudes to risk

111 There are differences in the behaviours displayed by local authorities that were non-investors in the Icelandic banks, those whose deposits matured between 1 November 2007 and 7 October 2008, and those that have funds at risk. Non-investors generally had more effective governance and scrutiny arrangements and took more measured approaches to managing risk than either local authorities whose deposits matured between 1 November 2007 and 7 October 2008 or those that have funds at risk (Table 4)Table from Audit Commission showing amounts and local authorities. Table from Audit Commission showing differences in the characteristics of investors and non-investors

112 Non-investors tended to display a combination of one or more of: more risk averse; more risk aware; more effective users of information. Their treasury management policies indicated a cautious approach, which was reflected in high rating thresholds and/ or the use of more than one type of credit rating. Others used additional information to supplement credit ratings and came to their own judgements about the suitability of potential counterparties. As early as the start of 2008, a small number of local authorities reacted proactively to increased risks in the markets. They adopted a more risk-averse approach by restricting counterparty lists to banks with the strongest credit profile.

113 In contrast, local authorities with the largest sums at risk tended to have weak governance and scrutiny arrangements, were overly dependent on external advice and failed to consider adequately the risks associated with their decisions. For example, when comparing deposits made on the same day for the same amount of money and the same duration, on average, the Icelandic banks offered better interest rates than other banks with the same credit rating. On average, local authorities received an extra 0.065 per cent interest when they invested in Iceland in comparison with other, similarly rated institutions, equivalent to an extra £650 per year per million deposited.

114 Local authorities with deposits that matured between 1 November 2007 and 6 October 2008 displayed elements of the behaviours of local authorities that had never invested and those with funds at risk. In other words, deposits made in the Icelandic banks were returned because they had good judgement, were lucky, or both.

Local authorities without Icelandic deposits tended to exhibit more of the characteristics outlined in the left-hand column. Those with funds at risk tended to exhibit more of the characteristics outlined in the right-hand column.

SandyHood

Typically, Unit 15 simulations ask you to demonstrate that you can see how there are more regulations relating to the management of cash balances in the public sector than there are in the private sector.

If you want to be ready for such a question then ask yourself:

If I was treasurer in an organisation where there was a £1.5 million cash balance which will not be needed for 9 months. What is there to stop me investing that money:

1. As today is Grand National Day - on a horse
2. In one of Alan Stanford's high interest paying deposit accounts
3. In an overseas bank offering similarly attractive terms
4. In marketable securities issued by the UK government

Hopefully you will say

What type of organisation?

Because of course, that is the heart of the question, namely:

How does the nature of the organisation (Public or Private Sector) affect the management of surplus cash balances?

sarahwilson

God Sandy you're really clever, I didnt even look at that for Unit 15.

SandyHood

Updated so that webinar students have a chance to see it before Monday's class