Treasury management half-year review 2008/09

Report: 09
Date: 20 November 2008
By: the Director of Resources on behalf of the Commissioner and the Treasurer

Summary

This report provides a review of treasury management for the 6-month period ended 30 September 2008, reviews current developments in 2008-09 and recommends changes to the 2008-09 treasury management strategy.

A. Recommendations

That

1. Members agree to the proposed revisions to the Treasury Management Strategy:
   • revised Fitch credit ratings and counterparty list
   • the addition of Moody’s credit ratings
   • revised counterparty limits
   • use of the Debt Management Office facility for approximately 25% of the investment portfolio
   • the addition of UK Nationalised Institutions
   • limiting the term of investment to 3 months; and
2. note this report and the budgetary implications
    

B. Supporting information

Introduction

1. On 21 March 2002, the Metropolitan Police Authority formally adopted the key recommendations of CIPFA’s Code of Practice for Treasury Management in the Public Services as set out in Section 4 of that Code.

2. In line with the Code the MPA have adopted a treasury management policy statement that requires that the Treasurer submit a regular report on treasury and debt management operations during the financial year. This report is submitted in accordance with that requirement.

3. Additionally, under Part 1 of the Local Government Act 2003, the Authority is required to have regard to the Prudential Code for Capital Finance including the setting of Prudential Indicators. Relevant treasury management indicators were incorporated into the Treasury Management Strategy 2008-09 approved by this Committee on 21 February 2008.

4. This report sets out:

• a review of investment operations for the 6 months to 30 September 2008
• a summary of interest rate movement and investment performance for the 6 months to September 2008
• a comparison of MPA return to Benchmarking Club average return for 2007-08
• recommended amendments to treasury management strategy 2008-09
• a review of debt management operations
• an update on the treasury management Prudential Code indicators

Investment Operations for the 6 months to 30 September 2008

5. The average size of the investment portfolio for this period was £307 million. These cash balances available for investment include balance sheet reserves and provisions, unapplied capital receipts and grant and cash arising from the timing of large receipts and payments.

6. The structure of the portfolio continues to reflect the investment instruments selected for investment purposes as defined by the Treasury Management strategy. Table 1 provides an analysis of average investment balances for each counter-party sector and the number of counterparties used within each sector.

Table 1 – Portfolio average sector size 6 months to 30 September 2008

7. The non UK Bank sector of the portfolio represents 45% of funds invested across six countries with 12 banks. This includes the £30m of funds with an Icelandic Bank and frozen by the Icelandic Government. The UK Banks sector and call money at 35% represented funds invested with 6 banks and the Building Society sectors at 20% with 8 societies. Placing funds with a number of financial institutions spreads risk across the portfolio.

8. The contraction of the counterparty list, which started with the removal of Northern Rock in September 2007 and subsequently other banks such as Bradford and Bingley removed in May 2008, resulted in a reduced number of opportunities available for the placement of funds. This created difficulties for treasury operations, particularly on days when large grants were received, the counterparty limits with some banks had already been reached and other banks did not want the size or term of deposits that met MPA/MPS cash flow requirements. The recommendations set out later in this report for the revision of the Treasury Management Strategy address such difficulties.

9. This Committee considered an update on MPA Icelandic Investments at the meeting of 23 October 2008 assessing the fallout from the unprecedented turmoil in financial markets, which has continued throughout this period. The collapse of Lehman Brothers in the USA sent shock waves across international markets leading to further tightening of the Interbank market (where banks lend to each other) and increased scrutiny of banks and the support offered by Governments. Speculation led to a run on many banks worldwide leading to decreasing share prices and capital value. Led by the UK, Central Banks and Governments had to offer substantial financial assistance to their banks to avoid further insolvencies.

10. From the outset of the financial market difficulties, all MPA investments have been compliant with the credit rating requirements set out in the Treasury Management Strategies 2007-08 and 2008-09. In line with CIPFA, guidance credit ratings underpin the Treasury Management strategies and the creditworthiness of investment counterparties is monitored continuously. Additionally the Treasury section accesses other sources of information to inform decision making. This includes press and other media comments, broker knowledge and analysis and networking with other local authority and GLA Group treasury practioners. Advisory services are available and, whilst used by some local authorities and other members of the GLA group, they are not used directly by the MPS Treasury Management team.

11. Compliant investments include the two investments with Landsbanki frozen by the Icelandic Government. Although the Icelandic Banks were operating effectively with a large capital base, the relatively small Icelandic Government was unable to guarantee support such as the support subsequently seen in the UK and elsewhere. This led to the unprecedented action by the Icelandic Government of freezing assets and assuming responsibility for their banks, an action not predicted by the rating agencies until a downgrading on 30 September 2008.

12. At the time of writing the Icelandic and UK Governments continue negotiations. The Local Government Association and the Association of Police Authorities continue to lobby the UK Government for a successful and speedy resolution for the return of local authority and police authority deposits. The MPA/MPS has registered its creditor interest with Deloitte and Touche, appointed to assist with communication and consultation directly with creditors about the realisation of assets and making payments to creditors.

Interest rate movement and investment performance for the 6 months to September 2008

13. Since July 2007 when the Base Rate was at 5.75%, we have seen four rate reductions. The last 50 basis point fall was in October 2008 to 4.50% but the Interbank market has been slow to respond while confidence remains low.

14. The reported annual budget for interest receivable on investments is £11.8 million, and as at period 6 we are on track to exceed this.

15. Performance is monitored against the British Bankers Association (BBA) London Inter-Bank Offer Rate (LIBOR). This offer rate is higher than the daily rate that can be achieved but does offer a guide to performance. The 6-month MPA return of 5.38% compares with BBA LIBOR (1 week) of 5.17% and BBA LIBOR (1 month) of 5.49%.

Comparison of MPA return to Benchmarking Club average return for 2007-08

16. The MPA is a member of the Institute of Public Finance (IPF) Treasury Management Benchmarking Club. Analysis from financial year 2007/08 is reviewed at Table 2 and compares the MPA return to the group average.

Table 2 – Comparison of MPA return to Benchmarking Club Average 2007/08

17. The higher return the MPA achieved on call accounts reflects the competitive rate paid on the call account. The MPA return on fixed term investments (cash < 364 days) is slightly below average for the group reflecting the need to cover the short-term cash position. The return on fixed term investments (cash> 364 days) is lower for the MPA because this return reflects investments placed 2 years ago when long-term interest rates were lower. However, these longer-term investments represent about 13% of the portfolio and when combined with the other investments the MPA return is slightly below the average for the group.

18. The average return shows that the MPA has continued to take regard for security and liquidity of its investments and not pursued high returns as a priority.

Amendments to MPA Treasury Management Strategy

19. The recent events in the financial markets, the requirements for Governments to guarantee support for their banks and the performance of rating agencies particularly concerning Icelandic Banks, requires that we thoroughly evaluate the treasury management approach to risk and review the counterparty list, individual counterparty limits and consider other investment opportunities.

Credit Ratings

20. It is proposed that the Fitch Ratings criteria will be revised as follows:

Additionally, in view of guaranteed support from their Central Governments, only UK, Eurozone and Australasian banks will be considered as suitable counterparties.

21. Applying the above minimum criteria the revised MPA lending list now contains six UK and nine foreign banks, reduced from seven and 15 respectively. Please see Appendix 1.

22. Only the largest building societies provide credit ratings. While the 2008-09 strategy accepted non-credit rated building societies as non-specified investments it is now proposed that only building societies that meet the revised rating criteria above are included on the lending list. One building society meets these criteria (reducing from 18 the number of societies on the counterparty list) and is included in Appendix 1.

Additional credit ratings

23. The guidance issued under the Local Government Act 2003 and incorporated in the MPA/MPS Investment Strategy requires the use of a credit rating agency for monitoring the security of investments. As detailed above the MPA/MPS uses Fitch Ratings but it is now proposed to add ratings from Moody’s and in assessing minimum risk use the lowest common denominator from the two agencies.

24. With access to ratings information from the GLA the Moody’s ratings comparable with the proposed Fitch Ratings are:

25. The ratings agencies also advise when an institution’s ratings are under review. Institutions under review and any changes to ratings will be monitored to identify any weakening of an institution’s credit worthiness. The names of institutions being monitored and institutions that are removed from the counterparty list will be advised to the MPA Treasurer. Equally, the Treasurer will be advised when an institution is no longer being monitored or when an institution is to be added to the counterparty list. This additional level of credit risk monitoring will provide added assurance about the security of investments.

Counterparty Limits

25. Appendix 1 also shows the proposed individual limit for each counterparty. The counterparty limit for foreign banks is unchanged at £30m but to provide sufficient opportunity to place funds, particularly when the portfolio is in excess of £400m, it is proposed the individual counterparty limit with UK banks and one UK building society is raised to £60m, from £40m and £30m respectively.

26. The proposed combined individual limits of the 16 banks and one building society is £690m. While this is large compared with the actual portfolio size banks are not always active in taking funds that meet the cash flow requirements of the MPA/MPS.

27. The notional individual limit for our banker RBS is also proposed to be £60m, in line with other UK banks, but is noted on Appendix 1 as having no counterparty limit. Occasionally very late receipts, such as the capital receipt from the sale of a building, will be received into the current account. Late funds cannot be placed elsewhere and will remain within RBS accounts and a ‘no limit’ assignment to RBS allows for this.

Debt Management Account Deposit Facility

28. The Debt Management Office (DMO), an Executive Agency of HM Treasury, operates a Debt Management Account Deposit Facility that carries the government’s sovereign AAA credit rating This facility offers the highest available security at a lower return and has been used increasingly by local authorities and other public sector bodies with over £10bn placed during the first three weeks of October, compared to previous levels of about £1bn. It is proposed that the MPA/MPS maintains about 25% of funds in this facility with no upper limit to the balance of funds invested.

Local Authorities

29. The Treasury Management Strategy for 2008-09 provides that investments can be made with a Local Authorities. There have been limited funds placed with local authorities, the last placement being made in May 2007. Local authorities are not active in the money market for borrowing but when they do seek funds, their requirements for the size and term of funding are unlikely to meet MPA/MPS requirements. However, there will be no change to the current strategy and if opportunities arise these will be considered. The counterparty limit assigned to a local authority is based on the authorities budget (standard spending assessment).

Nationalised Institutions

30. It is proposed that two nationalised banks, Northern Rock and Bradford and Bingley, will be considered for investments. The Government currently fully guarantees short-term deposits and in line with that guarantee funds placed with these banks will be for a maximum of three months. In line with UK Banks the proposed counterparty limit is £60m for each bank. However, these banks are currently experiencing a large inflow of short term cash and opportunities may be limited.

Cash Money Market Funds (MMFs)

31. The Treasury Management Strategy 2008-09 also provides that funds may be placed with cash money market funds. These funds consist of cash deposits invested across a wide range of institutions thereby spreading risk. Invested funds are also easily accessible providing additional liquidity. It is proposed that use of such funds continues as a possible investment option with a maximum of £30m placed with any one fund.

Other investment options

32. To continue current practice investments will not be made that involve the acquisition of share capital or loan capital in any body corporate. Additionally it is not intended to invest in other marketable securities such as Certificates of Deposit, Gilts or Treasury Bills where throughout the term of the investment the value of the principal sum invested is determined by market conditions.

Term of Investment

33. The Treasury Management Strategy 2008-09 provided for limited long-term investment (one year to three years) of £40m with the balance of the portfolio to be short term (less than 364 days). During 2008-09, all long-term investments will have matured and currently £34m of short term investments mature during 2009. To reduce risk further it is proposed that during current market conditions the term of all investments made with financial institutions and local authorities is less than 3 months.

CIPFA Treasury Management Panel – Risk Management

34. CIPFA’s Treasury Management Panel have initiated a discussion on how best to promote the practice of active and effective treasury risk management in local government. In October 2008, the Panel issued their discussion paper on extending the risk management techniques used by local authorities and will lead to active risk management being incorporated into high-level guidance issued by the Panel. The MPA/MPS supports the issuance of such guidance and possible accompanying initiatives such as:

• The production of a risk management ‘toolkit’
• The provision of a more formal education and training programme in treasury management
• The development of a practitioner’s treasury management manual

Treasury Management Governance

35. Currently the Finance and Resources Committee receives three reports annually: a report setting out the annual treasury management strategy, this report on treasury management activity in the first six months of the financial year and an outturn report. It is proposed to increase MPA governance of treasury management operations by submitting additional reports to the Resources Sub Committee. The detail of this reporting will be determined once the terms of reference and meeting arrangements of the sub committee are established.

Debt management operations

36. The balance of debt outstanding at 30th September 2008 is £42.34 million, unchanged from 31 March 2008. The rate of interest paid on the debt portfolio was 5.69% and no long-term debt management operations were undertaken this period.

37. Borrowing to finance capital investment is presently forecast at £40m in 2008/09, £50m in 2009/10, and £40m for subsequent financial years. At the present time, cash flow predictions indicate that the £40m borrowing in 2008/09 can be met from internal resources e.g. reserves and it will not be necessary to secure external loans to cover the level of borrowing envisaged. From 2009/10 onwards, it is calculated that external loans will need to be negotiated to ensure sufficient cash is available to the MPA/MPS to meet the level of borrowing required to finance the capital programme.

38. The borrowing limits set by the GLA for the MPS for 2009/10 and 2010/11 only allow for existing levels of external debt. They would need to be renegotiated to allow for new external loans to be taken out. The GLA has agreed to review the borrowing limits as part of the 2009/10 budget setting exercise.

Treasury management Prudential Code indicators

39. Prudential Code indicators specific to treasury management are designed to ensure that treasury management is carried out in accordance with good professional practice. Indicators for 2008-09, 2009-10 and 2010-11 were presented to this Committee as part of the 2008-09 treasury management strategy.

40. The 2008-09 indicators and actual figures for the 6 months to 30 September 2008 are set out at Appendix 2. Investment activity has been maintained within indicator limits.

Abbreviations

BBA

British Bankers Association

CIPFA

Chartered Institute of Public Finance & Accountancy

DMO

Debt Management Office

HBOS

Halifax Bank of Scotland

LIBOR

London Interbank Offered Rate

RBS

Royal Bank of Scotland

C. Race and equality impact

1. Consideration is given to the requirements of the Race Relations (Amendment) Act through the MPA/MPS Environmental Strategy and Ethical Investment Policy whereby best practice standards are promoted.

2. The draft MPS Ethical Investment Policy was included for consideration by Finance Committee on 21 February 2008 as part of the Treasury Management Strategy 2008/09. Following review of the proposed Ethical Investment Policy by Finance Committee further information and consultation is ongoing before the policy can be communicated to all MPA finance counter parties. The proposed amendments to the Treasury Management Strategy in this report will not affect that process.

D. Financial implications

1. The financial implications of the freezing of £30m deposits by the Icelandic Government cannot be determined until negotiations between the Icelandic and UK Governments are concluded.

2. Whilst the freezing of these deposits has no immediate impact on the MPA being able to meet its liabilities, the Authority is currently foregoing some £4,500 a day interest.

3. In the event of the funds deposited not being recovered the £30m loss will have a significant impact on the Authority’s finances.

4. The proposed changes to the Treasury Management strategy will impact on the level of future income from investments. The lower return from deposits placed with the DMO, Nationalised Institutions and Local Authorities and the short placing of funds (possibly foregoing enhanced returns from placing longer term deposits) will reduce income from investments.

5. The 2008/09 budget includes income provision for interest receipts of £11.83m. At period six, the forecast for the year was £15m, i.e. an overachievement of £3.2m. The proposed changes to the Treasury Management strategy including the placement of 25% of the investment portfolio with the DMO, is expected to reduce potential interest receipts by £0.5m in the current year and £1.5m in the full year.

6. Interest receipt income will also be affected by recent moves by central banks to reduce base rates as governments move to reduce the size and impact of the anticipated global recession. A 1% variation on interest rates secured on deposits equates to some £3m. This volatility in the market will have to be considered in finalising the 2009-12 budget. The draft submission, which is considered elsewhere on the agenda currently holds the income budget at the 2008/09 level of £11.8m. This position will be kept under review and, if necessary, adjusted before the Policing Plan and budget is finalised in March 2009. However, any reduction in this budget will need to be accommodated within the overall resources available to the MPA/MPS.

E. Background papers

None

F. Contact details

Report author(s): Simon Hart, A/Director of Finance, MPS

For more information contact:

MPA general: 020 7202 0202
Media enquiries: 020 7202 0217/18

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