Treasury Management and Investment Strategy 2009/10

Report: 10
Date: 19 March 2009
By: Treasurer

Summary

This report sets out the Treasury Management and Investment Strategy recommended for 2009/10.

A. Recommendations

Members are invited to:

1. Approve the 2009/10 Treasury Management and Investment Strategy set out in this report

B. Supporting information

Background information

1. On 21 March 2002 the Metropolitan Police Authority (MPA) formally adopted the key recommendations of the Chartered Institute of Public Finance and Accountancy’s (CIPFA) Code of Practice for Treasury Management in the Public Services as set out in Section 4 of that Code.

2. The Code requires that the MPA will receive an annual strategy and plan in advance of the year. This report is submitted in accordance with that requirement.

3. Additionally, guidance issued 1 April 2004 by the Secretary of State under Section 15(1)(a) of the Local Government Act 2003, requires an Annual Investment Strategy that contains specific reference to the security and liquidity of investments. This report will incorporate those requirements.

4. Furthermore under Part 1 of the Local Government Act 2003 local authorities are required by Regulation, effective 1 April 2004, to have regard to the Prudential Code for Capital Finance. The Prudential Code introduced requirements for how capital spending plans are considered and approved as part of an integrated treasury management strategy.

5. The Prudential Code also requires the Authority to set a number of Prudential Indicators and this report incorporates recommended relevant treasury management indicators set out at Appendix 1.

Strategic objectives

6. The objectives underpinning the strategy for 2009/10 are as follows:

• To undertake treasury management operations with primary regard for the security and liquidity of capital invested.
• To minimise the cost of borrowing and to maximise the yield from investments consistent with the security and liquidity objectives identified above.
• To ensure that sufficient cash is available such that the MPA is able to discharge its financial obligations in accordance with approved spending plans.
• To promote and encourage commitment to the ethical investment guidelines set out in the MPA Ethical Investment Policy Statement.
• To undertake treasury management activity with regard to Prudential Code Indicators.

Market conditions

7. Treasury management operations undertaken to meet the objectives set out at paragraph 6 must have regard to the prevailing economic climate. Reports to this Committee have provided members with updates on the unfolding turbulence in the global banking and money market system from the first evidence of the credit freeze in the UK in 2007, through the extreme conditions following the collapse of Lehman Brothers in the USA, the freezing of Icelandic Bank assets and the substantial financial assistance provided by Central Banks and Governments in a bid to avoid further insolvencies.

8. To reduce the impact of global economic downturn Central Banks have reduced interest rates. The Bank of England has reduced UK base rate from 5.75% in July 2008 to 1% in February 2009 in a bid to reverse the biggest slide in the UK economy since the depression of the 1930’s.

9. Shares in the UK banking sector remain under pressure as huge losses are announced by some banks as the full extent of exposure to bad debt, either resulting from acquisitions and mergers or from flawed retail lending policies, is revealed.

10. This Committee on 20 November 2008 reviewed treasury management activity and due to uncertainty in the economic climate accepted recommended changes to the 2008-09 treasury management strategy. These changes recognise the need to strengthen minimum rating criteria following compliant investments with Iceland that were subsequently frozen and the realignment of the portfolio to secure deposits with the Government Debt Management Office). To ensure the placement of funds the individual limit with UK banks was increased. The use of an additional rating agency, Moody’s, was also agreed.

11. This Committee on 20 November 2008 also resolved to commission KPMG to undertake an external independent specialist review of the actions taken that led to the MPA having investments with Icelandic banks. The report and recommendations were reviewed by this Committee on 5 March 2009.

12. It is in the context of the evolving and turbulent environment and considering the KPMG report and revised 2008-09 strategy that the 2009-10 investment strategy is devised. The 2009-10 strategy complements revisions made in November 2008 but adds additional ratings to reduce risk, such as sovereign ratings. Individual limits are reduced, lowering exposure to individual counterparties but also recognising the reduced cash balances following the purchase of NSY.

13. The KPMG report mentioned that the revised strategy was conservative and appropriate for prevailing market conditions. While the MPA is aware that other members of the GLA Group have taken a different approach in their lending practices (e.g. either lending to the DMO only, or in another instance having an extensive lending list of banks and building societies) the MPA believe the proposed strategy is currently appropriate.

14. Further recommendations of the KPMG report concern delegated responsibilities and the requirement to update the treasury management policy. A revised treasury management policy together with alignment of the scheme of delegation/financial regulations will be brought to the next committee.

The Investment Strategy

15. Cash balances will be invested in accordance with the Code of Practice and with regard to guidance, which requires a prudent approach to the investment of temporarily surplus funds with priority given to security and liquidity. Under this guidance investments fall into two separate categories, either specified or non-specified investments, and there should be further regard to liquidity levels.

Specified investments

16. Specified investments offer high security and high liquidity and satisfy the conditions set out below:

• The investment is denominated in sterling and any payments or repayments in respect of the investment are payable in sterling only.
• The investment is not a long-term investment (has a maturity of less than one year).
• The investment does not involve the acquisition of share capital or loan capital in any body corporate.
• The investment is either:
  • made with the UK Government or a local authority or a parish or community council, or
  • made with a body or in an investment scheme which has been awarded a high credit rating by a credit rating agency

17. It is proposed that specified investments include the following institutions:

• UK Banks, foreign banks registered in the UK and mutual building societies with a high credit rating
• Debt Management Account Deposit Facility
• UK local authorities
• Nationalised Banks (Northern Rock and Bradford & Bingley)

UK Banks, UK Building Societies and Foreign Banks

18. Fitch Ratings and Moody’s provide ratings. To be deemed to have a high credit rating the institution must satisfy the minimum of six criteria. These minimum criteria were approved by this Committee on 20 November 2008 and are currently applied to the lending list:

19. The ratings agencies 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 are advised to the MPA Treasurer. Equally the Treasurer is advised when an institution is no longer being monitored or when an institution is to be added to the counterparty list. This credit risk monitoring provides added assurance about the security of investments.

20. Indications are that future CIPFA guidance on treasury management is likely to cover “country risk” [1] to assess the risk in the financial sector of a particular country rather than that of a single bank. Ahead of CIPFA guidance it is proposed to introduce country, or sovereign, risk as an additional criteria in assessing a high credit rating with only the highest AAA rating accepted.

21. While credit ratings underpin our approach to reducing exposure to risk the treasury section uses its contacts and other sources, such as brokers and other treasury professionals, to assess market conditions to determine the suitability of investments. This includes liaison with the treasury sections of the GLA and other functional bodies. The MPS Treasury Management Team will also be subscribing to CIPFA’s Treasury Management Forum.

22. Other tools to monitor credit worthiness will also be considered. One of the recommendations of the KPMG review was to examine the use of Credit Default Swap (CDS) prices as a market indicator of the creditworthiness of counterparties. While our enquiries indicate that CDS prices are not used elsewhere by the public sector further consideration will be given to this possible indicator and discussions are taking place with KPMG to ascertain the best cost effective way of taking this forward.

23. Applying the above minimum criteria, including the sovereign rating, provides credit rated institutions to the counterparty list at the exempt Appendix 2. This includes 4 UK Banks, one UK Building Society and 4 Foreign Banks. The MPS Treasury management Team are currently in the process of commissioning a third rating agency, S&P, to give an even broader spread of rating views. When this process is complete the proposed minimum criteria will be reported to the Resources Sub-committee.

Non-specified investments

24. Non-specified investments do not, by definition, meet the requirements of a specified investment. And the guidance requires that greater detail is provided of the intended use of non-specified investments due to greater potential risk. Previously two types of non-specified investment have been used:

• investments undertaken with mutual building societies that do not meet the specified criteria of section 16 above
• investments that have a maturity greater than one year

25. However, in line with the revised changes to the 2008-09 strategy accepted on 20 November 2008 the MPA does not invest in non-specified investments and currently has no investments with building societies (other than the high credit rated society listed at exempt Appendix 2) and no long-term investments.

Liquidity of investments

26. Each investment decision is made with regard to cash flow requirements resulting in a range of short-term maturity periods within the investment portfolio. To reduce risk this Committee approved on 20 November 2008 that the term of investment is limited to 3 months. To cover short-term commitments and to further assist cash flow planning we shall continue to maintain an instant access account with Royal Bank of Scotland (RBS) and Bank of Scotland (BOS) providing a maximum balance of £50 million.

27. This Committee on 22 January 2009 received an update on banking with RBS, contracted to provide MPA banking services. This advised that although the individual credit rating for RBS was now below the minimum required, the Government’s commitment to supporting RBS provides a degree of confidence in the security of funds held with RBS. It is proposed to continue to make full use of the RBS call facility.

Counterparty limits

28. Exempt Appendix 2 also shows the proposed individual limit for each counterparty. These limits must provide sufficient opportunity to place funds particularly at the time of receipt of large scale grants and funding. However, with the purchase in December 2008 of New Scotland Yard from cash balances the size of the portfolio has reduced and the proposed individual limits for foreign banks are reduced to £20m with a sector limit of £20M and for UK banks to £50m (from £30m and £60m respectively).

29. The notional individual limit for RBS is also proposed to be £50m, in line with other UK banks, but is noted on exempt Appendix 2 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 and a “no limit” assignment to RBS allows for this.

Debt management account deposit facility

30. 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. It is proposed that the MPA continues to maintain about 25% of funds in this facility with no upper limit to the balance of funds invested.

Local authorities

31. Although local authorities have been included as counterparties limited funds have been placed with this sector. However there will be no change to current strategy and if opportunities arise that match MPA requirements these will be considered. The counterparty limit assigned to a local authority is based on the authority’s budget.

Nationalised industries

32. It is proposed that two nationalised banks, Northern Rock and Bradford & Bingley, are retained on the counterparty list with individual limits of £50m. There have been no opportunities to place short-term funds with these banks and it is expected that future opportunities may be similarly restricted.

Other investment options

33. Continuing 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.

Treasury management governance

34. The MPA governance of treasury management operations will be increased by submitting additional quarterly reports to the Resources Sub-committee. The detail of this reporting is at an early stage but initial reports were considered by the sub-committee on 16 March 2009. One of these reports set out a draft MPA Ethical Investment Policy for consideration and comment.

Treasury Management Prudential Code Indicators

35. The Prudential Code has a key role in capital finance decisions with objectives that ensure capital investment plans are affordable, prudent and sustainable. The prudential indicators specific to treasury management are designed to ensure that treasury management is carried out in accordance with good professional practice including the adoption of the CIPFA Code of Practice for Treasury Management in Public Services approved by this committee on 21 March 2002.

Interest rate exposures

36. The purpose of the prudential indicators that set the upper limits on fixed interest rate and variable interest rate exposures is to set ranges that will limit exposure to interest rate movement. On the one hand fixed rate borrowing and investment can contribute to reducing uncertainty but on the other variable interest rates give flexibility that can assist in enhancing performance. The indicator required by the prudential code considers the net position of borrowing and investment. The upper limit on fixed rate exposure of 95% and variable rate of 30% on net principal sums (set out at Appendix 1) means fixed interest rate exposure can be managed within the 70% to 95% range and variable interest rate exposures within a 5% to 30% range.

37. To assist operational treasury management purposes two discretionary indicators have been selected, setting upper and lower limits for interest rate exposure on gross borrowings and on gross investments (see Appendix 1). These indicators give an upper limit for variable rate borrowing of 15% and for investments of 40%.

38. The prudential code also identifies the risk inherent in the maturity structure of an investment portfolio that there may be a requirement to realise an investment before it reaches final maturity. To address this risk we have a policy of maintaining up to £100 million in instant access accounts and cannot foresee that early maturity of a fixed term deposit would be necessary. As an additional measure the prudential code requires that a limit is set for sums that are invested for periods longer than 364 days, to limit over commitment and further reduce the need of early maturity. As previously described there will be no investments undertaken with a maturity of greater than 3 months.

Maturity structure of borrowing

39. At 1 April 2009 the MPA debt portfolio is estimated to be £47.34 million This includes debt held on behalf of the former Inner London Magistrates’ Courts Service (ILMCS) and the former Inner London Probation Service (ILPS). The breakdown between the three services is shown in Table 1.

Table 1 – Outstanding debt at 31 March 2009

40. The Greater London Magistrates’ Courts Authority and the National Probation Service have an obligation to reimburse the MPA for costs incurred in discharging the debt of ILMCS and ILPS respectively. Currently the Courts and Probation services make annual repayments to the MPA of 4% of the balance of debt outstanding plus interest charges.

41. Maturity loans totalling £4.34 million are due for repayment during the year plus the principal repayments of new loans which are structured as Equal Instalment of Principal (EIP) loans. The recommended maturity structure of borrowing at Appendix 1 reflects the maturity profile of the 11 maturity loans in the portfolio plus the EIP loans.

External debt

42. Finance and Resources Committee of 5 March 2009 considered the proposed Capital Programme 2009-10 to 2015-16 which included the recommendation to approve a capital spending programme for 2009-10 of £216.1 million.

43. In deciding the policy for undertaking new borrowing consideration is given to MPA cash flow, which represents both capital cash and revenue cash, and whether to raise funds externally. In view of the likely size of cash balances and the planned capital programme, which includes the escalation of the estates strategy and Olympic expenditure, it is proposed that external long term borrowing, limited to £50m, could be undertaken in 2009-10to finance the programme. Decisions to borrow, authorised by the Treasurer, are determined by the level of cash balances and prevailing interest rates and an anticipation of the funding requirement for 2009/10 and beyond. This can be done within the existing headroom allowed under the prudential code indicator for the external debt operational boundary.

44. To allow for the possibility that additional capital expenditure beyond that included in the approved capital programme may be agreed during 2009-10, it is proposed that external long term borrowing to fund this expenditure be allowed. This will be subject to prior approval by the Treasurer. This borrowing would need to be contained within the existing prudential code indicators on debt to ensure affordability. Any increases in the external borrowing limit would require the Authority’s approval. The timing of such borrowing will be determined by cash flow requirements and prevailing interest rates.

45. The prudential code requires that two limits for external debt are set and the treasury management strategy will have regard to these. The authorised limit is set at £228.2m and the operational boundary at £217.3m (see Appendix 1) and includes provision for additional long-term borrowing. Separate agreement from the Authority will be sought in advance for any proposed borrowing where the operational boundary would exceed £217m with separate consultation also taken in advance with the GLA.

46. The Treasurer reports that the authorised limit is consistent with the Authority’s current commitment, existing plans and the proposals in the budget for capital expenditure and financing, and with its approved treasury management policy statements and practices. The Treasurer confirms that the operational boundary is based on the estimate of most likely, prudent but not worst-case scenario, sufficient to allow for operational management, but without the additional headroom to allow for example for unusual cash movements. Plans for capital expenditure have been taken into account, as have estimates of capital financing requirement and estimates of cashflow requirements for all purposes. The Treasury Management Prudential Code indicators will be monitored monthly with an update provided in the six month stewardship report to Finance and Resources Committee.

C. Race and equality impact

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

D. Financial implications

1. Since the freezing of £30m deposits by the Icelandic Government in October 2008 the Local Government Association (LGA), representing public organisation creditors, have had a number of meetings with Icelandic officials and more recently the LGA have appeared at two select committee hearings relating to Iceland. Discussions are ongoing although it is too early to predict the time scale and value of funds that may be recovered.

2. 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.

3. The reduction in Base rate from 5.75% in July 2007 to 1% in February 2009 and lower cash balances since the purchase of NSY will also reduce income on investments, which is forecast to be £12.2m for 2008-09. The Policing London Business Plan and Budget considered by the Joint Finance and Resources and Strategic and Operational Policing Committees on 5 March 2009 agreed a reduction of £7M in interest receivable for 2009-10 and future years. This was based on the current interest rates, borrowing decisions on New Scotland Yard and the Authority’s Treasury Management policy agreed on 20 November 2008 in respect of placing funds in the Debt Management Office. Annual income is now estimated at £2M – a reduction of £7M. This is subject to further downward pressure depending on the interest rates applying. There was a further cut in Base Rate to 0.5% on 5 March 2009.

4. The proposed strategy for 2009-10 including the placement of 25% of the investment portfolio with the DMO is expected to reduce potential interest receipts by £0.75m. Income budget for 2009-10 is £2m.

E. Background papers

None

F. Contact details

Report author(s): Simon Hart, Acting Director of Finance Services, MPS

For more information contact:

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

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