Treasury management strategy statement and investment strategy 2010/11

Report: 8
Date: 25 March 2010
By: Treasurer

Summary

This report sets out the Treasury Management Strategy Statement and Investment Strategy recommended for 2010/11. The strategy has been scrutinised at the Resources and Productivity Sub Committee and Finance and Resources Committee and in line with CIPFA’s revised Treasury Management Code of Practice is now presented to Full Authority for approval

A. Recommendations

That the Treasury Management Strategy Statement and Investment Strategy 2010/11 set out in this report be approved.

B. Supporting information

1. The Chartered Institute of Public Finance and Accountancy’s (CIPFA) Code of Practice for Treasury Management in Public Services was revised in November 2009 in response to the financial crisis. The Code requires that the MPA adopts an annual Treasury Management Strategy Statement (TMSS) in advance of the year, which is approved by Full Authority, and this report is submitted in accordance with that requirement. This statement also includes the Investment Strategy which is a requirement under the Communities and Local Government (CLG) Investment Guidance.

2. Furthermore the Local Government Act 2003 requires local authorities to have regard to CIPFA’s Prudential Code for Capital Finance in Local Authorities when setting and reviewing Prudential Indicators. Following a review in 2008 CIPFA issued a revised Code in November 2009. This statement incorporates recommended relevant treasury management indicators set out at Appendix 1.

Strategic Objectives

3. The MPA defines its treasury management activities as ‘the management of the organisation’s investments and cash flows, its banking, money market and capital market transactions; the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks.”

4. While no treasury management activity is without risk the MPA regards the successful identification, monitoring and control of risk to be an important and integral element of its treasury management activities. The objectives underpinning the TMSS for 2010/11, and the area of risk that the objective will control, are as follows:

• To undertake treasury management operations with regard for the security of capital invested (Credit and Counterparty Risk).
• To ensure that sufficient cash is available such that the MPA is able to discharge its financial obligations in accordance with approved spending plans (Liquidity Risk).
• To minimise the cost of borrowing and to maximise the yield from investments consistent with the security and liquidity objectives identified above (Market or Interest Rate Risk).
• To minimise the amount of borrowing to be replaced at any one time by maintaining an evenly spread maturity profile (Refinancing Risk).
• To undertake treasury management activity with regard to Prudential Code Indicators (All areas of Risk).

Outlook for interest rates

5. Treasury management operations undertaken to meet the objectives set out at paragraph 4 must have regard to the prevailing economic climate. Since 2007 reports to this Committee have provided members with updates on the 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, including the £200bn asset purchase facility implemented by the Bank of England.

6. The economic interest rate outlook provided by the MPA’s treasury advisor, Arlingclose, is attached at Appendix 2. While future interest rates will rise from the current very low position the timing and extent of rises will be determined by a range of economic and political variables. The MPA will continue to monitor evolving market conditions, the impact on interest rates and the consequences for treasury management activity.

The Investment Strategy

7. To comply with CLG’s guidance the MPA’s overriding objective is to invest its surplus funds prudently and to reduce risk in accordance with the strategic objectives set out above at paragraph 4. The guidance reiterates that security and liquidity must be the primary objectives of a prudent investment strategy and sets out criteria that identifies investments as either specified or non-specified.

Specified Investments

8. Specified investments offer high security and high liquidity and meet the CLG criteria set out below:

• The investment is sterling denominated.
• The investment has a maximum maturity of one year.
• The investment meets the high credit quality as determined by the MPA, or is made with the UK government or a local authority or a parish or community council.
• The investment is not defined as capital expenditure, i.e. not loan capital or share capital in a body corporate.

9. It is proposed that specified investments for use by the MPA are as follows:

• Deposits in the Debt Management Account Deposit Facility.
• Deposits with other UK local authorities.
• Deposits with banks and building societies.
• AAA rated Money Market Funds with a Constant Net Asset Value (NAV).

10. In any period of significant stress in financial markets, the default position is for investments to be made with the Debt Management Office or with institutions that have Government support or have very high credit ratings. This has been the position adopted by the MPA (approved by Finance and Resources Committee in November 2008). At least 25% of investments have been with the DMO (low returns an acceptable trade off for the guarantee of capital security) and with institutions rated at least AA- (long term) and F1+ (short term) and with a sovereign rating of AAA. These criteria have provided a counterparty list of six institutions.

11. With the financial crisis focussing attention on the security of capital invested CLG, in their revised guidance, state that a specified investment is one made with a body or scheme of high credit quality (this is a revision from the previous guidance of a high credit rating).The MPA, with the guidance and assistance of treasury advisors Arlingclose, will continue to maintain a counterparty list based on high credit quality criteria and will monitor and update regularly the credit standing of institutions. This assessment will include credit ratings and other alternative assessments of credit strength as outlined below at paragraph 13.

12. Conditions in the financial sector have begun to show signs of improvement giving the MPA the opportunity of now diversifying its counterparty list but adopting the concept of high credit quality as recommended by CLG. Arlingclose have recommended that it is now appropriate to extend the counterparty list by considering non UK banks for investment. This position has been reached following analysis and monitoring of a range of criteria that together create an assessment of an institution’s, or a sovereign’s, credit quality.

13. The sovereign states whose banks are to be included are Australia, Canada, Finland, France, Germany, Netherlands and Spain. These countries, and the banks within them, have been selected after careful analysis and monitoring of the following:

• Credit ratings (minimum long term A+).
• Credit Default Swaps (CDS).
• Gross Domestic Product (GDP) and net debt as a percentage of GDP.
• Support mechanisms, either from Central Government or a well resourced parent institution within a financial group.
• Share price.

These criteria include the criteria that KPMG recommended the MPA use in their review of treasury management considered by Finance and Resource Committee in February 2009.

14. The expansion of the counterparty list by 15 banks will provide additional opportunities for the placing of funds while meeting the requirement of the CIPFA Treasury Management Code, and the CLG, that the MPA is focussing on a range of indicators to determine high credit quality and is not considering credit ratings in isolation. The revised counterparty list is attached at Appendix 3.

15. Appendix 3 includes 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. The increased opportunities that will result in the spreading of risk amongst a wider range of institutions means that the individual limits for UK banks can be set at £30m, reduced from the 2009/10 limit of £50m. It is proposed that the individual limits for non UK banks are set at £20m with a sector limit of £100m.

16. The notional individual limit for the MPA banker RBS is also proposed to be £30m, in line with other UK banks, but is noted on Appendix 3 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.

17. When placing surplus funds the investment decision is made with regard to cash flow requirements resulting in a range of short-term maturity periods. CLG guidance recommends that procedures are in place to determine the maximum periods for which funds may prudently be committed, with specific reference to funds committed for more than 365 days. In practice funds are placed very short term but it is nevertheless proposed that the MPA does not invest funds for more than 365 days and this will be reflected in the relevant Prudential Code indicator at Appendix 1.

18. The inclusion of Money Market Funds provides the MPA with access to pooled funds that invest in highly diversified and high credit quality investments. Arlingclose recommend a number of AAA rated money market funds that will provide security, high liquidity and a return commensurate with high security and liquidity. Arlinglose currently recommend seven of these AAA rated funds and the MPA will consider these for placing funds with an individual limit of £20m and a sector limit of £50m.

19. Although local authorities have been included as counterparties the MPA has placed only limited funds with this sector. It is not proposed to change this approach 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.

Non-specified Investments

20. Non-specified investments do not, by definition, meet the requirements of a specified investment. These would include investments undertaken with mutual building societies that do not meet the specified criteria above or investments that have a maturity greater than one year. It is proposed that the MPA does not undertake non-specified investments.

Summary of recommended changes to the investment strategy

21. To assist members Table 1 below provides the key components of the proposed 2010/11 investment strategy with a comparison to the 2009/10 strategy. The emphasis is to move away from reliance on the DMO by creating opportunities elsewhere. Although there is an increase in the number of non UK banks there is no guarantee that the selected banks will actively take funds in line with MPA requirements. Also money market funds tend to be low yielding but should provide at least a small marginal return over that received from DMO deposits. The most significant opportunities are likely to be call accounts with UK banks that will provide a relatively attractive return and offer liquidity.

22. Short term money markets are likely to remain at very low levels, clearly having an impact on investment income. However looking at prevailing opportunities it is estimated that the benefit of placing funds in UK bank call accounts, and not with the DMO, will be approximately £0.4m a year.

Table 1: Summary of 2009/10 and proposed 2010/11 investment strategy

23. Resources and Productivity Sub-Committee of 11 January 2010 and Finance and Resources Committee of 21 January 2010 approved a borrowing strategy which included estimated new external borrowing of£50m in Quarter 4 2009/10 and outlined further borrowing to be undertaken in 2010/11.

24. It is confirmed that new borrowing of £50m, in fixed rate maturity loans, was undertaken in Quarter 4 2009/10. With the repayment of one maturity loan in March 2010, the level of external debt on 1 April 2010 will be £121.95m. (Against the 2010/11 operational boundary prudential code indicator of £303m).

25. Members are reminded that the seven year borrowing and capital spending plan confirmed the borrowing element that supports the capital programme which (including the additional borrowing contingency of £60m approved in July 2009 to address the lack of capital receipts due to the depressed property market) is set out below at Table 2. The decision to take up £90m of external loans during 2010/11, or to fund from internal sources, is driven by cash flow. The current cash flow forecast, which includes provision for capital expenditure as set out in the capital programme, is that external borrowing to support the cash position will need to have been undertaken by December 2010 / January 2011.

Table 2: Borrowing (Supported and Unsupported) to Fund the Capital Programme

26. During 1st quarter 2010/11 cash flow estimates and estimated future interest rates, will be closely monitored prior to the anticipated increase in PWLB rates expected during quarters 3 and 4 of 2010/11. It will be advantageous to schedule any new loans before anticipated rate increases even though the cash flow requirement may be later in the year. It is permissible under the prudential code to borrow in advance of need (up to the level of the Capital Financing Requirement (CFR)) with the cash forming part of invested balances until the related capital expenditure is incurred.

27. Upward pressure on long term interest rates will also be aided by the Bank of England’s decision not to extend the quantitative easing programme beyond the current £200bn for the time being. This will add greater importance to the timing of 2010/11 external borrowing. This will be closely monitored by MPS Treasury team, the Treasurer and Arlingclose. It is therefore proposed that new external borrowing of £90m is approved, with the timing of borrowing determined by the factors discussed above.

Treasury Management Prudential Code Indicators

28. 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. Prudential Code Indicators are set out in Appendix 1.

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

The proposed strategy for 2010-11 increases opportunities for the placing of funds away from the DMO; this is expected to increase potential interest receipts by £0.4m. Income budget for 2010-11 is £0.8m.

E. Legal implications

1. Under Section 1 of the Local Government Act 2003, the MPA as local authority defined under s23 of that Act, may borrow money for any purpose relevant to its functions under any enactment, or for the purpose of the prudent management of its financial affairs.

2. The Mayor is required under s3 of the Local Government Act 2003 to determine how much money the GLA and each functional body (which includes the MPA) can afford to borrow. In complying with this duty, Regulation 2 of the Local Authorities (Capital Finance and Accounting)(England) Regulations 2003 requires the Mayor to have regard to the Prudential Code for Capital Finance in Local Authorities when determining how much the MPA can afford.

3. The MPA’s standing orders provide the Treasurer, as the s127 officer, is responsible for the proper administration of the MPA’s financial affairs. Part F of the MPA’s standing orders also requires the Treasurer to report to the Authority, or designated committee of the Authority, on treasury management operations on a quarterly basis.

4. As is indicated in para 1 of section B an investment strategy statement must be completed as part of risk management and good Governance. The report is submitted in compliance with TMSS and CLG requirements in this regard.

5. Any further legal implications relating to the proposed capital programme will be reflected in the final report to the Authority on the capital programme in March 2010.

F. Background papers

• None

G. Contact details

Report author(s): Paul Daly, Director of Exchequer Services

For more information contact:

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

Abbreviations

CIPFA

Chartered Institute of Public Finance and Accountancy

TMSS

Treasury Management Strategy Statement

CLG

Communities and Local Government

NAV

Net Asset Value

DMO

Debt Management Office

CDS

Credit Default Swaps

GDP

Gross Domestic Product

RBS

Royal Bank of Scotland

PWLB

Public Works Loans Board

CFR

Capital Financing Requirement

ILMCS

Inner London Magistrates Courts Service

ILPS

Inner London Probation Service

EIP

Equal Instalment of Principal

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