Local Authority Credit Risk

Wednesday 21 February 2018   Category: Local Authorities By Amar Jandoo

Introduction

Arlingclose is often asked whether a certain local authority, or local authorities in general, are a safe counterparty for investing cash. The unease about the impact of continued budget cuts on local authority finances has prompted concern over their ability to repay creditors. More recently, investment by local authorities in commercial property has created further speculation regarding their creditworthiness. 

Why Lend to a Local Authority?

Local authorities are regarded as very low credit risk investment counterparties. As public sector organisations they are far less subject to the type of market forces that can make banks and other businesses insolvent and although they may merge, split or otherwise change, they and the functions they provide are unlikely to cease to exist. 

Most local authorities are not rated by credit rating agencies, however those that do possess strong ratings.

Legislative Requirements

Under the Local Government Act 2003, a local authority in England and Wales may borrow or invest “for any purpose relevant to its functions under any enactment, or for the purpose of the prudent management of its financial affairs”. Similar legislation applies to authorities in Scotland and Northern Ireland.

Local authorities are required to determine and keep under review the limits of how much money they can afford to borrow. Scottish local authorities are also required to create and keep under review the limits of how much money is allocated to capital expenditure. 

The 2003 Act prevents an authority in England or Wales from mortgaging or charging any of its property or assets as security for borrowings or amounts it otherwise owes. Further to this, all creditors of a local authority, including businesses, banks, the PWLB, and trade creditors, rank equally without any priority. This is in stark contrast to wholesale depositors’ ranking in the creditor hierarchy of a bank, where they sit below most types of investor other than shareholders and junior bondholders. Again, similar legislation applies in Scotland and Northern Ireland.

The Local Government Finance Act 1992 requires a local authority to calculate its budget requirement for each financial year, including the revenue costs which flow from capital financing decisions. The 1992 Act requires an authority to set a council tax sufficient to meet its expenditure after considering other sources of income. This is known as the ‘balanced budget requirement’.

Public Works Loans Board (PWLB)

The PWLB is a statutory body operating within the United Kingdom Debt Management Office, an executive agency of HM Treasury. Unlike private sector entities, local authorities have access to loans from the PWLB at any time, for any amount and for maturities up to 50 years. Access to these loans is granted within two working days. 

All local authorities are treated by the PWLB on an equal footing, hence making a situation where an authority may literally run out of cash to pay creditors unlikely. The National Loans Act 1968 limits the aggregate amount that may be outstanding in respect of commitments entered into by the PWLB; this was increased to £95bn in December 2017. The total of loan principal outstanding at 31st March 2017 was £67.1bn. (source: PWLB Report and Accounts 2016-2017).

In 2015 the government announced its plans to abolish the PWLB and transfer its lending functions to another body using powers set out in the Public Bodies Act 2011. Local authorities will continue to have access to an identical range of new borrowing facilities and terms that currently exist with the PWLB. Despite its intended abolition, HM Treasury has confirmed that its lending functions will continue unaffected, albeit under a different body; local authorities will continue to access borrowing on favourable terms. 

Central Government Oversight and Likely Support

The legislation gives the Government and devolved administrations the power, in exceptional circumstances, to intervene in local authorities’ self-regulatory process if:

  • they consider an authority plans to undertake borrowing or incur expenditure that is considered unaffordable, imprudent or unsustainable
  • or if macro-economic reasons demand, to set limits to the overall level of borrowing and capital expenditure of all authorities

These powers have not been used since the commencement of the 2003 Act.

English local authorities are required to issue a notice under section 114(3) of the Local Government Finance Act 1988 if there is a significant risk that it will not be in a position to deliver a balanced budget by the end of the year. Until a meeting is called, and a report into the authority’s finances is considered, section 115(6) of the Act prevents the Council from entering into new agreements which may involve the incurring of expenditure by the authority in most circumstances. This is likely to include loans that would incur interest expenditure. This financial control enables authorities to highlight budgetary shortfalls at an early stage, enforcing remedial measures on the authority.

What are the Risks?

Reduced Central Government Funding

Local authorities continue to face budgetary pressure as Central Government funding is reduced. In England, the Revenue Support Grant is being phased out, with plans to allow authorities to retain 100% of business rates by 2020. This will place more reliance on revenues generated in local economies, creating volatility in revenue streams and disparity in the financial performance of authorities. The transfer of power and funding from central to local government, via devolution deals, transfer freedoms and flexibility to a local level, but also transfers risk.

Capital Investment Projects and Commercial Activity

Many authorities have developed plans to stimulate local economies and provide housing through capital investment projects, typically funded via additional borrowing. Some have diversified revenue streams through the acquisition of commercial properties, funded with debt, predominantly from the PWLB.

This chart shows the increase in capital expenditure financed by borrowing across English local authorities.

Increased Revenue Volatility and Risk Profile at Some Authorities

As local authority finance evolves, there is an increased probability of individual authorities encountering budget difficulties. Risk will be heightened where the strategic response to budgetary pressure includes reducing reserves and increasing exposure to both debt and capital investment projects, with uncertain revenue streams. However, Arlingclose believes the probability of a UK local authority default on debt obligation remains low, with expected loss given default lower still. The Local Government Finance framework, creditor protections and likelihood of central government support result in local authorities, including those facing particular budgetary challenges, retaining high levels of credit worthiness.

Summary

The perception of local authority credit risk has changed over the past decade as councils have been forced to find alternative ways to balance revenue budgets. As local authorities seek to generate other income streams and borrow to make capital investments in more diverse projects with potentially volatile cash flows, more emphasis has been placed on the risk profile of individual authorities. 

Regardless of these developments, local authority credit strength remains high, due to the legislative requirements and likely support of central government. Councils are also able to access funding from the PWLB quickly and easily. Although some authorities may falter, the prospect of a local authority defaulting on loan obligations remains low. If an authority were to default, an event unprecedented in modern times, the expected loss given default is expected to minimal.

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