Recent updates to the prudential framework, MRP guidance and Public Works Loan Board lending terms have all made providing loan capital to council subsidiaries less attractive. The prudential code and PWLB rules have both strengthened the limits on lending for commercial return, whereas the proposed changes to the MRP guidance requires an “Expected Credit Loss” on any capital loan to be charged directly to revenue up front; in essence charging a provision to the council taxpayer based on the level of risk involved in the loans.
The overall direction of travel for the legislative environment is clear; discouraging risk taking by councils either by refusing to fund purely commercial endeavours (the PWLB), setting a framework which seeks to prevent risk taking (the prudential code) or requiring councils to recognise the risk they are taking up front (proposed MRP guidance).
This seems to be having the desired impact, with councils redesigning projects or in some cases cancelling them all together. However, some authorities have looked at ways of undertaking planned projects whilst complying with the new rules, and one way of doing this is by obtaining third party loans for their subsidiaries, rather than lending the companies the money themselves.
On the face of it, this is “mission accomplished” for central government and CIPFA; if a risky project is undertaken the private sector is taking the risk, then the rules are working as everyone hoped.
There is of course a catch; a major reason private sector lenders are attracted to these projects is the strong credit of local authorities, and most project plans have been based on interest rates available to the council, not the interest rates on offer to a risky start up. The answer for some authorities is to provide a guarantee to their subsidiary for its private sector borrowing.
All the rules are being followed; there’s no capital loan made by the council so no MRP guidance to follow, guarantees aren’t included in the capital plan so the Section 151 officer can sign off the certainty rate form with a clear conscience and the prudential code is relatively silent on what an authority should and shouldn’t be guaranteeing.
There are two flies swimming in the ointment. Firstly, under proper accounting practice, councils are required to value the guarantee they are providing, based on the amount of risk involved and the amount of money they are guaranteeing. This calculation is very similar to the ECLs required for loans and is also required to be charged up front to the revenue account.
A back of a cigarette packet calculation might look like this; you are guaranteeing a project of £200m, if it fails, you’ll likely need to cover 50% of the loan, but luckily there’s a 99% chance the project succeeds. In this case 1% risk of paying 50% of a £200m loan is £1m that needs to be charged directly to revenue in the first year. That’s £1m that needs to be cut from budgets or £1m of council charges that need to be increased.
It is likely auditors will want to see your justification for the risks you’ve calculated, and if that risk is 2% not 1%... that is another £1m to find. Getting the calculation correct, with detailed working papers will be vital, especially as this up front charge will need to be built into budgets and business plans.
The second fly doing backstroke is that the risk we’re accounting for isn’t some academic requirement of IFRS with no relation to the real world; it is a real risk to the council – if things do go wrong the organisation has agreed to compensate a private sector investor for the risk it took, something that could stretch council budgets, and frankly will not look fabulous in the local press.
This is why it is so important to fully understand the risks involved in any project, and properly map out and disclose to members and the public what is being agreed to. In reality “a £200m guarantee” tells us little without knowing many more details of the project. Is this a step-in guarantee? A financial guarantee? Which organisation is being guaranteed? What happens if the loan is transferred? Are there any situations where the guarantee can’t be enforced?
Arlingclose has extensive experience identifying the risks associated with providing a guarantee, both to disclose the situation correctly to members and to provide auditors with assurance that the guarantee has been valued correctly in the council’s accounts.
If you would like to discuss valuation techniques, or any other element of treasury management please contact email@example.com.