As featured in Public Finance on 04/10/2021.
The provisions of the prudential framework are under scrutiny once again with the main aim to address continued borrowing by some local authorities for commercial investment purposes. CIPFA is seeking to make it crystal clear that local authorities should not be borrowing for the primary purpose of obtaining a commercial return and that such activity is a risk to prudent investment. Alongside the recent changes to PWLB access rules, local authorities should be left in no doubt that CIPFA and central government do not think that they should be investing in capital assets just to earn a yield. The message is simple: stop buying commercial property for yield or further intervention in the prudential framework will follow.
This is the key issue the revisions to the Code will be addressing through new wording, clarifications and definitions, aiming to get rid of ambiguities and misinterpretations. Alongside this, a new objective of the Code will be added in the form of proportionality, such that an assessment of risk to the level of resources is carried out for capital expenditure, while also recognising that commercial risk is often part and parcel of successful capital plans such as regeneration schemes.
Another change which may seem less worthy of column inches at first, but which Arlingclose believes warrants further attention is the formal adoption of the ‘liability benchmark’ as a treasury indicator. This is a concept that CIPFA has long promoted and which we have supported as a fundamental part of the treasury management toolkit to help make borrowing, investment and related risk management decisions. Indeed, it is an essential piece of analysis we use when advising our local authority treasury clients.
The liability benchmark is a useful treasury management tool because it represents an authority’s expected net borrowing requirement (plus any liquidity allowance), succinctly capturing the fact that while the capital financing requirement represents an authority’s underlying need to borrow
for capital purposes, the underlying need to borrow for all purposes is likely lower. This is because there will be internal resources available, such as useable reserves, giving rise to cash balances that can be used to fund capital expenditure instead of utilising external borrowing (the concept of ‘internal borrowing’). Given the current interest rate environment, maximising the use of internal borrowing remains a sensible approach.
Without projecting the optimal level of borrowing (from a risk management perspective) that the liability benchmark represents, authorities may end up borrowing too much, for too long and/or using an inappropriate structure. Borrowing above the liability benchmark level will give rise to investment balances, which may mean incurring a cost of carry and taking additional credit risk. Of course, there may be legitimate reasons for doing so, such as interest rate risk management, but the benchmark is key to making such decisions on an informed basis.
So we think the liability benchmark taking on increased prominence within the prudential framework is a positive development. Its new status as an indicator means it will definitely sit within strategy documents next year and therefore local authorities will need to look at it in more detail than perhaps they have previously. A good understanding of its use and limitations is essential to risk management and CIPFA has promised that substantial guidance will be provided on its calculation and use in the new Code.
The liability benchmark is a great tool to help optimise the maturity structure of debt portfolios and analysis can be extended to identify refinancing risk and quantify interest rate risk. However, on its own, it can’t tell you if borrowing is prudent, affordable, or sustainable. An increased focus on the proportionality and affordability of debt should help improve the code in this area, although the challenge is developing a system that can be sensibly adopted by all.
Revision to the Prudential Code - A method of Capital Control?