KYLAC: Know Your Local Authority Counterparty Amar Jandoo

While a section 114 notice is a clear indication of financial distress, the existence of this procedure underlines the strength of the local government financial framework.

A notice issued under section 114(3) of the Local Government Finance Act 1988 signifies that the issuing authority’s expenditure incurred in a financial year is likely to exceed the resources available. Until the Chief Finance Officer’s report is considered at a Council meeting, section 115(6) of the 1998 Act prevents the Council from entering into new agreements involving incurring expenditure in most circumstances. This allows intervention by central government to help the authority address their projected budgetary deficit, with a high probability that some form of support may be provided, preventing the problem from getting worse.

This raises an interesting question regarding the credit quality of authorities where these notices are issued. On the one hand, they are clearly showing signs of financial distress, on the other, the embargo on non-essential expenditure and likely government intervention, combined with other pillars of local authority creditworthiness, will probably protect investors from loss.

It would appear unlikely there will be any impact on any loans made before the notice was issued, which are expected to be repaid in full and on time, therefore limiting credit risk. Providing the authority can provide evidence that expenditure, including arrangement of new loans, prevents the situation from deteriorating, these can be sanctioned by the section 151 officer even with the section 114 in place.

Despite this, concerns remain amongst some local authorities around the reputational risk of lending to an authority that either has or may soon be required to issue a 114 notice.

The negative media attention which Midlothian Council received prompted the authority to tighten up their credit controls by creating a checklist to embed a more robust due diligence process for potential “LA to LA” counterparties.

The ‘investment checklist’ has been designed in line with Treasury Management Practice 3: Decision Making and Process to ensure a written record of due diligence is maintained, and will act as an audit trail for future transactions.

The checklist covers a range of criteria including the requirement for the counterparty to be a local authority with both a larger population and cost of services compared with Midlothian. This may prove difficult for other authorities of varying sizes to implement elsewhere, a form of ratio analysis which compares the proportionality of debt, interest and reserves may be more appropriate here.

Interestingly, a significant emphasis is placed on the level of investments and the commercial agenda of the potential counterparty to flag potential counterparties who are engaged with “debt for yield” activities. The criteria states that the counterparty must not ‘intend to buy commercial assets outside the borough/local authority area primarily for yield’ and ‘has not bought such commercial assets primarily for yield in the last two sets of audited accounts’.

From a credit perspective, authorities undertaking commercial activity continue to have recourse to the PWLB for treasury management activity, however the checklist highlights some authorities’ concern regarding lending to peers who are not complying with government guidance. From a practical perspective, it could prove difficult to ascertain which authorities are complying with the guidance without detailed analysis.

It is important to have an audit trail of the due diligence undertaken when making an investment decision to highlight that the authority has prudent practices and procedures in place and comply with CIPFA’s Treasury Management Code of Practice.

iDealTrade, Arlingclose’s local authority matching platform, provides discrete, frequently updated Financial Strength Ratings (FSRs) on local authorities that are bidding for loans on the platform. The FSRs analyse several balance sheet metrics to give each authority its own rating ranging from Gold, Silver and Bronze. Why the Olympic themed bands? We hope they imply that even when local authority financial strength is weak relative to peers, creditworthiness remains high.

Similarly, CIPFA’s Resilience Index provides a range of indicators to help authorities in their investment decision making process. Both of these tools, along with internal checks, can ensure the authority has a prudent decision-making process in place.