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Subject: GLA Family Exposure to Counterparty Risk Report Number: 11 Report to: Budget Committee Date: 13 September 2001 Report of: Executive Director of Finance & Performance 1 Summary 1.1 This report presents the response from the core GLA to a member request for more information on the GLA family-wide exposure to credit risk when placing investments with financial institutions. 1.2 All information in this report pertaining to core GLA has been provided by each of the functional bodies. 2 Background 2.1 The core GLA operates a Treasury Management function and each functional body independently operates their own Treasury Management function in accordance with local policies. Treasury Management involves the management of each authority’s borrowing, its investments and the containment of the obvious risks associated with carrying out these functions. One of those risks involved is that the authority is not repaid in full or at all on the day that monies fall due by the party on the other side of a trade i.e. the counterparty. This may be for one of several reasons including the collapse of the counterparty institution concerned. The GLA and its functional bodies manage counterparty risks locally and at present no corporate strategy has been formulated to manage the exposure to risk across the family 2.2 Any decision reached on whether to establish a GLA Group strategy will be by way of mutual agreement between the S127 officers of the GLA and the functional bodies who have the delegated authority for the implementation and monitoring of the Treasury Management function within their organisations. 2.3 The report outlines the current arrangements within the core and each functional body and concludes that existing arrangements manage risk. However, other options considered by S.127 officers are outlined for information. Appendix 1 – Summary of arrangements Appendix 2 – Joint counterpary list Appendix 3 – GLA family counterparty limits options 3 CORE GLA 3.1 Introduction All Treasury Management activities of the core GLA have been delegated from the Mayor to the Executive Director of Finance and Performance (the core GLA S.127 officer). The overriding objective of the core GLA Treasury Management Investment function is to minimise the risks to the principal amounts invested. The core GLA is conscious of the potential risks posed by counterparty organisations not being able to fulfil their obligations to repay investments placed with them and has built in controls within its policy and scheme of delegation to ensure diversification and limits on investments placed in order to minimise risk. 3.2 Criteria for selection Only the most highly rated institutions are included within the core GLA’s counterparty list. The main criterion for inclusion is that the institution is rated by either of the three major credit agencies, Moody’s Investors Service, Standard & Poors and Fitch IBCA. The core GLA has also appointed external advisors whose responsibilities include the provision of a counterparty service. They provide monthly updates of all our counterparties and their ratings from all three bodies. This is further supplemented by their own in house research and sector analysis together with a detailed investment matrix allowing the core GLA to take informed decisions. The core GLA also receives, from its advisors urgent notifications of institutions put under credit watch or encountering other more serious problems that might lead to their demise. The core GLA uses a combination of long term, short-term individual and support ratings to determine the level of investment to place with counterparty institutions. All the institutions with which we invest are rated by all three agencies and have the highest short term rating and substantially high long term ratings with sound individual financial strength and support ratings. The highest amount that can currently be lent to any one institution is £25m. 3.3 Limits on Deposits Specific dealing limits are placed to ensure that our exposure is limited and diversified. In addition the time horizon of exposure is controlled and smaller limits are placed for maturities scheduled beyond 6 months. Each day the counterparty limit schedule is updated so the next dealer is aware of which institutions the core GLA can invest with. On any given day four to five people are involved in the process of dealing and transacting funds to a counterparty bank account. The dealing verifier and supervisor check to see that the counterparty limits have not been breached. Due to the very short-term nature and high fluctuation of core GLA investments mainly individual bank limits are maintained. However, institutional groups are identified and though each institution within the group has an individual limit, a limit is also assigned to the group as a whole. The institutional group limit is paramount if one member of the group has a limit equivalent to the group limit and has been invested with to it’s maximum investment limit, the core GLA will not be able to invest concurrently with any other institution within the group in question. Institutions are only grouped where a relationship is formed by way of merger or acquisition (i.e. wholly owned subsidiaries). The core GLA have also assigned a limit to its own bankers the Royal Bank of Scotland (RBS). The effect of this being that even though funds are left with RBS on days when their Corporate Money Market Account is offering a better rate than the money market only their assigned limit is left in the bank. The highest amount that can be lent to any one institution under the current agreed strategy is £25m. The building societies all have a £5m limit except for Nationwide, which has been assigned a £15m limit in view of its substantial asset base. 3.4 Reporting Arrangements Clear reporting arrangements exist within the core GLA and have been incorporated within the core GLA scheme of delegation. The Executive Director of Finance & Performance, being the officer to whom the Mayor has delegated all treasury functions, is kept informed of all Treasury Management activities on a weekly basis. All breaches are also reported immediately to the Executive Director. In addition no investment is placed for longer than three months without the prior agreement of the Executive Director of Finance and Performance. The Treasury Section within the core GLA is subject to at least one annual Internal Audit review, which examines all of the internal controls surrounding the Treasury Management function. The recommendations are reported to Executive Director of Finance and Performance and the Audit Panel. 3.5 Conclusion The core GLA takes a local proactive approach to the containment of risk and practices a robust diversification policy with respect to investments. The Treasury Policy and annual strategy have been designed to ensure that there are clear limits and guidelines to ensure effective management of the treasury management function. 4. TRANSPORT FOR LONDON 4.1 Introduction TfL has developed a draft Group Treasury Policy for consideration by the Finance and Audit Committee. This takes account of the CIPFA recommendations contained in Exposure Draft March 2001 for Treasury Management in the Public Service and will be revisited after CIPFA has completed its consultation process and issued its Standard. 4.2 Criteria for Selection With the exception of the Bank of England, all banks used are assessed using the ratings systems of Moodys, Standard & Poors and, if a bank has not applied for either of these, IBCA. Ratings are updated every six months using Thomson Global Banking Resource and bank-lending limits are reviewed at the same time. For practical operating purposes the number of banks used is kept to no more than a dozen. Apart from the Bank of England, deposits secured by gilts (Gilts Repos) and the UK Clearing Banks, limits are imposed by reference to a bank’s credit rating rather than by sector. 4.3 Limits on Deposits Limits applied are set out below National Loans Fund account at the Bank of England No Limit Gilt Repos No Limit UK Clearing Banks £30m Other Banks rated PRIME 1 £25m Other Banks rated PRIME 2 £20m Other Institutions rated PRIME 2 introduced through brokers £20m(in total) Our relationship banker is covered by the above criteria. 4.4 Reporting Arrangements It is the responsibility of the individual authorising the payment (always a mandated account signatory) to ensure limits/positions have not been breached. If a breach were to be discovered this would be reported to the Group Treasury Manager who is responsible for reporting this to the S127 officer. 5. LONDON DEVELOPMENT AGENCY 5.1 Criteria for Selection The LDA use The Royal Bank of Scotland (RBS) for all their banking services. They were chosen as preferred banker primarily because the Greater London Authority had already conducted a tender exercise, from which the RBS emerged with merit. As well as a current account facility, RBS undertake our automated treasury management function. The LDA wants to adopt a minimal risk approach, and use the corporate overnight money market rate offered by RBS. This has proven to be competitive and offers instant access. 5.2 Limits The cash flow forecasts used by the LDA dictate how much money is drawn down by way of grant. The RBS treasury system automatically sweeps any amount into the overnight accounts, and therefore the LDA do not at this time operate a limit for treasury purposes with RBS. i.e. any unspent balance could be invested overnight. 5.3 Reporting arrangements The LDA report treasury management activity to the Performance and Audit Committee (one of the LDA Board delegated committees), who are content with matters at the present time. Were there to be any abnormal or irregular activities this committee would be alerted. In addition the LDA has exceptional reporting arrangements to the Board. 6. METROPOLITAN POLICE AUTHORITY 6.1 Introduction Section 127 of the Greater London Authority Act 1999 requires that each authority shall ‘make arrangements for the proper administration of its financial affairs’ and ‘shall secure that one of its officers has responsibility for those affairs’. The Section 127 officer for the MPA is the Treasurer. Under delegation from the Treasurer the Director of Resources of the Metropolitan Police Service undertakes Treasury Management operations (among other functions) within the Finance Directorate. The Treasury Management Policy Statement was accepted by the MPA Finance, Planning and Best Value Committee on 20 July 2000. This statement operates within general principles including: To undertake treasury management operations with primary regard for the security of capital invested To maximise the return on investments subject to (the point) above. Investment instruments, prescribed by the Secretary of State, include deposits with authorised institutions, (i.e. banks regulated by the Bank of England under the Banking Act 1987), deposits with UK mutual building societies, and short term loans to UK local authorities. A list of approved organisations for investment (The Lending List) is maintained by the Treasury Team. 6.2 The Lending List – Criteria for Selection The financial institution section of the lending list is based on credit ratings provided by Fitch IBCA, Duff & Phelps (Fitch). Fitch provides a monthly ratings book and informs the MPS immediately by fax any rating changes or credit rating warnings (both favourable and adverse). The ratings we use are therefore always current. Institutions that meet the criteria are added to the list. The individual lending limit is determined by the institution’s size, based on its net worth, again provided by Fitch IBCA but the MPS also refer to The Banker’s top 1000 banks published each July. Additional information for Building Societies is obtained from Butlers Building Society Guide compiled by Garban Intercapital. The MPS also follow the financial press for comment on mergers etc but Fitch will always provide their own summary of market developments. A credit rating reduction below the minimum results in immediate suspension from the list. The MPS fully review the list annually. This is an additional measure to confirm each institution’s credit rating criteria and enables a reassessment of the size of the institution. This is carried out each July to coincide with the publication of The Banker top 1000 banks. Proposed additions to the lending list resulting from the MPS review will be recommended to the Treasurer. The Treasurer similarly approves any other changes to the list (for example the addition of foreign banks previously excluded from the lending list). 6.3 Limits Net worth is used to determine an institutions individual limit within a tiered structure up to £25million. The majority of UK and foreign banks have a £20 million limit. The top tier also requires an institution is AAA rated (Fitch criteria). There is no limit with the MPS own bank, National Westminster Bank plc. In the unlikely event funds cannot be invested on the money market they remain with the MPS banker. A limit is not therefore appropriate. The lending limit for local authorities is also tiered, based on SSA. To maintain a balanced portfolio overall limits are imposed for the four market sectors. Overall limits are imposed for these sectors and are reviewed as required. Currently the maximum limits are: 6.4 £ Million UK Banks 150 Foreign Banks 150 UK Building Societies 70 Local Authorities 70 Reporting Arrangements A monthly report on investment activity includes analysis of sector size and return achieved. A quarterly report on Treasury Operations is submitted to the Finance, Planning and Best Value Committee. If a limit is breached the Head of Exchequer Services or Head of Finance are informed immediately. The Treasury Manager will provide a risk assessment and analysis of events surrounding the breach with proposals for preventing a similar future occurrence. The Treasurer will be advised of the breach at the regular meeting with the Head of Exchequer Services and the Treasury Manager when operational activities are discussed. 6.5 Conclusion The lending list and the limits that apply to sectors and institutions are designed to spread risk and provide a balanced investment portfolio. Credit ratings that underpin the list are continually monitored to maintain the risk adverse position of the MPA. Sector and individual limits are monitored daily within treasury management to ensure compliance with parameters set. Breaches are rare but are immediately advised to senior management and subsequently reported to the Treasurer. 7. LONDON FIRE EMERGENCY PLANNING AUTHORITY 7.1 Introduction The Authority lends only to banks and building societies (both subject to credit rating), nationalised industries or public corporations, Local and Joint Authorities, and levying bodies, all of which are as laid down as approved investments under the terms of the Local Authorities (Capital Finance)(Approved Investments) Regulations 1990. In addition the Authority has adopted the CIPFA Code of Practice for Treasury Management in Local Authorities and has approved a Treasury Policy Statement, which lays down the ground rules under which treasury management activities are undertaken. 7.2 Criteria for Selection The LFEPA have a contracted service with Fitch, the international ratings agency, who provide unlimited faxed updates and news flashes relating to all financial organisations rated by them. Only those banks and building societies that meet LFEPA’s very tight criteria for counterparties are added to our approved list. They are immediately removed if, and when they fall below the ratings contained within our defining matrix. The institutions have to be FSA listed, and licensed for operating within the European Union. The approved list is updated as often as is necessary, and copies provided to all LFEPA’s money brokers. The list is also submitted regularly to Authority meetings 7.3 Limits The loan portfolio (at the day of lending) shall not exceed the following percentage limits:30% per non UK country, 15% per institution, 50% overall limit to Local Authorities, 15% overall Building Society limit. There is also a financial limit of £1 million and a term limit of 3 months to all building societies (other than to the Nationwide), who must in any case be credit rated by Fitch. 7.4 Reporting Arrangements The Authority approves the lending strategy on an annual basis, monitors activity on a quarterly basis, and receives an annual performance report after the end of the financial year. In addition fully reconciled monthly internal management reports are issued to all senior management in the Directorate of Finance & I.T. (the Director is currently the Section 127 Officer). Any problems concerning treasury activities would be discussed with the Director as a matter of standard procedure. Internal and external auditors regularly examine the treasury activities, and any breach of the various statutory, Code of Practice and Authority requirements would be reported to the Section 127 Officer. 8. CREDIT RISK GLA FAMILY WIDE ISSUES 8.1 All bodies within the GLA family except the LDA have to operate a treasury management function by virtue of receiving their budgeted income without recourse to need. The preceding sections have outlined the current practice within each organisation. However, to date no review has been carried out of family-wide exposure. As shown above all the functional bodies operate a sound counterparty risk management strategy using a combination of credit ratings and exposure limits to manage risk. Appendix 1 is a matrix, which summarises the position within each functional body. Also, family wide approach would not reduce the overall exposure and funds would be higher and therefore limits per institution would be higher see Appendix 2 The deliberations leading to the S127 officers deciding that a family-wide approach is not appropriate are outlined in Appendix 3. 9. Strategic Implications 9.1 Proper and effective management of the treasury management function is an essential element of the financial administration process within the core GLA and functional bodies. The function also makes a significant contribution to the resources available to each organisation in fulfilling their strategic objectives. 10. Financial Implications 10.1 There are no direct financial implications from this report. 11. Recommendations 11.1 That each body continues to operate its Treasury Management function independently. 11.2 That a corporate register of GLA family-wide exposure is maintained and updated and monitored. 11.3 That any significant changes to Group-wide exposure are reported to the GLA S.127 officer group. Background papers: None Contact Officer: Bridget Uku, Finance Manager, Treasury Tel: 020 7983 4252 Appendix 2 APPROVED LIST LIMIT IN £ MILLIONS GLA TFL MPA LFEPA BUILDING SOCIETY Bradford & Bingley Britannia Chelsea Cheshire Coventry Derbyshire Dunfermline Leeds & Holbeck Nationwide Newcastle Norwich & Peterborough Nottingham Portman Principality Skipton West Bromwich Yorkshire 5 5 5 5 5 3 3 3 15 3 3 3 5 3 5 3 5 15 15 2 2 4 2 Local Authorities ** 70 up to £1m 10 20 5 UK CLEARING BANKS & SUBSIDIARIES Abbey National pl Time Deposit Ledger 2260 Abbey National plc Business reserve R15237396GRE Alliance & Leicester Bank of New York Europe Bank of Scotland Barclays Bank Halifax plc HSBC plc Lloyds TSB Bank plc co-operative Bank National Westminster Bank plc - Ulster Bank Markets Nothern Rock plc Royal Bank of Scotland - Royscot Trust 1 1 2 20 2 4 2 2 2 10 1 1 1 10 10 5 20 25 20 20 20 25 5 5 25 5 TOTAL 20.00 21.00 7.00 7.00 10.00 5.00 3.00 5.00 35.00 3.00 5.00 3.00 9.00 6.00 8.00 5.00 16.00 35.00 10.00 25 30 30 20 25 25 20 5 20 20 20 20 20 5 5 5 5 0 5 20 5 60.00 5.00 45.00 50.00 45.00 75.00 70.00 20.00 55.00 5.00 5.00 75.00 5.00 - Adam & Co. Woolwich plc N M Rothschild & Sons LTD Merril lynch Robert Flemming & Co Standard Chartered 5 10 20 5 5 25 5.00 10.00 20.00 5.00 5.00 25.00 OVERSEAS BANKS AUSTRALIA Australia and New Zealand Banking Group Commonwealth Bank of Australia National Australia Bank Ltd Westpac Banking Corporation 10 10 20 10 20 20 5 15.00 5 5 5 35.00 45.00 15.00 AUSTRIA Bank Austria 10 BELGIUM Banque Brussels Lambert Fortis Bank NV KBC Bank NV 10 10 10 5 5 5 15.00 15.00 15.00 CANADA Bank of Montreal Bank of Nova Scotia Canadian Imperial Bank of Commerce Royal Bank of Canada Toronto Dominion Bank National Bank of Canada 10 10 10 20 10 5 5 5 5 5 5 15.00 15.00 15.00 70.00 35.00 5.00 DENMARK Danske Bank International Jyske Bank 10 5 5 15.00 5.00 5 20 5 5 5 5 10.00 40.00 5.00 5.00 60.00 5 5 5 20.00 5.00 20.00 40.00 25.00 FRANCE BNP Paribas Credit Agricole (Casse nationale de) Credit Agricole Indosuez Credit Commercial de France Societe Generale GERMANY Bayrische Landesbank Girozentrale Commerzbank Dresdner Bank AG Deutsche Bank A G Hamburgische Landesbank Girozentrale 10 20 5 15 15 20 10.00 25 20 20 20 25 20 20 Landesbank Baden-Wurttemberg Landesbank Berlin Girozentrale Landesbank Hessen Thuringen Girozentrale Landesbank Schleswig-Holstein Girozentrale Landeswirtschaftliche Rentenbank Norddeutsche Landesbank Girozentrale Westdeutsche Landesbank Girozentrale Hpovereins(HVB) IRELAND Allied Irish Bank Corporation plc Bank of Ireland DePfa Bank Europe plc 20 20 20 20 25 20 20 20 20 10 10 5 NETHERLANDS ABN Amro Bank NV NV Bank Nederlands Germeenteen Rabobank International Bank Nedelandse Gemeenten ING Bank NIB Capital bank NV 20 20 20 20 20 5 45.00 20.00 20.00 5.00 5 5 5 15.00 15.00 30.00 5 5 5.00 5.00 5 45.00 5 5.00 20 5 25 20 5 5 5 45.00 20.00 50.00 20.00 5.00 5.00 5 5.00 5 10.00 5.00 20.00 20.00 5 15.00 20 20 PORTUGAL Banco Commercial Portugues SPAIN Banco Bibao Vizcaya Argentaria Banco Santander Central Hispano Banco Popular Espanol Caja de Ahorros y Monte De Piedad De Madrid SWEDEN Svenska Handelsbanken AB 5 5 5 20 20 10 45.00 50.00 25.00 20.00 ITALY San Paolo IMI Unicredito Italiano LUXEMBOURG Dexia Banque Internationale a Luxembourg Banque Generale Du Laxemburg 5 5 5 SWISS Credit Suisse First Boston UBS AG USA Bank of America Bank of New York Bank One Chase Manhattan Citibank First Union National Bank Morgan Guaranty Trust Company of New York GURNSEY Kleinworth Benson 10 20 25 10 10 5 20 20 5 20 5 5 15.00 50.00 5 15.00 10.00 5.00 25.00 25.00 5.00 25.00 5 5 5 7 7.00 Appendix 3 GLA FAMILY COUNTERPARTY LIMIT One option is to formulate and operate a GLA Group wide exposure limit for all counterparty institutions. Disadvantages This option will not be practicable because the Treasury Management function of the GLA Group is not consolidated. It would be unrealistic to expect all the various Treasury officers to liase each day to establish which institutions are clear to be invested with. Breaches could occur regularly under such a scheme. ASSIGN PARTICULAR INSTITUTIONS TO THE CORE GLA & EACH FUNCTIONAL BODY Disadvantages All institutions will be disadvantaged because this would restrict their diversification strategy. They will each have fewer banks to deal with and may find that they have difficulty offloading their investments. This could lead to increased risk as funds may have to be left with the functional bodies own bank which is not risk free as it may cause them to breach the limit assigned to their own bank. Best value principles and S.127 responsibilities require the core GLA and all its functional bodies to ensure that they obtain the best rates whilst securing the principal sum involved. It may be that an institution assigned to a particular Functional Body is not invested with on a given day, however all other GLA Group members would be precluded from investing with the institution concerned even though they may be offering the best rate of the day. It will be difficult to allocate approved institutions to each functional body for a number of reasons. The core GLA for instance have a large counterparty list, but mainly deal with a handful of these institutions as they are the institutions prepared to take the smaller sizes that the core GLA mainly invest on the money market. Furthermore, some Functional Bodies and the core GLA have established direct dealing lines with various banks, and it would be unreasonable to expect them to sever these established relationships. GENERIC FAMILY–WIDE LIMIT, ALLOCATED ACROSS THE GLA AND FUNCTIONAL BODIES. Under this option the GLA Group would establish a framework around which there can be corporate as well as local management of exposure to counterparty risk. This would entail the section 127 Officer group reaching a consensus on the maximum exposure the family is prepared to have with each counterparty or class of counterparties. Where more than one functional body use a particular counterparty, individual limits would be allocated amongst the organisations concerned. Effectively, where the individual limit allocated is more than the functional body’s local counterparty limits, their individual counterparty limit would be paramount. However, where the limit allocated to the individual functional body is less than it’s local counterparty limit then the limit allocated by the core GLA will become paramount. Where there are no conflicting demands between the core GLA and functional bodies more flexibility can be built around this option to accommodate local needs. The GLA as a whole has a budget of some £3 billion and it would be unreasonable to expect the generic limit set for each institution to be £20m as this would make it virtually impossible for the core GLA and functional bodies to manage their treasury dealing functions effectively, especially where more than one party use the same institution. The generic counterparty exposure limit set for the GLA Group would therefore have to be substantially higher than the current individual limits that exist within each functional body. However, it can be argued that since each body currently takes a proactive approach to the management and monitoring of their counterparty exposure the GLA Group exposure (i.e. the aggregate) should not exceed an amount considered too high for an organisation of this size i.e. if we have combined limits this would result in the same level of exposure as we have now. The GLA Group counterparty limits are outlined in Appendix 2. This shows that the maximum exposure to any one bank is £75m for the Royal Bank of Scotland and HSBC and mainly due to the fact that the GLA and TFL bank with these institutions. Disadvantage Any corporately agreed limit may have an impact on existing counterparty limits.