Download Report to the insert Leader, Deputy Leader or Cabinet

Appendix A
Report to the Leader of the County Council
Report submitted by: County Treasurer
Date: 4 December 2012
Part I - Item No. 1
Electoral Division affected:
None
Amendment to Lancashire County Council Credit Matrix
Contact for further information:
Mike Jensen, 01772 534742, County Treasurers Directorate,
[email protected]
Executive Summary
As a result of the financial crisis and the on- going Euro Zone debt crisis, there has
been a systemic re-rating of credit risk by the main credit ratings agencies post the
financial crisis of 2008/09. The perceived credit quality of all major financial
institutions and a number of national governments as expressed by the ratings from
the agencies has been steadily diminishing.
The counterparty credit matrix at the heart of Lancashire County Council's Treasury
Management Policy and Strategy 2012/13 was conservatively constructed to protect
the County Council against credit risk, whilst allowing for efficient and prudent
investment activity in 2012. However, as a result of recent down-grades of the rating
for financial institutions, our approach no longer achieves its objective and the
proposed solution is set out below.
Recommendation
The Leader of the County Council is asked to approve that the following changes (in
bold) to the County Council's Treasury Management Strategy 2012/13 be
recommended to Full Council for approval with immediate effect.
Instrument
UK Government
Gilts, Treasury Bills
& bodies
guaranteed by UK
Govt
Sterling
Supranational
Bonds Sterling
Sovereign Bonds
Term Deposits
with UK and
Overseas Banks
(domiciled in UK)
and Building
Credit Rating
(blended
average)
Credit
Default
Swap Score
Limit
Maximum
individual
Investment(£m)
Maximum total
Investment(£m)
Maximum
Period
N/A
UK Government
AA+
P1/A1/F1
N/A
120bps
100
unlimited
50 yrs
100
500
50 yrs
25
200
1yr
Societies,
Certificates of
Deposit up to 1yr
Term Deposits
with UK and
Overseas Banks
(domiciled in UK)
and Building
Societies,
Certificates of
Deposit.1yr to 5yr
Corporate Bonds
(Medium term)
Corporate Bonds
(Long term)
Government Bond
Repurchase
agreements
(Repo/Reverse
Repo)
Bond Funds
AAP1/A1+/F1+
95bps
100
400
5 yrs
95bps
50
200
5yrs
90bps
50
200
30yrs
100
250
1yr
100
250
These
investments
do not have a
defined
maturity date.
AAP1/A1/F1
AA
P1/A1+/F1+
AA+
AA Rated
weighted
average
maturity 3yrs
Debt Management
Account Deposit
Facility
Government
Institution
unlimited
unlimited
364 days
UK Local
Authorities (incl
Transport for
London)
Implied
Government
support
100
500
50yrs
Money Market
Funds
AAA Rated,
weighted
average
maturity 6
months
100
300
These
investments
do not have a
defined
maturity date.
Collateralised
lending agreements
backed by higher
quality government
or local government
and supra national
sterling securities.
AA, with AAA
for any
collateral used
100
250
25yrs
Nationalised UK
Banks
P1/A1/F1
Long term A
Government
support
400
In line with
clearing
system
guarantee
(currently 4
years.)
120bps
100
Background and Advice
1. Introduction
The continued stress in the global financial sector has led the major credit ratings
agencies to proactively reassess the credit strength of individual institutions as well
as the governments in which those institutions are domiciled.
The agencies had been roundly condemned by regulators, politicians and the press
for their perceived sloth in the crisis of 2007-2009. They were judged to have been
over optimistic in their assessment of asset backed securities and too slow to lower
ratings as the financial stress took hold.
In the subsequent period, agencies have sought to regain the initiative, adjusting
ratings and announcing in advance that institutions were "under review" in a more
active manner.
This increase in the pace that ratings are adjusted requires investors to be nimble,
and pro-active in managing their credit risk. Previously it was appropriate to establish
credit quality frameworks on an annual basis with the reasonable expectation that,
whilst there may be a number of downgrades, in overall terms the access to
investments which sit within the credit quality framework would be only marginally
changed. This model is no longer practical to operate within the current economic
climate.
Lancashire County Council constructed a very conservative credit matrix in its
2012/13 Treasury management policy. The credit matrix sets out the ratings criteria
which must be fulfilled by institutions in order for the County Council to invest.
Whilst the County Council's credit matrix was conservative in its construction, and as
a result limited the number of available counter party institutions, at the point of
construction this still gave sufficient bank diversity when taken in conjunction with the
opportunity to invest in Government and Supra national bonds.
During the year the rate at which banks have dropped out of our credit matrix due to
downgrading in their credit ratings has been relentless. As a result of recent
downgrades of the French state and Dutch and Scandinavian banking systems there
are no longer any, non government owned or guaranteed banks worldwide that sit
within our matrix.
2. Impact on the County Council's Investments
The Council currently has two investments with counter-parties who, as a result of
recent downgrading in their credit rating, no longer fulfil the criteria within the County
Council's credit matrix.

An investment of £0.871m with Rabobank
Rabobank is now rated AA2/P1 by Moodys, AA/F1+ by Fitch, AA-/A1+ by
Standard &Poor and AAA/R1+ by the Dominion Bond Rating Service. It is the
one notch reduction from AA to AA- by Standard & Poor which removes
Rabobank from our counter-party list.

An investment of £11.5m with Svenska Handelsbanken
Svenska Handelsbanken is now rated AA3/P1by Moody's, AA-/A1+ by
Standard & Poor and AA-/F1+ by Fitch.
As has previously been discussed at Cabinet, as well as ratings information, the
Credit default swap (CDS) market is a very important barometer of the market's view
of the level of credit risk offered by an institution. The CDS is a measure of the cost
of insuring against the default of an institution, the lower the score the lower the risk
of default, for example the UK Government CDS is 30.5 basis points (bps) compared
to the French Government's CDS of 83.8bps.
As part of the Council's Treasury Management function, close attention has been
paid to CDS prices as part of the process of placing the County Council's
investments; however this has never been formally adopted within the County
Council's counter party list.
In relation to both Rabobank and Svenska Handelsbanken it is important to note that
although there has been a change in the credit rating from the agencies, the CDS
price of these investments has not changed are still considered by the market to be
both safe and secure. As a result, in consultation with the Councils Treasury
Management advisors Arlingclose, it is not considered necessary to take any
immediate action.
3. Impact on the County Council's Approach to Investment
This development leads to a number of issues for efficient and conservative treasury
management:



It leads to an increased concentration risk with the very small number of
government owned banks (RBS and Lloyds) with whom we still deal.
Reinvestment risk should the ownership or government support for either RBS
or Lloyds change.
There will be periods when any bank is not active in a particular segment of
the market and this may coincide with investment needs of the Council.
As treasury management is an ongoing necessity for the Council a conservative yet
workable credit matrix is essential. In light of the announced ratings changes and
that further ratings moves are inevitable, a systematic re-consideration of the
Councils credit matrix is required in order that the Council can continue to fulfil its
duties under the “Prudential Code for Treasury Management”.
4. Proposed Action
The current grid requires institutions to have a minimum rating of AA/AA2 with all or
any of the agencies and that we take the lowest rating as our base line. Currently, no
banks worldwide qualify. However, this approach may be characterised as ultra-
conservative, and has over-stated the level of credit risk, and as a result, increased
other types of risk the County Council is exposed to.
In consultation with Arlingclose, it is possible to incorporate both the views of the
rating agencies, together with the CDS market, to provide a more mature approach
to the Council's credit matrix, whilst ensuring the Council transacts with only the
highest quality counter-parties.
It is therefore proposed to amend the Council's risk matrix as follows:

For short term lending of up to 1 year that the short term ratings from the
ratings agencies be used and that a counter-party must have a minimum of the
following:
Moody's. P1
S&P
A1
Fitch.
F1
Short term ratings were specifically created by the agencies for money market
investors placing deposits for up to one year as they reflect specifically the
liquidity positions of the institutions concerned. The ratings of P1, A1 and F1 are
considered to be strong investment grade with a extremely high degree of
confidence in the liquidity position of the body over at least a one year period.
It is proposed that any institution must also have a 1yr CDS score of less than
120bps (with the price history and trend data taken into account, the Bloomberg
system provides live pricing and the team track and will revise limits should
prices move by greater than 1 standard deviation on a rolling monthly basis ).

For medium term investments in form of tradeable bonds or certificates of
deposit (1yr to 5yrs, where immediate liquidation can be demonstrated), it is
proposed that a blended average of the ratings be taken (averaging across all
available ratings) , with a minimum of:
- Long term AA3/AA-, and
- Short term P1/F1+/A1+
It is proposed that any institution must also have a 5 year CDS score of less
than 95bps (with the price history and trend data taken into account as above).

For longer term investments (5yrs and above in form of tradeable bonds
where immediate liquidation can be demonstrated, it is proposed that a blended
average of the ratings be taken, with a minimum of:
- Long term AA2/AA
- Short term P1/A1+/F1+
It is proposed that any institution must also have a 10 year CDS score of less
than 90bps (with the price history and trend data taken into account as above).
5. Impact on the County Council's Investment Strategy 2012/13
The limits for scale and duration of investment in specific categories are set out in
the table below. Should an existing investment, due to a change in credit rating after
a fixed deposit has been made, fall outside the policy, full consideration will be
made, taking into account all relevant information, as to whether a premature
settlement of the investment should be negotiated in order to protect the County
Council.
The strategy must still be operable should the UK lose its AAA rating, and so the
minimum sovereign rating for investment is AA+, although in practice the majority of
transactions will be with organisations based in the UK and other AAA rated
countries.
Instrument
UK Government
Gilts, Treasury Bills
& bodies
guaranteed by UK
Govt
Sterling
Supranational
Bonds Sterling
Sovereign Bonds
Term Deposits with
UK and Overseas
Banks (domiciled in
UK) and Building
Societies,
Certificates of
Deposit up to 1yr
Term Deposits with
UK and Overseas
Banks (domiciled in
UK) and Building
Societies,
Certificates of
Deposit.1yr to 5yr
Corporate Bonds
(Medium term)
Corporate Bonds
(Long term)
Government Bond
Repurchase
agreements
(Repo/Reverse
Repo)
Bond Funds
Debt Management
Account Deposit
Credit Rating
(blended
average)
Credit
Default
Swap Score
Limit
Maximum
individual
Investment(£m)
UK Government
N/A
100
unlimited
50 yrs
100
500
50 yrs
120bps
25
200
1yr
95bps
100
400
5 yrs
95bps
50
200
5yrs
90bps
50
200
30yrs
100
250
1yr
100
250
These
investments do
not have a
defined
maturity date.
unlimited
unlimited
364 days
AA+
P1/A1/F1
N/A
Maximum total
Investment(£m)
Maximum
Period
AAP1/A1+/F1+
AAP1/A1/F1
AA
P1/A1+/F1+
AA+
AA Rated
weighted
average
maturity 3yrs
Government
Institution
Facility
UK Local
Authorities (incl
Transport for
London)
Implied
Government
support
Money Market
Funds
AAA Rated,
weighted
average
maturity 6
months
Collateralised
lending agreements
backed by higher
quality government
or local government
and supra national
sterling securities.
AA, with AAA
for any
collateral used
Nationalised UK
Banks
P1/A1/F1
Long term A
Government
support
100
120bps
500
50yrs
100
300
These
investments do
not have a
defined
maturity date.
100
250
25yrs
400
In line with
clearing system
guarantee
(currently 4
years.)
100
The placing of residual overnight deposits with the County Council’s bank, National
Westminster, will not count against the above individual limits but will be limited to a
total investment of £50 million.
Consultations
ArlingClose, the County Council's external treasury advisors have been consulted on
these proposals.
Implications:
This item has the following implications, as indicated:
Risk management
The Council having adopted the "Prudential Code" is required to prudently manage
the investments of the Council. The current situation exposes the Council to
heightened counterparty concentration risk inconsistent with its duty. As managing
the Council's investments is intrinsic to its continuing operations a prudent yet
workable policy is necessary.
List of Background Papers
Paper
Date
Contact/Directorate/Tel
Prudential Code for treasury
management
2009
Andrew Ormerod / County
Treasurers / 534700
Treasury Management Policy
2012/13
February 2012
Andrew Ormerod / County
Treasurers / 534700
ArlingClose Credit Report
November 2012
Reason for inclusion in Part II, if appropriate
N/A
Andrew Ormerod / County
Treasurers / 534700