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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