Download Scrutiny November 3 2011 - Hertfordshire County Council

Agenda Item No.
TREASURY MANAGEMENT TOPIC GROUP
FRIDAY 23 MARCH 2012 AT 10.00AM
4(b)
Background Report
1.
Introduction
1.1 This Scrutiny is intended to provide members with an understanding of
the treasury management function, the risks managed by the treasury
management team, and the regulatory background.
1.2 In particular, the Scrutiny will be addressing the following questions:
(1)
What is Treasury Management and why does Hertfordshire
County Council have a treasury management function?
What are the treasury risks that the Council is exposed to and
how does the treasury function manage these risks?
Why does the Council have an annual treasury management
strategy?
How do external consultants support the Council’s treasury team?
How does the economic climate impact upon treasury strategies
and activities?
(2)
(3)
(4)
(5)
2.
Background
2.1 The Treasury Management team is a small specialised team that sits
within the Specialist Accounting team in finance. The role of the treasury
team within an organisation was originally to ensure the liquidity of the
organisation i.e. to ensure that the organisation could pay its debts as
and when they became due. Treasury has evolved since then, taking on
new roles such as the management of financial risk, particularly those
associated with fluctuating interest rates, exchange rates, and
counterparty credit risk.
2.2 The activities of the treasury team include funding of the Council’s capital
programme, the management of the Council’s investment portfolio, the
management of its relationship with its bank and the day-to-day
management of the Council’s cash flow.
2.3 The definition of treasury management activities in the Council’s
Treasury Management Policy Statement is defined as the:
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Management of the Council’s investments and cash flows, its
banking, money market and capital market transactions;
Effective control of the risks associated with those activities; and
Pursuit of optimum performance consistent with those risks.
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2.4 Treasury Management is the organising, monitoring, and controlling of
the treasury activities outlined in 2.2, and the size of a treasury function
can vary depending on the size of the organisation. Generally a treasury
management team within a local authority is small consisting of no more
than four officers, compare this to a multi-national organisation where
there will be specialist teams managing a number of treasury operations
such as foreign exchange, corporate funding, investments etc.
2.5 This paper will provide members of the scrutiny committee with some
background information to inform them about the treasury management
function and gain a better understanding of the activities in this particular
part of Finance.
3.
What is Treasury Management and why does Hertfordshire County
Council have a treasury management function?
3.1 Treasury Management as an activity in a local authority can be broken
down into the following functions:
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Liquidity Management
Capital Funding
Investment management
3.2 Taking each activity separately, as discussed in 2.1 the primary role of a
treasury management team was traditionally to ensure that the Council
had sufficient liquidity to meet its financial liabilities when they became
due. Liquidity management is therefore the process of maintaining the
right amount of funds in the right place and at the right time. The key tool
that officers use to meet this objective is the cash flow tool. An annual
cash flow forecast is prepared by officers using various sources of
information to determine peaks and troughs in available funds and
officers use this forecast to inform their decision making i.e. whether to
borrow short or long term and vice versa how long to invest surplus cash.
Liquidity can be managed over different time horizons from days and
weeks to years.
3.3 Capital funding involves the arrangement of debt finance to fund the
Council’s capital programme. As part of the Integrated Planning Process
(IPP), a capital programme is agreed by Council each year and the
funding of this programme can be by grant, revenue, or by borrowing.
The treasury team will arrange this borrowing from either banks or the
PWLB1 and will take into account the prevailing interest rate climate and
the maturity profile of the Council’s current loan portfolio. An alternative
form of funding available to local authorities is the bond market whereby
a local authority can make a bond issue. A bond issue is usually for
amounts greater than £100m but it is now being considered as a viable
alternative to the traditional sources of funding for local authorities.
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PWLB – Public Works Loan Board, part of HM Treasury’s debt management office.
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3.4 The other main activity conducted by the treasury team is investment
management. This activity occurs when there are surplus funds and the
treasury team will invest these funds to gain a return. However, the
principal tenet of treasury management is that security and liquidity rank
above yield when investing surplus funds. The length of investment will
be determined by the cash flow and funds can be invested with banks,
building societies, and money market funds.
3.5 In order that the Council can perform these treasury activities it is
necessary for it to have a specialised team of officers and this is why
Hertfordshire County Council has a treasury team. In addition, this team
manages the relationship with the Council’s bank and are currently in the
process of managing the transition of our bank from Nat West to
Barclays Bank.
4.
What are the treasury risks that the Council is exposed to and how
does the treasury function manage these risks?
4.1 The previous section talked about the activities of the treasury teams. As
with any activity there will be some form of risk, and these risks need to
be managed. This section identifies some of those risks and explains
how the treasury team manage them.
4.2 The main risk in liquidity management is that funds will not be available
to meet obligations as and when they fall due. For example, a company
may need to pay salaries at the end of the month, but does not have the
money in the bank or access to additional borrowing facilities to make
the payment. The treasury team uses its cash flow forecast to identify
where the authority may need to borrow either short term or long term
and will arrange for funding to be in place to meet these demands. Short
term borrowing can be arranged through money brokers who act an
intermediary between lenders and borrowers. Longer term borrowing will
be arranged either through banks, the PWLB, or the bond market.
4.3 There are a number of risks associated with funding and they are as
follows:
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Refinancing risk – the risk that when borrowing facilities are
due for renewal, the terms and conditions will compare
unfavourably with the existing facilities.
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Concentration of maturity risk and supply – this essentially
means that all your borrowing is due to be repaid at the same
time when market conditions such as interest rates are
unfavourable. Supply risk is the risk of using a limited number
of suppliers for key financing such as banks, bond markets and
the PWLB.
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Interest rate risk – the risk that interest rates may change,
raising or lowering the cost of borrowing.
The treasury tries to mitigate these risks by ensuring that the maturity
profile of its loan portfolio is not skewed to one particular period of time,
and works with its treasury advisors to identify optimum points in the
interest rate cycle when identifying opportunities to borrow. Officers will
look at future interest rate forecasts from various economic sources to
assist them with these borrowing decisions.
4.4 Investment risks are counterparty credit risk and interest rate risk.
Counterparty risk is the risk that the counterparty with whom funds are
deposited will be unable to repay at maturity. Interest rate risk is the risk
that interest rate may change, raising or lowering the yield on
investments. In managing counterparty credit risk, officers receive daily
bulletins from its treasury advisors informing them of economic news,
economic data and credit agency notices. To supplement this
information, officers will refer to other sources such as credit default
swap rates, equity prices, outlook reports from credit agencies, and news
sources such as the Financial Times and reputable news websites.
Officers also meet weekly with the Head of Specialist Accounting and/or
the Assistant Director of Finance to review all information available and
adjust investment policy accordingly. The current investment strategy is
defensive in that funds are kept at short notice preserving security of
deposits and instant access to funds should market conditions change
quickly.
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Why does the Council have an annual treasury management
strategy?
5.1 CIPFA’s Treasury Management in the Public Services: Code of Practice
requires the Council to adopt the CIPFA code and to approve a treasury
management strategy in advance of each financial year. The Department
for Communities and Local Government (CLG) has published guidance
on local authority investments in March 2010 and this guidance requires
the Council to approve and investment strategy in advance of each
financial year. The Localism Act 2011 provides additional freedoms to
local authorities including the use of financial derivatives.
5.2 The Council’s treasury management strategy forms part of part C of the
Integrated Plan (IP) and is approved by the Council before each financial
year. As well as the treasury management strategy, Part C of the IP
includes the prudential code for Capital finance; this outlines the capital
expenditure and capital financing requirement of the Council for the next
three years.
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5.3 The Treasury Management Strategy is made up of a number of sections
which are as follows:
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Context for the Treasury Management Strategy – this sets the
economic background and forecast for the forthcoming financial
year, including an interest rate forecast;
The actual Treasury Management Strategy which sets out the
Council’s borrowing and lending strategy for the financial year;
Treasury management Prudential indicators – the Prudential
code requires us to set a range of indicators relating to
borrowing and lending activities such as an authorised limit for
borrowing and a maximum tenor for investment;
Financial implications and sensitivity to interest rate changes;
Policy on use of Financial Derivatives –the use of derivatives will
be permitted under the Localism Act 2011 with effect from 1 st
April 2012;
Treasury management performance indicators and frequency of
reporting;
Training and use of advisers; and
The investment policy.
5.4 The treasury management strategy is a plan of the Council’s treasury
activities for the forthcoming financial year and provides members with
background to its planned borrowing and lending policy as well as the
criteria for lending surplus cash to counterparties.
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How do external consultants support the Council’s treasury team?
6.1 There are many third party specialist providers that can provide support
to a treasury management function. These providers can provide
specialist advice on the development of interest rate and foreign
exchange rate hedging strategies, advice on leasing arrangements, and
capital strategies for borrowing.
6.2 Local authorities use specialist treasury management advisers to provide
advice and information relating to its investment and borrowing activities.
This authority has a contractual relationship with Sterling Consultancy
Services who support the Council’s treasury team by providing the
following services:
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Advice and guidance on relevant policies, strategies and
reports;
Advice on regulatory changes and their impacts;
Advice on investment decisions;
Notification of credit rating changes to counterparties;
Other information on credit quality of counterparties;
Advice on debt management decisions;
Technical accounting advice;
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Reports of treasury management and performance;
Forecasts of interest rates and economic news; and
Training courses for officers and members.
6.3 This additional layer of consultancy provides the treasury team with
support in the delivery of the Council’s treasury management strategy
and managing the risks associated with some of these activities.
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How does the economic climate impact upon treasury strategies
and activities?
7.1 The economic climate and government policy sets the backdrop to the
decision making process in the implementation of the treasury
management strategy by the treasury function. The treasury section
receives a great deal of economic information on a daily and weekly
basis from both its external advisor and other financial sources.
7.2 Interest rates and exchange rates fluctuate as a consequence of
developments in the economy as a whole and this will have an impact on
the timing of some of this authority’s borrowing and investment
decisions. Officers follow closely the macroeconomic climate and key
indicators such as Gross Domestic Product (GDP), inflation
expectations, consumer indicators, unemployment figures, monetary
policy indicators and some global indicators such as the US non-farm
payroll figures.
7.3 Monetary policy and in particular the decisions by the Monetary Policy
Committee on interest rates has a direct impact on short term interest
rates and indirectly on longer term rates via their relationship with
expectations for short-term rates in the future. It is with this information
and advice from external advisers such as Sterling Consultancy Services
that the Council’s treasury officers determine the appropriate time in the
interest rate cycle to borrow money.
7.4 In addition, investments decisions are also influenced by economic
indicators and long term interest rates expectations. For example, an
authority may defer lending surplus cash long term until a later date if the
expectations are that interest rates will rise in the future.
7.5 Sovereign stability is another factor that will influence market sentiment
and the Eurozone sovereign debt crisis has seen the UK as a safe haven
with a consequent fall in gilt yields and hence PWLB rates. What does
this mean for a local authority with a borrowing need? Well, it allows local
authorities to borrow funds at currently very low interest rates. Once
there is a resolution to the Eurozone crisis and there is a faster economic
recovery than the expectation is that interest rates will rise in the future.
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8 Summary
8.1 The treasury management team plays a key role in managing the day-today cash flow of the Council as well as implementing its borrowing and
investment strategies. In undertaking these activities there are
associated risks and treasury officers mitigate these risks by the use of
external consultants, market information, and a regular review of its
treasury strategy to ensure these risks are managed effectively.
Patrick Towey
Head of Specialist Accounting
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