Saturday, 11 October 2008

Councils and the Icelandic goose

We have now learned that numerous councils, police authorities and other public bodies had money in Icelandic banks and face a combined loss in excess of £1billion. There has been much wailing and gnashing of teeth about this with people asking why these organisations were hoarding money, why they put it with Icelandic banks in the first place and why they did not withdraw it to a more secure location once doubts were expressed about the creditworthiness of our friends in the chilly north.

Surprisingly, the first point has generated a lot of ire but it seems to me this is misguided. Local councils receive most of their funding from central government but still raise very substantial sums through Council Tax. Their income is not received in handy-sized pieces once a month just in time to meet that months' bills, it arrives in large chunks at irregular intervals, much of it at or close to the start of the financial year. When money is received in large amounts and is not all needed for current expenditure the sensible thing to do is put it to use earning interest. If you know a certain amount will not need to be spent for, say, five months you look for the best possible return on a five-month investment; even that which will need to be dipped into in the short term can earn a few quid. This has nothing to do with councils, county police forces or Transport for London hoarding money, it is all about budgeting sensibly by gaining as much additional money as possible while a lump sum remains unused in any other way.

This also answers the second point. Because it is sensible to get the best return possible, the money is deposited in the place offering the best rate of interest. Recently that has been Icelandic banks. That, of course, is not the whole story and that is why the third point arises.

It appears to be the case that many knowledgable commentators expressed concern about the viability of Icelandic banks more than a year ago. Given that the sums deposited in them by some councils and other bodies were very large indeed (I have heard figures of up to £50million from a single county council and £40million from Transport for London) one must wonder why the warnings were not sufficient to cause a change of approach.

In principle the position should be fairly simple. If you are in charge of a fund of other peoples money or, as the case may be, money given to you to use for the benefit of other people, your first obligation should be to keep the fund safe. That is far more important than seeking to increase it by investment. In order to keep the fund safe you have to take into account that inflation will reduce its value, so you must place it in an interest bearing account. Leaving aside issues of taxation and how best to measure inflation, what should be achieved as a bare minimum is to receive the same rate of interest as the rate of inflation. In general terms, if inflation is 2% you need to get 2% interest in order to maintain the starting value. A return above that level enhances the fund, which is beneficial, but a balance must be struck between the amount of profit you try to earn and the risk to the integrity of the fund. Putting it all on a horse at odds of 5-1 against will give you a massive profit if the horse wins but a total loss if the horse loses; so horse racing is not a viable investment vehicle.

A bank which offers, say, 6% when inflation is 2% gives you a good profit, but there is no such thing as a free lunch so you have to be satisfied that the bank is sound. There are internationally recognised standards for banks based on their perceived creditworthiness so you check its rating and find it is "AAA". Great, your money appears to be completely safe because those who monitor these things have said so by their rating. It goes without saying that ratings are reviewed regularly and can change, because you are in charge of a fund which is intended to be used for the benefit of other people you must keep an eye on the ratings and remove the fund if the bank is downgraded. In the absence of an enforceable guarantee that your money is safe, anything less than the top rating is not good enough when you are dealing with other peoples money (unless they are aware of the risk and direct you to keep the fund where it is).

Let me suggest three reasons why numerous public bodies kept substantial sums in Icelandic banks despite clear warnings that they were not good for the money.

The first reason is sheer sloppiness. A good return is received, no one thinks the bank will fold even when its rating falls and no other bank offers as high a rate of interest. The warning is heard but not heeded because it is not perceived to be an immediate problem. Years of good returns build trust in a continuation of the bounty, the golden eggs keep popping out of the goose and it is assumed they will do so forever. In these circumstances there is perceived to be no requirement to change the method of investment other than to move funds if a new goose is found producing 24 rather than 18 carat ovoids.

The second reason is that the high return is built into the accounts for the year. The council's spending plans cannot be put into effect in their entirety unless a minimum of, say, 5.5% interest is earned. So the money goes into an account at 6% when the best alternative gives 5%. Switching to the 5% account means that the council will breach representations it has made to the voters and an election is never far away. The treasurer knows his life will not be worth living if he rocks the boat. He sees himself as the servant of the councillors rather than as the custodian of taxpayers' money so he takes the path of least resistance. Plans were made on the basis that the high rate of interest will be achieved so locking funds into the dodgy bank becomes a political necessity.

Finally there is the belief that central government will come to the rescue if there is a problem.

Underlying all three reasons is the fact that the position of principle I identified above does not pertain in the public sector. The money collected through tax is not seen as belonging to the taxpayer but as belonging to government - most to central government and some to local government. They take risks with it that no one would ever take if employed to look after a fund for someone else and they do so knowing that the taxpayer can always be forced to lay another golden egg.

1 comment:

Bobsheadrevisited said...

Excellent post. Lots of useful info there. Ta.