The level of local authority lending to other councils rose by more than £1bn in the first three quarters of this financial year.
Borrowing and investment statistics released by the Department for Communities and Local Government show that more than £6bn is now invested through the mechanism.
The amount lent between local authorities is now almost double the level in March 2012, when it stood at just £3.1bn.
David Green, client director at treasury adviser Arlingclose, said that local authorities are moving away from their traditional stance of mainly borrowing at long-term fixed rates in order to secure themselves against the risk of rising rates.
“Many are starting to realise that not only are short-term loans much cheaper, they are also a useful hedge against interest rates staying low,” he said.
He said that because the Public Works Loan Board (PWLB) charges a margin of 0.8% above gilt yields, local authority loans are the obvious source for short-term borrowing.
Aiden Brady, chief executive of the Municipal Bonds Agency, said: “Another attractive feature of borrowing from another local authority is that the PWLB won’t lend on terms less than one year.”
He added that some councils were choosing the route as a way of diversifying their investments away from banks.
“They are not getting a real return from banks anyway. Banks aren’t pricing deposits effectively because they don’t really want to hold them.”
He said that councils now look like a more secure source of investment than banks due to bail-in regulations.
The DCLG figures also reveal the scale of lending made by some local authorities to their peers.
Sixteen authorities have invested more than £100,000, with Hampshire County Council topping the list at £268.7m lent to other councils.
Local authority lending now makes up 14.7% of total investments across the sector, compared to 11.7% at the end of 2012, the DCLG figures show.
But, speaking this week, Greater London Authority chief finance officer Luke Webster said that he thought the amount of inter-authority lending could go higher still.
He told delegates at the Chartered Institute of Public Finance and Accountancy’s Treasury Management Network Annual Conference: “If we had some means of sharing information a bit better I would like to see the amount go above 50%.”
He said that to increase the amount of authority to authority lending to those levels would require a more detailed knowledge of each organisation and a degree of consolidation of treasury management functions.
But he added: “Just market forces can get us to quite a high level anyway.”
However, one sector voice warned that forthcoming MiFID II rules, reclassifying local authorities as retail investors by default, could hamper growth.
The source said: “It is possible that the local authority to local authority lending sector could be under threat from the changes to MiFID II regulations. Not from the point of view that they can’t borrow from each other, but they may struggle to lend.
“A number of local authorities think they might be caught by it, assuming they are unable to opt-up to professional investor status and the loan they are making is a MIFID-type instrument.”