Mark Luntley on the local authority collective bond agency

Mark Luntley is Programme Director for Finance at the Local Government Association and has led the research into the viability of a collective bond agency for local authorities. 

Room151: Tell us about the research you’re doing into a collective bond agency?

Mark Luntley: After the increase in the Public Works Loan Board’s interest rates a couple of years ago, we began looking at whether there was an opportunity for councils to set up a self-sustaining collective agency, similar to what Scandinavian countries have done for a long time and to the system New Zealand has just implemented. One of the issues is if councils just go out and borrow their own money, instead of going to the Government, the large councils will be able to do that but the smaller councils will be much more disadvantaged because they won’t get the same sort of deal. We felt it was at least worth exploring whether if the local government sector worked as a whole we could ensure that all councils had the possibility to access better rates.

Room151: What do you mean by self-sustaining?

ML: Well we think there’s a gap in the market and rather than let that be filled by a bank or a group of banks, we’re proposing to set up something that’s owned by the public sector and run on a not-for-profit basis – so it won’t be generating surpluses that go into the private sector. It’s about a sector looking outwards.

Room151: Is there more in this idea for the smaller councils and does it require the bigger councils to make it happen?

ML: There’s probably something in it for all councils. If you end up creating a larger and more liquid market for local authority bonds in effect what it means is if you’re a large council and you choose to do something you’ve got more competition out there for your bond. For a smaller council, who may only want to borrow a small amount and wouldn’t be able to go out and raise their own bond, they would have an alternative to the PWLB. If there were no PWLB and no corporate agency like the one we’re proposing, councils would be in a very difficult position because you’d have all the huge costs of getting a credit rating when maybe you only want to borrow once in a blue moon.

Do you need large councils to be in it? Yes you do. An agency just made up of smaller councils wouldn’t get the sort of credit rating you’d want because it wouldn’t have the diversity of councils. So to be effective the agency really needs a diversity of small and large councils from across the UK and it needs a sufficient number of them. We’ve got a financial model that underpins the business case – produced for us by Ernst & Young – and in that model we talk about something like there being a minimum of 25% of the local authority market. So we’ve made a broader assumption there about what the long-term level of capital spending, and borrowing to support that spending, has got to be. And one of things we want to be really clear about is, is the current lower level of borrowing a short-term phenomenon, as councils run down their balance sheets, or is it the start of a longer term trend? If it’s the latter, then we need to look again at our financial model.

Room151: What sort of level of borrowing do you expect to see in the agency? 

ML: We haven’t necessarily specified what a minimum amount might be but if a council wanted to borrow, say, £250,000 then they could do that. Where we would probably differentiate in the early days is that we’re likely to look more at funding for the longer-term rather than short-term money. So we’d be looking at 15, 20 or even 30 year money, say.  Local authorities have lots of alternatives already for short-term lending; they can go to a bank for a three year loan and that might well be more efficient for a council to do that.

Room151: What would the agency look like?

ML: It’s important to be clear that at this stage our research has looked at whether an agency could work. There’s a second stage of work, if we go forward, which will cover what it should look like. But the whole purpose of having a local authority led agency is to have something that local authorities themselves design rather than something that’s imposed upon them.

What we certainly see is an agency in which councils are the members and one with a proper set of rules setting out things like when councils can borrow. It would have a level of capitalisation – so funds put into it to help with set up costs  but also to provide equity in the agency which would strengthen its financial standing. Our working assumption is that the agency itself would have a rating. Looking at the sector and what other similar agencies have done it’s not an unreasonable assumption that the agency would have a triple-A rating. That depends on a series of other things. Ratings agencies will certainly want to look at the level of central government support for the agency so it’s really important that there is direct support there but also support through the regulatory system. Councils are highly regulated so that therefore means ratings agencies are likely to take comfort from that.

It’s important that the oversight and governance are strong and it would want to reflect some of the models that have existed in the Scandinavian agencies I mentioned earlier. As one of the bankers we spoke to said: this agency should have a very cautious and prudent approach to lending.

Room151: Who do you think the investors would be and what rate could the agency offer?

ML: We’ve spoken to one of the major advisors to pension funds about their clients’ potential investment. We’re not just looking towards the LGPS either but a range of pension funds who are interested in high quality bonds. In terms of return we’d be positioned somewhere between gilts and corporate bonds.

Room151: At this stage, why do you believe this could provide an attractive alternative source of funding to the PWLB and other sources?

ML: Well, when we completed the business case in January the interest rate we were looking at was less than that of the PWLB. Since then the PWLB has made two announcements through the budget and reduced their rate by 20bps which is round about where this agency would operate. That then poses the question for councils about do they want a diverse source of funds or are they happy in having a near monopoly of supply in the shape of the PWLB?

There have been around six changes to the PWLB rate in the last three years and having the agency there will make it harder for a subsequent government to change the PWLB rate again.

Room151: Is there scope for working with local authorities from other countries?

ML: Our working assumption here is that this would be an England and Wales funding agency and certainly there are issues surrounding the legislative framework. What is an interesting point is the extent to which, if any, these kind of agencies can learn from each other about best practice. There are agencies abroad with decades of valuable experience that we could potentially draw on.

Room151: And would the agency be open to foreign investors?

ML: In the first instance I think it would have to be focused on UK investors. We’d want to minimise the leakage from the UK and if we can access the LGPS and let’s say for argument’s sake they were willing to buy up all the bonds then we could end up in the ideal situation where there was no leakage from the local government sector whatsoever.

Obviously pension funds, quite rightly, have all sorts of rules and constraints and they have to invest on behalf of their members.

Room151: Would an LGPS fund be able to invest in the paper of its own sponsor?

ML: No. The collective agency wouldn’t issue a million pounds of Birmingham bonds or Oxford City bonds, it would issue local government bonds so you wouldn’t say that bit there belongs to Norfolk or anything like that. So a local authority fund would be investing in a generic local authority bond allowing us to lever pensions investment into infrastructure without those sorts of conflicts of interest.

Room151: Is there room in the market for both the agency and single issuance bonds from local authorities?

ML: We’re very clear that the agency shouldn’t seek to be a monopoly. We’re talking about the importance of competition and a variety of supply so we couldn’t argue that and then suggest something that becomes a monopoly. We would see this agency, by creating more of a local government market and having set a decent price for bonds in normal market conditions, enhancing the market for councils with single issuance bonds by driving competition. So we’d actually see the agency as supporting councils who wanted to do single issues.

Room151: Would there be a role for the private sector in the agency?

ML: I think you’d certainly need that sort of expertise to create an agency. When we built the business case we drew on the expertise of Clifford Chance, HSBC and Ernst & Young – so we commissioned city institutions on a transparent basis to advise us. We would want the agency to have the values and, dare I say it, the salaries of the public sector but it would certainly want to draw on the expertise of city institutions. The agency may ask a bank or a number of banks to organise the bonds, for example. The bits it may well keep in-house are the credit appraisal functions when it’s looking at its members, but it will have to look outwards to ratings agencies, financial institutions and potential bond investors etc.

Room151: Who would it be open to?

ML: It would be open to bodies that were covered by the 2003 Local Government Act which underpins the Prudential Code and which gives creditors rights on future revenues. So it wouldn’t, for example, be open to a health authority or a university.

What we need to now do is test much more comprehensively what the level interest in the proposed agency would be. Are people prepared to create this agency? We’re very clear that this should be something that’s driven by need and is designed by the sector for the sector, based on the highest standard of governance principles.