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LOBOs, Fiascos & Liquidity Management

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  • by David Green
  • in Blogs · David Green · Recent Posts
  • — 11 Nov, 2011

What did the grape say when the banker trod on it?  Nothing, as the old joke goes, it just gave out a little wine. Maybe it was a drop of Chianti. The bond markets are certainly piling the pressure on Italy this week, and it’s Silvio Berlusconi that’s whining this time. “Italy is facing a liquidity crisis, but not a solvency crisis”, he tells us, meaning that the country that invented viticulture and banking can afford to repay the world’s third largest national debt, but like any wino, it just needs one more loan before it starts.

Solvent banks facing liquidity problems can access funding at their central bank.  But Mario Draghi, the European Central Bank’s new Italian president is sticking to his predecessor’s line – the ECB is not the lender of last resort to governments.

Luckily, there is an extensive legislative framework in place to prevent UK local authorities from becoming insolvent, including requirements to set and monitor a balanced budget and to hold adequate reserves. Liquidity management is far less enshrined in legislation, though, and relies much more on treasury managers’ good judgement.

The time period between income being received and payments being made normally leaves local authorities with a healthy working capital surplus. But cliff-like cuts in grant income matched with more gentle reductions in expenditure, equal pay settlements and dwindling capital receipts are all squeezing authorities’ bank balances.  Recently announced proposals for residents to pay their Council Tax in 12 rather than 10 instalments in future will be a further drain on liquidity.

Authorities that have borrowed LOBO loans, giving banks the option to effectively demand repayment at regular intervals, face liquidity risk each time an option date comes around. The winding down of Depfa Bank and the breaking up of Dexia increase the risk of LOBOs being called for political rather than financial reasons.

There are some safeguards – the PWLB remains the lender of last resort to local authorities, even if its recent policy change makes it no longer the lender of first resort.  However, if a full meeting of the Council hasn’t approved a high enough authorised borrowing limit, the PWLB won’t lend.  Most treasurers sensibly keep a liquidity buffer in instant access bank accounts and money markets funds.  Tapping the money markets for short-term loans at regular intervals is another good practice, so that if you do suffer a
liquidity crisis, you won’t be a fresh face in the market.

Traditionally, bottles of Chianti came in protective straw baskets to prevent the disaster of dropping a good bottle of red. Italy’s fragile economy needs something similar, just in case it gets dropped by the bond markets.  The Italians have a word for the basket – but rather worryingly, it’s a fiasco.

David Green is Head of Sterling Consultancy Services, a treasury management adviser for local
authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice. It should not be relied upon when making investment decisions.

Image courtesy of Dottor Peni’s Photostream

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    • Government preparing to intervene in Nottingham City Council
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