Capturing the ‘spirit’ of borrowing rules and a sequel for interest rate swaps

The year in treasury has been marked by a return for interest rate swaps and new rules from PWLB on borrowing for yield. Jackie Shute asks whether they will sprinkle a little Christmas joy.

Even aside from the religious connotations around the word “spirit”, it conjures up many other possible meanings, especially at this time of year.

Many of us will be spending this unusual festive season indulging in a drop or two of our favourite distilled, rather than fermented, alcoholic beverage. And some of us may be reminded of Scrooge’s spirit visitors; especially the Ghost of Christmas Past, who has special resonance with recent events in local authority treasury management. I am referring to the Return of Interest Rate Swaps.

That may be a rather unlikely Christmas movie title perhaps, but something that has been pricking the interest of LAs, regulators and other commentators. The character in this sequel looks very different to the original antagonist. Indeed, a shadow of its former incarnation which ballooned to such a scale it shook LA treasury operations 30 years ago.

A much tamer beast at present, will it grow throughout the story? I’d like to spend a few moments hypothesising about how the plot may unfold.

General power of Competence

Setting the scene, the legal environment now is very different to the original, with the general power of competence now playing a key role in the fundamental questions of legality.

There seems to be something of a consensus around the fact that, as long as it is for risk management purposes, interest rate swaps are likely to be within the powers of a local authority.

Last time round, even if the current legal framework existed then, I don’t think anyone would be able to argue that risk management was a key driver of the strategy. This time,however, albeit more of a “leg-dipping” than a “toe-dipping”, the scale of the current swaps in place are much more proportional to the debt that the swap is theoretically hedging.

But there are more hurdles to be overcome before everyone can sleep well. The most interesting test will be by the external auditors at the end of the financial year when they determine whether hedge accounting rules have been met. As long as they have, then the fair value of the swap won’t be hitting revenue accounts as it swings about throughout its duration.

Of course, this test will be taking place annually throughout the 20-year duration and if swaps fail—maybe as a result in changes to short-term funding access or any other potential regulatory changes occurring over the period—then hedge accounting no longer applies and the fair value will need to be recognised, thus increasing the risk to future taxpayers.

If risk is increased as a result, can it still be argued that the legal basis is for risk management? Grab the popcorn and let’s see if the sequel gives us more of a hero than a villain this time round.

Spirit of the law

My final painfully tenuous spirit reference relates to the “sprit”, rather than the “letter” of the law, or guidance. This, of course, relates to the brave new world following the outcome of the PWLB consultation, that had everyone in the sector on the edge of their seats since March. Had I been a betting person, I would have lost a few quid on the outcome, I have to admit.

A number of key statements leapt out of the consultation at me:

• The objective was to develop a proportional and targeted intervention to prevent local authorities from using PWLB loans to buy commercial assets primarily for yield;
• There was no intention to impede local authorities’ ability to pursue service delivery, housing and regeneration; and
• The PWLB does not ask for the intended purpose of a loan, on the basis that local capital projects will have already passed the scrutiny and internal governance process of the democratically elected council of the applicant authority.

What I, therefore, expected to happen was a realisation that the approach proposed in the consultation was not compatible with these concepts.

On the one hand, it is recognised that LAs’ capital aspirations are driven by democratically elected representatives of the people, but then also saying if certain democratic decisions are made, there will be no low-cost loans available to support core service delivery, despite the vow to not impede delivery of services. However, the outcome ignored this contradiction and pushed on, almost exactly in its proposed form.

There will be many authorities who have never had a commercial agenda and can comfortably continue business as usual, accessing the PWLB.

But there will be many others who have a democratically determined commercial agenda, clearly stated as such in their current capital strategies, upon which their budget is reliant on the income.

Those authorities will be stuck between a rock and a hard place: drop the commercial agenda and lose essential income, or lose low-cost loan financing for the entire capital programme, regardless of the proportionality of the commercial aspect.

Of course, there is a third option for those authorities, and that comes down to the gaps between the spirit and the letter of the guidance.

If one of the most commercially focused authorities has publicly stated a continuance of their agenda would not restrict them from the PWLB, then quite possibly there will be several authorities re-branding their commercial agenda into something which more closely appears to follow the rather loose letter of the guidance.

However, the spirit is clear, HM Treasury do not want to lend to those LAs. They are not looking for clever tactics to be used to enable commercial activities to continue as they were with use of PWLB funds.

Let’s be clear, it’s a brutal way of achieving their aims: the sledgehammer didn’t just crack the nut, but damaged the surrounding area. But there is no doubt about what they are not wanting to support.

Parallels could be drawn between this and the Covid guidance. The objectives are clear: to limit non-essential interactions between people to reduce the spread of the virus. If people find justifications for circumventing the spirit of the guidance, by applying the various exceptions listed in order to continue to mix with people, the objectives are not met. The spirit is what matters.

So, for any CFOs of authorities who have legitimately decided to pursue commercial activities, I urge you to apply the if-it-looks-like-a-duck test. It may not be fair for central government to no longer support core service-led capital spending plans if a locally-made decision also includes a commercial scheme that the LA is dependent on. But sadly, that is what they are clearly trying to achieve.

Will that put a hard break on commercial activity? Or, will it still continue at a proportional extent to meet local objectives, though being careful whose money is used to fund it?

And let’s not forget that with gilt yields remaining at very low levels, it is likely that even if PWLB rates cannot be matched, the outright borrowing rate in the market is still very likely to be within budgeted levels.

That said, poking the hornets’ nest by navigating around the rules while going against the government’s spirit will likely bring serious impact on an authority and the wider sector.

There is always the hope that this penal approach will be revisited in the fullness of time and LAs will continue to be able to exercise local decision making without losing out on central government funding to support core spending needs. But until then let’s raise a glass to the end of 2020 and keep our spirits up.

Jackie Shute is co-founder and director at Public Sector Live.

Photo by Davidson Luna on Unsplash

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