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David Green: How to set an inter-authority loan rate

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  • by David Green
  • in Blogs · David Green · Treasury
  • — 14 May, 2018

Lending between councils has become controversial with some accused of offering loans at “bargain basement” rates. David Green analyses the elements that go into setting a rate.

Inter-authority lending has hit the local headlines again, with Wirral Council being accused of “bailing out” other councils with “bargain basement” loans. As most readers of this site will already appreciate, the story is unfair for several reasons.

Would the accuser instead prefer the council to “bail out” the bank by leaving the cash interest free in the current account? Or, pay staff and invoices before services have been received? And the average interest rate received on the quoted loans is well above the average base rate for the period in question.

But it does raise the question: what is the correct interest rate to lend to another local authority? One way to consider this is in the time-honoured tradition of security, liquidity and yield.

Method

CIPFA/LASAAC ruled recently that no impairment provision need be made for loans to other local authorities, since they allegedly cannot default. But the Prudential Regulation Authority takes a different view of banks lending to councils. And public credit ratings for UK local authorities vary from AA (the third highest and equal to central government) to A+ (the fifth highest), so hardly risk-free.

A quick analysis of councils’ accounts and budgets shows markedly different levels of reserves, a key indicator of the likelihood of repayment. So some caution is merited, especially with longer term loans. But the safeguards in the Local Government Acts are thorough, and so credit risk appears minimal, at least within the timeframe for legislative change. Lenders should therefore expect to earn little margin for security.

Liquidity will be an issue, as local authority loans are usually non-transferable and the market for tradable loans is pretty thin. So, some element of term premium should be built into interest rates beyond a couple of months to compensate the lender for tying their cash up and giving the borrower certainty of funding.

Yield in this context means considering alternatives. Instant access bank accounts and money market funds pay around base rate, so a fixed-term loan needs to take account of expected increases in base rates over the term. Economic weakness and the Bank of England’s “unreliable boyfriend” notwithstanding, lenders should build in at least some rate rises in the coming year.

But alternative rates for borrowers should also be considered and, in this context, this includes the PWLB. Their one-year loan currently stands at 1.43%, providing ample room for competitor lenders to undercut the board.

Supply and demand

A separate method of determining the “correct” rate for an inter-authority loan is to evaluate supply and demand by testing the market. Treasury managers will be used to receiving guidance from brokers on where the market is, but with cheap electronic platforms increasing in popularity, more transparent price discovery is now available.

When lending, the key is not to just rely on the bids entered by potential borrowers showing the rate they would like to pay, but to input your own offers at the higher rate you would like to receive. To use the market jargon, you should be a price-maker rather than a price-taker. In a well-functioning market, the bids and offers will move closer together until a deal is struck.

The fees charged to borrowers by brokers and platforms also have a part to play in the interest rate. Where fees are lower, the lender should expect at least a half share of the saving.

In summary, local authorities with surplus cash for a period of time should calculate the minimum interest rate that compensates them for the risk of lending for that term. If this is higher than the bid rates currently available, you should communicate your required rate to potential borrowers via brokers, platforms and direct contacts and let the market come to you. A robust process like this should help you to counter claims of subsidising other authorities at unreasonably cheap rates.

David Green is strategic director at Arlingclose Limited.

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