Security, liquidity & yield – in that order?

Without question, security should be the prime consideration of any treasury management investments strategy – perhaps how we ascertain that remains something of a debate but nonetheless it should be the number one consideration.

Then what about liquidity?  Clearly the risk that cash will not be available when it is needed should be actively considered – but how real is this risk in the world of local authorities?  Hands up any treasurers out there who have even come close to not being able to pay their creditors or staff (as a result of not having the cash, rather than as a result of an IT problem!).

Let us start by taking a look for a moment at our cousins in the world of corporate treasury – if cash flow is not planned appropriately and funding is not secured, the payment of creditors may be genuinely at risk – the management of working capital and accurate cash flow projections, as well as securing reliable funding sources, is pivotal.  The downside risk to the corporate treasurer in leaving liquidity unmanaged is the possibility of the company not surviving.  Therefore, making deposits or investing for periods that don’t match your cash flow expectations really can jeopardise the business objectives.

However, back in the world of the local authority, does it really have the same significance?  The fact is, most local authorities have cash, liquid cash and lots of it.  But even those that don’t retain large investment balances have access to short-term borrowings through the money markets, PWLB or bank overdrafts in the event of unforeseen payments.  Don’t get me wrong, I am not encouraging complacency about cash flow management – in fact quite the reverse.

For the last couple of months I have had the enviable pleasure of sifting through Treasury Risk Study submissions from around 170 authorities across England and Wales; an eye opening experience without a doubt.  Included in those submissions were £15bn of investments.

For some authorities, 100% of their deposits were in liquid instruments such as call accounts or money market funds.  Overall 35% of the universe of deposits were invested this way.  Whilst a handful of outlying authorities were not afraid to push duration out, at the other end of the spectrum, one or two had as much as £250m in instant liquidity.

So the question worth asking is whether this extent of liquidity is required to manage liquidity risk?  Or is there excessive erring on the side of caution?  Perhaps there are two main reasons why duration is kept so short: the first, because it’s a simple way of reducing credit risk, and the second because we lack confidence in our cash flow forecasts and are therefore uncertain about when payments may actually be expected.

Whilst duration is indeed a factor that can assist with managing credit risk, using credit concerns to determine duration will have unintended consequences.  I would suggest that credit risk depends as much on the quality of counterparty than it does on the duration of the deposit – it is therefore possible to have relatively low credit risk whilst having a slightly longer duration.  More robust means of assessing credit, as opposed to time limits being arbitrarily placed on institutions, is certainly achievable. If implemented then duration can really become the tool that it should be – to aid liquidity exposures (more on credit in my next blog).

The upward sloping yield curve, which may or may not be realised in the fullness of time, provides good opportunities for higher returns for well-informed  practitioners to move out the curve a little – and consequently providing more certainty to their revenue budget.

In conclusion, I therefore feel that too much emphasis is given to liquidity risk within investment strategies; I do not believe that it presents as significant a risk as that posed by interest rate volatility.  The familiar mantra of SLY presents an element of distraction to local authority treasurers and suggests the liquidity concerns are equivalent to those in the corporate sector which, while the money markets still have bodies willing to lend to the sector and the PWLB retains its position as lender of last resort, can never be considered comparable.  But until better ways of assessing credit risk are developed, and cash flow forecasts can provide the confidence in lending a proportion of balances for longer, I fear that interest rate risk will remain dominant and returns will suffer putting undue pressure on already stretched revenue budgets.

So back to the unenviable task of continuing to work through more than 160 submissions for this years’ Treasury Risk Study. Actually, it might be more truthful to say “is it weird that I’m enjoying this so much?!”. Having been through two previous studies, it’s interesting to see how your strategies are evolving in such a varied way. For those of you who’ve booked surgeries at the forthcoming workshops, I look forward to your views on the liquidity dilemma!

Jackie Shute is the Co-founder of Public Sector Live