The UK government has moved to clamp down on what it sees as excessive borrowing by local authorities following a sudden surge in loan requests to the Public Works Loan Board, the 200-year-old public body that is the main lender to councils.
Local authorities borrowed £2bn from the PWLB in August, a record for a single month and more than local authorities borrowed on an annual basis just a few years ago. While borrowing eased in September, councils still took out £1.6bn of loans, making it the second busiest month ever.
With the PWLB running close to its £85bn statutory lending limit, the government was forced to act to avoid a total shutdown and possible liquidity crunch for councils. It upped the limit to £95bn, but simultaneously hiked interest rates by 100bp in a bid to rein in borrowing.
Many local councils are pushing through loan requests following a collapse in Gilt yields, off which PWLB loans are priced, over the past six months. Gilt yields hit a record low in September, pushing PWLB rates down to 1%, lowering the bar for borrowing proposals to be approved by councils.
The Treasury has been at pains to play down the impact of the hike, arguing that councils will still be able to borrow at extremely favourable rates. But officials admit there is concern about rising council debts, which stood at £105bn - including bank loans and bonds - at the end of June.
"Some local authorities have substantially increased their use of the PWLB in recent months, as the cost of borrowing has fallen to record lows," the Treasury said in a letter to council finance chiefs. "HM Treasury is therefore restoring interest rates to levels available in 2018."
The Local Government Association, a council lobby group, criticised the move, saying it would cost councils £70m a year and threatens to derail capital schemes, including vital house building projects. Many local councils are struggling financially after a 60% fall in revenues since 2010.
Moody's concurred, concluding that the rate hike would be credit negative for councils, since it would increase their cost of capital. However, it said that over the medium term the hike might rein in the recent rise in debts and could even push councils to look at other funding options.
"The rate hike will not affect the availability of finance from the PWLB, and we expect it to remain the sector's main source of finance," said Zoe Jankel, a Moody's analyst. "Nevertheless, the higher cost may increase demand for financing from other sources, including capital markets."
The UK government has long held the ambition of weaning councils off PWLB loans, which come with no strings attached. Local officials just need to make a request stating how much they want and over what term. They don't need to explain why they want the loan or how it will be repaid.
The lack of oversight has allowed some to take on huge debts to fund questionable investments: Spelthorne has taken on £1bn of debt in the past three years to buy commercial property, while Warrington has borrowed £800m to lend on to housing associations and buy a stake in a bank.
BOND MARKET HOPES
But real reform of the system is yet to be seen. In 2010, the government announced that the PWLB would be dissolved, and in 2016 a consultation was launched on the subject. The Treasury previously told IFR that it remains the government's intention to "abolish the PWLB at the earliest opportunity".
One hope was that the bond market might prove to be an alternative source of funding. The UK Municipal Bond Authority was set up in 2014 as a vehicle to co-ordinate bond issuance. An inaugural deal has supposedly been imminent for the past four years, but nothing has come.
One problem is that councils like to borrow small: the average PWLB loan size in September was just £9.3m, way too small for a bond deal. The UKMBA was in part created to allow councils to pool together so that they could bring a benchmark-sized deal to market.
Many believe that a move to a more market-based system of funding might also instil a little more discipline into local authorities and add an extra layer of scrutiny - in terms of ratings agencies, bond analysts, investor roadshows and pricing metrics - that might punish wayward councils.
But bankers are doubtful that the hike in PWLB rates will necessarily lead to bond deals - at least ones through the UKMBA scheme - despite the potential for substantial regular business if it takes off.
"We have decided not to get involved with this," said one debt advisory banker, referring to the UKMBA. "It's doomed to failure. It's based on a principle of cross-guarantee, which is crazy. Can you imagine a Tory council cross-guaranteeing the debts of a Labour council?"