Housing associations must have the skills, knowledge and experience at both board and officer levels, as well as the systems and access to independent advice necessary to identify and manage the treasury risks to which they are exposed. Many housing associations are now finding that they need to seek specialist advice from funding advisors.
Treasury management policy should be heavily weighted towards the minimisation of risk. The maximisation of returns should be of lesser importance.
The first of the four key recommendations in the CIPFA Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes 2017 Edition (Section 5) focuses on risk management, that “this organisation will create and maintain, as the cornerstones for effective treasury management:
- a treasury management policy statement, stating the policies, objectives and approach to risk management of its treasury management activities
- suitable treasury management practices, setting out the manner in which the organisation will seek to achieve those policies and objectives, and prescribing how it will manage and control those activities.”
The first treasury management practice is risk management, (noted earlier, under “Approach”) which covers the following nine risks:
- credit and counterparty risk
- liquidity risk
- interest rate risk
- exchange rate risk
- inflation risk
- refinancing risk
- legal and regulatory risks
- fraud, error and corruption, and contingency management
- price risks.
Credit and counterparty risk
This is the risk that an organisation with which the housing association has a contractual relationship is unable to meet its obligation to the housing association. There are two main aspects to this risk.
Firstly, there is the risk that an organisation with which the housing association has deposited surplus funds does not repay the monies. This aspect of the risk should be controlled by the approval of formal lending criteria based on the nature of the counterparty (either regulatory status such as bank or building society or credit rating), maximum amounts to be lent (in monetary value and as a proportion of total lending) and term of deposit.
Secondly, there is the risk that an organisation that is due to make a payment to the housing association under a contractual agreement (eg loan facility or derivative agreement) may default on its obligation, or in the case of a long-term loan agreement, may be unco-operative if the housing association needs to renegotiate the loan.
Quantifying counterparty risk in relation to derivatives is possible but significantly more complex than in relation to investment. Management of counterparty risk in relation to borrowing requires a more subjective approach, combining a lender’s financial status with an assessment of its commitment to social housing.
Credit rating information is one indicator of financial status and is freely available on the internet from Fitch (which, being UK based, may have ratings for more counterparties that housing associations may wish to lend to) and Standard & Poor’s. (The third major credit rating agency is Moody’s, but its ratings are only available on a paid-for basis.) Associations should not rely on credit ratings alone for their understanding of counterparties.
Associations should ensure that their counterparty lists and limits reflect a prudent attitude towards the organisations with which they invest, borrow or engage in other financing or derivative arrangements. A sound diversification policy avoids overreliance on a small number of counterparties.
This is the risk that the housing association will be unable to meet its liabilities as they fall due. This risk needs to be managed using reliable short-term (daily, weekly and/or monthly as appropriate), medium-term (rolling 24 month) and long-term (business plan period) cash flow forecasts backed up with a combination of adequate, though not excessive, cash resources, borrowing arrangements and/or overdraft facilities.
Sensitivity analyses should be run on key variables within range limits that reflect likely outcomes. Combinations of variables should be tested to see which scenarios have the greatest impact on the business.
As mentioned above, once a loan has been agreed, property generally needs to be charged to secure the loan. This process can take up to a year to complete before funds can be released. In some cases, funds can be released in tranches as security is completed, but nonetheless, plenty of time needs to be allowed for in forecasting the receipt of funds.
Interest rate risk
This is the risk that future interest rates (either paid or received) will be worse than budgeted or forecast. This risk can be managed through the maintenance of a loan portfolio with a balanced interest rate profile, which should include a mix of different fixed periods and variable rates. Realistic and prudent budgeting and forecasting, including sensitivity analyses, should highlight any adverse cash flows that need to be covered.
A housing association may mitigate (sometimes referred to as hedging) future interest rate risk by using derivative products (see Debt Portfolio Management below). However, interest rates can fluctuate so as to create a ‘mark to market’ loss position (by comparison of current market value to original cost) in respect of the derivative.
In such a case, collateral, or margin calls (additional security) may be demanded under the terms of the agreement to provide security to cover the loss position. Alternatively, where security is not provided, an adjustment to the pricing of the loan may be required. The terms of the derivative need to be carefully evaluated to determine the potential for this situation to occur.
Housing associations will need to consider the risks regarding International Financial Reporting Standards (IFRS) requirements and rules on hedging where any mark to market differential will need to be reported in the income and expenditure account, potentially causing significant fluctuations in the surplus/deficit situation and thereby risking possible loan covenant breaches. Currently, these detailed rules apply to a relatively small number of associations, but the application of IFRS will undoubtedly broaden.
An association should manage exposure to fluctuations in interest rates with a view to containing interest costs or securing interest revenues in accordance with the amounts provided in its budget. It should achieve this by the prudent use of its approved instruments, methods and techniques, primarily to create stability and certainty, but at the same time retaining a sufficient degree of flexibility to take advantage of unexpected, potentially advantageous changes in the level or structure of interest rates.
Exchange rate risk
Exposure to exchange rate risk will not normally arise. However, some associations have raised finance via private placements (see Capital Markets below) dominated in foreign currencies. Wherever an exchange rate exposure arises, suitable hedging arrangements should be put in place, seeking professional advice as necessary.
Inflation risk, also called purchasing power risk, is the chance that the cash flows from an investment will not be worth as much in the future because of changes in purchasing power due to inflation.
An association should keep under review the sensitivity of its treasury assets and liabilities to inflation, and should seek to manage the risk accordingly in the context of the whole organisation’s inflation exposures.
Refinancing risk (the risk that loans falling due, which the housing association does not have cash resources to repay, cannot be replaced at an acceptable cost) can legitimately be considered as a type of liquidity risk. This (sub-) risk should be controlled by regular monitoring of loan payment profiles, a proactive approach to refinancing and the avoidance of a material maturity of funding sources in any one year. As previously noted, it can take substantial time and resource to raise a loan, so spreading maturities ensures a more manageable workload, reducing the operational risk of refinancing, as well as mitigating any issues there may be around the availability of a material amount of funding due to lenders’ exposure limits to individual associations.
Revolving credit facilities (RCF) provide flexibility in that it is possible to draw and repay them during the term of the loan; nonetheless, they do have a set term after which they need to be formally renewed, so a refinancing risk also applies to this kind of loan. With housing associations increasingly using RCF to fund development programmes, these need to be replaced with long-term facilities. Managing this refinancing risk becomes more significant.
Legal and regulatory risks
These refer to the possibility that the housing association or its counterparties may be prevented from fulfilling their obligations or intentions due to legal or regulatory restrictions. Housing associations should seek legal advice on all loan and derivative contracts.
The Regulator of Social Housing requires associations to forecast cash requirements and to have a buffer to provide sufficient liquidity, allowing for the time needed to negotiate and secure facilities before they become available, for drawdown. If liquidity is not sufficient over a range of reasonable scenarios, then the regulator may take enforcement action against the association.
Fraud, error and corruption, and contingency management
This can apply within the housing association and in third parties. It can be caused by human error or system failure but the risk is not specific to treasury management. However the value of the sums involved and the specialist nature of much of treasury management mean that the risk of fraud or error is significantly greater in this area than in other areas of a housing association’s operations.
Such inherent risk should be controlled using a range of policies, procedures, reporting and training with particular focus on the segregation of duties. Identified risks should appear on the risk register with plans to manage the situations in which the risks crystallise. Money laundering is a key risk within the area of corruption. The Proceeds of Crime Act 2002 established the main offences relating to this.
Within the strict ambit of treasury management, price risks only arise if housing associations are investing in non-cash deposits with a market value such as bonds or equities. Obviously the value of such investments can fall.
However, other market risks relating to the economy generally can have a significant effect on cash flows. For instance, the buoyancy or otherwise of the property market will have an effect where property sales receipts are a material part of a business plan. Where changing market conditions are likely to have a material effect, cash flow actuals and forecasts should be intensively monitored to evaluate what problems may arise and how they may be mitigated.
The value of treasury management transactions and the fact that housing associations’ continued existence depends on their ability to maintain liquidity and comply with loan covenants mean that reputational risk is inherent throughout the treasury operation. If anything significant were to go wrong in a housing association’s treasury operation it is likely that the opinion third parties (eg financial institutions, the regulator, the rest of the housing sector and tenants) have of the housing association would be diminished.
Reputational risk is virtually impossible to quantify but can have a significant impact on the way in which such parties do (or do not do!) business with the housing association including, for example, the cost of future borrowings. Reputational risk is controlled by managing the other risks of treasury management.
There are potentially a further six mainstream risks (lenders’ covenants, management, inflation, systems, banking and political) but even this list is not exhaustive and each housing association may also have unique risks. It can be argued that each of these is a variation or subset of one or more of the above.
The inability to satisfy lenders’ covenants is worth identifying separately due to the possibility that this could cause the risk of cross default. This, in turn, arises from the clauses in most loan agreements which mean that a breach of covenants for one loan could lead to a requirement to repay them all.
Systems risk is ‘operational risk’ which arises through the failure to employ sufficient system and control procedures to prevent losses arising out of fraud, error, wilful override of controls or other eventualities.
Banking risks are particularly to the fore at present with many banks actively looking to reprice older loans and lend at shorter maturities.
Political risk is a variation on legal and regulatory risk, but not one that can be controlled by taking legal advice. A change of housing policy could radically change the environment in which housing associations operate. As far as is possible, adverse scenarios need to be modelled to determine the effect on cash flow.
It has to be accepted that the diversity and the extent of potential risks is such that it is not possible for all eventualities to be covered. There can be no absolute protection. However, these risks can be substantially mitigated by having a balanced portfolio of debt (ie a mix of fixed and floating rate, different terms and different lenders) backed up by sound controls.