At last week’s CIPFA Conference, all the talk at our stand was around two topics – the LGA’s Municipal Bond Agency and the new challenger banks, particularly Metro Bank and Sainsbury’s Bank who were also exhibiting. These present two very different investment propositions to local authorities, although both popular with many politicians.
Buying shares in the bond agency is a low value, high risk investment with potentially high returns. A £100,000 investment now could generate dividends for many years and be sold for more than face value if the agency is profitable. You might even double your money. A successful agency could also significantly reduce your borrowing costs, although you needn’t be an equity investor to borrow from them. On the other hand, as the share subscription agreement notes, you could lose the entire amount invested if the agency can’t find enough borrowers and makes heavy losses.
And there’s a real risk that borrowers won’t be found in sufficient numbers or size to make the agency a viable business, especially as there are other sub-PWLB options around without the unusual features of the agency’s loans. Local authorities are not used to making firm commitments several months before they know the interest rate. They normally expect to receive every penny they borrow and not have some held back to boost the lender’s capital. And there may well be political issues in guaranteeing the debts of other, unnamed, local authorities, let alone accounting challenges.
Depositing cash in a challenger bank is a very different proposition. You might place millions of pounds in what is undoubtedly a lower risk investment, but the best you can hope for is the return of your principal plus a small amount of interest. You could put £10m at risk for three months and earn less than £25,000 in return.
But what is the risk of depositing with a challenger bank? That is the million pound question. They don’t have credit ratings, or credit default swaps, or traded share prices, to help you measure the risk. So you need to do some good old fashioned credit analysis, or appoint an advisor to do it for you.
At Arlingclose, we already have a robust credit analysis model for unrated financial institutions, and we currently advise on lending to a number of small building societies, for example. But there is a world of difference between a stable 100-year old building society and a rapidly expanding startup bank. When next year’s balance sheet might be three times larger than last years, but levels of capital and liquidity may not have kept pace, standard credit assessment models need adapting.
And for banks that are currently exclusively retail funded, there comes the added risk of local authorities being the only depositors eligible to be bailed in if the bank does get into trouble, which could significantly increase the size of loss given default. These new banks certainly live up to their names as challengers! But we are stepping up to the mark, discussing growth rates and equity raising plans with the senior management, and evaluating the off balance sheet risks. We will be sharing our analysis of challenger banks with clients later this year, and any that meet our stringent tests will be added to our recommended counterparty list.
So, if you want an exciting ride with a small portion of your investments, if you have the capital financing available, and if you expect to borrow at some point in the future, I can see why you might fancy a small equity stake in the bond agency. You’ll be gambling on there being enough other authorities also looking for long-dated maturity loans, willing to enter into joint and several guarantees, and unfussed about the hold-backs and lead times of borrowing from the agency.
On the other hand, if you are looking for a boring ride with very little upside and a very small chance of a large loss, then short-term deposits in challenger banks may be up your street. You’ll also be helping promote competition in the banking market, something we should all be in favour of.
David Green is a Client Director at Arlingclose Ltd. The views expressed are his own and do not constitute regulated investment advice.