I’m going to start with an excellent summary of the problem by Grant Thornton:
“A decade of austerity led many councils (encouraged by the Localism Act 2011) to alter their risk appetite to become more innovative and seek to generate additional sources of commercial income, including via the creation of arm’s length council companies.
The accounting implications of financial transactions between a council and its companies can represent are often poorly understood by key council decision makers. Some councils have chosen to continue to fund companies rather than face the reputational damage of winding up a loss-making organisation. Indeed, some have been seen as ‘too big to fail’. This is poor governance.
If entering into complex or large company arrangements, councils should focus on accessing the right financial and legal advice from a suitably qualified and independent party, company directors should have appropriate skills and experience (including understanding Company Act requirements) and Member oversight is essential to protect the council as shareholder.”
Ten mistakes some councils make when setting up companies
To set the scene for this sequence of posts, I’ve summarised ten errors that have impacted the way local authority companies have been set up and then performed. Subsequent posts will consider ways we can reduce the probability and/or consequences of these errors.
Error 1
Seeking to repeat a successful model – without understanding why it worked
It’s natural and rational to observe someone else’s success and seek to repeat it in your own patch.
But humans habitually evince confirmation bias in our decision-making.
“…we often start the process of judgement with an inclination to reach a particular conclusion. … Either we jump to that conclusion and simply bypass the process of gathering and integrating information, or we…come up with arguments that support our prejudgement”.
Kahneman, Sibony & Sunstein: Noise
Successful projects succeed because of the combination of a number of factors.
Context, strategy, capability and execution all play a part – and the details really matter.
Sometimes in local government, we act as though the only relevant success factor is the legal character of the entity that worked well!
“X council’s company has made a profit and its customers are happy, so we should have one too…” is effectively the thought bubble that characterises this error.
But if the success factors aren’t understood and considered, it is possible that one or more important critical success factor that has made the approach work is absent in our case.
The difference between successful and unsuccessful projects and ventures becomes evident eventually – but if that’s in an audit report looking into what went wrong, well – not much comfort there!
Error 2
Optimism bias - insufficient challenge in design phase
To be fair, not every project that doesn’t deliver everything that was hoped for should be labelled as having been over-optimistic at the start.
You can have reasonable assumptions that prove to be incorrect because of external factors.
Business ventures encounter competition, and competitors sometimes win.
But…we can all think of councils that have borrowed large amounts of money to invest in particular projects in specific markets that only made sense on the basis that adverse conditions didn’t develop in those markets.
Adverse conditions like changes in law or regulation, the intensification of competition, changes to interest rates or other macro-economic drivers.
All of which are…well, commonplace.
If the risks were hedged in the design of the venture such that it was equipped to retract the council’s exposure to such adverse developments when they occur, then less criticism would be justified. But often councils have gone ‘all in’, making irrevocable commitments on the basis of a collection of expectations whose real-world collapse proves costly. For taxpayers.
Error 3
Two black swans can’t both fly past, can they?
Time and time again, we see in financial markets how herd behaviour and the Fear Of Missing Out (FOMO) combine to permit people to sell complicated, poorly understood products to apparently sophisticated buyers.
I’m thinking of the collateralised debt products that triggered the 2007-08 financial crisis and, much more recently, the Liability Driven Investment (LDI) products bought by pension funds whose collective exposure to 30 year gilts within the LDI structure is now adding large sums onto people’s mortgages across the UK.
In both cases, each buyer reasonably believed that these risk exposures were manageable, discounted the probability that a system-level issue would crystallise the risk for everyone holding the types of assets in question and (if they even got this far) under-estimated the extent to which their assets would be impaired if all asset holders experienced the same adverse event simultaneously.
Perhaps local government has quietly passed through a comparable, although much gentler, moment. I’m thinking about the councils who bought part or all of their own or even remote shopping centres in order to generate income from rents…while interest rates were low and before retail real estate had suffered the blows it took from the pandemic.
(Of course I’m not saying ‘councils should have predicted the pandemic’ – but Taleb’s ‘The Black Swan’ published in 2007 explained how highly improbable events tend systematically to be underestimated in advisors’ models.)
Insurers are very attentive to the aggregation of risks. Their exposure models, which drive pricing, are crafted so as to alert them to multiple instances of the same risk within a portfolio.
At the Local Government Mutual, we prepared a Risk Appetite Statement that would provide us with a framework to assess whether we were getting too deep into particular risk exposures that might not be immediately obvious when looked at from the perspective of individual councils’ insured risks. It would be interesting to see councils’ Risk Appetite Statements…and to show councils the aggregations that sit inside them when they’re laid on top of one another.
A risks X-ray, if you like.