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Croydon’s insolvency could be just the beginning

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By Silas Brown
17 Nov 2020

Giving cheap loans with few restrictions to local authorities via the Public Works Loan Board is not a suitable replacement for central government funding. This must change, or London Borough of Croydon will only be the first council to fall into insolvency.

Croydon, one of London's most populous boroughs, issued a section 114 notice last week, that stops it making any new expenditure, apart from on statutory services protecting vulnerable people. The council said it has a £66m hole in its budget it is struggling to fill.

Although this is only the second insolvency from a UK council in the last decade, trouble has been brewing for some time.

Since 2010, when the Conservative-Liberal Democrat coalition that came to power after that year’s general election launched draconian austerity policies in a response to the 2008 financial crisis, funding provided by central government to local authorities has fallen by roughly 49%.

Instead of directly funding local councils, the government encouraged them to borrow from the Treasury at below market rates, via the Public Works Loan Board. Over two-thirds of council borrowing is via the PWLB, and many have gone on debt-fuelled buying sprees in attempts to drive up their revenues to offset the steep decline in public funding.

Commercial real estate has seen particularly heavy investment. According to the National Audit Office (NAO), local authorities spent £6.6bn on commercial property between 2016 and 2019 — more than 14 times than the preceding three year period. Croydon, for example, borrowed more than £900m from the PWLB and now owns a hotel and a local leisure park.

A significant minority of councils entered into commercial real estate forays outside of their borders. For example, East London’s Newham council spent roughly £91m on commercial properties in Skegness, Surrey and Yorkshire.

Sources close to certain councils have been critical of their funding habits. In October, Croydon’s auditors, Grant Thornton, issued a withering report that said the council showed “collective corporate blindness to both the seriousness of the financial position” it was in and “the urgency with which actions needed to be taken”.

The NAO has also reported that other auditors have seen local authorities demonstrate poor corporate governance and inadequate transparency, and decision-making processes that included limited internal challenges.

Here's the rub. Croydon is no outlier in its borrowing habits. Many councils have borrowed more than Croydon from the PWLB, such as Birmingham (£2.45bn), Edinburgh (£1.05bn), Spelthorne (£1.06bn), Warrington (£1.1bn) and Woking (£1.3bn).

Commercial real estate, particularly outside of London, is an unforgiving sector in the best of times. But during the pandemic and the subsequent lockdowns, the sector has struggled to keep tenants and attract new business. 

Meanwhile, councils face acute demand for essential services, further straining their budgets.

This tension doesn’t just hit Croydon. As one adviser who has worked with several UK councils, told GlobalCapital, “in a very simple sense, it is quite hard to differentiate between Croydon and other local authorities on the upper end of borrowing to invest”.

The PWLB offers little in the way of due diligence, relative to a typical investor, which has led to claims that it may be too easy for councils to find cheap funding. The PWLB tried to tackle that problem by raising rates by 100bp last October. In the two months before the rate rose, local authorities borrowed totals of £2bn and £1.6bn respectively — the first and second highest months of debt raising on record.

If councils were forced into the capital markets to borrow money, they would find investors far more rigorous creditors, who ask more questions and hold them to account over their spending.

But these same investors may take local authorities down dark paths, by pushing for tough terms, playing hardball if covenants are breached or even guiding councils to cut costs by funding fewer services. In this scenario, it is the taxpayers and the vulnerable who would ultimately suffer.

What Croydon demonstrates is that the no man’s land between capital markets and government funding is unstable ground for public sector borrowers, and councils are being pushed into dangerous territory. Philosophically speaking, it is deeply unsettling when a local authority feels it must invest in commercial real estate to fund its services.

Central government needs to start funding councils again, or tighten the PWLB’s guidance on use of proceeds and disincentivize allowing unqualified people to make unsuitable investments.

Croydon’s crisis could be the first in a run of insolvencies that sweep the UK’s councils. The time to stop this happening was years ago, when local councils were experimenting with commercial real estate. Now the government has to find a fix for this situation, and fast.

By Silas Brown
17 Nov 2020