Councils are in talks with City fund managers to set up a bespoke money markets fund - a decision poised to exacerbate the multi-billion pound flight of local authority cash from building societies that followed last year's Icelandic banks collapse.
The £1bn lost by councils in the Icelandic debacle has triggered a fundamental review by local authorities of where they place their £30bn-plus of cash on deposit.
The Local Government Association's executive last week sanctioned official negotiations with fund managers to set up specialised vehicles designed for councils. The association reckons councils could use their collective bargaining power to gain a rebate on the annual fee of up to 0.2 per cent charged by the typical cash money market fund.
The association will also set tight criteria for disclosure of the underlying investments as a condition to approve any fund.
A survey in March 3008 found only about £600m - or 2 per cent - of council funds was held in money market funds. But the association believes a bespoke fund could attract much greater amounts of council cash. Officials hope a fund could be up and running within six months.
The initiative is another blow for building societies, which have seen their deposits by local authorities more than halve from £12.7bn in July 2008 to £5.6bn this July. The cash exodus reflects a flight to safety, as council treasurers abandon small mutuals with less-than-perfect credit ratings for government-backed savings. Councils have also pulled cash out of banks, but to a lesser degree - deposits fell from more than £20bn in late 2008 to £14bn at the end of March.
Adrian Coles, director general of the Building Societies Association, said on Sunday that local authority treasurers had been "traumatised" by the Icelandic fallout. "They found themselves being crawled over by councillors and the local media and got nasty letters from members of the public. . . now they value safety of money above all."
He accused councils of "shooting themselves in the foot, by missing the opportunity to support the local housing market and to get better rates than the [government] debt management office."
But Mr Coles admitted a decision to set up a bespoke fund "clearly makes it even less likely that that money will return to building societies".
Building societies are lobbying government to match ministers' rhetorical support for mutuals by a state guarantee, to allow councils and other savers to put cash into small societies with greater confidence.
"If ministers are not prepared to offer a guarantee, I can understand local authorities' reticence [about depositing cash in smaller societies]," Mr Coles said.
The Local Government Association last week approved revisions to tighten the treasury management code for councils in the wake of the Icelandic fiasco.
A report by MPs on the communities and local government select committee this summer said the financial crisis had exposed a "degree of misunderstanding, misinformation and complacency" on the part of some councils.