Over the years, Rainy Day Funds (RDFs) have been debated on the merits. What is reasonably clear is that they are viewed positively from a credit perspective. An RDF should not be a financial fallback solely. It is intended to smooth out the financial operations when revenues and/ or expenditures do not behave in accordance with the financial plan. Having an RDF does not automatically contribute to a rating increase. However, having one is grouped with other favorable characteristics of the credit under consideration.
Fortunately or unfortunately, the definition of an RDF is a relatively loose term in the world of municipal finance. The definition may be compared with the concept of Days of Cash on Hand in the healthcare sector. They are very different concepts and yet, their meanings converge on the notion of how long could the entity continue to operate with steady draws on the fund if necessary.
I tend to view the RDF as separate and distinct from the Fund Balance or other specified or required reserves. A fund balance is typically in the range of 2% to 10% of expenditures, depending on the kind of entity and what the characteristics are of that entity’s cash flow.
For example, many local governments in Texas maintain large fund balances so they never really need to do any short-term borrowing beyond their own internal funds. Other governments maintain balances due to uneven cash flow or special needs that affect cash balances. In California, most governments make their pension contributions early in the fiscal year when revenues are not as robust. Having a fund balance eases the pressure generated by the need to make those critical payments early in the fiscal year.
An RDF is intended to counteract the effect of the unintended or unanticipated drain or fluctuation in revenues. An RDF is usually sized in accordance with a percentage of expenditures or a specified period of operations. There is no one single guiding factor on what number or percentage to select. Two months of operations would be a very large amount that most governments would not be able to justify. A range of 2% to 10% is frequently adjudged to be an appropriate amount and a level that would be less subject to criticism by select parties.
Another valued consideration is that under what circumstances may the RDF be tapped and how would such action be authorized. This part of the discussion may contribute to many complexities. The construction of the RDF does not need to be a very complex consideration but building in some safeguards is of paramount importance. One does not want to witness a random willful draw on an RDF without a substantial rationale.
Some RDFs require that the legislature authorizes a draw on either a partial or the full amount of the funds. Part of the reason to fund an RDF in the first place is to provide a modicum of financial flexibility to the financial leaders in charge. Tying up the financial officers with too many constraints detracts from the purpose. At times, we see provisions that allow for unrestricted draws up to part of the funds and a more formal process associated with a full draw.
The refilling of an RDF after a draw is also an important consideration. One reasonable approach to the replenishment would be to rebuild the RDF over the next fiscal year or 18 months. The period for the replenishment is not as critical as having regiment to do so. The art of constructing a proper refill is to make certain the process will not be overly taxing on an already stressed operation.
I believe that the discussion surrounding RDFs is rising to the top in light of all of the healthy debate underway concerning the next potential recession. There is no preordained exact way to prepare for a recession. We all concur that no one sees the development of a recession on the near term horizon. However, having some extra funds on hand may provide an important buffer until such time as the government is able to adjust its budget and spending to the new circumstances.
Many of our newer leaders have never been through a severe downturn especially if they entered into the business after the 2008 period. No two recessions have been caused by the same fact pattern. However, the rise in unemployment and the decline in economic growth are two consistent economic markers.
Given the level of taxation in most states and localities, it is no longer a given that taxes would be increased to produce the required level of funds given a change in the economy. It is also true that cutting spending in a downturn is quite difficult and is not always linear in nature. We tend to speak of the mandated part of the budget versus the discretionary.Over the years, the mandated portion of the budget has increased in part with requirements imposed by the federal government in order to accept grants and aids.
In its final formulation, an RDF must be formulated taking into account not just the politically expedient preferences, but, said formulation should also be constructed with the many important financial considerations that exist at the time in mind. One has to be careful that the funding of the RDF and other aspects do not weigh unduly on current operations.
We believe that all good credits may benefit by having an RDF. Taxpayer sentiment must be considered but the prudence of creating and maintaining an RDF would prove to be a valuable precaution over time.
