The banks’ latest mis-selling scandal

Britain's banks have been at it again. This time they've been mis-selling interest-rate swap' products to small businesses, which have then blown up in their customers' faces, according to the Financial Services Authority (FSA).

Based on a sample of 173 sales by Britain's four biggest banks Lloyds, Barclays, HSBC and Royal Bank of Scotland the regulator reckons more than 90% of swaps may have been mis-sold. Lenders are thought to have set aside around £700m for compensation, but some experts put the bill as high as £10bn.

So what went wrong? The details of how swaps work are complicated. But the principle is simple. Most were sold as a way to protect against a rise in interest rates. Say a small business borrows £10m from a bank over ten years at a variable interest rate of Libor + 1%. If interest rates rise, the business will pay more in interest, but if they fall, it will benefit just like a homeowner with a variable-rate mortgage.

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Here's the twist. The bank insists that the business also take out a swap deal. Otherwise, says the bank, it will be too risky to lend the business the money, as it might be bankrupted by interest costs if rates rise. So alongside the loan, the business buys the swap.

Every quarter, the business gets a payment from the bank, based on a variable interest rate (we'll use Libor, in this case), on a notional' £10m (notional' because it is just used to calculate interest payments; there is no new loan involved). In return, the business pays the bank a fixed rate, also on that notional £10m, of, say, 6%. Why 6%? Well, if the deal was agreed in 2007, this rate would have been linked to the Bank of England base rate, which peaked at 5.75%. So let's call it 6% (in practice it could be much higher).

What's the net result? Say Libor rises to 8% over the term of the loan (perhaps because the Bank of England raises rates). On £10m, the business pays 9% (Libor + 1%) on the original loan. Under the swap terms, the business gets 8% (Libor) from the bank and pays 6% (the fixed rate). In effect, the business is paying a fixed 7% and is hedged against rising rates it will always pay a net 7% no matter how high Libor goes.

The trouble is, Libor has plunged since the financial crisis, as the Bank of England has slashed rates. So in an environment where it should be able to borrow way below 6%, the business is locked into the 7% rate, due to the swap. Say Libor hits 2%. On the original loan the client pays 3% (Libor + 1%). Under the swap, it gets 2% (Libor) and pays 6% (the fixed rate). Add it up, and you are back to 7%.

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So far you might be thinking: well, it's just a case of buyer beware'. But there are a few twists the FSA doesn't like. For one, the obvious solution is for the business to cancel the swap deal. But one complaint is that the huge penalties that this incurs were never made explicit.

Another nasty trick is that in some cases clauses built into the swap deals allowed banks to cancel themselves, should rates rise rather than fall. These callable swaps' allow the bank to have it both ways profiting from the client if rates fall, and simply scrapping the deal if rates rise.

A third trick was to sell a product called a collar'. This locks the client into a competitively low rate on their loan: as long as the base rate doesn't drop below, say, 3%, or spike above 6%. Clients complain that banks failed to explain the huge penalties that would be triggered should the base rate plummet.

In short, the regulator is going after the banks for selling their clients unsuitable products that they didn't understand. It's like payment protection insurance all over again, and yet another good reason to avoid investing in the minefield that is the British banking sector.