How banks are killing small businesses
Complicated financial products called interest rate swap agreements (IRSAs) have been mis-sold to thousands of small and medium-sized enterprises (SMEs) by big UK banks, bringing otherwise healthy businesses to their knees.
The swaps were sold to bank customers with large loans between 2001 and the onset of the global financial crisis in 2008 as a means of protection from rising interest rates that could cause loan repayments to become unaffordable.
Swaps allow borrowers to fix their rates and control their costs. But when interest rates fall they can be massively expensive as they come with hefty exit fees - which the Financial Services Authority (FSA) says the banks often hid from SMEs.
After looking into the selling practices of IRSAs, the FSA - which will not comment further while its review is ongoing - identified other shoddy practices. Apart from a failure to check whether a customer understood the risk associated with the product, the main criticism was that banks were selling IRSAs based on financial reward rather than on a business's needs.
The banks earned huge profits by trading swaps on to other banks. To explain how, The Daily Telegraph gives the example of a SME customer taking out a five-year loan for £1 million.
The bank knows it can sell the swap on to another bank at a rate of, say, 5.2% but because it wants to make a profit and knows the customer has no access to the swap market it quotes the customer 5.5 to 6%. So the bank effectively sells a swap worth £200,000 for between £225,000 and £250,000, netting itself a gain of between £25,000 and £50,000 in the process.
When the base rate was slashed at the end of 2008 and again in March 2009, the SMEs that had been sold swaps alongside loans started to realise the risk they'd been exposed to. While the Bank of England had cut the base rate to ease the burden on borrowers and to keep the economy moving, it became clear that the result of IRSAs on the businesses they were sold to was the exact opposite.
Paul Adcock runs an electrical shop in Norfolk. This year marks Adcock & Sons' centenary, "but there's not much to celebrate", he says. The company was sold an IRSA alongside a commercial mortgage of £970,000 by Barclays back in 2007. Since then, additional interest and fees relating to the swap have cost Paul £188,000.
He now pays more for the swap each month than he spends repaying his mortgage. "It has put a tremendous strain on us. The most visible effect within the shop is that we don’t have the range of stock to keep up with customers as we can’t afford it."
Paul says the bank pushed the IRSA and that it was mis-sold: "It was sold to us on the basis that if rates went up we wouldn’t pay more than the capped level, which was about 6%. It was not until after we had taken out the swap that we learnt that interest rates only had to fall a little before we ended up being in a cost situation, whereas they would have had to go up by nearly 2% for the IRSA to have been any benefit."
A Barclays spokesperson told Moneywise all dialogues with Paul are ongoing. Other businesses sold IRSAs claim they were simply lied to during the selling process. Tom Beynon, 38, development director of commercial property developer Oastlodge in Northamptonshire, was recommended a callable swap - an IRSA the bank could cancel at any time - by Lloyds in 2008 that would halve his borrowing margin from 2.5% above the base rate to 1.25%.
"We trusted our relationship manager and it seemed like a good way of reducing our borrowing costs with no upside risk," he says. But in July 2009, Tom was informed the margin was going back to the old rate. "We had a heck of a lot of cash going out to the bank on the swap for something that has no benefit to us," he says.
"All the money we get in has to go straight back out. We can’t grow." Lloyds justified its actions to Tom by explaining that the cost of its funding had gone up so it was forced to increase the cost of his loan.
"We complained but the bank said there was nothing it could do. It didn’t care what it had stated in writing," says Tom. Martin Berkeley at hedging specialist Vedanta Hedging likens it to Tom as a form of fire insurance the insurer is able to cancel if your house burns down.
Sadly, some SMEs have been ruined by IRSAs. Colin Jones, 48, from Llandudno, was sold a swap by RBS linked to a NatWest loan for £400,000 he used to buy a B&B. It ended up costing him £25,000 a year and when he could no longer keep up with his repayments NatWest repossessed the B&B. Colin lost his business and family home and suffered a breakdown.
His case came to the attention of his local MP, Guto Bebb, who believes Colin has a strong case for mis-selling. Given that the FSA review of the selling of IRSAs means those mis-sold are entitled to redress from their bank, "the losses he could claim for are potentially huge", he adds.
Bebb, who was the first MP to raise the issue in Parliament back in January, believes the extent of mis-selling is such that it could cost the banks billions. "A business from my constituency spent £800,000 on fees related to an interest rate swap and then had to pay £492,000 to get out of its agreement. If the company was mis-sold the product – and I think it has a strong case - that's compensations of at least £1.3 million for just one comparatively small business."
The FSA put an initial estimate of the number of IRSAs sold to businesses by the Big Four banks at 28,000. But business secretary Vince Cable believes as many as 100,000 small companies may have been mis-sold swaps.
The biggest settlement yet has been paid out to Dublin-based property developer David Agar, who took out a €47 million (£37 million) property loan with RBS's Irish arm, Ulster Bank. The London office then sold him €87 million of interest rate hedging products linked to the loan. Agar successfully claimed the products were mis-sold and RBS has paid him more than €30 million in compensation.
Playing it down
Unsurprisingly, the banks are keen to play down the scandal. Bob Diamond, Barclays' former boss, said in April the bank had made "mistakes", but that only a "very small number" of complaints had been made. However, the bank has now put aside £450 million to pay IRSA compensation.
Meanwhile, the Sunday Telegraph - which first investigated the misselling scandal earlier this year - claims experts have informed it they believe compensation could cost the banks far more than the £10 billion PPI bill.
John Walker, national chairman of the Federation of Small Businesses, describes IRSA mis-selling as an "appalling breach of trust", adding "firms that turned to their banks for support were instead exploited".
Bebb is optimistic, however, that the issue is now being taken seriously by the regulator and the government. "The idea that the banks have cleaned up their act and are now behaving properly has been shot to pieces by recent revelations, so there's an appetite now to get things right," he says.
Payment protection insurance is designed to cover you should you fall ill, have an accident or lose your job and can’t make repayments on loans or credit cards. However, research by consumer watchdogs found the cover to be overpriced, filled with exclusions (policies exclude self-employment, contract employees and pre-existing medical conditions) and were often mis-sold because the exclusions were never fully explained. In May 2011, the High Court ruled banks had knowingly mis-sold PPI and ordered them to compensate around two million consumers.
The practice of a dishonest salesperson misrepresenting or misleading an investor about the characteristics of a product or service. For example, selling a person with no dependants a whole-of-life policy. There have been notable mis-selling scandals in the past, including endowment policies tied to mortgages, employees persuaded to leave final salary pensions in favour of money purchase pensions (which paid large commissions to salespeople) and payment protection insurance. There is no legal definition of mis-selling; rather the Financial Services Authority (FSA) issues clarifying guidelines and hopes companies comply with them.
The Financial Services Authority is an independent non-governmental body, given a wide range of rule-making, investigatory and enforcement powers in order to meet its four statutory objectives: market confidence (maintaining confidence in the UK financial system), financial stability, consumer protection and the reduction of financial crime. The FSA receives no government funding and is funded entirely by the firms it regulates, but is accountable to the Treasury and, ultimately, parliament.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.