How to spot a mis-sold interest rate swapby
The scale of interest rate swaps mis-selling is only just becoming apparent, according to All Square Treasury's Daniel Hall.
Around 40,000 small to medium sized businesses are estimated by the FSA to have been mis-sold swaps, do identifying whether clients have been mis-sold is vital.
The following advice is taken from an All Square Treasury guide for accountants on interest rate hedging products. The guidance presents an overview of signs that clients may have been mis-sold. These key indicators include:
The bank didn't explain the risks of the swap
In this case, a bank may have failed to adequately explain the risks of the interest rate swap (IRS) or hedging product (IRHP) in the run-up or at the point of sale. If the bank did not provide these explanations, your client may have been mis-sold the product.
Some companies may think they were mis-sold an interest rate swap (IRS) or interest rate hedging product (IRHP), when they actually got a fixed rate business loan.
According to All Square Treasury, during the period these products were sold, banks often:
- Failed to clarify that the loan and IRS or IRHP were separate products
- Failed to clarify that there was an alternative, more suitable IRHP
- Failed to clarify that the interest rate payable on the IRS was separate to, and in addition to, the margin payable on the loan
- Failed to clarify what would happen if interest rates fell to their current levels
- Provided misleading examples of the performance of the IRS or IRHP in a presentation or email.
The bank didn't explain the termination costs of the swap
In this case, a swap may have been mis-sold if a bank failed to adequately explain the break costs if a client ended the IRS or IRHP early.
What is an interest rate swap?
- A financial instrument in which two parties agree to exchange cash flows relating to an interest rate, such as the Bank of England’s base rate.
- The agreement is based on a specified amount of money, or Notional Principal, over a specified period of time.
Source: All Square Treasury
According to All Square Treasury, the actual cost of ending an IRS or HP can only be calculated at the point of cancellation, as it's determined by the live swaps market.
However, banks should have given indicative termination costs, which they often failed to provide.
The break costs often amount to 20 - 50% of the size of the swap, of which most businesses who bought the products were unaware of either their existence or size.
Mismatch between term and size of loan and swap
This, according to Hall, works well for sophisticated companies that need flexibility, but is not appropriate for small businesses.
Banks have applied the same technique to standard borrowing facilities for small businesses, such as selling an IRS with higher notional than underlying loan, or an IRS with a longer term than underlying loan.
Bank only provided a loan on the condition a swap was bought too
Although this condition may be based on the bank's commercial discretion when providing the loan, this insistence was often only introduced at the last minute of discussions.
This measure forced businesses to take on an IRS or IRHP, as they needed the loan.
Bank failed to explain risks of 'callable' product
Callable products allow one party to call or cancel the product early.
The bank does this if interest rates have risen as they will make a profit by unwinding the product at higher levels, according to All Square Treasury.
This situation denies the holder of the callable product protection from higher interest rates.
The bank would usually terminate the product; if the caller did so significant break costs would be incurred. The holder would effectively be locked in to paying the higher fixed rate under the swap and would not benefit from the low interest rate environment.