Major banks in the UK could face another financial bloodbath after the Financial Services Authority (FSA) ordered them to begin compensating small businesses for mis-selling them interest rates swaps. More than 40,000 small businesses could line up to demand compensation for this latest scheme. Compensation could total billions of pounds.

Small Business IRSA Victory

This is the second major scandal to rock UK banks. Last month, the City watchdog unveiled an undercover probe that faulted the banks for mis-selling payment protection insurance (PPI) to ordinary consumers. Analysts estimate that that scandal could cost banks as much as 10 billion pounds in compensation. That misconduct on the part of banks has already hit the Lloyds Banking Group with an estimated £5.3billion in provisions.

The banks ordered by the FSA to begin paying compensation to small businesses include the Allied Irish Bank, Santander UK, the Co-Operative Bank, Bank of Ireland and Clydesdale & Yorkshire banks. Other banks that have started to assess swap claims include the Royal Bank of Scotland, Llyods Banking Group, HSBC and Barclays.

Some businesses that took out these swaps at the advice of High Street banks were hammered with hundreds of thousands of pounds in additional interest payments.

Small Business IRSA Examples

The Financial Mail highlighted the case of Colin and Julie Aldous, owners of the Ufford Park golf and spa hotel located in Suffolk. The couple employ about 200 people in a business that brings in about £5million annually. The pair were hit with about £750,000 in interest after rates fell during the bank financial crisis in 2008. When they tried to buy their way out of the contract, the bank informed them that it would cost them another £450,000.

The Aldous couple were smacked with the breach of terms clause after profits in their business fell in 2007. They had previously taken out a £5.5million bank loan from Allied Irish Bank. After they had failed to meet the profit clause, the bank encouraged them sign up for an interest rate swap, but as the rates fell, they were forced to pay the £750,000 in interest.

An interest swap instrument is a hedging product sold by banks to businesses that take out loans. Banks sell these instruments with the promise to borrowers that they will be protected if interest rates rise dramatically. It’s a way to minimize risk.

Essentially, a customer will purchase a contract that will compensate them if interest rates rise from a mutually agreed upon point. This acts as an offset to higher payments on a loan. Should rates fall, the customer would pay additional interest to the bank. That additional payment, though, will be offset by a lower interest on the loan. The net effect is to fix the customer’s interest rate. That did not happen, say businesses.

The FSA charges that the banks sold these hedge instruments with the understanding that they were a no-cost product. Additionally, businesses were not informed about the fees to exit the contract.

Last summer, the FSA said it found major failings in the way the banks sold these products to businesses. After that finding by the FSA, 11 banks inked a deal to join a pilot programme to determine how much they were at fault for mis-selling the hedge scheme.

The banks were also required to establish a programme to pay compensation. Initially, the banks contributed £720million to cover claims by businesses. Barclays itself is expected to kick in another £1.1billion into the compensation kitty.

Bullybanks, a lobbying group for about 1,000 businesses, estimates that the total sum necessary to compensate businesses could hit close to £10billion. According to Financial Mail, a representative of Bullybanks said this: “The banks are downplaying the extent of this scandal. Firms that have been mis-sold interest swaps need to be put back in the position they were prior to being sold a swap. This doesn’t mean just paying back the interest, it should take into account all other costs incurred.”

To muddy the waters further, an unnamed source told the newspaper that the FSA is coming under intense pressure from both the government and the banks to delay payoffs to businesses.

A banking analyst with Liberum Capital said it would be helpful if payments could be delayed for a year or two because banks and the UK Treasury are expected to be in a financial pinch during that period, meaning all parties will be short on cash.

Both the Federation of Small Businesses and Bullybanks are hunting for an ally in MP Greg Clark, the Financial Secretary to the Treasury. They want more banks on the hook to pay compensation. In addition, the lobbyists want interest payments on swaps suspended immediately. They make the case that if businesses were not informed about break fees to banks, that a prima facie condition exists for mis-selling. “We want a clear statement from the FSA of what constitutes mis-selling and what is fair and reasonable redress,” said a Bullybank spokesman.

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Tim Capper

Bringing you financial news and information in plain english for Maple Leaf Financial. My aim is to help readers understand these often complex financial instruments.