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If you thought PPI was costly, wait till you see the price of this scandal

We had a fascinating insight into the issue of swaps
mis-selling from Jeremy Roe last night at the Financial Services Club.

Jeremy was a victim of the process and has been championing the
cause ever since.  He now counts 1,200
companies in his group, Bully Banks, out of the 40,000 cases that have been
identified so far.

It does not sound like much, but if each case averages £2.5
million compensation, this is a £100 billion exposure and is far bigger than
the PPI mis-selling scandal we all know about already.

Why would it be so much?

Because many of the businesses that were sold these Interest
Rate Swap Agreements (IRSA) have been forced out of business due to the issue.

How come?

Because IRSAs were sold without the small business owners being
informed of what they were getting into.

The process of the mis-selling, according ot Jeremy, went as
follows.

The bank went through their customer base and identified which
businesses were asset rich and cash poor.

Typically, the SME (small to medium enterprise) would
require funding for expansion or to cover short term exposures, and the bank’s
relationship manager would work with the business owner on a loan funding
cover.

The loan may be for five or ten years, and the relationship
manager would often call the client after a short time and say “congratulations,
you’ve got the funding”.

The business owner would be delighted and would start committing
the funds.

Only then would the relationship manager call them back and
say, “ah, we have a concern here about interest rates”.

This would start the process of the disturbance sale of the
IRSA.

The client would be assured that they could avoid any issues
of interest rate costs creating an unaffordable loan by taking out this
protection.

Often the business owner would not even realise this was a
derivative being sold to them, or a complex product, but would be introduced to
an advisor who could explain it to them: the Derivatives Salesperson.

The sales rep from the bank would be introduced to the small
business owner by their relationship manager as an interest rate advisor, and
the sales person would then get the client to buy the product.

Bearing in mind we may be talking about a £1 million loan over
ten years with a joint £1 million IRSA, the derivatives sales rep and the relationship
manager are both making a healthy commission on these deals, typically several thousands
of pounds each.

Therefore, the incentive to sell, regardless of need, is
high and many of these sales were made inappropriately.

For example, a 70 year old farmer with a caravan site in
Devon borrowed £1 million with a £1 million IRSA.  When his wife died five years later, he asked
to terminate the IRSA and was told that the break clause in the contract would
mean a payment of 30% of the value of the contract.  In other words, a £300,000 penalty payment to
terminate the IRSA contract.

This was normal, according to Jeremy, who has found that
almost everyone who has taken an IRSA went through the same process described
above.  In other words, this was not an
exceptional sales process, but the norm across the big four banks.

In fact, to prove this, Bully Banks surveyed their 1200
members and found that:

  • The average age of SME Owners sold an IRSA is
    over 50 years of age at the time they entered into the IRSA.
  • The average turnover of the business was over
    £1.7 million when sold an IRSA.
  • 72% of the businesses sold an IRSA had a
    turnover below £1 million.
  • The average value of the IRSA entered into was
    £1.9 million.
  • The average value of the associated loan was
    over £1.9 million.
  • The average value of the security provided to
    the bank in connection with the loan was over £3.8 million

From this survey, Bully Banks discovered that:

  • 85% of respondents were sold an IRSA in connection
    with the grant of new loan facilities or the extension of existing loan
    facilities
  • 87.5% of respondents were advised by their Relationship
    Manager that he or she was of the opinion that interest rates were going to
    increase, with 87% saying that the Relationship Manager felt that the bank
    believed this to be the case as well.

This was when the IRSA idea was introduced, with 96% of respondents
saying that it was their Relationship Manager who introduced the concept of an
IRSA.

I think you get the idea (you can read the rest of the
survey results) as in this was systematic and focused mis-selling and, just for clarity, Jeremy defines an IRSA mis-sale as:

  • any sale made that has over-hedged the requirements for the SME in either the value of the IRSA or its term
  • any sale where the IRSA purchase was presented as a bank condition or requirement in order to be given the loan
  • any sale where the customer was not informed clearly about the cost or conditions for terminating the IRSA 
  • any sale where the Derivatives Expert for the bank was presented as an 'advisor' or other description that could lead to misinterpretation of their role as a sales representative of derivatives for the bank
  • any sale that would be viewed as not fit for the purposes of the client, based upon their educational background
    or work history
  • any sale deemed as unsuitable for the SME, given their future plans 

Since Jeremy set up Bully Banks, he’s achieved a fair bit.
In particular, getting media coverage (watch the Sky News interview at the end
of this blog) and lobbying of Parliament such that back bench MPs formed a
committee to investigate what had been happening.

So what has happened as a result?

Mainly because of the Parliamentary investigation, the Financial
Services Authority was kicked into action and, on June 29 2012,
announced that it had found "serious failings in the sale of IRSAs to
small and medium sized businesses and that this has resulted in a severe impact
on a large number of these businesses.” 

However, it then left the banks to investigate the cases and
work out how to compensate and address them.

The banks response was released on January 31 2013,
and it was notable that between the June announcement and bank response in
January that the number of cases rose from 28,000 to 40,000.  It was also noteworthy that of those 40,000
cases investigated, over 90% were found to have been mis-sold.  That’s a pretty damning indictment.

Even then the real issue, according to Jeremy, is that the
banks are in charge of the process.

The bank is working out how to compensate and how much, and
has the customer – the SME – by the short and curlies so to speak.

The SME depends upon the bank for their funding, they do not
want to annoy the bank or be slapped with increased charges and they are completely
vulnerable to the banks views.

In particular, the core issue is that no-one has defined
whether the bank will be responsible for contingent liabilities. 

The liabilities are for losses made by those businesses that
were mis-sold these products and, as a result, have now gone into bankruptcy or
been constrained so much that they have been unable to compete or grow their business
as they would have if they had not taken these products.

This is where the exposures can balloon, as the banks could
be responsible for not juts repaying the costs of the IRSA mis-sale but the
consequential losses as a result of the SME taking those products.

That could balloon to billions (£100 billion?) if the courts
determined that the banks were responsible to compensate for all consequential
losses and contingent liabilities related to the mis-sale.

However, there is no court case determining this today, as
each mis-sale is unique (unlike PPI mis-sales which were for a standardised
product).

That does not mean that something will not happen.  For example, as just mentioned, Bully Banks
may take the issue to court to get a definition of how much banks would need to
compensate for contingent liabilities and consequential losses.

That would be interesting, as that’s what eventually caused
the banks to cave in over PPI compensation.

So watch this space. 
There may well be another PPI mis-selling wave of claims coming through
the banking system, but this one costing almost ten times as much.

Ouch!

Sky News Interview with Jeremy Roe of Bully-Banks from Bully-Banks on Vimeo.

 

 

About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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2 comments

  1. It is very clear that the Banks can and will dump dodgy practices if they are perceived to damage their brand. Quoting the Economist:
    For sponsors like ING, disassociating the company or a brand from corruption in sport simply makes good business sense, protecting reputation and image from the negative perceptions of consumers. For banks, this matters especially. *Domestic banking is built upon customer trust; how then could such an organisation be associated with a team that was demonstrably untrustworthy?* It is such incongruence that is at the heart of the newly emerging market-driven morality: sponsors do not want to be associated with corruption and hence recoil from it.
    http://www.economist.com/blogs/gametheory/2013/04/corruption-sport-0?fsrc=nlw|newe|4-22-2013|5582513|35262316|
    Which tells the public that this is not a mystery to the banks, they know how to do this. But without some adverse incentive such as brand damage, it is also clear that Banks will pursue the practices with a vengeance.
    This dichotomy of message is now abundantly clear in the public’s mind.
    Fatally so, I would argue – we are well beyond the tipping point now. Which leads to a problem, how to deal with the ever-growing list of scandals, and a meta-problem, how to deal with the ever-concreting distrust in the public’s mind.
    The problem here seems to be that in the minds of close stakeholders — employees, execs, shareholders, regulators — there isn’t a lot of incentive to address either problem. Which therefore leaves the banks heavily exposed to the next systemic shock. Capital games notwithstanding.

  2. What will be interesting (excuse the punn) is when, in 3, 5, or 7 years form now, a customer sues the bank for NOT providing interest rate protection…

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