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.
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.