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Interest rate swap mis-selling: when there’s none left, is there (still) some more?

The Interest Rate Hedging Products (IRHPs) Review is almost completed, but it might be too early to finally draw a line on the interest rate mis-selling story. Since its official start in May 2013, nine banks reviewed altogether close to 30,000 sales of IRHPs.  A significant amount of resources were devoted by the banks to carry out this considerable amount of work.

The FCA indicates that the Review led to £1.1 billion paid out in redress offer, employment of 3,000 people, to which the costs of engaging independent reviewers must be added. The FCA estimates that the Review will be concluded by the end of the year.

Nevertheless, the end of the Review is unlikely to be the end of the interest rate mis-selling story, to which two chapters might be added.

Sophisticated investors left out

A sophistication test was developed for the Review, in order to distinguish the “non-sophisticated” customers from the “sophisticated” ones.  The Review was focused on the sale of IRHPs to “non-sophisticated” customers, who were unlikely to possess the expertise to understand the risks associated with the IRHPS.  The “sophisticated” customers were excluded.

One third of the 30,000 sales were excluded, since they were made to “sophisticated” customers.  An undetermined number might choose to pursue a judicial court of action. Although the matters heard by the English courts and involving interest rate break fees had limited success to date (See Green), the outcome ultimately depends on the particular facts of each case. The banks are likely to estimate their exposure as lawsuits pile up.

Embedded swap loans

For the moment, the Review does not cover “embedded swap loans”, also known as “hidden swaps”. These are effectively fixed-rate loans, generally subject to the same break costs which were heavily criticised in the IRHPs. The customer is charged the difference between the interest rate at the inception and the one prevailing at the moment of the break, calculated for the remaining period of time.  As determined by the FCA in the pilot reviews, one of the most significant issues in assessing the compliance of a sale was the break costs. These costs cannot be known with certainty at the time the loan is made, but they might be significant.

The FCA adopted the position that it does not possess the power to regulate these loans.  In a letter from 9 May 2013 to Greg Clark MP, Financial secretary to the Treasury, Martin Wheatley, Chief Executive of the FCA, expressed the view that “embedded swap loans”, as they are commercial loans, are unregulated. The FCA is in discussion with the Treasury concerning this regulatory loophole.

The size of this issue would be potentially significant, since the data collected by the FCA shows that 70,000 sales of such loans would have been made. It makes up more than twice the number of the IRHPs which are being reviewed.

The Treasury Committee launched a SME lending inquiry on 26 February 2014, in which it considers if the remit of the regulators should be expanded to include more lending and selling of financial products to SME. In oral evidence hearing held on 29 April 2014, Mr John Thurso, MP expressed the opinion that the Government is “decidedly uninterested” by the mis-selling of embedded swap loans, while the FCA “does not want to have anything to do with it”.

Meanwhile, the measures put in place by the Government are much softer. On 16 April 2014, HM Treasury indicated that the Government has reached a voluntary agreement through the British Banker Association (BBA), under which the banks accepted to  provide the same level of disclosure of features within embedded swap loans (such as break cost) as for products that fall within the scope of products regulated by the FCA.

At least one bank has undertaken a specific review of its embedded swap loans.

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