It found that over 90 per cent did not comply with one or more of the FSA’s regulatory requirements. In particular, the failings included:
• Poor disclosure of exit costs
• Failure to ascertain customers’ understanding of risk
• Non-advised sales straying into advice
• Over-hedging, where the amounts and/or duration did not match the underlying loans
• Rewards and incentives being a driver of these practices
It is going to be expensive for the banks to take another hit to the balance sheet.
The last point, rewards and incentives, explains everything. These products made money for the banks especially because the customer, the borrower, usually did not understand the product and how it worked or even that the bank would be making a profit out of the product in addition to the profit on the loan.
Borrowers were offered loans and encouraged, but more often required, to acquire an interest rate hedging product. Most of these products were interest rate swaps which effectively converted a floating rate loan into a fixed rate loan. This removes the problem of interest rates rising which would be bad for a borrower with a floating rate loan that would then be faced with higher interest costs. Hedging interest rate risk is perfectly sensible and is a practice adopted by many borrowers, particularly large companies that understand these products. But for unsophisticated borrowers, it got out of hand in a big way.
The bank’s incentives worked in a simple way. First, find a borrower and make a loan on a variable basis such as Libor plus a margin of say 3 per cent. Then tell the borrower that they have a risk of Libor rising in the future which would increase their interest costs. To mitigate this risk, offer them an interest rate hedging product such as a swap. This effectively “swaps” the Libor variable for a fixed rate such as 5 per cent for the life of the loan. The effect is to fix the interest cost for the borrower at 5 per cent plus the margin of 3 per to make 8 per cent cost in total. The risk of Libor rising in the future vanishes.
