Interest rate swap mis-selling scandal

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Nine banks including Lloyds, RBS and HSBC agreed in 2013 to compensate companies that were sold inappropriate products that were supposed to protect them from changing interest rates on their debts. However, these hedges could expose the firm to the risk of rate movements even after their initial loan had been repaid.

— Daily Telegraph, 10 February 2015

In 2008, interest rates plummeted and thousands of customers found the mark-to-market value of their IRHPs materially changed, leaving them with significant losses if those IRHPs terminated early. Alternatively, customers were tied in under the IRHP contracts to pay far higher interest rates than the prevailing market rate for years to come; in some cases the IRHP contract terms extended well beyond the period of the underlying loan.

— Swift Review into the supervisory intervention on interest rate hedging products

The interest rate environment in the early 2000s

Weird things were happening in the interest rate markets which had been pretty stable since — well, the Glorious Revolution:

For two hundred years the Rate hovered between 2 and 10 per cent, and in the gloom of Threadneedles’ cave, it waited. Darkness crept back into the forests of the world. Rumour grew of a shadow in the East. Whispers of a nameless fear. And the Rate of Power perceived its time had come.

Since the early seventies, interest rates had bounced around mainly staying between about 8 and 15 per cent. But after the UK’s exit from the exchange rate mechanism in 1992 they had fallen towards thirty-year lows. As the Cool Britannia vibe suffused the nation, rates stayed abnormally low, around six per cent. In the meantime some bright sparks at Salomon had invented the interest rate swap and tradable interest rate derivatives were a thing.

But we can surmise that businesses seeking to borrow money in 2002 might have been thinking rates were abnormally low, and it might be a good time to lock in an interest rate.

Before swaps were invented, one did this by borrowing at a fixed term, and there is an argument that had interest rate swaps not been invented corporate borrowers fixing term loans in 2008 might have been just as badly burned, but would not have had anything to complain about.

The banks

Skulduggery in the LIBOR submission process was not the only saucy carry-on in the interest rate market. For something that is meant to be dullsville, after school chess club was quite the hotbed.

Take the business of lending to small and medium enterprises.

What follows is not authenticated history, but something more like a fable or a “just so” story. A bedtime story. The actual facts of any particular case might differ, but it stands as a simple device to paint a general picture.

Bear in mind what the businesses of middle England want from their banks: finance, for a predictable term, at a predictable cost.

We take it as generally axiomatic that if you want to give, or take, back your money at any time, interest will accrue at a variable rate, and if you want to lock in the borrowing or lending for a term, interest will accrue at a fixed rate.

And remember, in the good old days — specifically before 1981 — if you wanted “exposure” to an interest rate, you had to actually borrow, or lend, money. But England’s businesses didn’t want “exposure to interest rates”. They wanted money. Capital. Indeed, before 1981 the idea of “isolated exposure to interest rates” would have seemed more or less incoherent, the same way a shadow seems incoherent, without the boy who cast it.

Interest came with a loan, and how it was calculated depended on its term: if you wanted your money back at any time without penalty, there was no “term” — well: strictly speaking there was, but it was overnight — and your interest rate could therefore “reset” every day. If you didn’t like the new rate, you could take your money away, or pay it back, without penalty. Hence, interest on call deposits (and revolving credit facilities) is calculated by reference to a floating rate.

If you wanted to lend or borrow for a set term, you could lock in a fixed interest rate for that term — but you couldn’t have your money back, or voluntarily repay it, before that term, either, without incurring a “funding break cost”.

We can see here that interest rate “risk” sits with the bank: it is funding the customer’s loan from its own borrowing — that’s what banks do — and if the cost of that borrowing rises or falls, the bank loses or gains.

This is how it ought to be: banks are the financial experts. They have the size, scale, expertise, information and position to manage their interest rate risk. The caravan parks of Middle England are better spending their energy managing, well, caravan parks.

The great financial innovations of the 1980s led bankers to see their liabilities in a whole new way. A fixed rate loan was a funded credit derivative with an embedded interest rate swap.

This was all well and good — you could see it that way, and with derivatives, you could certainly manage your risk that way — but bankers were still left with the rather unitary problem that their interest rate risk was buried intractably in a term loan.

What if, wondered the bankers, we separated them? We could offer our customers floating rate loans and sell them interest rate swaps, under an ISDA, by which they can convert those floating rates into fixed.

You might be wondering what the appeal of that would be, over a plain old fixed rate loan, for the customer. JC wonders that, too.

The appeal to the banks was obvious. Floating rate loans are easier to fund. But they expose customers to interest rate risk, which neither they, nor their bankers, want: if interest rates go so high as to ruin the customer, the bank is likely to lose money too.

Interest rate swaps are easier to manage. They are managed by different people in the bank.

At about the same time, Britain’s commercial bankers were having fun at the hands of the caravan parks, flying clubs and property investment consortia of middle England. The interest rate swap mis-selling scandal is a many-headed hydra — it turns out most commercial banks in the UK had hit upon variations on the same idea independently of each other and then jammed it down middle England’s gizzard, but the gist was this: rather than just offering them straightforward loans, banks would offer floating rate loans stapled — loosely — to complicated hedging products.

This would be odd enough if it were just a floating rate loan and a fixed rate swap — why not just lend at a fixed rate — but these swaps had all kinds of funky features that didn’t suit any obvious commercial need, and banks sold them often by appealing to the borrowers’ vanity or dubious interest rate risks. A fun example was the “enhanced dual fixed rate protection” under which:

Borrower would pay 5.10%, if interest rates were between 4.75% and 6.25%, and 6% if interest rates were above 6.25% or below 4.75%. Additionally the Bank had the right to terminate without penalty each quarter after five years.

It is not obvious who this protects, or what it enhances, but it does not seem to be the borrower.

See also

• Greenclose v National Westminster Bank plc
• LIBOR rigging
• email
• electronic messaging system