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FSA publishes results of pilot study into Interest Rate Hedging Products (‘IRHPs’) or Interest Rate Swap Agreements (‘IRSAs’)

Posted on 31/01/2013 · Posted in Expert Witness, Financial Litigation, Interest Rate Swap

What are IRHPs or IRSAs?

During the period 2002-2008 many of the banks in the UK entered into agreements with customers where each month or quarter they would pay the customer a variable rate of interest depending on the current Libor rate and in return the customer would pay the bank a fixed rate of interest. When taken with a loan or overdraft this had the net effect of providing a fixed or predetermined rate of interest on the loan.

This was only one of a multitude of different structures and types of agreement that were used at the time. Some of them have a floor rate of interest and some a ceiling rate. Others have both. In some cases there is an option given to the bank to cancel the contract during the life of the agreement. All these factors would be taken into account in determining the pricing.

For any of these alternatives to provide interest rate protection and work with a loan, the agreement needed to match the underlying loan in terms of size and duration. If the agreement was for less than the amount of the loan it would only provide the benefit to that part of the loan. If it was for a shorter duration it would only provide the benefit for the period that the agreement was valid. However if it was an amount greater than the loan or for a longer period, it would then become an investment position for the excess.

What was the benefit?

There can be significant benefits for a customer of a bank in taking out an IRHP as it will provide the customer with predictability on the loan interest payments. Each month or quarter the customer will know what the interest costs are and can, therefore, plan ahead with greater certainty. For some of the more complicated versions it may provide a limit either on the up or downside of what the payments could be.

So what is the problem?

Many of the IRHPs sold did not match the underlying loans either in terms of size or duration. In many cases the IRHPs were not smaller but greater than the loan amounts. As a result the additional amount became an investment position based, usually, on interest rates.

Then in 2008 the market hit the credit crunch and, as a result, since 2009 interest rates have been at historically low levels. This means that any customers who bought an IRHP with either a fixed rate clause or floor level have found that they are paying a much higher interest rate than they would have done with a variable rate loan.

When the customers then sought to terminate the swap they found that there were termination payments payable linked to the difference in interest rates and the remaining term. In many cases these were found to be very large.

The FSA action plan.

In response to a House of Commons debate on 21st June 2012, the FSA conducted a pilot study into the situation. It found that serious failings had occurred in the sale of many of these agreements. As a result 11 banks agreed to review their sales from an initial date of 1 December 2001. On 31 January 2013 the FSA published the results from the four main high street banks. They had studied 173 cases where the sales had been to unsophisticated customers and found that 90% had been mis-sold.

In particular the pilot threw up some important points. Many of the clients who had bourght IRHPs:

  • did not understand the implications at the time of purchase.
  • were very unsophisticated in the investment markets.
  • had been required to purchase them as part of a condition to a new loan.
  • may have thought they were being provided with advice by the bank.

The FSA considered it appropriate to determine a set of redress principles so that there should be a strong degree of consistency between the many clients who became involved in the swap agreements. Barclays, HSBC, Lloyds and RBS have all agreed to conduct this review and expect to be able to complete it within six months although, in some cases where there are a very large number of clients. it could take up to 12 months. They hope to be able to prioritise cases where the customers are in financial difficulty.

The FSA examined the sales of IRHPs and as an example expected:

  • The bank to provide the customer with appropriate, comprehensible and fair, clear and not misleading information on the features, benefits and risks associated with the IRHP in good time before the sale.
  • If the IRHP exceeds the term or value of any lending arrangements, the potential consequences to be disclosed to the customer in a comprehensible and fair, clear and not misleading way.
  • In relation to an advised sale: A) The bank to obtain sufficient personal and financial information about the customer, including the customer’s investment objectives, level of education, profession or former profession and relevant past experience of IRHPs. B) The bank to take reasonable steps to ensure that the personal recommendation is suitable for the customer.

The bank needed to be able to show that the customer had been provided the information with consideration of:

  • the customer’s knowledge and understanding of these types of products generally;
  • the customer’s interaction during the sales process;
  • the complexity of the product; and
  • the quality and nature of the information provided during the sales process and when and how it was provided.

It is against these parameters that the cases will be judged.

Link: FSA Interest Rate Hedging Products Pilot Study

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