Friday, February 8, 2013

Mis-sold Interest Rate Hedges

By Tim Dulaney, PhD and Tim Husson, PhD

The Financial Services Authority (FSA), Britain's highest financial regulatory agency, has ordered Barclays, HSBC, Lloyds, and Royal Bank of Scotland to review all of their interest rate linked swap agreements sold to small businesses.  In an investigation, the FSA found (pdf) that four banks had violated at least one of its rules in over 90% of the 173 cases reviewed.  The London Evening Standard is reporting that seven other banks may also launch similar reviews.

Interest rate swaps -- and related interest rate derivatives -- are derivative instruments that are often used to hedge certain liabilities.  For example, a small business might use an interest rate swap to convert a floating-rate liability, such as an adjustable rate loan, to a fixed-rate liability.

Interest rate swaps are also widely sold throughout the world, including the United States, to businesses, municipalities, and other institutions.  In fact, the current major US class actions related to the LIBOR interest rate fixing scandal are led by investors, such as the City of Baltimore, who purchased interest rate swaps -- you can find the Baltimore complaint here (pdf).  For more information on interest rate swaps, see our review here.

From the FSA report:
We have evidence which raises concerns about the sales we have reviewed in certain banks. These concerns include (i) inappropriate sales of more complex varieties of interest rate hedging products (such as structured collars) and (ii) a number of poor sales practices used in selling other interest rate hedging products. We also found that sales rewards and incentive schemes could have exacerbated the risk of poor sales practice. Practices varied across banks, but we found sufficient evidence of poor practices to justify action by the FSA.
Interest rate derivatives can be extremely complex investments.  Although these instruments are often sold as purported hedges to "cut costs" or "decrease liabilities", their complicated structure obfuscates risk and can allow banks to embed fees.  We have found that even changing a parameter as seemingly insignificant as the day count convention can lead to substantial shifts in value.

Small businesses and municipal investors should be particularly careful when considering these types of derivatives.  The FSA found that in their sample, sales of interest rate hedging products to "non-sophisticated" investors often include:
  • poor disclosure of exit costs;
  • failure to ascertain the customers' understanding of risk;
  • non-advised sales straying into advice;
  • "over-hedging", i.e. where the amounts and/or duration do not match the underlying loans; and
  • rewards and incentives being a driver for these practices.
We have seen numerous examples of each of these poor sales practices -- sometimes even within the same case.  Finding a disinterested party, or an "independent reviewer", to analyze a prospective interest rate hedging product is of paramount importance.   Small and medium sized businesses need to be vigilant advocates for their own interests in these transactions, both before and after an agreement has been made.

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