Mis-Selling Derivatives and Mis-Trust: Britain's Banks Face a Crisis of Integrity

The recent spate of banking scandals in Britain has many asking whether the broken trust between lenders and customers can ever be repaired.

In less than a week, we've learned that the UK's largest lenders may have rigged interest rates, scammed small businesses and broken promises to lend cash to help ease Britain's on-going recession.

After an intense investigation by Financial Services Authority (FSA), the UK regulator found "serious failings in the sale of interest rate hedging products to some SMEs."

"We believe that this has resulted in a severe impact on a large number of these businesses. In order to provide as swift a solution to this problem as possible we have today confirmed that we have reached agreement withBarclays, HSBC, Lloyds and RBS to provide appropriate redress where mis-selling has occurred," said an official statement.

To be exact, a "large number of businesses" actually means 28,000 customers since 2001.

The announcement echoes the payment protection insurance (PPI) scandal that emerged in 2011, which has now cost banks billions of pounds in compensation claims.

But it doesn't stop there.

The news of banks mis-selling derivatives seems to be just another string to the bow of taking advantage of retail customers.

It seems even more ridiculous now that much of the media and public were outraged and baying for blood, after it was revealed that an individual, UK comedian Jimmy Carr, put money into a fund, along with 1000 people in total, to legally pay less tax.

The smokescreen of misdirected anger came at a good time because clearly there were a lot of banking industry revelations to be released shortly.

The news follows only a couple of days after Barclays was slammed with a record fine for fixing key interest rates, the London Interbank Offered Rate (LIBOR) and the Euro Interbank Offered Rate (EURIBOR), over several years.

In light of the manipulation of a market that affects trillions of dollars' worth of products and provide a benchmark for banks set rates against for mortgages, loans and credit cards for example, another 17 banks and 1 broker are currently being investigated.

If that wasn't bad enough, SMEs have had to try and survive with stifled lending as banks have shut up shop to retail customers but not necessarily to each other.

Especially after the collapse of the financial industry in the wake of the 2007 credit crisis and banks hovered up taxpayers' money to stop them going bankrupt, you'd think the banks would be grovelling to the public and amending the damaged relationship the industry had orchestrated over the last 20 or so years.

RBS is still 83 percent owned by the taxpayer.

Instead, we are greeted with daily news of bumper banker bonuses and executive pay pools that exceed far more than most people will own in a lifetime.

So where did it all go wrong?

Mis-Selling interest rate swaps

Over the past year, IBTimes UK reported that hundreds of small to medium enterprises (SMEs) are turning to specialist lawyers from overseas to help them wrangle their way out of what they believe are mis-sold complicated financial contracts, sold as loan protection products, that are now suffocating them financially.

The UK's four largest banks are now banned from selling Interest rate swap agreements (IRSAs).

IRSAs are contracts between a bank and its customer where typically one side pays a floating, or variable, rate of interest and receives a fixed rate of interest payments in exchange. They're used to hedge against extreme movements in market interest rates over a given period. Companies that have seen the value of these products move against them as rates fell during the recession, now owe banks crippling sums of money in interest payments each year.

But if these businesses want to cancel these contracts, the cost of doing so would be even higher in a lump sum payment, as banks demand cash upfront in lieu of future revenue.

The groundswell comes alongside Barclays' chief executive Bob Diamond's admission that the bank "made some mistakes" in the market for interest rate products during the bank's last annual general meeting.

Diamond, whose bank has now been found guilty of mis-selling interest rate swaps and had the most banking customer complaints in 2011 according to the FSA, said: "There was a worry about interest rates going higher in 2005, particularly in the property sector where consumers wanted to lock in interest rates. I can guarantee you we have made some mistakes, when we have a mistake we're going to own up and fix it."

We presented a case study of Adcock & Sons, a small privately owned electrical retailer in Norfolk that is indicative of thousands that are in the same situation.

Despite UK interest rates being held at a record low of 0.5 percent, Adcock & Sons is paying an interest rate of 9% on a commercial mortgage, which is generating a bill of just under £80,000 a year. The joint owner of the business, Paul Adcock said that he did not know that the interest rate swap that came with the extra features would have triggered the deal swinging against him. He was sold, he says, a bet on the Bank of England's office rate not falling below 4.7 percent.

Since rates have stood at 0.5 percent since May 2009, he, like many others, has been paying unsustainable amounts on a product that bears little resemblance to the loan he thought he had taken out in the first place. He has had to lay off staff and now says it is unlikely that the business will survive much longer. Adcock says that the Barclays Capital salesman who sold him the contracts had said that the protection would be "free".

PPIs: Again?

But this isn't anything new.

In fact, the mis-selling derivatives scandal echoes the a damning indictment of some of the industry's practices last year, when a six-year probe by the FSA in to the selling of PPIs resulted in a potential £10bn in compensation claims.

So far the UK's five biggest lenders have set aside £10bn to cover PPI claims, making it one of the most costly consumer scandals ever. Sixteen financial firms paid out £1.9bn in claims last year, according to FSA figures.

But the lack of confidence retail customers should have in banks doesn't end with the products.

Worryingly, at the very base level the latest news on Barclays being found guilty of fixing the Libor rate, means customers could be affected right down to the rates they pay on their credit cards, loans and mortgages.

Libor manipulation

UK and US regulators slapped Barclays with a record £290m fine for fixing key interest rates Libor and Euribor, over several years.

Moreover, there are reports that RBS is set to be fined £150m for its role in the same interest rate rigging scandal as Barclays, the Times reported.

Three of Britain's biggest lenders, RBS, Lloyds and HSBC are among the 17 banks and one broker that are being investigated, following Barclays' involvement in fixing two of the most important interest rates in the global financial markets.

Fixing Libor and Euribor rates does not just paint a different picture of the banks welfare or financial state - it also can have a profound effect on the everyday person on the street.

The effect on the general public can be felt on an immediate level because the wholesale rates influence how much homeowners pay on variable rate loans and mortgages.

Some mortgages are influenced by the Libor rate, which mean many homeowners could have been making monthly payments that were tracking rates that were artificially effected.

Even if a homeowner had not been on a variable rate, Libor is what banks use to set interest rates when it comes to charging interest on loans, credit cards and other mortgages.

For the last few years, if the Libor and Euribor rates had been found to be directly affected, consumers could have been paying either too much or too little in interest and payments.

The Libor rate was designed to reflect a far more accurate appraisal of real world circumstances because the rate is set by an average calculation by a number of banks.

However, if other banks are implicated in the Libor fixing scandal, then it could mean that rate setting system has to fundamentally change as it is too open to abuse.

Lending

Businesses are clearly not catching a break.

In the UK, banks are continually being criticised for not lending money to SMEs and to each other but the banks are crying out that they are and are sparing as much as possible.

Osborne's announced the £100bn package is set to support banks by increasing lending levels and tackle this. Apparently, the "funding for lending" scheme will cut banks' funding costs in exchange for lending commitments, which could see up to £80bn of new loans.

But will increased lending happen?

RBS' CEO Stephen Hester proclaims that the group are lending well above its marketshare of Project Merlin - an agreement between Britain's four largest banks, HSBC, Barclays, Royal Bank of Scotland and Lloyds Banking Group, which covers lending, bonuses and transparency.

However, RBS' lending contracted by nearly £2bn to SMEs in 2011, despite the claims by Hester.

The four banks were meant to commit to providing £190bn worth of credit to smaller businesses in 2011, however in February this year, the Bank of England (BoE) revealed that lending to SMEs fell £1.1bn short of the target.

So where is the money going to?

Well from the looks of it, into bonus payments for the bankers.

Bonuses

Bonuses and high executive pay is always going to cause friction, especially at a time where unemployment is high, the recession bites down harder and the industry is still recovering from the credit crisis and ongoing sovereign debt crisis.

So when scandal after scandal breaks, and this is ignoring major rogue trading incidences and JP Morgan's humungous legal trading loss from a bad bet, it is even more cutting for a customer to see money siphoned into bankers pockets in the form of additional payments.

Even in the wake of the credit crisis, banks and insurance firms doled out £12bn in 2008 in bonuses, according to the Office of National Statistics (ONS).

Since then, that number has gone up to at least £10bn in just the first few months of 2012.

While, Barclays CEO Bob Diamond and three of the UK bank's most senior executives rejected their bonuses this year after the regulators in the US and the UK fined the bank for Libor and Euribor manipulation, it just seems too little, too late.

"I am sorry that some people acted in a manner not consistent with our culture and values," said Diamond.

He also added that he, Finance Director Chris Lucas, Chief Operating Officer Jerry del Missier and investment banking boss Rich Ricci have agree to forgo any bonus this year.

But that is exactly what is wrong with the banking industry; the culture.

The culture has had example, after example, of mis-selling and systematic serious failings across many areas for the consumer and it will only get worse unless the culture fundamentally changes.