Mis-Selling Derivatives: Fitch Warns Bank Payouts Will Impact Earnings

Britain's biggest banks will take an earnings hit from the costs associated with paying compensation to the thousands of UK businesses which were mis-sold interest-rate hedging products.

Fitch Ratings estimates the amount owed to businesses which were mis-sold interest rate swap agreements (IRSA) will be 'manageable' but will still have a negative impact on its balance sheet over the next year or so. Barclays, HSBC, RBS and Lloyds have already started provisioning for IRSA mis-selling costs in 2012, amounting to £700m in total.

"It is difficult to quantify the redress costs for the whole industry but they are unlikely to be as large as other misconduct costs, such as the payment protection insurance (PPI) compensation and Libor fines. Nonetheless, we expect conduct risks to remain high," says Fitch in its research note.

"The remediation exercise for interest rate hedging products (IRHP) is likely to gain momentum following the Financial Services Authority's (FSA) revisions to its criteria and principles for assessing redress and the conclusion of the pilot review by the largest four UK banks. This could lead to a spike in provisions for IRHP redress," it warns.

On Thursday, the FSA's pilot scheme examined the sale of 173 so-called interest rate swap agreements (IRSAs) to British firms, and found that at least 90 percent did not comply with at least one regulatory requirement.

While some 40,000 interest rate swap agreements (IRSAs) sold to UK businesses are said to be eligible for review, the pilot scheme was aimed at assessing a select number of cases to test the range of disputes and assess the scale of redress for customers mis-sold these complex derivatives.

Fitch adds that while they expect the IRHP provisions to rise, "there are far fewer potential cases than for payment protection insurance (PPI) mis-selling, so the amounts involved should not be as large."

Provisions to redress PPI totalled over £12bn for the industry by end of the third quarter in 2012 and could rise further as claims continue to be submitted to the banks. Barclays and RBS have already set aside more for PPI compensation.

"Increased scrutiny of banking conduct and standards by customers, politicians and regulators means that the creation of new high-risk products, including benchmarks, will be substantially reduced. We expect banks to strengthen systems, controls and governance to minimise conduct risks. But it would be unrealistic to assume that the worst is over for the industry from the previous generation of complex products. We believe conduct risk may emerge from a number of sources that have yet to be identified," it adds.

This month, IBTimes UK reported that the FSA is discussing with the banks on whether they should implement a deadline to PPI claims in order to slow down the backlog in disputes and billions of pounds in payouts.

However, unlike the uniformity of the settlement process in the PPI scandal that afflicted millions of British savers, small business interest rate derivatives vary in length, value and purpose, making them unsuitable for collective action or settlement.

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.

However, unlike PPI where a straight refund from the sale of the product is usually granted, the redress for each IRSA dispute case is not standardised and ranges from exiting the product without the cost being borne by the customer, to being placed in an alternative hedging programme.

While some businesses have received some IRSA payment refunds, some other redress options have included securing a loan under more favourable pricing conditions for a set number of years.

IBTimes UK was the first to report in September last year that the FSA's concerns over UK banks' solvency, in light of potential IRSA dispute payouts, led to the regulator's 'Diluted' review on mis-selling derivatives.