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Interest rate swap doing your head?

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Insurance

A little logical thought shows that selling derivative-based contracts to SMEs should be restricted to simple caps sold through RMs – if that.

First, the current mis-selling scandal was caused by a commission-based salesforce pushing lucrative flooring under the pretence of providing capping for clients that they might actually need.

 (For the purpose of this note, I have referred to ‘flooring’ as products which provide benefits for the bank if interest rates fall, and ‘capping’ as products that provide protection for the client if interest rates rise. Therefore   products such as swaps and collars provide both flooring and capping.)

These types of derivative product are particularly susceptible to mis-selling. Slight adjustments in rates, the significance of which is not readily discernible by the typical client, can enhance the product’s profit (and increase the client's exposure) substantially.

But what if banks were banned from selling flooring, and were only allowed to sell caps?

Straight away, the sales force is out of a job. The cost of running a commission based sales force is substantial – at least twice the remuneration. The process would be restricted to standardised products sold through relationship managers.

But even then, the product does not, for the most part, make sense.

Pricing requires the use of a derivatives specialist, which is expensive. But would the product be sufficiently attractive without the hard sell?

Banks described this cover as ‘insurance’,’ hedging’ or ‘protection’.  Let’s have a look at the ‘insurance’ claim.

For a risk to be ‘insurable’, its occurrence must be either specific to individuals in a group, or unpredictable. For example, life insurance is taken out because an individual might die earlier than expected. If we all knew our date of death, there would be no life assurance.

Similarly, motor insurance is valuable, as a claim can occur at any time, and be of unexpected degree. For example, if one is found negligent and having caused the disability of a professional man with six children, the claim can run into millions. This is clearly an unexpected cost, and the risk is suitable for insurance. 

But rising interest rates? Banks lend tens of millions of pounds every day, and the risk affects all business to the same degree.  Clearly, pretending that there is, is absolute nonsense.

You might want to take out ‘pluvius’ insurance if your event on a certain date might be spoilt by rain. But you wouldn’t take out a policy that paid out every time it rained! No-one would ever sell one!

Now, the time honoured and traditional way of a bank pricing a loan is to start with a base lending cost (say base rate plus 1%), and add on a loading for client risk (say another 2%). This has the advantages of being clear and transparent, and allowing the client to compare quotes from more than one bank.

If the bank is concerned about interest rate rises, and has calculated the above loading correctly, the risk is general across all clients. The bank then can charge an addition to the 1% (in the example above). All very simple, acceptable, and transparent.

If the client is particularly concerned about interest rate rises, the RM can show him the products from the standard range, based on the forward curve at that date, and a reasonable margin for the bank.  No problem there, then. But the margins would probably have to be low, or the clients wouldn’t bite. In addition, there would be times that the shape of the forward curve would make these products highly unattractive, either to the bank, or the client. So you wouldn’t expect many sales.

It’s up to the bank whether they sell these products. Not likely to make much money, though!

So, bearing that in mind, you should be particularly aware if anyone talks about ‘the product you should have been sold’ as compensation for a mis-sale.  This is a misconception shared by the FCA and members of bank sales forces alike.

We have yet to see an alleged misselling case where either the capping or the flooring makes overall sense. We believe that the promotion of replacement products has set back a proper understanding of the misselling and fair redress by a not-insignificant period.

For further advice or information, contact us at mail@windsorac.com

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