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Interest rate swap doing your head?


There were four separate roles required for interest rate swap selling, as practiced by banks

                                  1 Salesman                2 Trader                           3 Relationship Manager    4 Big Boss

1 The Salesman' job was to close profitable sales. Due to the volumes of 2006-2009 sales, and cost of running such a team, there were likely to have been tough targets. Whether these were expressed in terms of bank day 1 profit, number of closes or total nominal sold is an interesting point.

They often announced themselves with titles such as 'Treasury Advisory', or something similarly authoritative.

Terms such as 'hedging', 'insurance', and 'protection' were used copiously.

They were also provided with slide presentations which, certainly in some. cases, painted a starkly contrasting picture to the financial picture known to the Trader - see below.

"I have found it is common practice to highlight (to clients) the rewards of any given structure and not identify the risk. It is also common to put in place unnecessarily complicated structures, which generate more profit, where a simpler structure is more appropriate."

"Bank salesmen are under intense pressure to hit ever increasing targets and hedging is very lucrative."

- Salesman Y, Huffington Post 19 March 2012,

"In some cases, banks were selling more complicated products than they needed to because they made more profit from it. "

Martin Wheatley of the FCA BBC Panorama Programme 14 October 2013

A multibillion-pound small business loan scandal was fuelled by bank salesmen earning up to £1 million a year for meeting aggressive profit targets, The Herald (Scotland) can reveal.

"Relationship managers were on £50,000 to £60,000 a year, but the person he was introducing to the client was typically getting paid five or six times as much. Earnings could go as high as £750,000 or£1m."

"A normal five-year swap would still make a £20,000or £30,000 profit instantly for the bank. But for salespeople there was an incentive to sell a hedge that was longer than the loan – a 30-year swap made £300,000."

Herald Scotland 21 June 2012

So, does Mr X feel that he personally mis-sold these products in his time at Lloyds?

"I'm comfortable regarding the risk personally from Lloyds," he says, explaining that he always followed regulatory procedures closely - although this did not preclude him from closing very profitable transactions.

And why did he do it?

"I had to," he says. "You had to meet targets if you wanted to get paid, and it was a pressurised culture."

BBC News 22 November 2011

2 Trader

As opposed to the salesman, who spent most of his working life arranging and attending meetings, and travelling to client locations, the Trader spent most of his working life in front of a screen. He designed financial products, each involving a mix of the following elements:

Customer Benefit, (Caps, which equated to bank risk or cost)

Neutral, which were transparent costs , and reasonable profit margins

Customer detriment (Floors, which equated to client risk or cost)

The benefit and detriment measures were assessed at the time by the banks by their value. This might not be what it intuitively seems.For example, if the current variable rate is 5% per annum, a cap at 5.25% might be worth less than a floor at 4.5%!

These profit measures take account of market risk only,and not counterparty risk, an issue which Basel II addressed more and more urgently over the period 2005 - 2009.

For most of the period 2005 - 2009, the forward curve illustrating these rates sloped downwards after 3-4 years, indicating that longer term floors were dear and caps could be cheap if set high enough.Accordingly, a collar, (a combination of these two products) could easily be priced by an expert to deliver any level of profit (based on market risk only)desired.

Sometimes the curve just dropped, making profitable sales easier, as the client was likely to only understand the initial rate.

A particularly attractive variant was where product could be sold where the earlier cash flows were expected to be in the clients favour. The bulk of the profit, however,related to later payments which the market very much expected to be the other way. The product would seem to contain a far greater element of client benefit than was actually the case, and those payments could create the illusion that the product was designed primarily around client benefit, rather than bank profit.

This process would be a closed book to virtually all SME's , who would not be aware of the expensive resources needed to carry out such a pricing process, or even that such a thing could be done.

3 Relationship Managers

These were the characters with which the SME's would be most familiar. In the context of swap sales, their role would be to identify clients with new or renewing borrowing needs, and recommend a meeting with a salesman. If 'hedging' was a condition of a loan, this would be simple. In some cases, I have also been told that in some cases they planted a 'seed of doubt', in opining that the bank was (and therefore the client should be) concerned about interest rate rises.

4 Senior Manager.

The precise role might vary between banks, but these individuals would understand the most in respect of derivative selling practices to SMEs:

These managers would have the following responsibilities:

- Responsibility for the SME sales profit centre, maximise profitable sales for this business unit.

- Avoid undue risk to the bank, eg, from allowing traders to maintain excessive open positions. This could also be described as making sure the bank hedged itself.

- Liaise with the compliance department regarding promotional literature and scripts. The 'small print' wording on presentations and documents was essential in case of subsequent complaints, and was designed to allow both bank and salesman to deny responsibility if rates subsequently fell.

The valuation in the bank's books of a swap product containing financial detriment for the client would have required the bank to allow an additional reserve for the extra risk. The bank is immediately exposed to extra risks - to the conventional risk of lending money to an SME must be added the additional risk of high swap payments based on a business in a recession - and the effect of the combination too. If the bank had sold on , or reinsured, the derivative, it would have been with the bank's guarantee. This introduces a mismatch with the quality of the SME's guarantee, clearly much poorer than that of the bank.

The manager would have had the job of managing sales with downward pressure on margin (due to increasing reserving requirements) while seeing increased pressure from business already sold, due to greater pressure on covenants. The music came to a stop at the end of 2008, when rates tanked,culminating in the 1/2% pa level in March 2009. At that point, swap sales became untenable, and the sales process stopped very quickly.

The aftermath we all know.

© Windsor Actuarial Consultants Limited

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