If the "Big 4" are Not trustworthy, then Who is?
Umang is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Whenever it comes to financial decisions we either go with our basic instincts or consult some investor with a sound background. In cases of small and medium-sized businesses with such relatively huge capital involved they cannot obviously just rely on their own instincts. They have the choice of either going to a private investment firm or approaching a top bank. Mostly people rely on banks as they are trustworthy.
But not in this case, as the Big 4 namely Barclays (NYSE: BCS), HSBC (NYSE: HBC), Lloyds (NYSE: LYG) and Royal Bank of Scotland (NYSE: RBS) proved to be unworthy of the trust levied on them by these groups of businessmen and consumers. They created what we now call a “Rate Swap Scandal.”
Barclays was fined £290 million ($452 million, 360 million euros) by British and US regulators just over one week ago, for attempted manipulation of Euribor and Libor interbank interest rates. It is one of the first banks to be fined as a part of global probe.
Mr. Paul Tucker, deputy of Bank of England, is said to have known that Royal Bank of Scotland and Lloyds Banking Group were posting false rates because their Libor submissions were lower than Barclays even after they had been locked out of markets and forced to take £60bn in secret loans from the Bank.
What is an interest rate swap?
An interest rate swap is a highly liquid, financial derivative which allows two parties to exchange interest rate cash flows, based on a particular amount. This exchange flows either from a fixed to floating interest rate or vice versa from one party to another. This is used primarily by small businessmen to protect themselves from gyrating market interest rates.
These banks have sold complex interest rate hedges to small businessmen which has reaped huge profits for the banks and at the same time huge losses for the customers. They have basically killed their own customers.
How did they manage to scam?
They did so by offering customers cheaper rates by suggesting they take out a hedge for a longer duration than their loan. This would mean if a 5 year swap cost them 6 pence, then a 10 year would cost an approximate 5.5 pence.The bank locks the money immediately and makes double profit on the 10 year bond as compared to the 5 year bond. The trick lies here, when people want to get out of the 10 year bond it is not easy and involves a lot of cost. If interest rates fall then the customers who have protected themselves against increasing interest rates would like to get out of the swap which will cost them huge!! Thus they reach a situation of No MANs land!
This scam was pushed by not just one bank but all the Big 4 banks. Although all the banks have agreed to compensate small and medium size businesses for the mis-sold interest hedging products, this happened after the Financial Services Authority (FSA) said that it found serious failings in the way they marketed their product to the customers.
Given the size of individual potential claims in each case - some running into millions of pounds - compensation for rate swap mis-selling could hit bank profits. But more importantly is the loss of faith and market trust. We have a lot of dependency on these banks and their investors as we find it safe to put our money into these banks. If they cheat us then where do we head on from here?
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