Banking StandardsWritten evidence from Ved a n t a H e d g i ng

The Government is considering whether to allow ring- fenced banks to offer simple derivatives to their customers. Should they be allowed to? If so, what safeguards would be necessary?

Vedanta Hedging is regulated by the Financial Services Authority to advise both large institutions and small firms on derivatives

It is our opinion that small firms in the UK should have access to derivatives.

1. Rationale for SMEs Using Derivatives

1.1 For SMEs that import, export or have a material exposure to foreign currency movements, derivatives can help them to budget and plan their business more effectively. Significant currency swings can easily erode tight profit margins in an increasingly global and competitive marketplace.

1.2 SMEs that have a substantial amount of borrowing relative to the value of their assets (gearing) may also wish to use some type of derivative to protect themselves from rising interest rates. In the same way that an individual obtaining a mortgage will have an option of repaying their loan on a fixed, floating or tracker basis, SMEs should also be able to make such risk management decisions.

1.3 Some larger SMEs who have a material exposure to the price of a commodity, such as oil or copper for example should also be able to use derivatives to help manage their risk.

2. Credit Risk

2.1 The vast majority of derivatives that may be appropriate for an SME for the above risk management purposes will carry a contingent liability for the provider of that derivative. There are of course simple derivatives such as currency options, or interest rate caps which do not have any on-going potential liability since they are paid for up-front. An SME may not want to use this type of derivative however.

2.2 A bank that is providing some debt facilities to an SME will almost certainly have some security over some of the assets of the SME (typically a legal charge on property). For such a bank, it is relatively straightforward for it to allocate a portion of this security to underwrite the contingent liability for the derivative.

2.3 If a ring-fenced commercial bank was not able to provide derivatives to its SME customers, it would presumably have to suggest to its customer (on an agency basis), other banks and institutions that could provide it derivatives. The SME however is unlikely to have material banking relationships (if any) with more than one bank. Therefore, if the SME has their borrowing with “Ring-Fenced Bank A” for example they will need to provide extra security to “Investment Bank B” in order to obtain a derivative from Bank B. This would have to be in the form of cash collateral, or equity in their property for example, which are unlikely to be options that an SME would want or be able to provide. This in effect means that the SME would not be able to use derivatives for risk management.

2.4 Even if the SME does wish to provide additional security to Bank B, the overall costs of hedging are likely to be higher for both the SME and the bank because there is no common usage of the same security for the SME from the ring-fenced Bank A.

2.5 It is worth noting that if the SME was forced to seek derivatives from Bank B, this is forcing the SME to be exposed to increased credit risk on Bank B. This is because Bank B is by definition a “riskier” bank because it is a non-ring-fenced bank. Bank B will be a more complex bank than Bank A and is less likely to be able to rely on the Government for support if required. Bank B is a bank that is likely to be a bank more suitable for large companies or financial institutions. Just as there can be break-costs payable for an SME if they terminate a derivative ahead of expiry subject to market movements, there could also be a breakage gain for the SME. If Bank B failed, it may not be able to pay the SME the breakage gain owed to it under the derivative.

2.6 It could be asked if an SME could adequately or inexpensively hedge their exposures through alternative means such as exchange-traded hedging products, rather than using an Over the Counter (OTC) contract from their bank. The simple answer to this is no, because if it is appropriate for an SME to hedge their exposure, they must only do so via a derivative that is suitable for them. This means that the derivative must be of the right length, notional amount and amortisation profile to match the underlying borrowing. Exchange traded contracts do not allow such flexibility and are typically for sizes that would be too large for an SME. It may be possible for exchange traded derivatives to be provided for smaller notional sizes and duration’s, but these have not yet been developed and will require both cost and time to develop. A further issue with exchange traded derivatives is that they may also not match the underlying basis required by the SME, for example Base Rate. With OTC derivatives, a bank can provide a Base Rate derivative to an SME, whilst the bank (not the SME) absorbs the basis risk of doing so.

3. Mis-Selling/Conduct

3.1 We do not believe that the above question can be answered without addressing the issue of the mis-selling of these products.

3.2 We disagree with part of the findings from the FSA on the 29 June 2012 which are particularly focussed on complex products (for which they use a set of products that could be described as “structured collars”). This is because, in our view, even “simple” products such as an interest rate swap, a fixed rate loan, or interest rate collar have and can be mis-sold. In cases where the derivative was provided for longer than the loan, for a larger amount than the loan, or the SME was not clearly shown the potential for large break-costs, there can be mis-selling even using “simple” products. In fact, on an equivalent basis, there will be many instances where it does not matter whether the SME was provided a “complex” structured collar, or a “simple” interest rate swap; the break-cost from either product at current levels of low interest rates will be very similar. The point we make here is that it is the manner and conduct in which these derivatives are sold, which is far more important than a label of a “simple” or “complex” derivative.

3.3 As we have already stated in our oral evidence to the Committee on 26 September 2012, this does not mean that derivatives are inappropriate for SMEs.

3.4 There are actually already robust rules provided by the FSA (the Conduct of Business Sourcebook) which require banks to assess the suitability and appropriateness of these derivatives for SMEs. Part of the problem has been that the compliance functions within these banks have failed in their duty to sufficiently check how and what the sales advisors were providing to the SMEs. In turn, the FSA has also failed to monitor and challenge the banks’ compliance functions for the adherence to these FSA rules in substance, rather than just via detailed written terms and conditions they provided to SMEs.

3.5 It is our view, that the derivatives provided within a ring- fenced bank should be of a relatively simple nature. Although more “complex” derivatives can be appropriate for SMEs, they can require a greater level of comprehension and analysis which some SMEs may not be able to undertake. By “simple” derivatives, we mean derivatives where there are no knock-in/knock-out or digital options (a feature of “structured collars”) and no ability for the bank to unilaterally extend or cancel the derivative. These “complex” products typically involve the SME selling one or more “options” to the bank. These types of derivative can be viewed as more akin to “speculative” products rather than “hedging” products. For example, a multi-callable swap whereby the bank can terminate the swap early cannot be considered a hedge because as soon as the bank feels interest rates are likely to move higher, they will cancel the swap. This means the protection is removed just at the time when it is likely to be required.

3.6 In addition, with regards to the appropriateness and conduct rules regarding the sale of these derivatives, we believe that they should always be of a term less than or equal to the term of the committed facilities provided by the bank. We also believe that the notional value of the derivative should be equal to less than the value of the committed loan facilities provided by the bank that is providing the derivative. We also believe that the underlying “basis” of the derivative must match the underlying index of the loan. For example, an SME with a Base Rate Loan should not be provided a LIBOR related derivative (subject to the exception mechanism below).

3.7 There may be legitimate risk management reasons why an SME may wish to request an exception from these rules. This should be permitted only after a significantly large “compliance hurdle” set by the Bank. For instance, requiring the authorisation from at least two FSA Authorised individuals, a Managing Director within the Bank and Compliance.

3.8 We believe that if ring-fenced banks are permitted to provide simple derivative risk management options as per above, this will actually improve the conduct of how these products are sold. This is because there will be tighter rules governing how and what may be sold to these SMEs. If the ring- fence bank cannot provide these derivatives, and the SME must seek an alternative (non ring-fenced bank) for them, there is nothing to stop that bank providing any type of derivative, for any amount of notional size and duration. In other words, the non ring-fenced bank could still mis-sell a derivative to an SME, which would become much harder to do so for a ring fenced-bank that had to adhere to some of the principles stated above.

Prepared 2nd January 2013