Evidence heard in Public

Questions 1 - 148



This is a corrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.


The transcript is an approved formal record of these proceedings. It will be printed in due course.

Oral Evidence

Taken before the Parliamentary Commission on Banking Standards Sub-Committee A

on Wednesday 26 September 2012

Members present:

Mr Pat McFadden (Chair)

Mark Garnier

Mr Andrew Love

Lord McFall of Alcluith

John Thurso

Examination of Witnesses

Witnesses: Mike Dailly, Financial Services Consumer Panel, Christine Farnish, Chair, Consumer Focus, and Peter Vicary-Smith, Chief Executive, Which?, gave evidence.

Q1 Chair: Good afternoon. Thank you for coming and speaking to us.

I want to begin by explaining today’s hearing and how it fits into the broader work of the Commission on Banking Standards. You will be aware that we were established in July as a consequence of the interest rate fixing scandal that will affect a number of banks. The Commission has had a couple of introductory meetings, and it has decided to divide its work into panels on particular issues, so we are asking you to give evidence to this panel on SMEs and the consumer experience. I stress that we are not here to reach conclusions today; we are still in the early stages of our work. We will take the evidence that you give us today and feed it into the considerations of the Commission as a whole as we come to write our final report.

The session relates partly to what we did on Monday when, as a panel, we visited the west midlands and took evidence from business people and consumers at two different hearings in Birmingham. I thank those who helped us with that.

Let me start with you, Peter, and ask your view of the discussion about free-in-credit banking. It has been put to us by some banks that free-in-credit banking is a distortion in the system. Indeed, it has been put to us that its existence pressurises banks to sell ancillary products because, for them, free-in-credit banking runs at a loss. What is your response to that argument?

Peter Vicary-Smith: Let us bear in mind that the retail banking sector has been profitable right the way through the financial crisis and right the way through institutions. There is a no crisis of retail banking profitability. On the specifics of charging a monthly fee, the idea that if banks charged a monthly fee, they would somehow stop the mis-selling is frankly, for me, both offensive and ludicrous. It is offensive because it is a parlous state of ethical standards if, in order to persuade people not to mis-sell, we have to bribe them by giving them a monthly fee. That is the logic of the protection racket-"I won’t hurt you today if you give me a fee to go away." Secondly, it is ludicrous because if it were the case that the lack of a monthly fee forces banks to mis-sell or forcibly to sell, as we heard on Monday, the introduction of packaged accounts would have meant that individuals were not subject to the same mis-selling and were not subject to the same hard sell.

At the consumer session on Monday, we from heard a lady, Sayyida, who has a Barclays packaged account and was saying that the same things were happening. She was still miss-sold PPI and reclaimed her money. She is still subject to the same hard-sell techniques. They have introduced the monthly fee, but it has not changed behaviour. That is not the problem. The problem we have with mis-selling is about ethics and professional standards, and the culture of remuneration that exists within the banking sector.

Q2 Chair: Would either of our other two witnesses like to come in on this?

Mike Daily: We think that free banking does not exist. In the 1980s, when it first came into the UK, it was actually innovative. What we have seen, ultimately, is that the banks have been innovative in the UK. Packaged bank accounts were actually an innovation. The use of smartphone technology is an innovation. The difficulty has been that that innovation has been to the exclusion of transparency of cost. If you think about it, we have really got this kind of heavy fog of fees and charges in the UK, where ultimately the consumer does not know what they are paying for in a transparent way-charges are opaque.

If you look at overdraft charges, it is ultimately a very unethical mess that we have in the UK, with the less well-off subsidising the better-off. Something like 12 million account holders cross-subsidise, disproportionately, 54 million account holders. That is not ethical and not fair, and ultimately, if we talk about packaged bank accounts, as Peter has, we see that those accounts are not really the solution. I think that something like one in five people in the UK now has one of these accounts, but we know that fewer than one in 10 use the bundled services.

If we are asking what is the fundamental issue about free-in-credit banking, I think the short answer is that the banks have got themselves into a cul-de-sac. It isn’t free, and everybody knows it isn’t free, but how do they move from that position to providing a fair and transparent service to all consumers?

Q3 Chair: May I ask about your point on cross-subsidisation? Can you explain that more clearly? What do you mean when you say that poorer customers are cross-subsiding the rest?

Mike Dailly: In terms of cross-subsidisation, what we know is that bank charges-overdraft charges when you go over your authorised limit-are imposed by banks. The level of fee that is imposed has no bearing on the actual cost of going over your overdraft limit. It is a nanosecond of the bank’s time that probably costs a fraction of a penny but, because of the business model, banks impose a certain fee. From the OFT study that was published in 2008, I think that something like £2.6 billion was gathered from this. The reality is that the people who are paying these overdraft charges are typically people who are financially vulnerable. They are in financial difficulties and they are not in a position to pay these things.

If you think about the position, overdrafts are a form of credit. One of the biggest problems that we have in the UK is that people cannot get access to credit-whether they are individuals, SMEs, or businesses at large-and what happens with overdraft charges is that somebody on a very low income who goes over their limit is then hit with a series of these charges. Ultimately, you could say, "Why doesn’t the bank just extend their overdraft?" I think that is the issue: why aren’t the banks basically lending to consumers short amounts of money, because the fact that they have failed to do this has resulted in the payday loan industry really taking off in this country, with 5,000% APR rates? We really need to do something about the mess that we are in.

Christine Farnish: May I say-

Q4 Chair: Christine, before you do, I just want to pursue this issue of overdraft charges. The banks’ argument on this free-in-credit banking point is that if they had a stream of revenue from the customer who remained in credit throughout the month, there would be less pressure on them to sting the others through heavy overdraft charges. I asked Peter for his response to this. What is yours?

Mike Dailly: You only have to look at the history of overdraft charges in the UK. For a long time, the banks were saying that overdraft charges were actually designed to pay the cost of somebody looking through the customer’s file. Then the banks started to say, "Well, that’s not actually what it’s for, " and ultimately we got to the UK Supreme Court case when they came clean and said, "Look, it’s a cross-subsidisation that we have."

The reality is that if you look back to the 1980s and the early 1990s, bank charges were not that high, proportionately. What has happened is that they have just gone off on this incredible upwards curve, as ultimately banks have seen this as a way to bring in money, basically, and the problem is that they are bringing it in from the most vulnerable consumers in the UK. That cannot be ethical; it cannot be fair; and it cannot be sustainable. Ultimately, we think that part of the problem is that because there is no effective competition between banks in the UK-we have got five banks with almost 90% of all customers-we have the difficulty that we have got stagnation. What we need to do is to get more competition, and we need to shake up this system.

Christine Farnish: I think that Consumer Focus is not quite in the same place as Which? on this. We are closer to where the consumer panel is. We can see a number of quite damaging side effects of the free-in-credit banking model for consumers at large-both now and looking into the future, bearing in mind how the dynamics of the market work.

First, pricing is completely untransparent, and although consumers are paying for banking services, no one knows how much they are paying. We do not think that that is a healthy feature of a market. Secondly, the system is unfair because, as Mike has explained, only a small part of the population benefiting from banking services end up paying the most for them-the ones who are going overdrawn, if you like. A lot of people are getting a service that is not meeting the cost of provision, and others are paying disproportionately for it. That does not seem to be a fair solution when banking is so essential to everybody in their lives. Thirdly, it distorts competition because everybody now follows the same business model. Nobody can break out of it. No one can enter the market and make money honestly from providing normal current account services because we have the free model. It would be suicide to come in and charge as a new entrant if everybody else is providing this free, so there is a market imperfection that needs to be sorted.

I think the UK could learn a lot from looking at other countries. We are the only country in the world that has this model of free-in-credit banking. How do other countries manage it? I am not saying that we don’t have other problems of mis-selling and culture and everything else-we will come on to those, I am sure-but I think that this is a particularly pernicious problem that really must be addressed.

Peter Vicary-Smith: May I point out that there are three other sources of revenue that we have not yet counted for the banks? They got £2.6 billion from charges, according to the OFT study. The same OFT study identified £4.1 billion in interest foregone. That will be less now because interest rates have come down, but lots of people are making less profit now than they used to. They also have two other important streams that are not costed in there. One is that they are your natural point to go to, if they are behaving properly, for all sorts of services. When my father took out his mortgage, he went only to his bank-that was who he turned to-and being that sort of preferential supplier is worth a lot. The second thing they have is an enormous amount of data on your financial services, what you are buying and your lifestyle. Tesco pays an awful lot of money to collect that data through its Clubcard system; the banks get it for free. Let us not think that the only way the banks make money is through the pernicious way they apply overdraft charges, because they also have many other sources of revenue.

Q5 Chair: One other area I want to ask about before bringing in Andy Love is this issue of what we might call other products. Christine Farnish, may I begin with you: why do you think consumers buy products they don’t need?

Christine Farnish: Well, if you are thinking of PPI, as I suspect you might be, often consumers were very keen to get a loan. They needed a loan, perhaps because they had a debt problem or they needed to buy something but had a cash flow problem. They turned to their bank for a loan, which is quite normal behaviour. After the conversation about the loan, there was this bit tagged on at the end: "Oh, by the way, you’ll need to insure this," or, "You might like to insure this." Whatever the words were, they suggest, "Actually, if you want a loan from us, just sign this other bit and you’ll get it." Although, strictly speaking, they were two separate sales, it was all done as part of the same conversation. The consumer was often desperate to have that loan. They felt they had almost got it in the bag and that a few more seconds of conversation over the phone with the telesales person would secure the loan for them. They were happy to volunteer to buy the other bit without realising quite what the other bit was. Too often, that has been the way in which sales have been conducted.

Q6 Chair: Is there something unusual about the information disparity here that makes it different from other market situations in the sense that the seller knows a great deal more about the product than the buyer?

Peter Vicary-Smith: Let me give you one illustration of that. To open an HSBC packaged account, the consumer is expected to read 165 pages of information. No one is going to do that. As long as banks-I have to say that the regulator at the time was complicit in this as well-design complicated products that require a lot of explanation; secondly, sell them through the pernicious system of sales-focused remuneration that we have; and, thirdly, provide so much gobbledegook that the real things you need to know are hidden, we will continue to have these problems. They need to tackle all those dimensions.

Chair: This is probably a good moment to bring in Andy Love.

Q7 Mr Love: Listening to you, I was reminded that to address some of the issues that have come up so far, the FSA introduced "Treating customers fairly"-to much hurrah at the time. From what you have said, it does not appear to be working. Is it working?

Mike Dailly: "Treating customers fairly" is a fantastic principle, but the sad reality is that it is not working. One of our problems is this idea of gaming the regulator. When you look at what happens with banks, you see that they are always challenging the FSA about the interpretation of rules. They did it over PPI, and it ended up in court. They did it over recurrent payments-CPAs, or continuous payment authorities. Some of the banks are still saying that you cannot cancel one of these things unless you have the permission of the merchant, and that is not what the FSA says. They did it over things such as power of attorney-where someone gets a power of attorney and the bank will not recognise it-and set-off, where they take money out of one account for a debt in another. The FSA sets the rules very strongly and robustly in all these areas, and the banks are always challenging them. We think that that is wrong, which is why the consumer panel was lobbying for a new regulatory duty to go into the Financial Services Bill that would require the new FCA to promote a duty of care on banks in terms of how they treat their customers. We have that duty of care in European legislation such as MIFID. We have it in IMD2, the insurance directive. What that effectively means is that some bits of our legal system require financial institutions to act in the best interests of their customers. When it comes to general treatment of customers by banks, there is not ultimately that duty of care, which we think needs to be addressed, and it can be addressed by way of toughening up the legislation.

Q8 Mr Love: I will not ask Peter or Christine about "Treating customers fairly", because I assume that you would agree that that has not happened. What would be your response to what we need to do?

Peter Vicary-Smith: The problem with "Treating customers fairly" was that it was fine as a principle, but it did not address the issues of culture and ethics within those banks that were supposed to be treating customers fairly. At the time that it was introduced, one of the heads at Lloyds said to me, "I don’t know what we are going to do about this because I don’t walk into work every Monday morning intending to treat my customers unfairly, so frankly I will be doing what I have always done." That was very much the prevalent attitude-nice principle, but of course we do it already. Unless it gets to the heart of professional standards, ethics and behaviour, these other principles will not work. We have to change that, and I know that the Commission will be looking at that closely.

Christine Farnish: May I make a quick comment? The regulatory system was very slow to wake up to the need to look at retail conduct issues in the banking sector. It was not until 2009 that the FSA formally took on responsibility for conduct regulation in banking, because that was delegated to a voluntary industry initiative before then. That is one thing to bear in mind. "Treating customers fairly" was far too vague. It always was too vague; it can mean all things to all people. Unless we are really clear about what it means, the banks, as has been said, and everybody else has pretty much licence to go on as they always have done. The trick is to look not just at the powers that the new regulatory regime will have, and to ensure that they are right, fit for purpose and strong enough, and that the will is there in the FCA to drive through some change, but to look also at what is driving behaviour in the banks themselves. Too often it is the short-term, profit-driven incentives that are playing out and incentivising behaviour within the banks. The shareholder interest is always put higher-this is enshrined in law in the UK-than the customer-consumer interest, and that has a lot to answer for in my view.

Q9 Chair: May I pick up on this duty of care point? In the consumer panel’s written evidence, two things were stressed: first, the professionalisation of banking, by which I mean in order to be a doctor or a lawyer you need years of professional study; and, secondly, this duty of care point. I just want you to be really clear about what difference you think that duty of care could make and how it could be legislated for, given the discussion that we just had on the information imbalance in the sale of some products.

Mike Dailly: We were advocating that it should be a regulatory objective for the new Financial Conduct Authority to ensure that there is a duty of care. Obviously, that duty, which would be a statutory duty of care, would be made by way of specific rules through the FCA’s rulebook. We see that as being something that could be in the Financial Services Bill or the Vickers Bill. We also advocated that there should be an obligation for the regulator to ensure that there was access to financial services.

There is a big concern. We talked about free-if-in-credit banking, but if you are a basic bank customer of RBS or Lloyds, you cannot use every ATM machine in this country-you have to use their machines. So much for free banking, if you are a basic bank customer. Our big concern is about what happens if other big banks in the UK decide to do the same. Our concern is that ultimately the whole Link ATM network in the UK could stop being free, because it does cost something. It is the jewel in the crown of British banking; it is a fantastic system. We need to ensure that there are ways that we can stop things going backwards.

Q10 Chair: But duty of care is about more than that, is it not? The banks would argue that it costs them 30p or 40p per transaction when you use someone else’s ATM, but I take duty of care to mean something more than that-there would be a commercial argument about that-such as that in areas of selling products where there is an imbalance of information between the seller and the potential purchaser, the seller has a duty not to sell products that are not in the interests of the purchaser. It is about more than charges for cash machines.

Mike Dailly: You are absolutely right. It comes with the language. We have had a lot of good debate about this idea with practitioners in the industry, and we have organised various events at the FSA to get the views of the different stakeholders. Ultimately, our idea of this duty of care is very similar to what you have in some of the European legislation, such as the markets and financial instruments directive for investment products, which says that the person selling a product has to act honestly and fairly, and in the best interests of the customer. If you had that kind of obligation for general banking, the problem that you are talking about-somebody going into a bank and being sold all sorts of stuff that they do not need-could be resolved.

Christine Farnish: My concern with such an approach is that too often we see the banks and other financial institutions responding to regulatory initiatives that are designed to protect consumers simply by building in a lot more process and a lot more disclosure, and by giving thicker, more dense information to the consumer, so that the consumer has everything they possibly need and no one can come back to those banks and say that they have not been treating people fairly or exercised their duty of care. It makes the whole thing more complicated and more expensive.

The other way to come at this sort of problem is through the thinking that has been going on with the simple products initiative. One of the ideas that Consumer Focus has been playing with is insisting that all the terms and conditions around a financial services product are boiled down to the essentials and put in big font size on one side of A4 paper-and that if you cannot do that, you cannot sell the product. That sort of thinking might be better for consumers and lead to better conduct than allowing the banks to make it even more complicated.

Chair: Andy, do you have any further questions?

Q11 Mr Love: Yes, quite a lot, actually. I will try to telescope some of them.

I will make the assumption-a number of you have already mentioned it-that we need greater competition in banking. I will come on to that in just a second, but does greater competition work for all consumers?

Christine Farnish: It doesn’t necessarily work for busy consumers who are time-poor, or people who really are worried about whether or not, if they move, their new bank will understand them and their needs. That is particularly important for small business customers. Obviously their credit record, and all the rest, is absolutely life blood to them, and they worry about switching and whether or not that information and relationship will be able to switch with the provider. It doesn’t work for people who maybe don’t have access to banking, or who find it difficult to have access to banking, because what they want is something that meets their basic needs and gives them a reasonable deal, and they are not necessarily going to be in a position to shop around for some time. I think it is important that we get the basics right but then try to make sure that banks can compete on the core product and that people can switch easily. I am sure that you are going to come on to that.

Q12 Mr Love: I am going to come on to switching, but I want to rest just for a moment on whether every consumer benefits from greater competition. I am thinking in particular about basic accounts as an access to the financial system. Everybody knows it is the gateway. Mike, you mentioned stopping going backwards specifically in reference to that, I think. If greater competition is not going to deal with this, how can we address the problem?

Mike Dailly: In terms of the ATM point, we know that the Treasury Committee said to RBS and Lloyds that they should reverse that decision, and we certainly support that position. In terms of the point I think Christine is making about how you get the appropriate accounts for consumers, we know there are something like 1 million people who are unbanked. Next year, the universal credit is coming in, in terms of the Welfare Reform Act, and people will need to have an account so that their benefits can be paid into it. The idea of forcing the banks to give them an account might seem attractive, but we don’t think it is necessarily the solution, which is why there is talk at the EU level about whether there should be a statutory requirement on banks to give a basic bank account.

We think there needs to be a more sophisticated solution because we think that giving somebody a bank account could actually be a source of their problems, in terms of overdraft charges and all sorts of stuff, so one of the things we should look at is alternative forms of banking. We are very encouraged by the work that has been done by credit unions across the UK on providing current accounts because that has been very successful at helping people who are otherwise unbanked to have a basic bank account with some facilities.

Q13 Mr Love: Peter, you are telling us what I think we know: the level of dissatisfaction among bank customers is probably at an all-time high. However, the level of switching, which is one solution to that problem, seems very low. Why is that?

Peter Vicary-Smith: I think there are a few reasons. One is that a lot of consumers think, "What’s the point of switching, because all these banks are the same?" They do not hear a tale of great exceptions. We keep on saying that there are exceptions, as there are banks that do well in our customer survey, but it is just that those with the biggest market share are consistently bumping along the bottom. As well as people saying, "What’s the point if everybody is the same?" they also have the fear of it going wrong. That fear is overstated but, believe me, if it does go wrong, it is a huge problem for an individual.

That is why we come back to the thought of portable account numbers being one of the vehicles for changing this. The banks will come back to you and say, "Yes, but the cost of it is so horrendous that we can’t possibly do it." My answer to that is to set a date well in the future-I don’t care what the date is; it could be 2025-and say, "By that date, through the system upgrades that you will be doing for the next 10 years, you must have introduced a facility for portable account numbers." That would not give them the cost of implementation, and at least we would know that, by then, we would have got something.

What we have at the moment is people saying, "Well, let’s try this other initiative first, because I am sure that will make it better," and then lo and behold it doesn’t. It is then, "Let’s try another initiative," and you will get to 2025 and find that we are in exactly the same place. Let us put a stake in the ground and say that, by a certain time, we ought to introduce it, and then let us stop hearing about all the other things that can be done in the meantime.

Q14Mr Love: Mike, the banks have come forward through the Vickers process and suggested a way forward that tries to address the issue of risk in switching bank accounts, and gives some idea of time scales as well. Will that be effective? Are you convinced that that will work, or are you minded to go further?

Mike Dailly: The consumer panel gives a lot of credit to banks in the UK for coming up with the seven-day switching guarantee, which will come into play next September, I think. I was at a BBA conference recently at which I think the banks said that they had spent about £1 billion developing all that. We need to say, "That’s a really good thing that you’ve done. We applaud that." Will it work? It is going to be much, much better than what we have at the moment. It will cure all the problems we know that put people off in the first place-direct debits going wonky. All that sort of stuff is going to get fixed, and we see this as being really good.

If you are asking whether our ultimate destination is portability, the bankers will tell you, "Hang on a second. You can’t just compare bank account and sort code numbers with a number from a mobile phone. The technology is completely different; it’s a different thing." However, we are very sympathetic to the idea that the ultimate destination that we want to go to is portability, because we think that that is probably going to be better for competition.

If you look at the data, 1.6 million people complained about their bank in 2011. The upheld rate-in terms of that being overturned by the banks-was 65%, and for those people who went on to the ombudsman service, the uphold rate was between 31% and 44%. Clearly the banks are making a lot of people unhappy at the moment, and we think that switching is a good way to create a dynamic for competition.

Q15 Mr Love: Christine, I think there are other barriers to people switching. Would either the banks’ proposal and/or account portability make the difference? Will making it much, much easier mean that we go from very low figures to almost just as low figures, because of the other factors that we know exist?

Christine Farnish: I tried to switch my bank account recently just to see how good this was, bearing in mind the claims of some of the main high street banks. It was actually pretty seamless, but I have talked to friends who have had different experiences, so there still are glitches in the system.

I think that the banks’ proposal to make this a process whereby the consumer cannot lose out is a good step forward that will make a difference. However, at the end of the day, consumers have to believe that they have a better offer from a competitor bank and that the process is worth the hassle. It is still a bit of hassle to do it. They have to bother to go in to make that change, and they will probably still be on tenterhooks until it has happened, because it is important that these things happen completely smoothly, with direct debits and everything else. They have to be convinced that they are going to get something better. Unless they can see the offer in terms of quality and price as being something better for them, why would they bother?

Q16 Mr Love: I have to say that I closed a bank account a year ago, and I am still receiving nasty letters about standing orders that have not yet been fulfilled by my other bank account.

Peter Vicary-Smith: That was a 52-week switching guarantee.

Q17 Mr Love: The OFT has started an investigation into the personal current account market, and I think that Peter quoted from a previous inquiry that it held. There are a lot of suggestions that it may recommend that the commission does a full inquiry. What would each of you hope for and expect from the OFT inquiry in this area? Perhaps we can start with Peter.

Peter Vicary-Smith: Sure. The evidence that we submitted is clear that there is only one body with the power to do something about the structure of the market: the Competition Commission. Rather than going through the process of referral, we would just like to see a straight referral to the commission. We think that the problems that we have in the market are so ingrained that the banks with the dominant market share are not there because they are good value for money or because they offer great customer service, but because of Government bail-outs, an implicit subsidy, and a disregard for competition law. Even after the divestment insisted on by the EU, the Lloyds market share will still be greater than in 2001-I think it was-when the OFT prevented the takeover of Abbey by Lloyds. In other words, we are worse in terms of competition than we were then. There is only one body that can sort that out, so let us just get on with it and refer it to the Competition Commission now.

Q18 Mr Love: Mike, you mentioned competition specifically and said that we needed to do something. Can the OFT, through the Competition Commission, do something about that?

Mike Dailly: Possibly, but it would be shame if things were kicked into the long grass with another inquiry. If you look at all the evidence that we have and the work of this Commission, we know what the problems are. We know what needs to be fixed. We have only had one new bank in the past 100 years-Metro Bank. All the other banks were kind of Virgin taking over Northern Rock, or a shifting of who owns what. We know that what we need to do is to make competition better by making it easier to get into the market as a new entrant. We need the challenger banks. We know what the answers are, to be honest.

Q19 Mr Love: Christine, do you know what the answers are-please tell us?

Christine Farnish: I understand the OFT’s inquiry to be about personal current accounts. It does seem to me that an essential first step in trying to work out the right answer, bearing in mind that a number of views exist, would be to get more information out there about how the current business model of free-in-credit banking works: where are the costs in the system for the providers, where is the money being made, how does it all work, and who are the winners and losers? That information is not available; it is not in the public domain. It is very difficult to have an informed policy debate about this important issue without that basic information being out there. I hope that if the OFT is going to do more work, it will get that bedrock of data and analysis done and put it into the public domain so that there can be a more informed debate about the best answer for consumers in the UK.

Mr Love: I am sure that the OFT will come up with that, but it is a rather long time scale and we will want to look at that and ask some of the questions that have been asked here.

Q20 Lord McFall of Alcluith: Mike, you say that you know what the answers are. I have been looking at this for 10 years, so I am sorry that I did not come for a cup of coffee with you 10 years ago. You mentioned the issue of gaming the regulator and Christine mentioned PPI. Is gaming the regulator seen as a cost of business? There was a super-complaint in 2005 by the CAB and others, but Barclays executives were still trying to convince their board in 2008 to continue with PPI. The only conclusion I can come to is that they see it as a cost of business, and that regulation, as John Kay said in a letter to the British Academy in June, is piled high and useless. Comment.

Mike Dailly: I think it is seen as a cost of business. Obviously the example of PPI is probably incredibly costly to business because, in the past 19 months, almost £6 billion has been refunded, mostly by banks. Nobody knows where it is all going to end-it could be double that figure. That is why the consumer panel thinks that the only way to tackle this cultural problem and the problem with incentivisation is, in some respects, to go back to the old-fashioned way of fixing things of having a profession with professional standards-a professional body. If bankers who had significant influence functions were members of a professional body, all this-the problems with ethics, the problems with how the regulator is treated, and this gaming of the regulator-could be sorted out through that professional body.

I think I am right in saying that all we have in the UK at the moment is the Chartered Banker Institute, which is a voluntary body with 9,000 bankers as members, only 4,000 of whom have the highest qualification. There is no mandatory qualification for bankers, yet with any other part of our life-whether this is doctors, accountants, lawyers, or other professionals-we have a system in place that is a profession. The other thing about having a profession is that it gets round all the legal problems about criminal sanctions and civil sanctions. At the moment, we find that you cannot hold people responsible for things that go incredibly wrong because of the complexity of the structures in place.

Q21 Lord McFall of Alcluith: In your other life in the Govan Law Centre, you have challenged the Law Society of Scotland and others, and said that a lot of their stuff has been inadequate, so professionalism like that just does not seem to work. The point you make, Peter, about culture, ethics and a professional arrangement will take a long time, because it needs buy-in from the individual and, at the end of the day, there is an uncertainty to that-look at the BMA with Harold Shipman, the biggest mass murderer ever-so it isn’t going to stop things. What is your answer to those points?

Mike Dailly: We are not claiming it is a panacea, and things will go wrong, but if you look at the incredible amount of dissatisfaction-I gave you the figure of 1.6 million people-and the fact that the vast bulk of those cases are overturned by the banks themselves and by the ombudsman service, it shows that things are wrong at the coal face in banks. We have PPI and other mis-selling scandals-people are talking about interest-only mortgages as being a chicken that could come home to roost as mis-selling-and having a professional body will resolve a lot of these concerns; not all, but a lot.

At the moment, the FSA finds it very difficult to bring criminal prosecutions against those with significant influence functions, because the complex structures of banks mean that it is hard for any one person to be responsible. We have seen that many times. If you are a member of a professional body with a code on criminal behaviour, that is a way for the public interest-the consumer interest-to be satisfied. We see it as a step in the right direction.

Q22 Lord McFall of Alcluith: So you think that the regulatory law needs upgrading.

Mike Dailly: Yes.

Peter Vicary-Smith: We absolutely need better regulation that is focused not on ticking boxes but on outcomes for consumers, but I agree entirely that if we are to get long term to a better system in this country, better professional ethical standards are really important, and that to me has a few components. It has to operate like so many of the other professional bodies out there and to be enshrined in legislation, because that is what gives the body its power. It has to control entry qualifications to the profession, as well as conduct, discipline and redress.

The crucial thing-if I can leave one thought only from this evidence session in your mind-is that this cannot be done by the industry, which has lost all credibility. We let the industry try to sort a lot of this out on its own post the banking crisis. That was drinking in the last chance saloon. We are beyond that. We have had PPI and LIBOR rigging since then. The industry has no credibility out there to sort itself out. This has to be independent. You only have to look at the submissions that the Commission received from many of the banks-not all, but many. I think it was Santander-I won’t quote the exact words-which said it was supportive of greater professional standards, but was not sure those needed to be compulsory. You have the BBA effectively saying, "We have so much on our plate. Let us carry on with it as is." The attitude has not changed enough in all of industry for them to be capable of doing it themselves. The regulation has to come from outside; otherwise you just have the fox running the henhouse.

Q23 Lord McFall of Alcluith: Christine, we are focusing on retail customer expectations, and you had the opportunity for many years within banks that sell to see this from an inside view. Given that banks game the system-as with PPI-will culture and ethics overcome this? It will never prevent a godlike chief executive getting his or her way. Is there not a need fundamentally to change the business model of banks to ensure that we get not just symmetry of information, but ownership. Symmetry of information is really about ownership, because the banks own all the information.

Christine Farnish: You make very good points, Lord McFall. A quick point on professional ethics: when I worked in the industry, I observed that internally the responses in firms to regulatory initiatives to try and make the system better for consumers-whether from the FSA, the OFT or whoever-were nearly always driven by lawyers, who are supposed to have their own professional ethics already. That raises a question mark in my mind about how much difference it would make were we to set up the most fabulous banking professional institute since sliced bread. However, that does not mean to say that it is not worth trying, but other things need doing as well. First, the regulator has to be a damn sight smarter. They have to follow the money; find out where the money is being made in a particular market; look horizontally in that market-not just in each firm-through their firm-by-firm supervision; and understand the way the commercials work a lot better than they have done before. There are plans to put more of a focus on that with the new FCA, and I hope that they are solid plans.

Secondly, within firms, just as a lot of thought has gone on recently to ensure that the risk director reports direct to the board and is a serious player answerable to no one in terms of executive management-in terms of trying to manage risk to the financial system within a bank-why is there not someone like a consumer advocate within a bank who is empowered to look across and challenge and report direct to say a retail sub-committee of a board, or whatever it happens to be, on whether they think a practice is in the long-term interests of the banks’ customers? That might not be the right answer, but thinking along those sorts of lines could really start to improve things.

Q24 Lord McFall of Alcluith: In your professional experience, have you ever noted an occasion when a legal compliance officer went to the FSA independent of the executive team in that organisation?

Christine Farnish: I cannot think of an example.

Peter Vicary-Smith: May I make one final point about professional standards? A professional body does not stop someone going off the rails. What it does mean is that if they go off the rails, it gets them, punishes them and puts in systems to prevent it happening again. That is what is not happening in banking.

Q25 John Thurso: Very quickly on that, where do we want these standards? Let us take medicine. Doctors are easy, because a doctor is a doctor and we have the General Medical Council, but there are other people who work in a practice at different levels. Are we talking about the manager of a branch having this responsibility and training, or every single individual behind the counter having a level of training? Just exactly where do you see this being targeted?

Peter Vicary-Smith: For me, the key thing is that it goes from the top down. You end up with the people who are running those banks having no kind of qualifications. They are running them as if they are a retail business, but then the sales targets often come out of that. It certainly goes down to the manager of the branch and to the team leaders of those call centres. You are making sure that they are trained and that they understand the ethical responsibilities and so on. As for whether it goes to absolutely every individual operating, your analogy with the medical and legal professions is valid. It does not necessarily mean that everybody has to pass level 3 banker exams, but you would expect them at least to have some form of qualification and training in things such as how to serve a customer and what is fair treatment. There should be a basic level of training. None of that goes on across the profession generically. There are some things that go on in individual banks, but not generically. I am talking about things such as training and qualifications. You cannot be a banker running these processes unless you know how to do the stuff. Conduct, discipline and redress are the sorts of things that you need to be trained in. That is about the senior levels, the HR people and so on within the institutions.

Mike Dailly: I would say that we will be introducing the retail distribution review, which is about bringing up standards in terms of advisers. Clearly, there would be cost implications for that across the board. Certainly, from the consumer panel’s perspective, we think the easiest way for it to be done would be to connect it to the existing infrastructure for significant influence functions. At the moment, the FSA has to approve persons. If you look at the figures, you can see that it has knocked back hundreds of people on the grounds that they are not suitable to hold an SIF position. Clearly, that is the leadership role in banks. That is somebody who we think should hold one of these professional qualifications. We appreciate, though, that there are cost implications, and that it is something that should be thought about in much more detail.

Q26 John Thurso: The reason-Christine, you might want to add into this-is that if you look at a wide range of industries, there are key people who need to be qualified, and there are lots of support functions that need qualification in the support function. Not every person in a hotel has to be a fellow of the Institute of Hospitality, but everybody who is a food handler needs to have passed their basic food handling and hygiene course. I hear a lot of people say, "I can’t talk to a bank manager I trust," and I hear a lot of people say, "There isn’t a manager in the bank." They do not mean the significant influence functions; they mean the guy in the high street. When we ask for people to be trained and for that training to be in a certain place, do we not have to be very careful that we actually direct that to the place where it is going to impact on the customer?

Peter Vicary-Smith: Yes.

Mike Dailly: Very quickly, that has been a classic failure of banks, because a lot of all the problems in terms of not obeying the rules and regulations come down to the fact that the front-line staff are not trained. I am not having a go at front-line staff, because it is not their fault that they are not trained; it is the people at the top who are not making that happen.

Christine Farnish: But I think that this drives back to where the conversation started this afternoon, which is the profitability of retail banking in the UK. Peter has quoted statistics suggesting that it has always been profitable and that it remains profitable. However, if you are an investor wanting to invest in a market, will you choose retail banking in the UK as the place to put your money? I suggest that you will not, because the rate of return you will have on that money is pretty low compared with other places you could invest. Unless that changes and the business model is looked at, I think it is unlikely that banks will particularly want to invest a lot more money in getting all their people up to a better standard. I think that this is a real problem actually.

Q27 Chair: Christine, you said we began by talking about profitability and a series of particular products. Mike, a minute ago you referred to interest-only mortgages. One product that people do want from banks is a mortgage, and we have moved from a lending feast in the run-up to the crisis to something of a famine with this for first-time buyers. Let us start with you, Mike. Has the consumer panel considered this and the impact of a generation of young people being locked out of home ownership?

Mike Dailly: We certainly have. We spent a huge amount of time working with the FSA on its mortgage market review before it went out to the public, and we are very concerned. What we need to get is a joining up of housing policy across the UK with mortgage policy. We do not seem to have that kind of joined-up set of policies.

Our big, big concern is that we are where we are-obviously, what the MMR is trying to do is to say, "Let’s make sure that that never happens again"-and what is to happen to all those people across Britain and Northern Ireland who are in a mortgage that they cannot get out of and who cannot get another mortgage, whether because they have negative equity, or because of their current financial position? Our big concern is mortgage prisoners in the UK. There are estimates that there could be as many as 5 million people.

We were pushing for the FSA to introduce a rule that would protect those people so that they would not be treated less favourably than, for example, new or existing customers with, say, 75% loan to value getting a preferential rate. We wanted to see a rule that would protect those people, and we are still pushing for that. That is our concern.

Peter Vicary-Smith: A similar focus-the mortgage business has a huge problem here. Those people are often trapped on SVRs, which have widened compared with base rate over the past couple of years, so they cannot move anywhere else. There is nothing going on, in policy terms, to protect them against rises in SVRs, or to enable them to move to some other form of lending. If you like, that is the unexamined part of what is clogging up this mortgage system.

Q28 Chair: The final thing that came out strongly from our evidence on Monday was people’s desire for a more personal relationship with their banks-for the phrase "relationship manager" to mean something. It was perhaps felt more strongly on the small business side than the consumer side, but it came out in both. Do you think that some of the issues we have been talking about could be resolved by fewer call centre contacts and more branch-level contacts, or is the idea of the old bank manager in the town who knew everyone’s financial affairs a bit nostalgic?

Christine Farnish: In an ideal world, you are absolutely right. Everyone would like to go back to more personal contacts. That is always preferable to having to deal with someone you do not know on the end of a phone, especially if you are talking about something quite personal, like whether your business is going to be solvent or viable, or whether you need a loan. However, I fear that that is back to the business model-its profitability, what incurs costs and how those costs are met. Of course, the small business market is part of the retail business in most banks. That is back to where the money is made, how it is made, and how sufficient money and return can be made on core products to enable decent levels of service to be provided. I do not think that we have cracked that.

Mike Dailly: It is almost like A Tale of Two Cities. If you are a customer who the banks are trying to sell something to, you seem to get the Rolls-Royce, fluff-up-your-cushions approach, whereas if you were somebody thinking, "Um, I have a bit of a problem here," it is almost like you go into a black hole and you get passed from pillar to post. We think that a lot of the problems could be resolved by banks investing in their front-line staff and those on the end of the phones and giving them a bit of authority. Often consumers phone up and are told, "Oh, I can’t do anything. All I can do basically is to stick to the line." In some respects, training and investment are part of the whole thing. The days of treating your customers as just some sort of conduit to meet sales targets have to change, surely.

Peter Vicary-Smith: I would like to see a multiplicity of models and some genuine innovation. I do not particularly want to go into a branch-I am happy to do stuff online and on the ATM-but that’s me. I have a bank that deals with me in that way-by the way, it is fantastic with its call centres and it actually deals with me like I am a human being when I ring up-but not everybody wants that. Other people want personal contact. That is fine, and they should be able to find a bank that delivers it to them.

I really do not understand the model that banks seem to have of not liking contact. It is almost as if it were just a cost. I encourage my members to ring in. I want to talk to them about what is in the magazine. I want to talk to them about how to use it better and about the other parts of the service they are not using, because that breeds loyalty. That is why 85% of my customers stay with me each year. What is at the heart of this, as I mentioned on Monday, is that there does not seem to be a reward for loyalty. The banks do not seem to be interested in keeping the customer and deepening the relationship with each individual customer and, for that reason, they look at the cost of something rather than the opportunity for contact.

Q29 Chair: I want to draw this part of the session to a close but, before I do, is there anything else you want to say, or a particular point that you want to make that you do not feel has been covered?

Peter Vicary-Smith: You were saying, "What’s the solution?" Three things that would make important changes spring out of what you heard on Monday. Let us put an end to the sales-focused culture and the focusing of remuneration on selling rather than providing what customers need. Let us introduce professional standards that are independent and rigorous. Let us get back to a system where, through those, we can hold individuals personally responsible, not just the corporations they work for, because that is what breeds true accountability.

Chair: Andy Love has indicated that he wants to ask another question.

Q30 Mr Love: It comes back to something from the earlier discussion about information overload. You can have 150 types of mortgages these days, and you get 150 pages when you buy a product. People have talked about having simple products, green and red lights, and all sorts of responses to that, but this is a critical issue that will not go away. What are your thoughts?

Christine Farnish: I think that we would get a lot further in terms of effective regulation if there was more focus on product and less focus on the sales process, advice, information and everything else.

Q31 Mr Love: Are you happy with how far the FCA is likely to go with that in terms of product regulation?

Christine Farnish: The last time I looked at the Bill, the powers looked a lot better than the current regime, but will they get watered down as part of the process, with the industry lobbying against them? When the FCA is set up, will it have the risk appetite to use those powers? That could, for example, require early intervention when you might be 90% sure that something would be damaging to consumers, but you don’t necessarily have all the evidence that a cautious person or a risk-averse regulator might say you needed. So I think this is about regulatory style and risk appetite.

Mike Dailly: We’ve got the Sergeant review, which is looking at straightforward outcome products. As a panel, we are very supportive of that approach. We don’t see it as the solution to all problems, but we think that customers should have the ability to know that there are straightforward outcome products that they can choose, and that they don’t have to worry about them. We see that as one part of an overall solution. Peter has talked about some of the other things today, but there is no reason why we can’t have that one part of the solution quite speedily.

Chair: Thank you all for coming and giving us your evidence. As I said, this will all be considered in the light of the final report.

Examination of Witnesses

Witnesses: Matthew Fell, Director of Competitive Markets, Confederation of British Industry, Mike Cherry, Policy Chairman, Federation of Small Businesses, Mike Spicer, Senior Policy Adviser, British Chambers of Commerce, and Andy Davis, Finance and Business Writer, gave evidence.

Chair: Thank you for coming along today and giving evidence to us. This is the SME and consumer panel, just part of the broader Commission on Banking Standards. The evidence that you give today will be fed in for consideration by the wider commission. I should also say that perhaps it is sensible to see this as the second stage, really, in a two-part process, whereby we went to the west midlands on Monday, and met a number of small and medium-sized businesses, to hear their experiences first-hand, of credit approval decisions, availability of finance issues, and so on. So I am going to begin by handing over to my colleague, Andy Love.

Q32 Mr Love: Good afternoon. In its submission, the CBI-I will come to Matthew first-suggests that there is an expectation gap between what businesses expect from banks and what banks think is the relevant service that they can provide to businesses. I suspect that that has always existed, but what has made it more acute at the present time?

Matthew Fell: I think the gap that has always existed, if you like, is that banks perceive that they work incredibly hard, both to win and to retain customers. Particularly, the customer acquisition part of the process is essentially a loss leader for them if they just spend a lot of time, energy and effort acquiring a customer and do one transaction, and then that customer moves on. The bank does not make a return on that. So from the banks’ point of view, they perceive that they invest a lot of time and effort in that.

But the big thing that stands out from the business user perspective, particularly at the small and medium-sized end of market, is that they do not perceive any choice, diversity or innovation in the products and services on offer from the banking community. If the only variable is price-by and large, within the odd basis point, regulation more or less dictates the price on offer-they do not see and feel much choice and diversity in the financial products and services on offer. That is the sort of expectation gap, so they would welcome a lot more choice, competition and diversity in the market. I think that is where the major expectation gap exists historically, and that has been accentuated by the difficulties that are well documented regarding the cost and terms of lending.

Q33 Mr Love: Myself and others will come on to that. Let me ask Mike Cherry. You represent the small businesses’ groups. Has this expectation gap expanded as a result of the credit crunch and the recession, or is it a phenomenon that has been growing over a much longer period?

Mike Cherry: I think it is a phenomenon that has been growing over some considerable years. What you have lost in the banks themselves is the expertise that they probably used to have to assess risk. Quite frankly, as we highlighted in our banking survey back in 2007, it is the communication between the banks on what they expect the customer to be providing, and what businesses are expecting the banks to be able to provide. The mismatch there needs to be addressed.

It goes wider than that, because banks do not communicate very well when they turn someone down. They still do not point them adequately to alternative forms of finance. I think there is a lot of work that the banks need to do internally to ensure that that process happens, so that the businesses that need the money get it going forward.

Q34 Mr Love: To the other Mike, if I can call you that, we were struck, when we went to Birmingham earlier in the week, in a meeting facilitated by your organisation, by the fact that quite a lot of people wished for a return to relationship banking. They want not just somebody to have contact with, but somebody they can raise the phone to and get on the other side of the line; someone they can meet, who understands their business. Is that an important consideration in these matters?

Mike Spicer: I think it is. I think it reflects something that we have heard since the onset of the recession in 2008-09. You saw this move away from what businesses perceive to be a relationship form of banking, as you said, towards something that was driven more centrally within the structure of banks. There was perhaps more of a tendency to reject loan applications on the basis that there was not enough information put forward to the bank, rather than the banks taking the time to work with businesses on individual cases.

Just to pick up on a point of Mike’s, which I want to reinforce, it is the whole issue of trust, transparency and relationships. In anticipation of this panel, the BCC conducted a large-scale poll of chambers members only last week. We wanted to get under the skin of this whole issue of how businesses view the business finance institutions that they are working with-not just banks, but the whole range of institutions. What we found was quite worrying. Around 50% said that they mistrusted banks either a lot or somewhat. Only 49% said that they trusted banks somewhat or a lot. That might not be surprising in itself, but it might be surprising that this level of trust seems to have diminished over the last year, not grown, as it were; so there is something that needs to be done by not just banks but other forms of institutions that are providing external finance, to really rebuild those relationships and rebuild that trust.

Q35 Mr Love: Andy Davis, as a commentator on these matters: this came through very clearly in our meeting on Monday, that there has been a slump in trust between many small businesses and their banks. Why has that happened?

Andy Davis: I think there are a lot of reasons. A particular one that I would point to as being important would be the events of autumn 2008, when not only small but large businesses suffered a sudden huge liquidity shock when the system seized up. For large companies this was very worrying, because they started to fear that their suppliers would not be able to finance the orders in train and that therefore their business would literally grind to a halt for want of working capital. For small businesses, of course, it meant that they faced a very real threat that they would actually have to cease trading, because access to immediate credit became very uncertain, very difficult.

I don’t think you can underestimate the effect that this has had on the attitudes of the people who run businesses, both large and small. They have become much more conscious of the financial risk inside their own businesses. Where, before the Lehman moment, they could assume that capital was freely available almost on demand, after the Lehman moment they started seriously to doubt that fact. I think this partly accounts for why so many companies are building up cash reserves on their own balance sheets; because they can’t be sure of that liquidity. They no longer trust that that liquidity will be available from outside their company in all circumstances. I think that partly accounts for why debt-the stock of small business debt-is falling, and why liquidity inside small businesses is rising. I think it has got to do with the fundamental reassessment of their risks.

Q36 Mr Love: We will come on to those issues in more detail, but I want to focus on one of the other things that struck me about our meeting on Monday-the lack of communication felt by small businesses. For example, if they had explained the consequences of Lehman Brothers to the banking industry it might at least have gone a small way. It has always been the case that if they cancel your overdraft they just inform you, and they don’t tell you why. What is it that has changed that has made communication such a big issue?

Andy Davis: I am not sure I would know all the answers to that. One suspicion is that the banks have a lot more internal headaches than they had before, and a lot more problems on their own doorstep. The second is that, as others have said, rightly, here, there has just been a long-term decline in the relationship between individual customers and individual bankers, and this is something that lots of people regret. Some are actually trying to address it. Certain entrants in the banking market are much more relationship-based, and are being very successful as a result of this, and growing quite quickly. That, I think, to my mind, is just so central here. You cannot underestimate the importance of having a known person to talk to, who knows your business.

Q37 Mr Love: Matthew, you mention in your submission a lack of price transparency undermining competition. What do the banks need to do to address those issues?

Matthew Fell: Essentially, price transparency comes down to unbundling the products and services that are on offer. I think there’s a sense from the business community that quite often you are not quite sure what you are paying for what, in the banking services that you receive. Some of the companies that we have talked to liken it to if you are a consumer and you go into a shop or retail outlet: by and large you know what you want when you go in there; you buy the product and you know the price you pay for it. I think they don’t get the same sense of that experience with their banking relationship, so I think greater transparency across the individual products and services that are on offer from banks, and a bit of unbundling that goes on, would help the business customer drive greater competition; because they would be able to have that visibility about what they are paying for those individual products and services, and be able to see how they apply across a range of institutions, not just all bundled up from the one that is their home bank, if you like.

Q38 Mr Love: Can I just ask the two Mikes finally about whether there are any other issues, over and above those that Matthew mentioned, to address this issue of the declining trust between banks and small business customers?

Mike Cherry: Can I come back on the competition issue? We have been highlighting for a very long time indeed that there has to be more competition out there in the marketplace. We have seen with the advent of Handelsbanken, Aldermore and others coming in that that has been beneficial to starting the process, but it still has not gone far enough. On the trust and confidence, I do not think that small businesses generally would be bothered by Lehman Brothers going down, although that clearly started the process. What has really shaken trust and confidence in small banks is the IRSA issue-the mis-selling of swaps, which has hit small businesses very hard indeed. On top of that, you had the manipulation of LIBOR, which the BBA has abdicated any responsibility for and has recommended is dealt with elsewhere.

Q39 Mr Love: I’ll come to the other Michael in a moment, but let me pursue that for a second. We understand that while the interest rate swaps are a scandal, it affects a relatively small number of businesses. No one knows what the impact of LIBOR is. Are you saying to us that it is not the direct relationship between a bank and a small business customer that is causing the lack of trust, but the overall framework-all these scandals upon scandals that are coming out in the newspapers-that is causing the lack of trust?

Mike Cherry: I think it is certainly the relationship within the banks and the attitudes of the banks towards the small business client as a proper customer, so there has always been a considerable issue there, but what has really capped it recently is the IRSA issue and the LIBOR issue coming on top of everything else that small businesses find when they are trying to get something out of their banks that they believe should be there.

Q40 Mr Love: Let me just come to Mike, because he has been waiting patiently and then I will come back to you, Matthew.

Mike Spicer: To add to Mike’s point, there are other things that have played into this narrative around lack of transparency. One of them I would point out is the attempt by the Government to increase access to finance through the various schemes that have happened over the past two years. The experience of businesses on the ground is that if they have heard of the schemes, such as the enterprise finance guarantee, and approach their banks about them, often the banks have not heard of the schemes-or at least the people that they deal with in the bank have not heard of the schemes-and if they have, there is little understanding of how that can play out in their relationship with the bank. When we speak to members, we hear a frustration whereby they say, "We know that there are things going on to help us, but we do not see it at the coal face when we are talking to the banks, which is our main relationship in accessing external finance." That just plays into the narrative of some of the events that Mike picked up in his piece.

Matthew Fell: In a sense, Mike Cherry illustrated that the number of scandals and mis-selling show how far we have gone from having the customer front and centre of everything that banks do. We may well go on to explore some of these matters, but that is the core of the issue. The culture and the values that are inherent in banks that have got the customer front and centre of everything need to be at the root of the diagnosis, I would suggest.

Mr Love: I am sure that some of my colleagues will pick that up.

Q41 Chair: Before I bring in John Thurso, Andy Davis, you referred to a change in mindset on the part of small businesses as a result of the rupture in the relationship, which happened in 2008 because of the sudden change in credit conditions. What do you think that has done in terms of the real economy and the investment decisions that businesses make?

Andy Davis: Obviously, it has made people a great deal more cautious about assessing the prospects for any investment plan that they might have. I suspect that it has made people want a slightly higher hurdle rate of return to make them feel a little safer about doing it, but it has also started to make them look beyond the banks for ways to finance their businesses. That is a particular interest of mine, as members of the Committee will know, and there is a lot going on in that area to answer people’s desire for greater diversity, as well as there being new banks. But I think the effect has been to make people question relationships they did not question before or, indeed, to criticise relationships they now feel are not really relationships and to look elsewhere and, in a small way, at the margins, I think some answers are emerging.

Q42 John Thurso: I want to explore two separate issues. The first is around products and what SMEs want, what banks give and the disparity. The second, which we have been touching on all the way through and is at the heart of all this, is around access to finance. I should like to try to do the product one first. Can I ask the two Mikes, starting with Mike Cherry, because many of the SME customers are your members and the chambers also represent many of those: what products do SMEs actually want from banks?

Mike Cherry: They basically want the money to enable them either to invest or to grow their businesses, to create jobs and to sell their products to any customer who wants to buy them and to fulfil those orders.

Q43 John Thurso: As simple as that, other Mike?

Mike Spicer: May I expand on that slightly and focus on two types of businesses in particular, which we are concerned about in terms of the products that are on offer and whether they can access them and so on? The first would be companies that are looking to export. We hear a lot about the need to transform the economy towards a new model based around exports and investment. But for a new exporter to embark on that process very often requires finance, and very often it requires the kinds of specialised products that they find difficult to access from banks. Now one of the welcome trends that we have been observing is an increasing awareness of the products that, for example, UK Export Finance provide. We have done quite a lot within the chambers network to raise awareness of that by bringing together members with representatives of that body.

It was quite welcome to see in our poll last week that awareness of UK Export Finance had gone up to about one in four businesses. It has come quite a long way over the last year. The other type of business would be medium and small businesses that you might class as growth businesses, the sort of younger businesses. The trends that are picked up in the likes of SME Finance Monitor, which tends to show that businesses that are older-beyond five years and have an established record-find it easier to obtain finance and so on. But these companies that provide or would provide a real kick to employment growth are the ones that often need bridging loans and such like. Making sure that they have the products they need, as Mike said, having the working capital to carry their business forward and to sell their product and, if necessary, having the right export finance-these are all important things.

Q44 John Thurso: Do you think there are products sold by banks that SMEs don’t want but are obliged to buy?

Mike Spicer: I know we’ve got the interest rate swaps panel straight after this so I would not pick up on any particular product. But to reiterate the point about transparency and the nature of the products that they are buying-that has been the leitmotif through the submissions so far, but we would re-emphasise that point-banks really need to be clear about what they are offering to businesses.

Q45 John Thurso: I am trying not to lead the witness-we are having the interest rate swaps panel and we will go into that-but most small businesses I talked to did not want a swap. They are very happy to self-insure and take the particular risk of the variance in an interest rate or they will just take a fixed interest rate. They do not want anything in a cap and a collar and all the rest of it. But banks insist. Why are the banks insisting and why do the SMEs agree?

Mike Spicer: I can speak about the second point. Many of the issues that have been thrown up by the interest rate swap scandal are analogous to some of the issues that we have seen on the consumer side, which is a lack of transparency about, for example, what it would cost to stop a product and a lack of transparency about how the cost of that product can change in different circumstances and how it can affect a business’s balance sheet. Transparency is the key word there, whatever the product. Businesses need to know what they are getting into. They need to know what the cost implications for them are. As to why the banks insist on those kinds of products, I would have to say that I really don’t have an answer to that.

Q46 John Thurso: Does anybody want to make a point on that issue?

Mike Cherry: I think that the banks insist, purely and simply, because it is more profitable for them to sell those products, and that has been a problem all the way down the line. They are not just offering a simple banking overdraft or loan facility any more: they are targeted with selling more product or scoring more points on however that works. The reason the business agrees to them all-we have seen evidence of this time and time again-is related not just to interest rate swaps but previously to the banks trying to tie something else in, so that there is often a reason behind the move from an overdraft to a loan or from a loan to an invoice discounting product, with the bank feeling it is more profitable for them.

Q47 John Thurso: Again, I don’t want to put words in your mouth, but what you are really saying is that the products are sold because the bank is making more profit, which would imply that the original credit offered was underpriced.

Mike Cherry: I think you would have to ask the banks that question on how they price their products.

Q48 John Thurso: I very much want to, but the suspicion is that the banks, in the days of the feast of credit, were attracting people with credit that was broadly underpriced and did not have enough risk in it, and then getting their money back by selling lots of other bells and whistles as part of the package that did make a profit.

Mike Cherry: I think you could surmise that that may be the case.

Q49 John Thurso: Let me move on to credit provision, and start with you, Andy, if I may. The background to this is that Adam Posen, just coming off the Monetary Policy Committee, made a very interesting speech in which he basically put forward the concept that the reason growth in this country is so low compared with America, where it is better, is the lack of domestic credit. At least in apocryphal terms, every SME you talk to seems to have a problem. Is there actually a problem in terms of access to credit? Where is it, and what is the scale of it?

Andy Davis: I would hesitate, personally, to say that there is an absolute shortage of money available. I think there is, in the banks’ eyes, a shortage of people they want to lend to. There is no doubt that there are still companies they are very keen to lend to: certain banks have introduced specific programmes directed at high-growth businesses. I don’t think they have a blanket view of all borrowers as people they don’t want to do business with. They are much more discriminating now. There is a big tendency towards seeking collateral. Personal guarantees are now very commonly requested. People often have genuine difficulties in accepting these terms. It is asking a lot of the small business person to give a personal guarantee over the family home, for example.

I am not certain that there is an absolute shortage of money available in the system. There is a shortage of appetite for the sort of risk that lenders typically see in small businesses. That is not just that they are likely to default, as the actual rate of default in small businesses is and remains very low and has never been particularly troubling: the problem from the banks’ perspective is that lending to small businesses is very illiquid and you cannot get your money back quickly if you need it, if conditions change. It is a commitment that you make over a number of years, and they are much less keen to enter into that level of commitment with such a large range of customers than they were before the credit crunch. It has to do with terms and collateral as much as with supply.

Q50 John Thurso: Can I go through that with the whole panel? Matthew, I have not come to you yet, so let us bring you in.

Matthew Fell: I would endorse a lot of that. The overall picture very much depends on the nature of the business, and we know that there are certain business sectors, particularly around the housing and construction-related industries, where, pre-crisis, banks were overloaded. It is now going to take an outstanding loan proposition for them to agree to anything, or to write any further business in those sectors relative to many others. I would also agree that bigger issues are around cost and terms rather than pure availability. You see that borne out in the rise and spreads over base rate, particularly for small business lending, which has grown by one or even perhaps two percentage points over three or four years.

Q51 John Thurso: May I stop you and ask a question? On Monday, when we were in Birmingham, a unanimous thought was put-at least on the table of people I was with-that we do not care about the cost of finance; it is actually being able to get it at all. The interesting thing was that businesses tended to be very much at the small end, rather than on the SME spectrum. Are we therefore wrong to talk about SMEs in one breath? Should we segment them from the micro to the small to the medium to the almost big, because they all have different pictures?

Matthew Fell: I agree with that. The most acute difficulties on pure availability would be at the smallest company end of the spectrum. Even if it is available, that is where you tend to find the most onerous requests for guarantees. The only other thing that is worth throwing in the mix as part of this debate is, rightly or wrongly, that some of the regulatory reforms that are taking place make small business lending, as well as some trade finance lending, much more unattractive for banks as a purely rational commercial decision than was the case four or five years ago.

Q52 John Thurso: This is a general question, so I am happy for anyone to come in on it. It is to do with credit scoring. Several people who know about this have contacted me to say that the algorithms used in credit scoring are essentially flawed. While they are an okay tool, they most certainly should not be the way in which credit is either given or denied. On the other side of the coin there is the lack of a relationship with a traditional manager who knows you and your business. Put those two together and you get a lot of denial of credit, so the allegation goes, and it is good business that is being turned down. Is that thesis correct? Mike, you will probably want to kick off on that.

Mike Cherry: I will, if I may. What we have found in several bits of evidence that members have given to us is the fact that, at that very low level-that relationship level where there is someone they can talk to-there is very often the idea that this is a positive thing and they are more supportive, but then it goes that one step up and that is removed. It might be the algorithm that is at fault or something else. Scoring is completely opaque as far as most small businesses are concerned. They will say, "We do not know about it, it is not transparent, we do not understand it." There are areas that need to be looked at going forward. Very often, once they have gone to that next level, the answer comes back no, although it may be a perfectly viable and attractive proposition. Indeed, if it were not, why on earth would the manager at the bottom end have said that they could support it? That problem has been exacerbated over the past four or five years, but it was apparent in some cases before.

Coming back to Matthew’s point, we would very much welcome the idea that micro and small are recognised outside the true generic SME term that is so often used, but has no relationship to that smaller end of the marketplace. There you have problems around cost and sectoral problems. Generally, the money is still there. Whether it is at a price that a business can afford or wants to accept is debatable, but the security question very much kicks in for start-ups or for young businesses wanting to grow.

Q53 John Thurso: May I just pursue you on that? When I was talking yesterday to one of the big banks, they told me that, first, they had never had such a high level of deposits from SMEs in banks; and, secondly, that they did not have the people to lend to and that they had money available everywhere. One of the things we are trying to do is to knit together such statements-all the banks are making similar statements-with the fact that, through our constituency surgeries and through your and everybody else’s research, and through Bank of England surveys and everything, there is the absolute reverse picture: "We can’t get any money." This appears to be the question. Can anybody help me to knit these two together?

Mike Cherry: I think that you have a problem to start with. When we talk-and probably when you talk-to the senior people in the banks, they have got the message, but it is not actually being delivered on the ground. That is very clear from what our members are finding. At the end of the day, you have to try to break through that and make sure that that very bottom end of the marketplace is split out when the banks are saying, "Actually, we are delivering to small businesses." This goes back to the micro and small, and to that generic term "SME".

Andy Davis: I think it is true that banks have record quantities of deposits from small businesses. Obviously, businesses that retain money within themselves on their balance sheet will tend to put it in their bank, so that really reflects how much cash a business wants to keep close by in order to feel safe. However, it also reflects a rebalancing between debt and equity, because it adds up to businesses carrying more equity and less debt.

To be devil’s advocate for a moment, I do not think that anybody here would necessarily agree that every business should be able to get credit at a highly advantageous rate. Part of the problem, surely, that we had leading up to the financial crisis was the fact that credit was almost universally mispriced, so part of the solution is for it to be more correctly priced, which means that for some people it is going to be harder to get. That is not necessarily in the interests of the economy as a whole, but surely one of the things we are asking the banking system to do is to lend more prudently.

Q54 John Thurso: To follow that up, what you are really saying is that we have been through a decade-plus where we have financed a lot of small businesses through very inexpensive bank-provided debt, one way or another, or through equity released from houses, or all of those-asset finance of one kind or another-when actually our real problem in this country is more to do with finding equity.

Andy Davis: The way I would characterise it is that across business, from probably about the mid-90s to the mid-noughties, there was a generalised shift away from equity and towards debt on corporate balance sheets; they just changed in character. Typically, investors were saying to businesses, "Make your balance sheet more efficient. Leverage up. Don’t be so flabby," so managements were being pushed in that direction. Banks had very cheap and very plentiful credit to supply, and that changed the character of business balance sheets generally. What we are seeing, partly, is a move back in the other direction, where equity is replacing debt. That is part of deleveraging, and it is partly why small business deposits are very high.

Q55 John Thurso: This is the last question, and I am happy for anybody to come in on it-you might all want to. It was briefly mentioned that the Government’s schemes are not necessarily delivering on the ground. That was something that came through again from our evidence day on Monday. People said, "Absolutely wonderful schemes, but either my bank does not know about them, or they are not being delivered." What should we be saying to the banks, and what actually is the lesson for the policy maker side of it?

Andy Davis: One of the things it is fundamentally about is customer service in the branch, to be honest. People are not sufficiently familiar with their own bank’s products, in a lot of cases. They are not sufficiently familiar with the customers who are coming through the door. Many banks have a terrible problem in IT, in that they have multiple systems and find it impossible to take a single view of a customer-whether a retail customer or a business customer-if they have a mortgage, some insurance and some basic banking products. There are all sorts of impediments to getting customer service right, but were those to be addressed, many people would have a much better experience of banking than they currently have.

Matthew Fell: I have a couple of things to say about that. First, I do not think that the sheer number, and complexity, of the attempts to intervene in the market by Government helps. In a sense, having that single portal, or a one-stop shop notion––what they are called on the tin or what the back office wiring looks like––is not really a concern for small business. I think a message about the complexity of the well-intentioned interventions would help.

The second thing that would help is clarity about what these interventions are designed to do, which goes back to a market gap analysis of what the actual problem is. While the perception is that some of these interventions are going to make lending much more freely available than previously, I do not think that that has ever worked. If you took a forensic look at what some of these interventions were ever going to do, they might have made a difference at the margins. Around costs, for example, they might have tipped some availability from a grey zone, which might have been a no or a yes, into positive lending. I do not think they were ever going to shift things by the order of magnitude perhaps suggested by the expectation that built up on the ground.

To illustrate that, we saw this week’s announcement about a Government business bank. That is a good development in its own right, but it needs to be really well targeted if it is going to make a difference. Consider the sums being talked about, with the Government initially putting in £1 billion. The major five banks collectively lent around £75 billion to the SME business community last year. Unless this is really well channelled to a gap in the market, it is not going to do much more than cause a ripple in the system.

Mike Cherry: Certainly from the banks’ point of view, it comes back to how they train their people and get them to understand what these initiatives are. With the previous Administration’s enterprise finance guarantee scheme, which initially was not well understood and was not delivered by some of the banks, we see that it still requires a considerable amount of security on occasions. There is confusion in the business community about what is or is not expected. You then had Project Merlin, which failed, quite frankly, to get down to that smallest end of the marketplace, even though the banks will say that the headline figures have delivered. You had the national loan guarantee scheme in the spring of this year, which is now being replaced by funding for lending, which is purely and simply about cost rather than access to finance. While we very much welcome this week’s announcement of a business bank, we would hope that there is enough time before it is implemented actually to deliver what small businesses need.

Q56 John Thurso: I do not want to put words in anybody’s mouth, but the message I am getting is broadly, "Don’t fiddle around with lots of new schemes. Make the existing schemes work and, if necessary, when they are working, make them bigger, but don’t keep changing them."

Mike Cherry: Yes.

Q57 Lord McFall of Alcluith: Andy made a point about IT. This is not the area that I want to ask questions about, but I have heard elsewhere that the state of IT systems in banks is pretty poor, and that it will take years and lots of money to correct them. Is that true of banks generally, or does it relate only to particular banks?

Andy Davis: I think that is a fairly generalised view. It partly comes from the amount of consolidation and merger in the industry. When you put companies together, they have different systems, and it is difficult and expensive to integrate them. If you are a bank, it is very high risk, because if you get it wrong, as we have seen, you can cause major headaches for people.

Q58 Lord McFall of Alcluith: Should we consider that in terms of customers’ experience of banks?

Andy Davis: It is relevant, yes; I think it makes a difference. It also makes it much more difficult for the banks to provide a decent service for people. They simply do not know what products people have from them because they cannot take a view that encompasses everything. That is their fundamental difficulty.

Q59 Lord McFall of Alcluith: You have done a report on the issue of complaints and redress, but this question is open to others as well. On our visit to Birmingham on Monday, all of us experienced the problem of businesses being frustrated in their relationship with banks, particularly if something had gone wrong. Has there been a change in banks’ handling of complaints as a result of the crisis?

Andy Davis: As you say, I have written a report, but not in that area, so it is not something that I would claim to know about. The only thing I would say from personal conversations is that people generally feel that they do not get enough feedback and that they are not guided about why they are unsuccessful, if they are unsuccessful, and what it would perhaps take to become successful. That is the general feeling of people.

Q60 Lord McFall of Alcluith: Is complaints handling widespread or focused on particular banks? If we were to take Monday’s experience, it seemed to be widespread, but I should like your view.

Matthew Fell: The complaints handling piece is something that does not really feature in conversations we have with our small, medium and large businesses. The relationship aspect comes through much more strongly, as does the idea of a dialogue or partnership approach to saying what is required and what businesses need. We hear a lot about what will get a lending decision green-lighted on the relationship side of things. From our perspective, the aspect of complaints handling is not something that companies focus on.

Q61 Lord McFall of Alcluith: Any other comments?

Mike Cherry: If you look at the number of refusals that are overturned by the new appeals process, many of the reasons are because the staff are just not asking the right questions or not trained properly, so there is an inherent problem there, but it is wrong to have a procedure that allows so many to be overturned on appeal.

Q62 Lord McFall of Alcluith: What about the external complaints mechanism? Is the cap on the size of a business that can access the Financial Ombudsman Service set at an appropriate level? At the moment, it is an annual turnover of less than €2 million and fewer than 10 employees. Has that come across your radar?

Matthew Fell: Not for me, personally.

Mike Spicer: That particular issue has not come up, but what has is the extent to which business is aware that appeals processes exist. When we ask member businesses what they did if they had had a loan rejected or an overdraft facility withdrawn, it comes through strongly that the awareness of the appeals process is quite low. I think that I am right in saying that the most recent report from the SME Finance Monitor gives hard evidence to that anecdotal information.

The other complaint we hear about customer service is on the lack of feedback about alternative sources of finance that can be accessed. There does not seem to be a widespread signposting of the services that might work for a business in particular circumstances. It really does go back to having a relationship of trust with your bank manager that can then be played out in ways such as, "Well, this might not be appropriate for you, but there are other products out there." Those are the sort of things we hear from members.

Q63 Lord McFall of Alcluith: We know that the OFT is responsible for the supervision of unsecured credit provision rather than the FSA. Does that have an influence on the level of banking standards?

Mike Spicer: I am not really sure that I am well placed to answer that, but the most important thing from the business point of view is-whatever the process is and whatever institution is overseeing it-that awareness is as high as it can be. Without that, you always run the risk that you are feeding into the negative perception that discourages demand for external finance. Clarity around the process is the major issue at stake.

Q64 Lord McFall of Alcluith: A question to sum up: in terms of complaints, is it a happy place at the moment-between banks and individuals?

Mike Cherry: I do not think that it is a happy place to be at all. What you need is either a yes or no, and transparency in the process, so that if you can get that money elsewhere, you are pointed in the right direction.

Q65 Lord McFall of Alcluith: And they are not getting it?

Mike Cherry: No.

Q66 Lord McFall of Alcluith: So it is a problem.

Matthew Fell: I would put the emphasis squarely back on the relationship banking issues.

Q67 Chair: Like Mike Cherry said, this is not a happy place. With those who do know about it, and who make a complaint, question the decision and make an appeal, have you done any work on what proportion manage to get a decision overturned at a higher level?

Mike Cherry: As I say, if you look at the current appeals process, where four out of 10 are actually overturned, there is clearly a procedural problem within the banks meaning that they are not allowing those to be accepted in the first place.

Q68 Chair: So the issue is not so much that the appeals process doesn’t work-it does work for four out of 10 who make an appeal-but that not enough people know they can do so.

All Witnesses: Yes.

Matthew Fell: And probably the threshold point in the first place, I think, is what you were alluding to, Mike, but actually the fact that they need to go to that stage to get the decision overturned probably suggests that the bar is set incorrectly in the first instance.

Mike Cherry: Whether it’s the algorithm that dictates that that should be a "refuse", and then something else comes in to overturn it, I don’t know, but something is wrong.

Q69 Mark Garnier: If I may, I am going to turn to competition and choice-Mike Cherry, I will start with you. You mentioned a bit earlier that you thought that competition was a big problem in this, and you talked about the challenge of banks coming in-in particular Handelsbanken and Aldermore capital-but what do you understand by the context of competition, and what do you think your members are seeking to get out of improved competition?

Mike Cherry: We want to see more competition, because 84% of small business lending is currently within the five main banks, and they are all offering very similar terms. They all have very similar ideas of how they do not deal with small business, necessarily, which is shown by the lack of finance that small businesses are actually able to get. I think it comes down further to making sure that when you have these new challenger banks coming in, they tend to have better training and better understanding of the business to deliver what the business needs, and also make it clearer what their requirements are for somebody to approach them in the first place.

Q70 Mark Garnier: So what you are not talking about, necessarily, is competition in pricing terms. It is actually competition in the service that can be offered and the breadth of product.

Mike Cherry: If you look at the pricing, as we heard earlier, it is not so much of a big issue. It is the access to the finance in the first place. Pricing, if the business plan actually stacks up-and you find this whether it is community development finance institutions, or alternative forms of finance that businesses are able to go to-is often affordable. It is the fact that they are not getting the money in the first place.

Q71 Mark Garnier: Are you finding that these challenger banks like Aldermore and Handelsbanken are actually being effective?

Mike Cherry: I think they are beginning to show some change in the marketplace. I don’t think there is enough competition out there yet to make sure that there is a sea change, but I think you are seeing other forms of finance coming in, whether it is cloud funding or others that are becoming very attractive to businesses. While they are just starting off, that is certainly something that the banks need to be aware of.

Q72 Mark Garnier: In terms of the choice available to SMEs-if anyone else wants to leap in on any of these questions, please do-are you finding that there is limited choice? You talk about 85% seeing the same model from the same big five banks, but I have certainly seen in my constituency that people are desperately frustrated that there is no specialist in aviation finance, marine finance or that type of thing. Is the choice out there just too limited?

Mike Cherry: I think there is a lack of understanding in the banks and in the people that they now use, perhaps, because whether you look at a bill of exchange or something like that, they are now held in commercial centres. The local managers and staff just don’t understand a lot of these products, so it is very much more concentrated in regional hubs, or however the banks do it.

Matthew Fell: I agree that to the extent that people are looking for greater choice, it is often around some of the non-price factors, if you like, in terms of the quality and innovation of product. I think that it would be a welcome boost to competition if there were a wider range of factors for companies to choose from. I think if you then drill down into what could really make a difference to increase competition, there are huge barriers to entry in this market from a regulatory perspective-capital liquidity requirements, the FSA approval process, and so on. Whenever we talk to businesses, the one thing that they perceive could make a difference to encourage the challenger bank part of the market would be an emphasis on infrastructure sharing within the banking network-for example, to increase the range of activities in individual bank branches that banks will undertake for rival firms, such as deposit taking and so on. That would make quite a difference, particularly for the small business community, if you extend the network. Thirdly, it would be a really good thing if companies were able to access what you might describe as non-bank finance. That is where we start to unpick what are the types of finance that companies require.

Q73 Mark Garnier: Are you suggesting equity-type finance?

Matthew Fell: A combination of both debt and equity. If you take a forensic look at the medium-sized, mid-market business, the gap there that is on offer is what you might describe as patient capital, which is investment money over a longer-term time horizon, which might be a combination of debt and equity. Some sort of diversity and choice in the types of financing on offer to business beyond pure bank debt financing would be a good development in the marketplace as well.

Q74 Mark Garnier: Andy, you mentioned earlier the lack of a personal touch. We have heard from a couple of other witnesses about the lack of expertise within banks. That is changing. What is your take on this from the point of view of competition?

Andy Davis: One particular interest of mine, as you may know, is the growth of non-bank choices-the shadow banking sector, if you like. It is very small and some people are very scared of it because it is perhaps thought to be not as regulated as it should be, but it already demonstrates certain things that are interesting and indicative. One of them is that a major reason why people go to peer-to-peer loan providers is that they get lending decisions very quickly, which is a critical factor for business people. They do not want to spend two or three months going through a lending process in order to get a no. You can get a decision in a few days through these people, and that is attractive. Irrespective of the price of the credit, if you need the money and you want it now, getting a quick decision is attractive.

Q75 Mark Garnier: Are you finding that it is dealing with the illiquidity problem that was mentioned earlier-that in peer-to-peer lending, people are more flexible about the terms?

Andy Davis: You can overplay this. There are not many examples, for a start. This is a very small phenomenon. However, on Funding Circle, which is the best known of the ones that exist, there is a secondary market in loan parts. In other words, if I lend money to a company and then I decide that I want my money back, I can get it back by selling those loan parts in their secondary market. Therefore I have transformed an illiquid asset into a more liquid one, from my perspective. That is maturity transformation. That is one of the things that banks do, and there is a very interesting seed there. How big it gets, who knows? But it is interesting. Another interesting thing about these operators is that they tend to use markets to set the price of credit, so you have some transparency about what the market wants to charge for credit at this moment. Again, that is a different model.

To be honest, I like competitive markets. They are not without their dangers but I like competitive markets. They also can encourage flexibility in terms of trade. Certain of the ways these products are sold in traditional channels tend to involve quite long lock-ins and certain sorts of fees that go around the basic product, such as service fees, arrangement fees and what have you. You pay those irrespective of how often you use the facility. Some of these operators work on a more pay-as-you-go basis, so you pay for what you use and you don’t have that tie-in. You have more flexibility as a business owner. So again, the terms of trade can evolve. That is an important kind of competitive advantage. It is happening at the margins, but it is important.

One other thing I would say-this was picked up in the Breedon report-is that banks sit on a great deal of information about their customers and about their borrowers. One of the key assets you have as a lender is access to the current account because that lets you model the cash flow. Once you have the current account, you know the cash flow of the business, and that is a key piece of information in terms of how creditworthy it is. Breedon concluded that one of the things that might be needed is more information sharing. Access to those critical bits of information would help to promote competition in the market.

Q76 Mark Garnier: What are the barriers for an SME wanting to move its account from one bank to another? My notes here say that information sharing is one of them, but what are the others? We talked about there being five banks covering 85% of the market, but the chances are you are only using one bank, and that does give you a choice of four others. Why aren’t people taking advantage of that opportunity?

Mike Cherry: I think that when people have a facility with their bank, be it an overdraft, loan or anything else, they are always scared to move, because they are not sure they will be offered the same facilities.

Q77 Mark Garnier: Why are they uncertain?

Mike Cherry: The perception, real or otherwise, is that they just won’t be offered it on the same terms, or will maybe have it refused or withdrawn at some stage, for whatever reason.

Q78 Mark Garnier: But surely they can pick up the telephone and ask.

Mike Cherry: Who do they phone? Who do they ask? That would be the first question, because they don’t have the name of the person. If they go into the branch, it could be somebody who is totally ill-informed, untrained, and does not know the business or product they are asking about.

Q79 Mark Garnier: But are not the banks trying desperately to get more business?

Mike Cherry: One would hope so, but clearly they are not doing it, because our members are finding that they still are not getting the access to finance they need from the banks.

Matthew Fell: I think this comes back to segmenting the market. Banks are absolutely looking for customer acquisition in what they would see as the more attractive parts of the market, but as I mentioned earlier, on a purely commercial basis. At the smallest end of the market, which regulation interprets as riskier for the banks, where they need to hold significantly more capital against lending-they are looking to deleverage in sectors that they are overexposed to pre-crisis, such as real estate and construction-I do not think there is the same appetite for customer acquisition. That is where forensic segmentation of the total business market, including down to the micro end and across different sectors, is needed to inform the debate.

Q80 Mark Garnier: Is this lack of transparency an important part of it? Is it very difficult to unbundle-I think you said-the complex products and try to understand what is going on and what the different services are?

Matthew Fell: I think that price transparency plays into it, because if that took hold you would see companies looking at different providers for different parts of the product, rather than purchasing everything from a single financial institution, and that in itself would be a good driver of competition.

Q81 Mark Garnier: Having the choice to buy one product from one person and another from another?

Matthew Fell: Correct. You might do lending from one and risk management from another, and so on.

Q82 Mark Garnier: On a slightly different subject, we have the next session coming up on the interest rate swap problems, and the FSA is looking into this and there is an ongoing investigation. Part of that process of resolving those problems is taking a bit of time. Are you finding that your members are suffering as a result of an unduly long process to try and unwind the situation?

Mike Cherry: The simple answer to that is yes, we are getting evidence of the problem around the time, and there are a lot of other issues around that, and particularly around the fact that we are not seeing independence in the process, which is a big issue for us. If you want to come on to that shortly, we can elaborate a bit on that, but yes, time is an issue.

Q83 Mr Love: There has been some comment on the proposal for an investment bank, with funding for lending working through the orthodox banking system. If relationships are as difficult as has been suggested today, should we be doing that in another way? Is that an issue? I have heard various proposals for alternatives to banks, but is there an alternative that could be up and running in a relatively short period of time? Perhaps I can ask you, Andy, as a commentator.

Andy Davis: These things tend to be done through the banking system for good reason, and I suspect that is partly to do with state aid rules and such measures, so it may be difficult to leap the fence immediately with an investment bank. That is only my understanding, albeit imperfect. I am not sure that you can quickly magic up a large-scale, fully operational answer to this problem in any form.

Q84 Mr Love: What is the impact? That means that there is no competition to the banks. Effectively, small businesses only have banks to go to. There is that lack of competition.

Andy Davis: The Government are doing things to encourage competition. The business finance partnership money is going into alternative lending sources to try to seed them and accelerate their growth. That is obviously working, but there is a limit to how fast these things can grow, even when they are really successful. It does take a lot of time to change a market that has consolidated as far as this one has.

Q85 Chair: Before we close, is there anything that you want to say or stress to us that has not been covered in the questions today?

Matthew Fell: In our written submission to the Committee, we focused quite a lot on where the changes are that would really go to the heart of tackling culture and standards in the banking institutions, and we have not spent the majority of time on that today. Most of that change would have to be driven through individual institutions with significantly increased individual accountability, so, for example, driving through corporate governance reforms and much more visibility and emphasis placed on risk controls. There should be a culture within individual institutions to escalate those issues and consideration of how to hold individuals to account. If we are looking at putting customers front and centre of what banks do, that then has to be at the heart of the value system within the banks, and the systems, processes and governance measures must all be squarely lined up behind that within individual institutions. I know that in our written submission, we focused a bit on that. If you are looking for solutions that go to the heart of a culture and values system, that is where we would see most of the productive reforms taking place.

Mike Spicer: In our written submission, we also submitted our blueprint for a British business bank. Of course that has been announced this week. When we were talking before, we said that that would happen in some form. I just want to pick up on the very last point about what you can do quickly and whether more things can be done. First, even if the bank does not have shop fronts on the high street there are still things that it can do pretty quickly, such as act as an aggregation vehicle for the securitisation of SME loans. In terms of originating loans and of having the capacity in-house to analyse creditworthiness and so on, I do not think that there are the state aid issues that were brought up before. For example, if that bank was open to taking loans from companies anywhere in the EU, the state aid would not be an issue and if those loans were provided at commercial rates, they would not fall foul of state aid rules. Although we really welcome this week’s announcement, we would like to see, as soon as possible, that move towards a model where the British business bank is originating loans and acting as a player and providing the sort of competition that you were talking about before.

Andy Davis: We also should recognise that, to some extent, we want two things that are irreconcilable. We want a safer financial system and better access to credit. It is a Venn diagram and it does not totally overlap. There are going to be some unintended consequences of a safer financial system that will make the other part of the remit harder.

Mike Cherry: As I have said, we very much welcome the announcement of a business bank. It needs to be the start of a process that leads up to a small business administration. I am sure that some of you are aware that we have been calling for that for some time now. On banks themselves, there needs to be transparency and proper training at a local level. They need to change their attitude and ensure that small businesses are seen and dealt with as the customer. In our submission, we recommended looking at community banks, and, more importantly, that the mis-selling of swaps should be an independent process, and we would hope that that is taken back to those who need to hear that message.

Chair: We will turn to the mis-selling of swaps in a few minutes. For the moment, I thank all of you for coming along today. Everything you have said will be considered by us when it comes to putting together our final report. I propose that we take a five-minute break and start the interest rate swap session at 4.15 pm.

Sitting suspended.

Examination of Witness

Witness: Abhishek Sachdev, Vedanta Hedging, gave evidence.

Chair: Mr Sachdev, thank you very much for coming along today. This is part 3-the third and final part-of our afternoon evidence-gathering session. The first two parts were on consumer issues and on small and medium-sized business issues, but for the next period we want to make a particular examination of one issue that has been very prominent in the business-lending field in recent months, which is the interest rate swaps issue. We are very grateful to you for coming along to give evidence to us today, and I turn immediately to Mark Garnier to begin the questioning.

Q86 Mark Garnier: Thank you very much for coming in. May I ask a very open, general question at the very beginning? What is the difference between a loan with an interest rate swap attached to it and a fixed-rate loan over a certain period, rather like a fixed-rate mortgage?

Abhishek Sachdev: That is actually a rather complicated question to start off with. A loan with a swap is designed essentially to give a business a fixed rate of interest. A loan is typically payable at a variable rate-in the UK, that is going to be against three-month or one-month LIBOR, or against base rate-and then, to protect the business against rising interest rates, they enter into a separate derivative contract, which is an interest rate swap. That essentially compensates the business in case interest rates go up, and if interest rates go down they actually have to make extra payments on the swap, so it gives them a fixed rate.

A fixed-rate loan can be designed in two different ways. One is that you have a loan and a swap packaged together, so the actual effect of it is exactly the same, but the business just has one payment going out of their account every month. The other way of structuring a fixed-rate loan is like fixed-rate mortgages, where you have a known specific, defined penalty clause if you want to come out of it early. Different banks over different time periods have structured their fixed-rate loans in one of those two ways, and they are radically different.

Q87 Mark Garnier: How does a bank structure one of these so-called swaps? Just for clarity in this session, why don’t we talk about what these swaps actually are? As I understand it, there are ultimately three different types, one of which is a cap-and-collar arrangement, so you have an upper and lower limit. The second is a lower limit, which has a penalty attached to it, which acts more like a noose than a collar. I think that that is it. If there are any more, please say.

Abhishek Sachdev: Essentially, there is almost an infinite combination of derivatives out there, because these derivatives are over-the-counter derivatives, which are designed and customised purely for that specific business.

Q88 Mark Garnier: For a specific customer?

Abhishek Sachdev: Yes, be it a small or large business. You can, as you mentioned, combine different swaps, caps, collars and options-combine all sorts of weird and wonderful derivatives together-to achieve different outcomes. There are different families of products, such as swaps, collars and caps. What you are referring to when you mention penalty clauses is what the FSA calls structured collars, but there are many different types of product out there.

Q89 Mark Garnier: If we take a very large company, which was trying to finance a major capital investment, such as building an oil rig or something huge like that, and wanted to raise finance for that, it would be perfectly reasonable that its treasury department approached a bank to try to limit its exposure to interest rates by having one of these products purpose or bespoke-built for that particular loan. Is that the typical way that they first came about?

Abhishek Sachdev: Yes, absolutely. Interest rate derivatives are just part of hedging derivatives, which are designed for risk management. Whether you are looking to protect yourself against the price of oil, such as British Airways may do, or whether you are trying to protect yourself against the dollar with the euro moving against you, or whether you are producing an oil rig and you are trying to protect yourself against lots of debt and interest rates going up, it would be perfectly normal to use a derivative.

Q90 Mark Garnier: But in that particular case with the oil rig, you would have a highly sophisticated treasury department within that organisation, which is used to handling very large amounts of money and which is used to talking to professionals at investment banks. There would therefore be a similar level of knowledge between the institution that wants to buy the product and the institution that is creating the product. Is that fair?

Abhishek Sachdev: Yes, it’s fair, although the situation is more complex than that. I think that derivatives, such as these interest rate swaps and even some of these ones that have been appearing in the headlines, can be appropriate for small businesses.

Q91 Mark Garnier: I am trying to understand how they originated in terms of the very specific, very complex structures for very complex demands, to how they seem to have morphed down the scale. You started with a big investment bank with a big treasury, and now we are looking at the other end of the scale, where you have an off-the-shelf product, which is being sold to an SME-possibly even a micro-business-which would not necessarily have the same level of expertise and which would not necessarily have a bespoke product created for them.

Abhishek Sachdev: Absolutely. These products have been around for many years and, especially in the UK, the banks have only started to market and actively sell these products to small businesses from 2004 to 2005 onwards. In that period around 2008, they started selling to much smaller businesses. The reason for that was that their technical and trading systems allowed them to take on smaller and smaller risks.

Q92 Mark Garnier: So this is all the background stuff, and the investment bank created the product.

Abhishek Sachdev: Correct. That is one side of it. The other is the continual pressure on margins and trying to earn a greater return of equity. I think it was Mike Cherry in the previous session who said that these things often relate to profitability. Actually, what would happen is that the credit margins that were being provided would not cover the cost of capital in some cases.

Q93 Mark Garnier: I definitely want to come back to this point, because the motivation for the bank selling them is the key point. What I want to concentrate on at the moment is the level of expertise in the marketplace that it is being offered to. I think you said that they were first being sold in 2006. Were these pretty simple, straightforward, vanilla products? Could you describe the product in 2006 that would have been typical of the high street?

Abhishek Sachdev: The products, even in 2005 and 2006, were quite complicated, even the ones for SMEs.

Q94 Mark Garnier: Can you give us an example?

Abhishek Sachdev: Sure. The simplest kind of product essentially is a swap, which basically just provides a fixed rate of interest to a business. That is the outcome of it. The actual cash flow and the mechanics of it, and the fact that there is a separate derivative that the business enters into, which is independent of its loan and therefore independent of its relationship bank, mean that it is potentially quite a complicated product.

Q95 Mark Garnier: But would that feel to that business like a fixed-rate mortgage that any of us around this table might buy, in practical terms?

Abhishek Sachdev: Yes, it would.

Q96 Mark Garnier: And the risk would be the same?

Abhishek Sachdev: Well, this is the difference. The risk would be that if interest rates fell, there would be significantly large exit payments to make on that swap if they were to cancel.

Q97 Mark Garnier: But that would be no different from a normal fixed-rate mortgage.

Abhishek Sachdev: Again, it depends on how that fixed-rate mortgage was structured, but yes.

Q98 Mark Garnier: For an SME owner who may well have bought himself a house and who might have got a fixed-rate mortgage for five years, he kind of understands what that is. He buys that, and he knows that if interest rates go down, he just got unlucky, but if interest rates go up, he got lucky. Either way, he is stuck for five years on 5% or whatever it happens to be. To all intents and purposes, an interest rate swap for a business behaves in exactly the same way. To a certain extent, you would have done your cash flow in the business and you would have worked out that you could afford that for five years, at whatever the rate of interest. If it goes down, unlucky, but it is not the end of the world because you have planned for it. Is that a fair assessment?

Abhishek Sachdev: Yes. I think you are right. First, a lot of the analysis you just mentioned is one of the things that often was not done. That is one thing that we should discuss later on. But you are absolutely right: if a business had a five-year loan for, say, £1 million, and it had a five-year fixed-rate loan, the effect on the business would be exactly the same as if it had just a five-year swap, which would match the debt and maturity of the loan. The net effect on the business would be exactly the same.

Q99 Mark Garnier: So it is not unreasonable that a businessman would have a reasonable understanding of what that kind of product was. Challenge me back if that is not the case.

Abhishek Sachdev: No, but the difference is this. Unfortunately the term "fixed-rate mortgage" or "fixed rate" is deceptive. Often, how these things are positioned to small businesses is that it is like a fixed-rate mortgage. But as we have just discussed, a fixed-rate mortgage, to a lot of people, means that if you come out of it, there is maybe a 2% or 3% penalty clause irrespective of market conditions. That is what a lot of small businesses thought they were getting, perhaps. But when it turns out that they want to refinance, pay back their loan early or make some sort of alteration, they are potentially hit with penalty charges or market charges, as they are called, of anything up to 20% to 40% of the loan amount. That is not something that they knew about at the outset.

Q100 Mark Garnier: How would the bank justify that?

Abhishek Sachdev: It is not the bank justifying it. It is a real cost to the bank.

Q101 Mark Garnier: Sure, but how would they calculate that?

Abhishek Sachdev: Again, it is relatively complicated. How swaps actually work is, at the time of providing, say, a five-year loan to a small business-if they are providing a five-year swap-the bank would simply go the wholesale money markets at that point in time. Just like there is a rate for the currency moving every second every day, there is a rate for a five-year swap. Only they have that information, and sophisticated customers have that information, so they know what the rate for a five-year swap is. They simply purchase that five-year rate from the market, add on their margin to it, and provide it to the small business and say, "This is your five-year swap rate." That is fine at the outset, and that is how they make their money.

What then happens is that if, two years down the line, interest rates have gone down and the small business wants to get out of that swap, the bank still has an obligation to the counter party. If it wants to unwind that transaction, it will need to unwind that into the market. If interest rates are lower, it has to compensate that counter party for the difference in interest rates.

Q102 Mark Garnier: So it is paying the cash flow on three years’ worth.

Abhishek Sachdev: Absolutely. It is essentially the net present value of those cash flows for the future period, which essentially means that this penalty clause, or exit charge, is not a kind of penalty imposed by the bank. It does not make any profit for the bank. It is simply the replacement cost of that derivative in the market.

Q103 Mark Garnier: Okay. So that was a pretty straightforward five-year term loan.

Abhishek Sachdev: Yes.

Q104 Mark Garnier: So as we wind on a little bit further on this, it seems that we get some slightly more complex products. You are now getting to a stage where you have a band or a cap and a collar. Sometimes the collar has a penalty. When did those come in?

Abhishek Sachdev: Again, they have been around for a long period of time as well. I have seen many instances where even as early as 2004 and 2005, very small, unsophisticated businesses were being sold these relatively complicated products.

Q105 Mark Garnier: These are not attached to the loan. The loan is one thing and the product is separate?

Abhishek Sachdev: Correct. These are all separate, independent, stand-alone derivatives.

Q106 Mark Garnier: So a business owner is now going along and doing one thing, which is to take out a loan, and separate to that he or she then buys a product which then limits that price movement or the interest rate movement within a certain parameter.

Abhishek Sachdev: Correct. But these sort of collar products and even what the FSA has termed a structured collar type product, which potentially has its penalty clause in there, although they are necessarily more complex, do not necessarily have worse consequences for the small business than a standard, straightforward swap does. In fact, depending on what happens to interest rates, they can work out more beneficial for a business. It just depends on what happens to interest rates thereafter.

Q107 Mark Garnier: So if interest rates go up you’ve done well and if interest rates go down it is unfortunate?

Abhishek Sachdev: Potentially, absolutely. There is no perfect hedging product unless you are looking at something back in hindsight.

Q108 Mark Garnier: Let me ask about the term of the loan. Say I am a business and I want to fund something. We talked about a five-year term loan, for which there was a penalty if you had to unwind it because you’ve got the net present value of the product. However, if I am a business wanting to finance something over three or four years and I then want an early repayment, if I take out one of these interest rate products is it cancellable at any point or does it run on and on? Does it have a fixed term? How does it work?

Abhishek Sachdev: No. When a swap is entered into it is purely created for that client on that day. The term of the swap, what is called the notional profile or the amount of borrowing that you choose to have on the swap, is completely customised for that business.

Q109 Mark Garnier: So even a very small business will have a customised product?

Abhishek Sachdev: Yes, because this is not an off-the-shelf product. These are not exchange trader derivatives. These are OTC derivatives which basically means that they are created on that day for that business.

Q110 Mark Garnier: We have had examples in our postbags of businesses that have had loans of one period and a product of a different period. Why would a bank sell a mismatched product?

Abhishek Sachdev: Again, this is a complicated question. There are valid justifications why a business may have a mismatch in their swap term and their loan. For example, if there is a business with a five-year loan and it feels that it will always have an amount of core borrowing in its business, but at that time a 10-year fixed rate is relatively more attractive than a five-year fixed rate, which is what happened because we had an inverted yield curve at the time, that business might say, "Hey, I want to go for the 10-year rate because I am confident that I will have this portion of debt for the period." So it can be appropriate in some circumstances. However, the problem-this comes back to the incentives-is that the bank will be very keen to provide a 10-year swap rather than a five-year swap because it makes twice the amount of income. Again, there is nothing wrong with a 10-year swap for a five-year loan if the business understands the consequences and the risks of doing so.

Q111 Mark Garnier: This is where we get to the nub of it. Again, I go back to the analogy of the big multinational corporation or the big treasury department. They get this. But we are now talking about a business that goes to its local high street branch and is presented with one of these products. How is that business manager expected to be conversant with this? I speak as someone who has 27 years’ experience of the financial services industries, and I am beginning to lose you on this point already. We are now talking about people who may be running a pub or a small property company, that type of thing. How are they expected to understand the complexity of this?

Abhishek Sachdev: That is absolutely the key issue. Again, it is a multifaceted question. These derivatives can be appropriate for those small businesses. You don’t need to have a degree in finance-

Q112 Mark Garnier: But how do they know? How does a small business know that it is appropriate for them?

Abhishek Sachdev: This is where the FSA comes in. The FSA has a number of rules, which say, "This is how the banks should be assessing the appropriateness-the suitability-of the product for this type of business." The problem is that small businesses, typically for advice on banking matters, will be expected to go to one of two sources of information: their solicitor or perhaps their accountant. But neither of those two professions are actually qualified or authorised by the FSA to advise on derivatives. That is quite an important point, because one of the major bones of contention that businesses have with banks is that banks will continually say and plaster all of their agreements with, "We do not provide you with advice."

As a result, they say that the businesses are entering into these things on an execution-only basis. If the banks are not providing advice and if the small businesses cannot go to their solicitor or accountant for advice, where are they supposed to turn? In fact, until only very recently in the past couple of years, has there actually been an FSA-authorised business to provide advice to small businesses on derivatives, so there was no one for them to turn to.

Q113 Mark Garnier: I speak as somebody who was a compliance officer a number of years ago, and I am sure that you had to classify your customer in order to be able to sell them a certain product, and that a derivative product was something where the customer had to be an expert investor at the very least.

Abhishek Sachdev: You are absolutely right. There are three different levels of classification. Today, there are essentially retail, professional and eligible counter party. Obviously, the smaller business you are, the greater level of protection and guidance the bank is supposed to give. You can still sell derivatives to all three of those classifications, but depending on which level you are at, the FSA says that there is a greater number of rules.

Q114 Mark Garnier: So when you are talking about selling to a retail customer, you are selling a complex product to somebody the FSA categorises as somebody who is unable necessarily to understand that product.

Abhishek Sachdev: Correct. The FSA allows banks to sell these products, even complex ones, to small businesses. Remember that even complex products can be appropriate for a small business, but the FSA requires that banks follow a certain amount of stringent rules.

Q115 Mark Garnier: Can you give us a description of those rules?

Abhishek Sachdev: Essentially, they are called the conduct of business rules that the FSA has in its handbook. They would require banks, for example, to check that the individuals they are dealing with have the knowledge and experience to understand the derivative that they are entering into.

Q116 Mark Garnier: Would those people have had to have taken exams in order to be registered as representatives?

Abhishek Sachdev: Yes, they would. All FSA-authorised advisers would have had to achieve FSA authorisation, which means that they have to sit regulatory exams.

Q117 Mark Garnier: You mean Chartered Institute for Securities and Investment exams.

Abhishek Sachdev: Absolutely.

Q118 Mark Garnier: Therefore, you have CISI-registered individuals at the branches selling the products.

Abhishek Sachdev: Not at the branches; they typically tended to be based around the country.

Q119 Mark Garnier: How would it work? Let us say that someone came into my branch at Kidderminster high street and the chap says, "I’ve got the product for you." He does not know anything about it, so he would feed you to somebody who does?

Abhishek Sachdev: Correct. It would be helpful for you to understand exactly how that comes about in terms of a small business. Let us say that a small business wanted to borrow £1 million from their local bank manager to redevelop properties or purchase a caravan park. They go to their bank manager, and the bank manager says, "Sure, you can have the loan, but we want you to take out some hedging instrument to protect yourself against interest rates going up." The bank may strongly suggest that the business does that. It may say, "You have been in business for a long time. You have seen interest rates of 10% or 15%. How can your business afford such interest rates if they were to go high?" Or they may actually mandate it to say, "It is a condition of sanction that, if we were to lend you this £1 million, you have to have some hedging."

Q120 Mark Garnier: Okay. We will come back to that. At this point, does the contact point at the bank in the high street say, "But you need to talk to somebody who knows what they are talking about"?

Abhishek Sachdev: Correct. It all starts with the relationship managers, because they are the ones who are the custodian for the clients. They have a day-to-day contact with them. They are the ones who are lending them the money. Then, they basically hand over to their specialist colleague from the investment bank who is FSA-authorised and regulated. They see the business and have a title of "risk manager" or "risk adviser", even though internally they are known typically as sales people. Their discussion then happens with the business: "Here are two or three different types of products that might be appropriate for you". Typically, PowerPoint presentations are given to the small business. In most cases, the small businesses won’t even understand the presentations, because they are full of technical jargon.

Q121 Mark Garnier: But according to the FSA rules, these individuals should be qualified in order to be able to sell to a retail investor who, by definition, does not understand what they are being sold.

Abhishek Sachdev: Correct. The guidance and the written information provided by e-mail, fax, letter or these presentations has to contain a certain amount of detailed disclosure and explanation of risks and benefits and how these products work.

Q122 Mark Garnier: In your opinion, are the banks therefore observing the letter of the rules but not necessarily the spirit?

Abhishek Sachdev: Correct. This is what a number of these cases and all these challenges to the banks come down to. Many of these small businesses absolutely felt that they were being advised by their bank, that they were being forced by their bank to enter into these products, yet the banks will have in all these instances multiple pieces of paper and terms and conditions saying, "You understand all the risks and implications of going into this product. You understand that you will seek your own independent advice," even though there is no independent advice for them to go to.

Q123 Mark Garnier: We talked earlier about why the banks were selling them. It seems that, in order to be competitive against each other, the banks were giving loans at very low rates of interest, so they were cutting it wafer thin. Typically, these would be prior to the crisis, so we are not talking about anything post 2007-08.

Abhishek Sachdev: Well, no. Interest rate derivatives were still sold after that.

Q124 Mark Garnier: But are there problems with those?

Abhishek Sachdev: There are not going to be so many problems with interest rates sold, typically, from mid to late 2008 onwards, because interest rates started to fall.

Q125 Mark Garnier: So the contentious ones are those which were sold prior to the crisis. Prior to the crisis, the banks were offering very low rates. The reason I am trying to get to the bottom of this question of pre or post is that there was much more liquidity around prior to the crisis––for the wrong reasons, as it turned out––and they were competing against each other to get the loans out. Now we are in a different situation and things are the other way round. It seems you can charge pretty much whatever you like. I am trying to get a flavour of whether these things were more prevalent when the margins were wafer thin than they are now when the margins are nice and fat.

Abhishek Sachdev: Yes. It is not necessarily just linked to the margins. You have to remember that it is about transparency. Even a very small business borrowing a few hundred thousand pounds will typically ask their accountant or local broker, "Hey, who’s lending at good rates now? What are HSBC offering me? What are Barclays offering me?" They will be able to check and compare the different loan margins being offered and the loan-to-value ratios. They check the headline credit margin rate. They are not, of course, able to check the price of hedging, because that happens later on down the line when the bank is already lending the money to you.

The other linked part to that question is that the actual lending is one of the key products that a relationship manager can provide to a small business. Earlier, we touched on the different kinds of products and services that an SME can have. A relationship manager can introduce 10 to 15 different types of products across the whole bank to that small business, but none of those products or services comes anywhere close to the profitability that something like interest rate hedging would generate for the bank. Whether it is invoice discounting, asset-based finance, vehicle leasing, trade finance or whatever it may be, interest rate hedging, because it is a derivative and an investment banking product, and because the net present value cash flows are calculated on day one, results in a huge economic profit for the bank.

Q126 Mark Garnier: You may not be able to answer this question, but are you aware of any specific incentives given to relationship managers for selling these products?

Abhishek Sachdev: I am aware of many instances across all the banks whereby there is essentially a carrot-and-stick approach. The carrot for relationship managers and their hedging salesmen is obviously financial incentives––significant bonuses, even for relationship managers.

Q127 Mark Garnier: These would be bonuses based on the value of the stock sold?

Abhishek Sachdev: Yes, sometimes on the value of the stock sold and even sometimes––

Q128 Mark Garnier: Given all the other stuff that can be sold, would this be a very exciting product for a relationship manager to sell, the cherry on the cake?

Abhishek Sachdev: Yes, absolutely. If the relationship manager has 10 different products he can offer to the client, the hedging product earns the most profit for him. Therefore, he looks the best to his superiors if he can meet this particular part of his target.

Q129 Mark Garnier: So he sees a guy coming in wanting to borrow £1 million for a property development, and he sees a loan as giving him a little bit of the thing, but selling the interest rate product that goes with it is the Audi TT at Christmas sort of thing?

Abhishek Sachdev: Correct, and the way that he sells a product is obviously by either mandating that it has to be sold or introducing him to the salesperson.

Q130 Mark Garnier: This is probably the wrong question, but would it therefore incentivise that individual to link the two things as being mutually exclusive-so that you cannot have the loan without the product?

Abhishek Sachdev: That is basically the biggest tool they have in their arsenal. Again, we will touch on this when it comes to incentives, but they have two things. First, they can say, "You are not allowed to have this loan unless you do the hedge." Sometimes, this is introduced quite late in the process. You have spent two or three months going through the whole process, the credit approval and all the bits and pieces that the bank requires you to do and then, sometimes at the last minute, the bank may say, "But we have to have some hedging." It is almost treated like an afterthought. Sometimes, it happens just a few days before the draw-down of the loan.

In fact, we have got some clients who have been given the loan-the money is in the bank account-and they have gone to auction and bought some properties, and yet three or four months later the bank says, "Right, we now want you to do some hedging and, by the way, if you don’t do some hedging, we are going to take away the loan." Sometimes the pressure, and you may be surprised to hear this, is absolutely relentless.

Q131 Mark Garnier: So there is no choice for the individual. Again, getting back to the multinational oil corporation, you can presumably go and get your loan from one bank or a syndicate of banks, and you can then get your hedging from whoever is offering the best thing, whereas, presumably, if you are a small business owner, you are not given the choice to go and source a cheaper or more desirable hedging product, assuming that you even knew what you were talking about.

Abhishek Sachdev: Absolutely spot on. When you are a much larger business, the issue of advice is less relevant, because you are genuinely, say, multi-banked. If you are a very large business and you have banking facilities with three different banks, they can all compete against each other on the hedging and you can get a decent price in that way. When you are a small business or you are sole-banked, you are wholly reliant on that bank.

The banks sometimes do not actually stipulate that you have to do the hedging with them but, by default, you almost have to. The reason why the small business has to is that they have got all their security tied up with that bank, and to have a hedging instrument, you actually have to provide some security to the bank to underwrite that hedge. A small business is not going to have enough security-

Q132 Mark Garnier: Underwrite the loan?

Abhishek Sachdev: No. Underwrite the loan and the hedge.

Clearly, as we have seen now, if interest rates fall and you want to get out of a hedge, there is potentially going to be a large cost payable, so the bank takes a little extra security to underwrite that risk. A small business, if they are taking a loan from the bank, is almost certainly going to have to do the hedge with the bank as well. A third-party bank, which has no security with that customer, is not going to be able to provide a hedge to them, so they are locked into that bank.

Q133 Chair: I have not had Mark’s 27 years’ experience in finance, and I want to ask what may be a dumb question. You said at various points in answer to Mark Garnier’s questioning that hedging could be completely appropriate for even a very small business to do. Am I right in drawing from your answers that, in your view, where this crosses a line is around the knowledge gap between the small business and the institutions selling them the hedging product, or is it around the linkage between that product and getting the primary loan that the small business wants in the first place?

Abhishek Sachdev: Again, that is a relatively complicated question. First, in terms of linking the two things together, the banks will often say that the reason why they make it a mandatory condition to have some hedging with the loan is that they would not feel comfortable in providing that level of credit to the business unless there was some hedging in place to make sure that the business would not suffer unduly if interest rates were to go to very high levels.

Q134 Chair: So they are saying a linkage, a complete conditionality between the two, can be appropriate?

Abhishek Sachdev: That is what the banks will say. My view is that yes, it can be appropriate for the banks to require some hedging. The banks are commercial entities. If they are providing a loan it is up to them to stipulate what conditions they want to stipulate. No one forces a business to take a loan from the bank. That is what the banks’ defence often is.

The issue is that when the banks make these conditions of sanction, in my experience, from what I’ve seen across all the banks, they do it almost on a kind of blanket basis. Without even knowing anything about the business, and at a very early stage, they just say to the business, "Okay, you want a loan from us; sure, but you have to have some hedging." That, I think, is inappropriate.

I think if the bank does some analysis for the business and looks at, for instance, the budget rate of the business: so, for instance, they say, "Right, you’re a caravan park owner, and looking at your forecast for the next two or five years you would not actually be able to sustain interest rates if they were to go above 6%, so let’s try to protect that level of 6% for you", that is evidence of some analysis. The bank has said, "We should get some protection at that level for you"; but from my experience that very rarely happens, and the bank just makes a blanket stipulation, saying "You have to have some hedging," without any detailed analysis.

Q135 John Thurso: I will give you a rest, Mark. Just on that, most banks would, somewhere in their covenants, have an EBITDA multiple. If you are on a three times EBITDA multiple, actually you would have a massive rise in interest rates, way beyond the 6%. Assuming normal times, as it was then-say you were at 4% and you were getting it at 2 over bank, or something like that, and you were looking to protect it above that-your point of protection would be way above that, so there are very few circumstances where a bank with a loan to the value of 70% and an EBITDA multiple of 2 or 3 as a covenant would not actually probably be better self-insuring rather than taking a hedge.

Abhishek Sachdev: The slight amendment that I would make to your question is that the more relevant ratio or covenant, perhaps, is actually the interest cover ratio, so some of those actually can be quite tight, especially for businesses that are property businesses, that are quite highly geared. Actually they are quite sensitive to interest rate rises, so they may require some hedging in those instances. Your question about self-insuring is very interesting, because, again, a lot of the clients that we work with-small businesses-would say "Actually, we’ve said to the bank we are not worried about interest rates going up. In fact, we have ridden interest rates going up to 10% or 15%. Our business has enough flexibility, so that we can sell some assets, sell some of our properties, to realise some cash." In some cases, I have heard businesses say to their banks, "I tell you what: here’s half a million pounds, or £1 million, to put on a side reserve account, which we won’t touch, which is just there to help us if interest rates go really high," but the banks weren’t interested in listening to that, in those cases, because doing that doesn’t generate many profits.

Q136 John Thurso: I am particularly interested in this because I have had the experience with a certain bank I had better not name. At the end of the day I just said to them, "Look, I’ll take the cost myself-this amount of money." I don’t know whether it was because I was sitting on the Treasury Committee, but they said, "Oh, all right then," so that was that. All the points you made about a relationship manager, and then somebody from a completely different office-the whole thing-I recognised it completely. It has always struck me, this question: in many instances, for small businesses, the businessman can actually make an astute decision on his business-not a financial product-and actually would be better off to, as it were, self-insure. Not always, but very often.

Abhishek Sachdev: Again, I would say even a small business, even with a relatively modest amount of borrowing of £500,000 or even £1 million, could and should potentially still consider some form of hedging; but this is where we come on to an appropriate hedging strategy, because if the FSA-authorised individual who is giving advice to this small retail business sits down and really works through the numbers with the business, they may come up with a strategy which says, "Okay, well let’s protect half of your debt: a 50% fix and a 50% floating. Let’s protect it for part of your loan term. So that gives you some flexibility." In those scenarios it can be a valid thing to do, because, again, nobody knows where interest rates are going to go. Again, what I have often found is that in these conditions of sanction that have been provided, banks have said you have to hedge the full amount for the full term, and in some cases longer than the loan term, and that is potentially where these businesses almost find themselves in a financial straitjacket.

Q137 John Thurso: This is a carbon copy of Pat’s question in a way. I know that you can only mis-sell to an individual, not to a corporate, but why is it "mis-selling" rather than just caveat emptor or whatever? What have the banks done wrong in selling these products?

Abhishek Sachdev: Again, we turn back to the FSA rules and the European MIFID guidelines, which stipulate that if you are providing derivatives to this type of business, be it a retail business or SMEs, you have to go through various different steps, with different knowledge and experience and fact gathering, and in many instances I have found that some of those steps have been missed out by the banks. For example, they may show three different products to the small business, but they may show five or six benefits for one product and just one disadvantage. That is not a balanced assessment of risks. They may show unduly complicated products or the kind of products that make a larger amount of profit for the bank than another product, so they are potentially misrepresenting these products to the small business. If they are not explaining the detail of the products and all the risks and disadvantages, they are not explaining the products properly.

Q138 John Thurso: You explained very lucidly the economic value to the bank: namely, the net present value of the swap is on the day it is done.

Abhishek Sachdev: Correct.

Q139 John Thurso: Does that mean that on the day it is done, the bank books the entire profit?

Abhishek Sachdev: Yes, absolutely.

Q140 John Thurso: So it is a very lucrative product, not only because it is lucrative in its own right but because it is entirely bookable on the day it is done?

Abhishek Sachdev: Correct. That income is booked within minutes of the hedge transaction being done, on the recorded line conversation, and furthermore that is the reason why the investment banking sales people who sell these products, and the traders, are paid investment banking salaries and bonuses, of in some cases up to £700,000 or £800,000 a year, as opposed to relationship managers, who earn a mere fraction of that.

Q141 Mark Garnier: I want to summarise some of the key things that I have taken from this, and ask one last question. We will be finished in two minutes. First, there is no evidence that there is any stress testing, or not enough stress testing, going on with the businesses, so they are not doing a full job in terms of-for the record, you are nodding. Secondly, there seems to be a huge misalignment with incentives for the sales staff being far too much, and a massive misalignment of knowledge between the investment banker salesman and the client. Thirdly, a key point, the banks seem to be adhering to the letter but not the spirit of the rules-again, for the record, you are nodding. Finally, if you were in our position, sitting in front of some of the senior executives of the banks, what would you be homing in on in terms of this scandal?

Abhishek Sachdev: In terms of the here and now, it comes down to part of the FSA redress scheme that has been introduced. You will no doubt find lots of small businesses that are complaining about that scheme, saying that it is taking too long, that it is not independent enough, and so on. To be fair to the FSA, this is a very complicated area and there is no blanket stipulation that can be made, like with PPI mis-selling, for example, and these cases have to be referred to individually.

Q142 Mark Garnier: They have to be individually assessed, one by one.

Abhishek Sachdev: Absolutely, because every business has been sold a different, unique derivative, so it all takes time and it is complex. However, some of the early redress options that clients have heard from banks are quite concerning. For example, part of the FSA redress scheme says that if you have been sold one of these structured collars, which everybody says are a really horrible, complicated product to understand for a small business, the bank may replace it with a simpler fixed-rate loan or a simple swap. On the face of it, that may tick some boxes, and it makes nice headlines if we can say, "Hey, look, a complex product has been replaced by a nice simple product." Everybody understands how a fixed-rate loan works. However, because that fixed-rate loan, or that swap, is going to be provided at the rate it was in 2006 or 2007, the impact on the business today still leaves them with an exit cost of that derivative of the same amount as a structured collar. So, yes, you have replaced it with a different name of product, but a small business does not care what you call the product. They were not told about the risks going into the product, and a swap will have the same exit costs. It is concerning if independent assessors or the banks are simply replacing complex products with more simple products.

Q143 Mark Garnier: They could still be the wrong product.

Abhishek Sachdev: Absolutely. If you want advice about the risks of entering into a structured collar, for example, which says that, down the line, you may have to pay a significant amount to get out of it, the same thing would happen if you entered into a swap, and you would still face a large cost to get out of it. If you were wrongly advised in that you were not told about the exit costs in the future, the banks should remove the entire product and, potentially, refund you all the money you have paid on that product thus far.

Q144 Lord McFall of Alcluith: The banks have put aside about £8 billion to deal with mis-selling PPI. In terms of interest-rate swaps, what is the magnitude of mis-selling that we could be talking about here?

Abhishek Sachdev: A very important, but again complicated, question. First, this does not just relate to small businesses-although that is the focus today. This applies to businesses that have borrowed hundreds of millions of pounds from the bank and also find that they have been ill advised about derivatives. Secondly, it applies not just to British banks but to banks all around the world. So far, the British high street banks have set aside relatively modest amounts. For example, RBS has set aside £50 million. Lloyds has said zero so far. In my opinion, the amounts that they are ultimately going to have to pay out will be massively more than they have stated so far. As more and more small businesses threaten litigation against the banks, the out-of-court settlements that the banks are providing will rapidly add up.

Q145 Chair: Mr Sachdev, I just want to ask something related to Mark Garnier’s last question. We are in the business of making recommendations to the Government by Christmas. If you were in our shoes, what is the policy recommendation that you would make in response to everything you have told us today about how this has developed over time?

Abhishek Sachdev: I think we can split that into two categories. One is what we do about the businesses that have potentially been mis-sold these products in the past. The second category is about what we do going forward. Let me tackle the first element. The banks, the independent assessors and the FSA must have greater focus and pressure put on them to say, "Was this small business really correctly and appropriately advised? Did they really understand what they were getting into?" If not, the correct and appropriate levels of redress should be provided to that business, not just something that ticks a box that satisfies some initial thing that the FSA might have said. So, they need to provide real redress where it is appropriate. They need to look at whether this small business was genuinely informed about what was going to happen further down the line.

As for the second element about going forward, it is the wrong answer to say that banks should stop selling all these derivatives to small businesses because that would deprive them of risk management to which they should have access. As undoubtedly will happen when Martin Wheatley’s FCA takes over next year, there should be a much greater and tighter focus on the compliance of these products rather than a culture of "These are the FSA rules and the compliance guys have just ticked off all these different boxes." There should be a much greater focus on how these products are advised to small businesses and what kind of products should be offered to them. If there are cases where a business just has a five-year loan, the bank should think very carefully before it provides a 10 or 20-year derivative to them. If it is appropriate in that case, it needs to be checked off by someone who is very senior in the bank to ensure that it is appropriate for that business.

Q146 Mr Love: Should we be looking at the contracts that were signed where the assumption was that advice had been received? These were impractical contracts.

Abhishek Sachdev: Yes, absolutely. The small print of these contracts is what the banks rely on. The banks have got significant defences against all these mis-selling allegations, because they have got multiple contracts and multiple clauses, which indemnify them from pretty much everything. It has to be looked at, and it has to be looked at from an unfair contract term perspective. It has to be looked at from a small business perspective. Could they really understand the terms and conditions, because the confirmations of these products are so complicated that a small business would find it difficult to understand a 30 or 40-page ISDA agreement, for example?

Q147 John Thurso: I find it all fascinating, but there are quite a lot of high street banks that do not have an investment banking arm. I can quite understand the universal bank, where the whizz kid from the investment bank turns up and earns £700k a year by flogging these things, but what about the plain vanilla banks that do not have an investment bank attached? Where is the motivation for them to get into this?

Abhishek Sachdev: I am not exactly sure which banks you are referring to. There are some banks and some building societies that do not have a separate investment bank per se, but do not forget that every bank will still have a treasury function, and that treasury function is responsible for funding the bank itself, so they can still provide these fixed-rate-loan-type products.

Q148 John Thurso: So, in fact, the point about this is that it is about the ring fence, or Glass-Steagall or whatever. What you are saying is that you could go full Glass-Steagall and you could still get a high street bank making a lot of money out of mis-selling this product. That is basically the point.

Abhishek Sachdev: Yes, absolutely.

Chair: That probably takes us beyond where we can go today. Mr Sachdev, thank you very much. We found your evidence very interesting.

Prepared 19th October 2012