What's the difference between a banker and Rumpelstiltskin?

Having explained how 'interest rate swaps' work in a previous post, we asked Honestly Banking to explain why they were sold.

The best fairytales are not just empty whimsies. The best ones seek to educate us about the hazards of greed, gluttony, pride, lust and all the other stuff we’d really like to do but probably oughtn’t. The Bully-Banks guest post on this blog compared their ripped-off situation to Little Red Riding Hood in the clutches of the wolf. Their situation also brought to our mind another salutary fairytale: Rumpelstiltskin. 


In the Rumpelstiltskin story a king decided the way to save his finances was to put the burden on a young girl, threatening her with death unless she turned straw into gold. The desperate girl takes a deal from a malevolent demon that provided her with gold for the king but as part of the deal she must give him her firstborn child. The demon guessed the unsophisticated girl, needing to avoid impending death, would not appreciate what she had promised. The trouble started when the demon came to collect.

In Ripped-Off Britain the government decided the way to save its finances was to put the burden on small and medium businesses (which make up 60% of the private sector), to turn the recession back into growth and employ all those sacked public sector workers. The desperate businesses took deals from malevolent bankers who provided them with the gold, but as part of the deal required the businesses to sign an “interest rate swap agreement”. The bankers guessed the unsophisticated businesses, needing to avoid impending ruin, would not appreciate what they had promised. The trouble started when the banks came to collect.

The demon gives the girl a chance to get out of the deal if she can discover his name. The FSA has given the businesses a chance to get out of the deal if they can explain the scam and get public opinion on their side.

Explaining the scam is not as easy as it sounds. Even Ed Miliband, leader of the Labour Party, with two degrees in economics (Oxford University & London School of Economics) conceded he didn’t understand it. In a Sky report, Ed said:

"I visited a guy called Alan who runs a signage company in Putney. He was in tears. It's a chilling story about what the banks are doing to people.

He has lost about a £1m because of the banks. He got sold a 'dual interest rate swap'. I have a master’s degree in economics and I can’t understand it."

The only person who knew Rumplestiltskin’s name was the scamp himself. Perhaps the only people who understand Interest Rates Swaps are bankers. So we asked a banker, our occasional guest blogger from Honestly Banking to explain a bit more how and why banks managed to get businesses to take this product. He responded thus:

Interest Rate Hedges fall basically into two categories; Swaps that effectively fix a rate and Caps that give you a ‘no higher than’ rate. All the other structures, such as collars are generally methods of hiding premiums and increasing bank profits.

When these structures are priced and sold the bank will make use of the ‘Yield Curve’, which shows the market’s expectation of future interest rates. If the curve is dropping away in the future, i.e. the market expects interest rates to fall, the bank makes more profit with a longer-term hedge that keeps the interest rate they receive up when market rates fall. Interpreting Yield Curves is fraught with danger. An example yield curve is given below.

Casino banks like to enter into bets with clients. Just like in real casinos, the house usually wins. They have the knowledge and information to out-manoeuvre clients into structures that will make the bank money.

Imagine the Cap the bank has sold has a ‘clean’ cost (i.e with no profit in) of £100,000 (this is what it costs the bank to buy the Cap in the market to give to the client). To make some money on this the bank might need to add say a 50% margin, but a £150,000 premium is unacceptable to the client who would walk away at this price. The bank has to find a way of generating a value of £150,000 without charging the client a premium. To do this, the bank shows the client a collar whereby the client is ‘tricked’ into selling the bank an Interest Rate Floor. If the bank bought this ‘floor’ in the market it may have cost it £150,000 – but it takes it for free from the uncomprehending client. The bank just subtracts the cost of the Cap from the Floor and makes an immediate profit of £50,000.

Bank gives Client a cap for free     =          cost to bank, £100,000

Bank ‘buys’ floor from client          =          value to bank, £150,000

(client takes on the falling rate risk without getting paid)

Nett Profit to Bank                       =          £50,0000

The client has become a derivatives trader unknowingly by selling a floor to the bank. The bank doesn't pay the client for the derivative it has unknowingly sold, but just trousers the profit. Sure the client has a Cap for free, but has just taken on two onerous risks: that of falling Interest Rates and the substantial break costs.

• Impact on client of different LIBOR rates, with Cap = 6%; Floor = 4%;    
• LIBOR = 5%               Business pays bank 5%
• LIBOR = 7%               Business pays bank 6% (cap invoked)
• LIBOR = 0.5%            Business pays bank 4%. However the bank will often trick the client with a 'Value' feature to give the client a 'better' or 'cheaper' rate, meaning they could pay an extra 3.5% on top of the 4%. 7.5% in total - bonuses all round!

With this extra money made from the client in addition to the loan margin when rates fall and the substantial breakage costs (typically 30%-50% of the amount hedged), the smug banker is ready to open a bottle of Bollinger. Of course the client has been duped. They will pay far more under this ‘free’ arrangement.

As Libor Rates have fallen, banks have taken the opportunity to do two things to increase their profits. Firstly they have started to increase the margins they are charging on loans. This means as Interest Rates have fallen, some debt has actually become more expensive! Banks will argue about risk and cost of capital, but the reality is they are in an oligopoly so they can do what they like!

The second change is more subtle and pernicious. Where they can, banks have started to shift borrowers from Base Rate to Libor (Libor is higher). Clients are usually strong-armed into this as part of a package of new reforms. Banks claim the clients’ costs reflect more what the bank is paying for its debt. The bank is of course being disingenuous, as when the debt was granted they would have bought the money using a hedge so their position is protected.

Additionally this often introduces a new risk to clients who are already hedged - “Basis Risk”.

Basis Risk is where the hedge is in one index and the debt in another, For example you borrow in Base Rate, but the hedge is in Libor. Libor is more volatile than Base Rate, so the chance of the hedge's barriers being breached is higher. This mismatch can be dangerous as the hedge may contain nasty ‘trigger’ type elements as well. Additionally the bank will have carefully set the calculation criteria in its favour, so that Libor may only need to breach a barrier for a day, but you pay a penal rate for a quarter. Nice!

Banks are Casinos. Remember, when you are dealing with them, the house always wins!

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