What is a "Tailored Business Loan"?
Business loans are not regulated by the FCA but derivative products are. The offer of a business loan by a bank to an SME is therefore unregulated and not subject to COBS rules, a set of rules controlling the selling of financial products and devised by the FSA. Derivative products are complicated and the selling of these products could be carried out unfairly if not strictly controlled by an extensive range of procedures detailed in the COBS rules.
Banks borrow most of the money they lend out from the money market and comparatively little derives from customer deposits. They borrow these funds from the market at an interest rate called LIBOR and add a percentage called the “margin” to give the bank its profit. LIBOR is in effect the cost of the bank’s borrowing and fluctuates. It is set by information received from reliable sources such as the trading floors of the main banks. The bank's margin only increases if the SME has breached its loan covenants. If an SME has adopted a variable rate loan, the rate agreed will fluctuate with LIBOR movements. Despite LIBOR movements, the bank’s income remains constant, because the movement, whether up or down, is passed on to the SME.
However, if the bank were to offer a fixed rate, or a partially fixed rate such as cap and collar, the bank is exposed to either a loss or a gain as a result of LIBOR movements. This is an unacceptable risk to the bank, because if LIBOR was to increase and remain high for a long period of time, then the bank might sustain unmanageable losses. In order to deal with this, the bank will adopt an insurance policy called an Interest Rate Swap Agreement, commonly referred to as an IRSA. It is signed with a counterparty, commonly a larger bank, and the terms are negotiated in the markets on the trading floor. If the SME's loan is large, the IRSA could be negotiated specifically for the loan. If the loan is relatively small, it could be bundled with other loans and an IRSA negotiated in respect of the total.
On completion, a commission is paid by the counterparty to the introducer in a similar way to the way insurance companies do. The commission is paid to the bank’s treasury salesperson and is calculated as a percentage of the loan and paid to the salesperson in one lump sum on completion. The commission earned from the IRSA backing my loan was 5.6% of the amount of the loan. The size of the commission is dependent upon the counterparty’s desire to proceed with the IRSA and is driven by the amount of the loan, the length of the term agreed on the contract and the counterparty’s view of future interest rate movements which is estimated by industry experts.
The IRSA contract provides for a movement of funds between the bank and the counterparty which mirrors the effect that LIBOR movements are having on the bank’s cash flow in respect of the SME’s loan. The bank agrees in the IRSA a “notional value”, a “term” and a “rate”. The “notional value” is equal to the SME’s loan amount. The “term” is the term of the SME’s agreement and the “rate” negotiated is added to the bank’s margin and given to the SME as their “fixed rate”. When LIBOR moves up, the counterparty pays the bank. When LIBOR moves down, the bank pays the counterparty. Whatever happens to LIBOR, the bank neither wins nor loses. If the bank has to pay more to its source of borrowing then it is compensated from the IRSA counterparty. If the bank pays less to its source of borrowing then it pays the surplus to the counterparty.
The IRSA contract appears to be legally independent of the SME’s business loan incorporating the fixed rate and is only signed by the bank if the SME simultaneously agreed to sign the business loan. The SME’s business loan and the IRSA contracts, although appearing to be legally separate, are linked internally by the bank in order to have a permanent record of the link for accounting prposes.
The IRSA contract signed by the bank can be broken at any time by the bank. In this event, a breakage penalty becomes due and must be paid either by the bank to the counterparty or by the counterparty to the bank, dependent upon the prevailing “mark to market” value of the IRSA. This is the value that the funding commitment is worth on the market if it was taken over by another party via the market. This value is driven by the prevailing interest rate and the long term outlook. Generally, if LIBOR is either higher or lower than the rate agreed in the IRSA, the market calculates how much money the purchaser of the commitment will either gain or lose in view of the prevailing rate and its expectation of what will happen in the future. In effect, this gain or loss will be the value of the IRSA. This value could be either positive or negative. Terminating the contract could therefore incur either a cost or a benefit to the bank.
National Australia Bank gave a name to this type of business loan agreement. It was called a “Tailored Business Loan” and was used for the majority of SME business loans issued through Clydesdale Bank and its sister company Yorkshire Bank over the past 8 years or so. The facility letter issued to the SME lists a number of loan types which are all given a name. Apart from the “Variable Rate” option, all of the other options listed involved the fixing either the whole of the loan or parts of the loan in variable degrees of complexity.
The rates were not stated in the Tailored Business Loans. SMEs were visited by a treasury salesperson shortly before completion of the loan and the products were explained in general terms. SMEs were told that the bank required them to adopt a product which gave the SME protection in the event of rising interest rates. The treasury salesperson did not explain that the bank would be signing an IRSA and that breakage penalties arising from the breakage of the IRSA could be substantial and calculated by reference to “mark to market”, unlike domestic fixed rate mortgages which state the breakage penalties clearly and specifically, typically as a percentage of the loan, usually 2% to 4% of the loan. SMEs were given an indicative rate before the day of completion and it was not until the day of completion that the SMEs discovered what the rate was to be.
The reason for this was because the rate being assigned was dependent upon the market rates on the day. In other words, the SME’s fixed rate was dependent upon the bank’s cost of insuring against LIBOR movement determined on the moment of completion.
The Tailored Business Loan states that the loan is subject to the bank’s standard Terms and Conditions. The bank’s standard Terms and Conditions state that the bank may pass on to the SME any costs arising from breaking any interest rate hedging arrangement that it has made with a third party. The bank has interpreted the breakage of an IRSA contract that it has signed as such a cost. Tailored Business Loans therefore contain embedded swaps.
What has gone wrong for the SME?
Four things have gone wrong for the SME:
1. Interest rates have dropped to a historically low level. This has caused the IRSA breakage penalties to rise to historically high levels. IRSA breakage penalties are presently between 20% and 40% of the amount of the loan. The bank is passing these penalties on to the SME via the bank’s standard Terms and Conditions. It is therefore economically unviable to break out of the Tailored Business Loan.
2. The SMEs’ turnover has contracted due to the economic downturn. Needless to say, the cause of this is not attributed to the bank. All SMEs are suffering.
3. SMEs are unable to benefit from low interest rates. The interest rates in the Tailored Business Loans agreed prior to 2008 are unsustainable to most SMEs.
4. Commercial property values have fallen generally by 30%.
What has gone wrong for the bank?
The bank has to rely on the SME to continue making interest payments to the bank in accordance with the Tailored Business Loan. The bank uses this money to service it’s commitment in respect of the IRSA contract. The enormous surpluses arising from the difference between the interest rate agreed with the SME in the Tailored Business Loan and the lower interest rates being paid to the bank’s source of borrowing are being paid to the counterparty. At the time of advancing the loan to the SME, the bank knew that in the event of an SME failing to meet its interest payments, it would break the IRSA contract, pay the penalty to the counterparty from its own reserve and then debit the SME’s loan account and foreclose on the business. The SME’s business and property would be sold and, as the bank does not normally lend more than 70% of the property value, the bank would recover the IRSA breakage penalty, together with the loan, by selling the property.
What has gone wrong for the bank is that after months and years of struggling to keep afloat, the SMEs have been giving up the battle in steeply increasing numbers and the bank has been unable to recover the IRSA breakage penalties due to the enormous collapse in commercial property values. Once the SME has stopped making interest payments, the bank is unable to continue making payments to the counterparty and has no alternative than to break from the IRSA, issue a cheque to the counterparty and then foreclose, creating a fire sale and further devaluing the property.
For years, National Australia Bank has been placing most of its business banking on Tailored Business Loans using Clydesdale and Yorkshire Banks as vehicles. The products have been promoted so heavily due to the lucrative commissions which are paid in one lump sum at the time the deal is signed. National Australia Bank has allowed this to occur on such a large scale due to the benefits of commissions and has failed to acknowledge what could happen in the event of an economic downturn in conjunction with falling interest rates and falling commercial property values.
The bank has now detached its commercial portfolio from the retail part of the business and transferred it to National Australia Bank for disposal. The effect on the economy is catastrophic, especially in Scotland.
National Australia Bank is faced with an enormous problem because the vast majority of the IRSAs have not yet been broken due to the sheer magnitude of the breakage penalties which the bank is unable to collect from the SMEs. The figure for the transfer that the bank has announced in its statement on its website is £5.6 billion. But this figure tells us very little. When the announcement refers to assets, is this the aggregate value of the loans?
What about the potential IRSA breakage penalties currently running at between 20% and 40%? Although these have not yet become due, is there any provision for this potential libility in the £5.6 billion transfer? In other words, does this figure exclude any provision for breakage costs?
Most of the SMEs in the transfer have been crippled from the lock-ins but are still trading. They are unable to rebank due to the prohibitive breakage penalties. What does the bank intend to do with the businesses? Create firesales? Realising that a firesale is imminent and that the breakage penalties have wiped out any equity in the businesses , most of the SMEs will not co operate with the bank in an orderly sale and will simply accept defeat and close the business down, especially if it has been requiring outside capital funding to service the interest payments.
What about the damage to the economy and all those SMEs who have been forced to sell their businesses?
What about the bankruptcies, Administrations and receiverships pending?
What about job losses resulting from trading for four years in a severe economy being locked into the fixed rate. The product has sucked out every surplus the business has generated, preventing the engagement of staff, preventing inflationary wage increases and precipitating redundancies.
Most SMEs are resilient and despite enduring four years of struggling to keep their businesses afloat, continue to fight on and anticipate bankruptcy with a degree of acceptance. However, for every SME who is bankrupted, there are numerous workers who have lost their jobs and are unable to meet their basic living expenses and who have no alternative than to claim benefits.
The Scottish economy is fragile, as it is everywhere in the UK, but has been made significantly worse by Tailored Business Loans sold by National Australia Bank through its subsidiaries, Clydesdale and Yorkshire Banks. The products have benefitted a handfull of bank staff who have been remunerated by instant commissions at the expense of the majority of other hard working bank staff, shareholders, SMEs and British workers.