Special Feature T

he UK has one of the most sophisticated financial centres in the world and the UK economy is very dependent on the state of the financial services industry. Therefore, banks making profits is a

good thing for the UK as a whole – after all, their profits generate a significant amount of money for the Exchequer through taxation and also fund dividends to shareholders, many of which are institutions such as pension funds from which millions of us benefit. What is key is that banks need to focus on making honest profits. It has become apparent that some of the profits that have been made and declared by banks were through activities that were less than honest.

The real question we must ask is: can banks make high levels of profit without doing so at the expense of their customers?

The first issue with that question is that banks tend to heavily incentivise, through bonuses, the products that will make them the most profit, whether they are appropriate to the customer or not, and ultimately it is this philosophy that results in mis-selling.

PPI and interest rate swaps PPI and interest rate swaps are good examples of where bonuses have been a driver for hard selling and mis-selling has occurred. Banks heavily pushed both products and for many banks and their sales people, the question of whether they were suitable was secondary to a sales person earning a bonus or the bank making a profit.

In the case of interest rate swaps, which were meant to protect businesses against fluctuations in interest rates, many were sold by banks to SMEs in particular during the last decade, resulting in the business having to pay thousands of pounds a month as interest rates have plummeted.

Following the completion of an investigation by the FSA which found evidence of a number of poor sales practices, 11 banks have now agreed to review swaps sold to around 28,000 businesses since 2001. During that period banks incentivised those employees selling the types of swaps that were most profitable and usually more complex, such as cap and collar, fixed rate swaps and structured collars. These swaps provided significantly more profit for the bank, compared to the simple straight interest cap or a

fixed rate loan, but, as the on-going investigation suggests, there is a question mark as to whether or not the swaps sold were in any way suitable for the small and medium-sized businesses which paid for them.

One such company, a property and construction company in Neath, Wales, is paying out £35,000 every quarter on its interest swaps deal. To meet the costs, the company has had to make redundancies and sell property at a vastly reduced price to ensure funds are released. All at a time when the Government is looking to the private sector and especially small businesses to lift the country out of recession.

Can incentives and bonuses continue? Financial services sales have been driven by incentives and bonuses for many years and this is part of the reason financial services regulation was originally introduced. The original Financial Services Act came into effect in April 1988 to put a statutory framework around the industry with the aim of preventing these types of abuses. However, despite the Act, which was replaced by the more comprehensive Financial Services and Markets Act in 2001, these dishonest practises continue.

Lord Turner, Chairman of the FSA, has also criticised some complex financial instruments and asked whether they serve any social benefit at all. Many of these instruments seem to be created and traded simply to generate profit, with little idea as to how they worked or where the financial obligation lay when the whole thing went wrong.

Due to the UKs and the economy’s dependence on the financial services industry, incentives and bonuses will probably always be a part of the banking system to drive results. There is nothing wrong with that, however, in order to move on from the latest headlines, banks need to ensure their bonus structures are aligned with their customer’s best interests. Sales people must be incentivised to encourage the customer to consider a range of suitable products and only recommend the products that are most suitable, regardless of whether those are the most profitable. Only then will the banks be able to create an honest banking system that regains consumer trust and generates fair and honest profit - this ultimately benefits everyone.

Following the completion of an

investigation by the FSA which found evidence of a number of poor sales practices, 11 banks have now agreed to review swaps sold to around 28,000 businesses since 2001.