Suitability in Banking: a Worked Example

A poorly fitting product is a conduct problem and, before long, a credit problem. An interest rate swap sold beside a loan is an exposure in its own right. If rates move against the customer and the hedge has to be closed, the amount owed joins the bank's claim on the business. The sale and the credit risk end up in one file.

The UK's experience is the standard warning. In 2012 the then regulator reviewed interest rate hedging products sold to small and medium businesses and found serious failings. They included poor disclosure of exit costs, failure to establish whether customers understood the risk, advice given in sales described as non-advised, over-hedging where the amount or term did not match the loan, and rewards that drove those practices.

Those four questions are the common ground; the law differs on who is owed them. In New Zealand the fair conduct principle, which includes ensuring products are likely to meet the requirements and objectives of likely consumers, applies to consumers: a debtor under a consumer credit contract, or a retail client of other financial services. A hedge for a business that is not a wholesale client can fall within it, while a company's term loan generally does not. Financial advice to a retail client must also be suitable under the Code of Professional Conduct.

In Australia, the 'not unsuitable' test in responsible lending applies to consumer credit, broadly for personal, domestic or household purposes or residential investment property, and loans to companies are not regulated by it. Derivatives are different: a company or trust can be a retail client, for example where its business is small (fewer than 20 people, or 100 in manufacturing), which can bring design and distribution rules and, if personal advice is given, the best-interests and appropriate-advice duties. In the UK, conduct rules set a suitability test for personal recommendations and a narrower appropriateness test for some non-advised sales. The Consumer Duty follows the existing sourcebooks rather than covering all small businesses: regulated credit and investment business with a client who is not a professional client are inside it, while most lending to companies is not. The older principles on customers' interests and communications continue to apply elsewhere.

A bedding manufacturer, constructed for this page like every figure in it, borrows US$8m on a floating rate for five years, repaying US$1m a year. Its EBITDA is US$1.9m. At the last review the owner told the bank that it plans to sell a surplus factory at the end of year two and use US$4m of the proceeds to reduce the loan. The bank offers a five-year swap fixing the rate on a flat US$8m. The credit charge built into the swap, 0.25% a year on the notional amount, is this example's.

The flat swap earns the bank US$55,000 more than a hedge shaped to the loan, and it hedges a debt that the bank already knows will shrink. If floating rates fall 1.5 points after the factory sale, the business pays about US$315,000 over three years on borrowings it no longer has, or one-sixth of a year's EBITDA. A hedge whose notional follows the repayment schedule and the planned sale, explained with its break cost, would have met the need.

The later moment matters as well. At the end of year two the factory is sold and the loan is cut to US$2m. The swap still runs at US$8m. The bank learns of the repayment because it receives the money, and the customer has not mentioned the hedge. The fair thing is to raise it then: the position has changed and the product no longer fits. Waiting for the next annual review means the customer may first hear of the mismatch from a loss.

The UK's two tests show the distinction clearly. Suitability, used for recommendations, looks at the client's objectives, financial situation, and knowledge and experience. Appropriateness, used for certain non-advised sales, asks a narrower question: whether the client has the knowledge and experience to understand the risks.

Affordability is a different question again. A credit assessment asks whether the customer can pay and whether the bank will be repaid. Suitability looks from the customer's side and asks whether this is the right thing to be paying for. The bedding maker could meet the payments on its swap in the first two years. It still should not have been sold a hedge larger and longer than its debt.

DEFINED IN ONE PARAGRAPH → · THE HEDGE RATIO → · A SWAP, FROM THE BORROWER'S SIDE →

It decides what has to be written down. A file that shows the customer's stated objective, the alternatives considered, what the break cost could be and why the amount was chosen can defend a sale years later. A file that shows only the signed confirmation cannot, and the UK review noted poor record-keeping among its findings. It also decides how a banker reads an incentive. Where one product pays the bank more, the conflict of interest needs to be dealt with openly, and the reason for the recommendation recorded.

Then comes the life of the product. Not every statute imposes a continuing duty, and some tests are applied only at the point of sale. New Zealand's fair conduct principle applies across dealings with a consumer. In practice a bank's review events are the natural trigger: an early repayment, a sale of assets, a refinancing or a covenant reset all change what a hedge is doing, and the conversation about it belongs at that moment.

HEDGING POLICY → · A ONE-MINUTE FILE ON IT →