Wall Street comes to Watton

Last week I visited Paul Adcock, joint owner of Adcock & Sons, a small retailer of TVs, washing machines and other consumer electrical goods in the small market town of Watton in Norfolk.

Like many retailers, especially in sectors facing sharp competition from the internet, he is struggling. But he has very loyal customers, as I discovered when a posse of the over-60s turned up to give him moral support whilst I interviewed him.

Now, as you know, I can't visit every struggling small business in the UK. So what is special about Adcocks, other than that this is its centenary year?

Well one reason why Adcocks is in serious financial difficulties is that it is paying an interest rate of 9% on a commercial mortgage of approximately £900,000, generating a bill of just under £80,000 a year.

To keep up the payments, Mr Adcock has had to lay off staff. Tearful, he is not sure how much longer he can survive under the interest burden.

So at this time of record low interest rates, why is the long-established Adcocks paying 9% for a commercial mortgage fully secured by freehold properties?

'Betting' on interest rates

Well, the reason is that in early 2007 Paul Adcock entered into a complicated derivatives transaction, which has the daunting name of an asymmetric cap and collar, with Barclays' investment banking arm, Barclays Capital.

This version of what is called an interest-rate swap was in effect a bet that the Bank of England's official rate, Bank Rate, would not fall below 4.7%. Under the complicated terms of the derivatives contract, if Bank Rate falls below 4.7%, the interest rate gradually rises for Mr Adcock to a maximum of 6.25% - plus a margin of 2.75%.

Ever since 6 November 2008, when Bank Rate fell to 3%, Adcocks has been paying that 6.25% plus 2.75% - or 9% in total. His business has enjoyed none of the benefit of the record low interest rates engineered by the Bank of England specifically to help struggling businesses like Adcocks during the recession and the subsequent period of economic stagnation.

Bank Rate may have been at a record low 0.5% since 5 March 2009, but not for Adcocks.

In other words, Mr Adcock lost this bet. If he hadn't taken out the swap, he would currently be paying interest on his commercial mortgage of 3.25%.

Your instinct may be that if Mr Adcock gambled and lost, he should stop whingeing and pay up to the winner, Barclays. Caveat emptor, you may think.

However, Mr Adcock says that he didn't know he was making a big bet against interest rates falling.

What he thought he was doing was getting protection against Bank Rate rising above 6.75%, or getting a cap of 6.75% (plus that 2.75% margin) on the interest he would pay.

He says that the salesman from Barclays Capital described the putative protection on offer as "free", in the sense that no fee was being charged for the interest-rate cap. But, as Mr Adcock has now learned to his cost, there was a big contingent cost for him, in the form of the penalty interest rates he pays as Bank Rate falls.

It is unclear whether this contingent cost was explained to him. If it was, it is highly likely that he did not understand it, because I am not sure he properly understands it now.

Now at the time that the transaction took place, on 15 February 2007, Bank Rate was 5.25% - well below the 6.75% interest rate cap. So the interest rate would have had to rise a good deal for Mr Adcock to benefit from this ceiling. And, as it happens, the Bank Rate had not been as high as that since December 1998.

However, at the time the deal was done, Bank Rate was a fraction above the 4.7% "floor", below which the penalty interest rates became payable.

So as someone who has run a successful business for many years, why on earth did Mr Adcock agree to a deal which he now says he didn't understand?

Well he says that having banked with Barclays all his working life, he assumed the bank was serving his best interests (Adcocks has had a relationship with Barclays since his great grandfather founded the business in 1912, he adds).

Mr Adcock also felt grateful to the bank for expanding the size of his commercial mortgage when he refitted and refurbished the shop. He therefore felt under a moral obligation to do what he felt the bank wanted him to do.

Many complaints

I, of course, rang Barclays about all this.

It said: "Interest-rate risk management products were sold by Barclays to customers in accordance with the regulatory framework. Barclays is satisfied it provided sufficient information to enable clients to make an informed, commercial decision about the products it offers. Barclays has an ongoing dialogue with Mr Adcock. We continue to work with the company, utilising the expertise of our Business Support team to respond to the challenging market conditions faced by the retailing sector."

To be clear, Barclays is by no means the only bank facing complaints from smaller businesses that they were sold inappropriately complicated derivatives products, in the boom years before the 2007-8 financial crash.

I have been contacted by clients of HBSC, Royal Bank of Scotland and Lloyds who make similar complaints to those of Mr Adcock.

The important background is that the profit margin for banks on plain vanilla loans has been very low. So the banks did their best to sell customers additional products and services, to boost profits - of which the most scandalous manifestation was the PPI credit insurance that the banks mis-sold to millions of retail customers.

So is there another great mis-selling scandal brewing in the way that the banks encouraged small business customers to take these swaps? Could they end up paying billions of pounds in compensation, in the way they've been forced to do for PPI?

Anecdotal evidence suggests there is potentially quite a serious headache here for the banks - though my sources at the Financial Services Authority (FSA) do not currently believe that the scale of banks alleged misbehaviour will turn out to be as substantial as in the PPI case.

One important issue is that some of the affected businesses are too big to benefit from the strict regulatory constraints that apply when banks sell products and services to retail customers.

Mr Adcock, for example, tried to take his case to the Financial Ombudsman, but failed because he employs half a person more than then the 10-employee threshold for the Ombudsman to have jurisdiction.

Also hard data on the scale of banks' derivative transactions with smaller businesses is hard to establish. I am reliably told that for the market leader in small business banking, Royal Bank of Scotland, just 5000 customers have swaps, or just a fraction of its 1.2m small business clients. At Barclays, roughly 2000 small-business customers have been sold swaps.

If that pattern were replicated across the industry, the total number of businesses with a possible complaint would be less than 20,000.

That said, there could be many more possible complaints, if it turned out that many small businesses weren't told of massive cancellation costs relating to simpler deals where they fixed their interest rates.

'Not PPI again'

Some businesses which claim to be victims of derivatives mis-selling have sued their banks, and so far the banks have preferred to settle out of court than see a precedent set with a judgement.

In a way, this is a story of profound cultural change in the banking industry. During the last 15 years or so, big banks changed from businesses that prided themselves on the way they nurtured long-term relationships with customers and understood their needs, to businesses determined to generate as many transactions as possible.

The problem, as Mr Adcock's pain may indicate, is that the customers didn't always understand that the nature of their relationship with their bankers had changed.

This cultural revolution may have implications for what action the FSA ultimately takes.

The watchdog is very close to finishing a preliminary probe into sales of swaps by banks to small businesses. On the basis of what it has found from a detailed survey of banks' behaviour, it will then decide whether to launch a more aggressive investigation.

Such an investigation could end up with banks paying hundreds of millions of pounds in compensation. Alternatively - and from what I can gather, more probably - it might reveal that the FSA's regulations for these sales are inadequate and need toughening up.

The head of one bank said this to me: "This doesn't feel as big as PPI. But let's be clear, we all went slightly bonkers a few years ago selling products that our clients didn't really need. We forgot to put the interests of our customers first."

For more on swap sales to small businesses, see this Q&A.