UPDATE 2-UK banks pay only one fifth of swaps mis-selling funds

* Banks have set aside 3.75 billion pounds

* Only 798 million pounds paid out so far

* Compensation scheme due to complete next month

* RBS 'marginally behind' schedule (Adds data, comment from hedging advisor)

By Matt Scuffham

LONDON, May 8 (Reuters) - Britain's biggest banks have sofar paid out only a fifth of the funds they set aside torecompense small businesses mis-sold interest-rate hedgingproducts, a month before the compensation scheme is due to end.

The mis-selling of these sophisticated financial products isone of numerous scandals in recent years that have cost banksbillions of pounds in compensation.

Britain's biggest four banks - Barclays, HSBC, Lloyds Banking Group and Royal Bank ofScotland - have set aside a total of 3.75 billion poundsto deal with the interest-rate swaps issue.

The Financial Conduct Authority (FCA) said on Thursday that,by the end of April, compensation amounting to 798 millionpounds ($1.4 billion) had been paid to 5,732 customers.

That comes on top of the more than 20 billion pounds bankshave set aside to compensate customers mis-sold loan insurance.

The FCA said banks were on track to meet a deadline forcompleting the review of nearly 30,000 cases for potentialmis-selling. The regulator ordered banks to start compensatingfirms last May after finding serious failings in the way theswaps were sold.

"We are in theory one month away from all this finishing andthe amount they have paid so far is a mere pittance," saidAbhishek Sachdev, managing director of Vedanta Hedging, whichadvises businesses on the products.

Banking and regulatory sources say a significant proportionof the funds banks have set aside is to meet the cost of closingthe original hedging contracts. That covers the loss of paymentscustomers would have made to banks under their hedgingarrangements if they were still in place. The cost of reviewingthe cases, and hiring advisors, is also included in the banks'provisions.

The products were sold on the basis they would help protectsmaller companies against the risk of rising interest rates, butwhen rates fell, they had to pay the banks large sums, typicallyrunning to tens of thousands of pounds.

Companies faced penalties to get out of the deals, whichmany said had not been properly explained to them.

The FCA urged 1,300 firms which have yet to join the reviewto do so. Some small businesses have chosen to take legal actionagainst banks instead, pursuing claims for consequential losseswhich could lead to bigger payouts. Others have been put off bythe prospect of being offered alternative products by the banks,which they do not want, instead of cash compensation.

The FCA data showed that the proportion of customers beingoffered full cash compensation by banks is falling and thenumber being offered alternative products is rising.

"We're seeing an increasing number of alternative productsbeing given. The stance of banks is certainly hardening," saidVedanta's Sachdev.

Banks have offered to pay full cash compensation in 52percent of the 11,871 decisions so far communicated to customersin the review, compared with 57 percent at the end of lastmonth.

Alternative hedging products have been offered in 39 percentof cases so far compared with 36 percent last month. Firms havebeen offered no redress in about 9 percent of decisions so far,compared with 7.5 percent at the end of last month.

The FCA said RBS, which has the most cases left to review,was marginally behind its schedule to meet the May deadline.Barclays had already been given until June.

($1 = 0.5894 British Pounds) (Editing by Erica Billingham)