UPDATE 2-UK banks slow to compensate firms for swaps mis-selling

* Banks paid out 2 mln stg so far

* Banks have set aside 3 bln stg for compensation costs

* Regulator says payouts slower than expected

* Regulator says banks told to make offers by end of year

* 1,000 offers expected to be made in October

By Matt Scuffham

LONDON, Oct 4 (Reuters) - British banks have paid out only afraction of the 3 billion pounds ($4.85 billion) they set asideto compensate small firms mis-sold complex hedging products,drawing criticism from businesses and the financial watchdog.

The country's biggest banks have run into trouble with theregulator over the mis-selling of these products and they havealso had to set aside more than 16 billion pounds ($26 billion)to compensate retail customers mis-sold loan insurance.

"Progress to this point has been slower than expected. Manycustomers have been waiting too long to find out if they weremis-sold, some for more than six months," the Financial ConductAuthority said on Friday.

The interest rate swaps were designed to protect smallercompanies against rising interest rates but when rates fell,they had make large payouts running to tens of thousands ofpounds.

The review of interest rate swap mis-selling, set up by theFCA, formally began in May after a pilot scheme. The regulatorhad said firms would be compensated within 6 to 12 months butthe process is now expected to drag out for longer even thoughbanks have taken on more than 2,800 staff to handle the cases.

The banks paid 1.5 million pounds in compensation inSeptember with 22 offers being accepted by customers, the FCAsaid. This brings the total the banks have paid out to just 2million pounds since the regulator ordered a review of nearly30,000 cases last year.

The lack of progress has angered small businesses, many ofwhich face crippling monthly repayments and hefty break-up feesto disentangle themselves from the arrangements.

"The fact that only 22 SMEs accepted offers last month showsthe unacceptably slow performance of the banks providingsatisfactory redress to those mis-sold," said Abhishek Sachdev,managing director of Vedanta Hedging, which advises companies onthe products. "We are aware of some SMEs that have been waitingfor 12 months since their review meeting with the bank."

PAINFUL PROCESS

Raj Bilakhia, a 59 year-old property investor from London,told Reuters he had been waiting to be paid for nearly a yearafter meeting with Royal Bank of Scotland to discuss hiscase last November.

"It is painful. The process is too slow," he said. "As wellas that, we cannot sell any of our properties. The price isright now where we could make a profit but we can't sell becausethese instruments give a penalty for breakage costs and thepenalties are quite horrendous," he said.

RBS declined to comment on the specific case. The bank saidit "remained committed to delivering outcomes for customerswithin the timelines set by the regulator."

The FCA expects the rate of progress to accelerate rapidlyin the next few months. It said banks are aiming to send outmore than 1,000 offers of compensation in October and thatnumber will continue to increase each month.

The regulator has told banks it expects most customers tohave been informed of a decision and to receive an initialcompensation offer, if applicable, by the end of the year.

Much of the work so far has focused on determining whetherborrowers were regarded as 'sophisticated' or not. Only'non-sophisticated' companies can claim under the scheme.

The regulator regards a business as sophisticated if it hasannual sales of more than 6.5 million pounds, assets worth morethan 3.3 million pounds and more than 50 employees.

Data from the FCA showed differing rates of progress indealing with cases at Britain's biggest four banks. Barclays has reached the redress offer and acceptance stage for159 sales, with 194 at HSBC, 32 at Lloyds and21 at Royal Bank of Scotland.

The FCA data showed majority state-owned RBS to have moreclaims under review than Lloyds, Barclays and HSBC combined.RBS is assessing 9,713 cases, compared with 3,412 at Barclays,3,315 at HSBC and 1,905 at Lloyds.

RBS has set aside 750 million pounds for compensation so far- far less than Barclays' 1.5 billion pounds, while Lloyds andHSBC have each set aside 400 million pounds.