UPDATE 5-Mis-sold swaps may cost UK banks billions

* Compensation could run to 10 bln pounds - consultant

* Barclays, HSBC, Lloyds, RBS to begin review of cases

* RBS says will 'meaningfully' increase provision

* Banks have set modest provisions so far

* UK lawmaker urges banks to help affected businesses

By Matt Scuffham

LONDON, Jan 31 (Reuters) - British banks face another roundof compensation claims that could total billions of pounds afterthe regulator found they had widely mis-sold complexinterest-rate hedging products to small businesses.

The interest-rate swaps are the latest in a series of costlybanking scandals that include insurance on loans and mortgagesthat was also mis-sold, rigged global benchmark rates andbreaches of anti-money laundering rules.

Britain's financial watchdog said on Thursday it found thatin the 173 interest-rate swap test cases it examined, more than90 percent did not comply with at least one or more regulatoryrequirements.

A significant proportion will result in compensation beingdue, the Financial Services Authority (FSA) said.

Martin Berkeley, a senior consultant at Vedanta Hedging,which advises on interest-rate hedging products, said the final bill for banks could be as high as 10 billion pounds ($16billion).

So far, the four biggest banks have set relatively smallsums aside for compensation. Barclays has taken thehighest provision at 450 million pounds, HSBC has setaside about 150 million pounds, RBS 50 million poundsand Lloyds has said the cost won't be material.

RBS said on Thursday that it would "meaningfully" increasethe amount when it publishes its final results on Feb. 28. Itwill decide how much more to put aside after further talks withthe regulator.

Investec's banking analyst Ian Gordon said he expected theoverall bill for the industry to be around 1 billion pounds.

Banks have already set aside 12 billion pounds to compensatecustomers mis-sold payment protection insurance (PPI) andindustry sources expect that number to double.

The rate-swap products were designed to protect firmsagainst rising interest rates, but when rates fell they had topay large bills, typically running to tens of thousands ofpounds. Companies also faced penalties to get out of the deals,which many said they had not been told about.

Berkeley said the scandal has had a worse impact on victimsthan mis-selling of payment protection insurance to individuals.

"The difference between this and PPI is that people losttheir homes and businesses. These products were toxic."

The FSA said Barclays, HSBC, Lloyds and RBS will reviewsales of the products. Customers will be contacted by theirbanks and need not involve other advisers.

Banks are keen to keep claims management companies out ofthe process, having blamed them for inflating the cost of compensation for mis-sold PPI.

The British Bankers Association, a lobby group, said theFSA's announcement will give clarity to businesses and enablebanks to get on with compensating customers.

"Any business which is currently facing financialdistress and is seeking a suspension of payments should get intouch with their bank immediately," its Chief Executive AnthonyBrowne said.

The FSA has estimated that over 40,000 interest-rate swapproducts were sold to small firms.

Claire Gill, a partner at legal firm Carter-Ruck, raisedconcerns that the process could take too long to rescuebusinesses already struggling with repayments. She said it couldtake over a year for banks to deal with complaints.

"The priority for many businesses who are strugglingfinancially will be to obtain a moratorium on payments, which isstill being determined on a case-by-case basis," she said.

Business Secretary Vince Cable said banks' immediatepriority must be to ensure no more small firms are driven out ofbusiness as a result of the mis-selling.

"This is an example of the little guy paying for the bigbanks' wrongdoing," Cable said.

Barclays said it had suspended swap payments for customersaffected by the mis-selling who were in financial distress.

The FSA's study, launched last year after it had found"serious failings" in the way the products were sold, was set upto allow the regulator to assess the banks' proposals forreviewing sales and to ensure customers got the right outcome.

The FSA said on Thursday it had tweaked the criteria underwhich firms are entitled to claim to focus on small firms thatwere unlikely to understand the risks associated with theproducts.

Companies such as bed-and-breakfast businesses, whichpreviously were unable to claim because they hired a largenumber of seasonal workers, can be included whereas small unitsof multi-national companies cannot.

The products range in complexity from caps that fix an upperlimit to the interest rate on a loan, through to complexderivatives known as "structured collars" that fix interestrates with a bank but introduce a degree of interest-ratespeculation.