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* 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 round of compensation claims that could total billions of pounds after the regulator found they had widely mis-sold complex interest-rate hedging products to small businesses.
The interest-rate swaps are the latest in a series of costly banking scandals that include insurance on loans and mortgages that was also mis-sold, rigged global benchmark rates and breaches of anti-money laundering rules.
Britain's financial watchdog said on Thursday it found that in the 173 interest-rate swap test cases it examined, more than 90 percent did not comply with at least one or more regulatory requirements.
A significant proportion will result in compensation being due, 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 ($16 billion).
So far, the four biggest banks have set relatively small sums aside for compensation. Barclays has taken the highest provision at 450 million pounds, HSBC has set aside about 150 million pounds, RBS 50 million pounds and Lloyds has said the cost won't be material.
RBS said on Thursday that it would "meaningfully" increase the amount when it publishes its final results on Feb. 28. It will decide how much more to put aside after further talks with the regulator.
Investec's banking analyst Ian Gordon said he expected the overall bill for the industry to be around 1 billion pounds.
Banks have already set aside 12 billion pounds to compensate customers mis-sold payment protection insurance (PPI) and industry sources expect that number to double.
The rate-swap products were designed to protect firms against rising interest rates, but when rates fell they had to pay large bills, typically running to tens of thousands of pounds. 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 victims than mis-selling of payment protection insurance to individuals.
"The difference between this and PPI is that people lost their homes and businesses. These products were toxic."
The FSA said Barclays, HSBC, Lloyds and RBS will review sales of the products. Customers will be contacted by their banks and need not involve other advisers.
Banks are keen to keep claims management companies out of the process, having blamed them for inflating the cost of compensation for mis-sold PPI.
The British Bankers Association, a lobby group, said the FSA's announcement will give clarity to businesses and enable banks to get on with compensating customers.
"Any business which is currently facing financial distress and is seeking a suspension of payments should get in touch with their bank immediately," its Chief Executive Anthony Browne said.
The FSA has estimated that over 40,000 interest-rate swap products were sold to small firms.
Claire Gill, a partner at legal firm Carter-Ruck, raised concerns that the process could take too long to rescue businesses already struggling with repayments. She said it could take over a year for banks to deal with complaints.
"The priority for many businesses who are struggling financially will be to obtain a moratorium on payments, which is still being determined on a case-by-case basis," she said.
Business Secretary Vince Cable said banks' immediate priority must be to ensure no more small firms are driven out of business as a result of the mis-selling.
"This is an example of the little guy paying for the big banks' wrongdoing," Cable said.
Barclays said it had suspended swap payments for customers affected 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 up to allow the regulator to assess the banks' proposals for reviewing sales and to ensure customers got the right outcome.
The FSA said on Thursday it had tweaked the criteria under which firms are entitled to claim to focus on small firms that were unlikely to understand the risks associated with the products.
Companies such as bed-and-breakfast businesses, which previously were unable to claim because they hired a large number of seasonal workers, can be included whereas small units of multi-national companies cannot.
The products range in complexity from caps that fix an upper limit to the interest rate on a loan, through to complex derivatives known as "structured collars" that fix interest rates with a bank but introduce a degree of interest-rate speculation.