Fixed rates were never purchased on the market as suggested by 44Brendan to any great extent. What happened was the Retail side of Banks hedged their fixed rate exposures with Treasury. That is not an external hedge or external swap.
In this context, "Treasury" simply refers to the department that buys the interest rate swap for the bank - it is very much an "external" swap (what's an internal swap?).
KBC's website provides a good description of the relationship between swap rates and break funding costs:-
If, during the Fixed Rate Period, the Applicant redeems in whole or in part or converts the loan into a variable interest rate or to another fixed rate loan, on that date (the "switching/redemption date"), a "break funding fee" will be payable to the Lender. If, at the switching/redemption date the Wholesale Rate is higher than the Wholesale Rate at the date the existing fixed rate applying to the Loan was set, no break funding fee arises. If, however, at the switching/redemption date, the Wholesale Rate is lower than the Wholesale Rate at the date the existing fixed rate applying to the Loan was set, then a break funding fee will be chargeable. The break funding fee will be calculated by reference to the following formula:
B = (W - M) x T / 12 x A, where:
B = The Break Funding Fee.
W = The Wholesale Rate Prevailing at the date of the existing fixed rate applying to the loan was set.
M = The Wholesale Rate prevailing at the switching/redemption date for the unexpired time period of the Fixed Rate Period.
T = Period of Time in months to the end of the Fixed Rate Period.
A = Principal amount which is subject to the existing fixed rate and which is being switched or redeemed.
‘Wholesale rate’ means the rate per cent per annum which the Lender determines to be the market rate applying to an appropriate interest rate swap for the relevant time period.
The following are examples of the calculation of the break funding fee:
A) Where Wholesale rate increases over the term of the loan:
Wholesale rate at the date the existing fixed interest rate applying to the loan was set (W): 7%
Wholesale Rate at switching/redemption date (M): 8%
Break funding fee €0
B) Where Wholesale Rate decreases over term of loan:
Wholesale Rate at date the existing fixed interest rate applying to the loan was set (W): 8%
Wholesale Rate at switching/redemption date (M): 7%
Break funding rate 1%
Unexpired Fixed Rate Period (T) Six months
Break funding fee (per €1,000 loan amount) €5
Break funding fee = (8%-7%) x 6 / 12 x 1,000 = €5.00 per €1,000.00