The Fall of Barrings Bank

Introduction The case of Barings Bank is one of the most famous histories in the world when one man led to the bankruptcy the oldest British bank. Barings collapsed on February 26, 1995, due to the activities of one trader, Nick Leeson, who lost almost $1.4 billion. The loss was caused by a large exposure to the Japanese stock market, which was achieved through the futures market. Leeson, the chief trader for Barings Futures in Singapore, had been accumulating positions in stock index futures on the Nikkei 225, a portfolio of Japanese stocks. As the market fell more than 15 percent in the first two months of 1995, Barings Futures suffered huge losses, which were made even higher due to the sale of options, which implied a bet on a stable market. As losses mounted, Leeson increased the size of the position, in a stubborn belief he was right. Finally, on 25 February 1995 he walked away, when he realized that bank was unable to make the cash payments required by the exchanges. Nick Leeson had totally wiped out the venerable 233-year-old Baring Investment Bank, which proudly counted Queen Elizabeth as a client. He left behind huge liabilities totaling $1.4 billion, more than the entire capital and reserves of the British institution. This situation and a similar scam at the New York branch of Japan's Daiwa Bank in October 1995 shocked all people, not only

the financial world. In the aftermath of the activity of Leeson, Barings collapsed and was purchased by the Dutch bank/insurance company ING for the nominal sum of 1. How it was possible? what exactly happened at Baring and how the board might have avoided this situation?

Brief history of the Bank Barings Bank, the oldest merchant banking company in England, was founded in 1762. Barings was an illustrious name what confirm the words of the French Foreign Minister, Duc de Richelieu, who in 1818 said: There are six great powers in Europe: England, France, Prussia, Austria, Russia and Baring Brothers. This accolade did not apply so well eighty years later, when in 1890 it faced bankruptcy in the aftermath of a significant amount of investment lost in South America following the Argentinean revolution. However, at that time, they had been bailed out by the Bank of England and other London banks. From then on, however, Brings continued in traditional merchant banking, building up a reputation based on corporate finance, strong investment management, and the trading it did for one of the best clients in London, including the Royal Family. In 1984 it acquired the stockholding business of small stock broking company, Henderson Crosthwaite, with a staff of 15 based in London, Hong Kong and Tokyo. Baring Brother and Company (BB and Co) then established Baring Securities Limited (BSL), as a

separately and liberally managed business within the group. BSL was very successful, enjoying the fruits of the 1980s Tokyo Stock Market boom, and specialized in Japanese equity warrants bonds sold with warrants exercisable into shares. Growth of business in emerging markets together with expansion of securities induced Barings to consolidate BB and Co and BSL. Board of the Bank was very satisfied with the presence on the Asian market and in order to develop much faster it perceived in the field of derivates a good source of profits and therefore decided to establish Baring Futures (Singapore) Ltd ("BFS") which was incorporated on 17 September 1986 and shortly after, applied for and was granted nonclearing membership by the Singapore International Monetary Exchange Ltd ("SIMEX"). On 21 February 1992, BFS applied for clearing membership of SIMEX and this was subsequently granted. BFS commenced trading on SIMEX on 1 July 1992. Activity of Nick Leeson on the Asian market The Barings board decided to send to Asia in 1992 a young trader from a humble background, Nick Leeson, who seemed to know how to deal in derivatives, a quite new game that few in the financial fraternity really understood. The Bank wanted to become one of the first active banks in this region of the world and also from this reason the board gave a trader a lot of freedom in his activity. In 1993, Nick Leeson was appointed general manager of the bank's Barings Futures subsidiary in

Singapore. Trader was authorized to conduct both proprietary and clients account trading on Far Eastern exchanges, on behalf of other Barings companies, specifically, Baring Securities Limited (Singapore), Baring Securities Limited (London), Baring Securities (Japan), Baring Securities Hong Kong Limited and Banque Nationale de Paris (Japan). He dealt in 6 main financial futures and some options on them, as follows: 1. Nikkei 225 contract traded on SIMEX in Singapore; 2. Nikkei 225 contract traded on OSE (Osaka Stock Exchange) in Japan; 3. 10-year JGB (Japanese government bonds) contract traded on SIMEX in Singapore; 4. 10-year JGB contract traded on TSE (Tokyo Stock Exchange) in Japan; 5. 3-month Euroyen contract traded on SIMEX in Singapore; 6. 3-month Euroyen contract traded on TIFFE (Tokyo Financial Futures Exchange) in Japan. Around 1993 arbitrage business began to be an important part of Barings Far Eastern operations. Initially this took the form of cash/futures arbitrage in Tokyo, and soon after the rapid build-up of arbitrage between SIMEX and OSE on Nikkei 225 futures contracts. The Barings management called this authorized business switching, although it would normally be known as a form of inter-exchange arbitrage. Leeson would buy and sell Nikkei 225 futures contracts simultaneously

on SIMEX and OSE, benefiting from small differences in identical contracts buying at the cheaper price and selling at the higher. These opportunities existed because OSE and SIMEX have different market conditions OSE has local business,SIMEX mostly off-shore business, and OSE conducts business more slowly than SIMEX.Leeson also switched JGB futures contacts on SIMEX and TSE. This arbitrage market provided good opportunities since the JGB market was rather volatile. He also did arbitrage business on SIMEX and TIFFE Euroyen contracts. The problem was Leeson kept unmatched position and he was able to conceal his unauthorized trading activities for over a year because he managed both the trading and back office functions. The senior managers at Barings came primarily from a merchant banking background and knew very little about trading. Even in the face of large profits, which should have tipped management off to the fact that substantial risks were being taken, they continued to believe that Leeson held matched positions on the SIMEX and the OSE, and hence was making a lowrisk profit. In fact, Leeson was trading derivatives contracts on the two exchanges that were, in some cases, of different types and, in some cases, in mismatched amounts. He executed a trading strategy known as a "straddle," with the objective of making a profit by selling put and call options on the same underlying financial instrument, in this case, the Nikkei 225 Index. A straddle will generally produce positive earnings when markets are stable but can result in large losses if markets

are volatile. Leeson created an error account numbered 88888 as a holding area for any premiums or losses that he made. A trader claimed that he initially had opened the account to conceal a single loss of 20,000 pounds sterling that had resulted from an accounting error until he could make up the difference through trading. However, he continued booking various losses on the account and also continued to increase his volume of trading and level of risk taking. Leeson increased the size of his open positions even as his losses increased due to volatility in the markets. When an earthquake (23 January 1995) in Japan caused a steep drop in the Nikkei 225 equity index, Leeson's unauthorized trading positions suffered huge losses and his operation unraveled. On March 3, 1995, the Dutch bank ING purchased Barings for the princely sum of 1, providing the final chapter in the story of the 223-year-old bank. The immediate damage to markets was less than might have been expected mostly resulting from falls in confidence. Nikkei 225 dropped by 5% on 27 February when markets re-opened while the London Stock Exchange Index (FTSE 100) lost only 12,4 points on 28 February. These rather small slopes were caused mainly because of the fact that Barings was a tiny player in international banking in comparison with the huge American and Swiss banks. Barings 354 million plus capital resources (assets 5.9 billion) were dwarfed by banks whose resources ran into several billions as Barclays.

To sum up the activities of Nick Leeson, it can indicate three major features of his operations: 1. His supposedly low-risk arbitraging with Nikkei 225 and JGB futures produced apparently large returns, quite out of proportion to the type of business involved, even taking into account the large number of contracts. From account disclosed for 1994, switching business contributed 28,5m to the Barings Group operating profits, about 8% of total profits, and nearly as great as the Banking Groups operating profit which was at the level of 36,9m. Of this switching activity, 23,4m was generated solely from JGB arbitrage. 2. Continuing call by BFS on the rest of the Group for funds for margin payments. By 24 February 1995, this cumulative funding represented well over the reported capital of the Barings Group. This astonishing situation was allowed to develop as the result of no reconciliation of the funding with client records. This fact confirms also that management board of Barings had not the vaguest idea about trading of derivates. Common sense suggests that margin cash should have been received in large amount, not paid if Leesons arbitrage was successful. 3. Leeson was building up substantial long position on SIMEX and short position on TSE. In the first two months of 1995 it was common knowledge among SIMEX, OSE and TSE traders that BFS had enormous open positions in the exchanges and it assumed there must have been some proprietary and unmatched

trades. BFS was very active on the SIMEX in the months of January and February 1995 when Leeson took dramatic steps in order to save the position of the Bank. The major reasons of the collapse of Barings: 1. Lack of internal checks and balances Even when segregation of duties was suggested by internal audit, the concentration of power in the Leeson's hands was scarcely diluted. 2. Lack of understanding of the business If Barings' auditors and top management had understood the trading business, they would have realized that it was not possible for Leeson to be making the profits that he was reporting without taking on undue risk, and they might have questioned where the money was coming from. Arbitrage is supposed to be a low risk, and hence low profit business, so Leeson's large profits should have inspired alarm rather than praise. Given that arbitrage should be cash-neutral or cash-rich, additional alarms should have gone off as the Bank wired hundreds of millions of dollars to Singapore. 3. Poor supervision of employees Although Leeson had never held a trading license prior to his arrival in Singapore, there was little oversight of his activities and no individual was directly responsible for monitoring his trading strategies. 4. Lack of a clear reporting line

Leeson's fraud may have been facilitated by the confusion caused by two reporting lines: one to London, for proprietary trading, and another to Tokyo for trading on behalf of customers. 5. Barings over many years was considered as a rather conservative bank and therefore the bankruptcy served as a wake-up call for financial institutions all over the world. Leeson had control over both the trading desk and the back office. The function of the back office is to confirm trades and check that all trading activity is within guidelines. In any serious bank, traders have limited amount of capital they can deal with and are subject to closely supervised position limits. 6. Problems with Senior management Showed little interest in the Singapore Branch. They had only a vague understanding of derivatives did not have a precise breakdown of Leesons profits. They also failed to question capital requests by Leeson to fund margin accounts. 7. Problems with Barings Funding Control Measures No distinction between proprietary and customer trades and ignorance to credit risks.

Internal Controls at Barings Bank The Barings collapse confirmed that internal controls at Barings were clearly insufficient to detect what was taking place with Leesons derivatives trades.

While initial accounts cantered on the fraudulent activities of Leeson, and evidence suggests that Leeson was in fact engaged in highly speculative transactions and deliberately tried to deceive his superiors, his actions were not the only reason for the group's failure. Totally inadequate internal communications, controls, and channels of accountability, as well as insufficient regulatory oversight, compounded these findings by UK regulators as did a lack of communication between regulators in the United Kingdom, Japan, and Singapore. The most glaring aspect of the lack of internal communication is that it was common knowledge on the futures markets that Barings was building an increasingly risky position. The failure of Barings management to prevent the collapse of Barings also resulted from Barings' flawed internal controls and channels of accountability. Leeson was responsible for both the trading and the settlement sides of the Singapore operations, which made it easier for him to conceal his contracts from his superiors. Nevertheless, senior management officials at Barings had been made aware of this situation as early as 1992. At that time the head of Barings Securities operations in Singapore alerted the firm's management in London to the potential dangers of having Leeson manage both trading and settlement.