Barings Bank and Nick Leeson

Introduction I would like to present the case of Barings Bank, 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. Later, he sent a fax to his superiors, offering sincere apologies for the predicament that I have left you in. 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? In my essay I try to answer this question and I will explain 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 1

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) Pte 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.

The meaning of derivatives Generally speaking, derivatives fall into two major categories. One consists of customized, privately negotiated derivatives, which are known generically as over-the-counter (OTC) derivatives or, even more generically, as swaps. The other category consists of standardized, exchange-traded derivatives, known generically as futures. In addition, there are various types of product within each of the two categories. Since the mid-80s the volumes and value of futures, options and swaps contracts traded have increased astronomically all over the world what is well illustrated by the table and graph below:

Markets for selected Derivate Financial Instruments: Notional Principal Amounts Outstanding (US$ Billions) North America 1986 1990 1991 1992 1993 1994 1995 1996 518,1 1268,5 2151,7 2694,7 4358,6 4819,5 4849,6 4839,7 13,1 461,2 710,1 1114,3 1777,9 1831,7 2241,6 2831,7 87,0 560,5 657,0 823,5 1606,0 2171,8 1990,1 2154,0 0,0 0,2 0,5 1,8 28,7 39,5 106,8 59,3 618,2 2290,4 3519,3 4634,3 7771,2 8862,5 9188,1 9884,7 Europe Asia-Pacific Other Total

Source: IMF, International Capital Market, November 1997

Historical OTC Market Derivates Activity (outstandings, US$ billions)

$60 000

$50 000

$40 000

$30 000

$20 000

$10 000

$0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Source: International Swaps & Derivates, http://isda.org/

Simultaneously, with the rapid growth of the use of derivates, many analysts were aware of the lack of procedures of management risk A report prepared by the Economist Intelligence Unit after the collapse of Barings, indicated that 95% of the international

companies wanted still to maintain their favourable attitude to derivates, with 52% regarding derivates as an essential and regularly utilised tool. On the other hand, a company Touche Ross, in one of its study from 1995 concerning the use of derivates by 26 companies in the London FTSE 100 Index found that only 65% of companies surveyed had a written policy on the use of derivates, and in many of these, the policies were inadequate. Only 50% said their policies specified the types of derivates allowed, and 50% had policies which imposed limits on the volume and principal amounts of derivates transacted. Only 58% of companies calculated the market value of their derivates on a frequent basis. However, less than 10% reported that derivates were used for speculative purposes.

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 4

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. In this moment it can ask what exactly happened at Barings if arbitrage is theoretically risk-free since orders are matched? The problem was here Leeson kept unmatched position and he was able to conceal his unauthorised 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 low-risk 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. For example, 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 unauthorised trading positions suffered huge losses and his operation unravelled. 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 5

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. During these months BFC was the largest trader holding between 8 and 12 percent of SIMEX comparing with this data: 1992 26th position 1993 9th position 6

In December 1993 it held about 2 percent of outstanding contracts on Nikkei 225 futures traded on SIMEX, and in January 1995, 34 percent. In January 1993 it held 1 percent of outstanding contracts of Nikkei 225 options traded on SIMEX, and in January 1995, 35 percent.

Consequences When Nick Leeson realized that his operations came to light he walked away, but he was arrested in March while on a stop-over in Germany. He and his wife Lisa were flying to London from Malaysia, where they said they had been holidaying. On December 2, 1995, a Singapore court sentenced him to six-and-a-half years in prison but he was released from a Singapore jail after serving three-and-a-half years of a sentence for fraud. As one of the further consequence of the collapse of Barings Bank, a syndicate at the Lloyds of London insurance market announced on 2 February 1998 that it had sold its first insurance policy covering banks for the risk of rouge trader. SVB Syndicates, a managing agency, launched the policy in October 1997 and the first buyer was as the agency said large New York based financial institution with global operations. SVBS policy provides cover for a trading loss which has been concealed by a trader or falsely recorded. The cover of up to $300m extends to commitments in excess of permitted limits, trading in unauthorized instruments and trading with unapproved counterparties. To qualify, banks will have to show they have the necessary internal controls in place.

What are lessons from Leeson case? What is crucial to underline in the mid-90s the financial world observed several significant collapses of various companies which were very active in the filed of derivatives and securities. It is interesting to mention here only about the most painful: 1993 Metallgesellschaft The German industrial company lost about $660 million on mismatches between its derivates hedges and long-term oil contracts with customers. April 1994 Kidder Peabody (KP) KP dismisses a trader, Joseph Jett, and accuses him of recording phantom profits of $350 million on trades involving derivates created by stripping the interest and principal from bonds and selling them separately. 7

 September-October 1994 Bankers Trust (BT) BT is sued by Gibson Greetings and Procter&Gamble over derivates losses, which amounted to $21 million for Gibson and a $200 million settlement for P&G. December 1994 Orange County (OC) OC reports a $1,5 billion loss, largely because of investment in derivates, leading to the resignation of the countys treasurer, Robert L. Citron, and lawsuits against Merrill Lynch, among others. September 1995 Daiwa (12th largest bank in Japan) This case provides a striking counterpart to the Barings disaster. The bank announced that a trader in New York, Toshihide Igushi, had accumulated losses estimated as $1,1 billion. A man concealed more than 30 000 trades over 11 years starting in 1984, in U.S. Treasury bonds. A trader had - as Leeson - control of both the front and back offices.

After the collapse of Barings, appropriate steps were taken by investment houses, which announced measures to tighten oversight of their traders. Regulators also bolstered their defences and for example SIMEX, where Leeson traded, formed a Regulatory and Risk Management Division and set up information-sharing arrangements with other bourses. To sum up, it can indicate 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.

Summary 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. The disaster has revealed an amazing lack of control at Barings: 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. To avoid conflicts of interest, the trading and back office functions are clearly delineated. In addition, most banks have a separate risk-management unit that provides another check on traders, but in the case of Barings it looked different. In my humble opinion, the management board wanted to enter a new market but in reality the Bank was not prepared to the activity on a derivate market. On the other hand, stronger competition in the banking sector induced the board to search additional profits in different business areas and from this reason it gave so much control only to the one person. Derivates have become in recent years a powerful tool in the hands of traders and after some confusion at the beginning I think it can notice that financial institutions are aware of the fact that strict regulations are needed in this area in order to avoid the next Barings.

References:

1. Jane E. Hughes and Scott B. MacDonald, International Banking, Addison Wesley 2002 2. Report of the board of banking supervision inquiry into circumstances of the collapse July of Barings 18 July 1995 - http://www.numa.com/ref/barings/bar00.htm 3. Web site of International Swaps and Derivatives Association https://www.isdadocs.org/index.html 4. Web site of ERisk company http://www.erisk.com/Learning/CaseStudies/ref_case_barings.asp

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