LAUSANNE | SWITZERLAND % Fis4 02.10.95 THE COLLAPSE OF BARINGS BANK This note was prepared by Professor Stewart Hamilton as a basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation, At 7.15 am on Friday 24 February 1995, Peter Baring, the ‘Chairman of the oldest Merchant Bank in the United Kingdom, received the call from Singapore that he had been dreading; a "big hole" in the accounts was confirmed; how big was not yet known, but was clearly greater than the bank's capital. A “rogue” trader had run up massive losses! on unauthorised derivative dealings in the Far East, which threatened to bring the bank down. Following time honoured tradition, Baring sought an interview with the Govemor of the Bank of England (B of E) for late on Friday aftemioon. He was seen by Rupert Pennant-Rea, the deputy governor, as his boss, Eddie George had just left for a skiing holiday. There was frenzied activity throughout the weekend; George, on receiving the news, immediately retumed from Geneva; senior representatives of fifteen or so UK Clearing and Merchant banks were called to the B of E carly on Saturday moming. They were asked to help assemble a rescue package, although the extent of Barings’ obligations was not known. Neither the B of E nor the Treasury would provide a "cap", or limit, to the potential liability, and the Chancellor of the Exchequer, Kenneth Clarke, would not sanction the application Of public funds. The assembled bankers were not prepared to take an unquantified risk with their shareholders’ funds, despite recognising that there were some very valuable parts to Barings’ business. No deal could be agreed, and all departed despondent. Administrators were appointed on the Monday momning, and 2 pillar of the UK banking establishment had been allowed to fail. Copyright © 1995 by IMD- International Institute for Management Development, Lausanne, Switzerland. Not to be used or reproduced without \written permission directly from IMD. " Subsequently quantified at £860 million.eal) ‘There was an immediate. public outery. Expressions of shock and disbelief came from senior figures in politics and the City. Editorials in the major newspapers suggested that there had been a serious, and possibly fatal blow to the Citys reputation as the B of E, for the first time, had failed to act as “lender of the last resort". "The Sixth Great Power"? Barings Bank was established in 1762, by Protestant immigrants from Holland. The family, business had been originally based on the textile wade and latcr had expanded into banking. The bank made its early fortune from trade, particularly in the Americas; it did well out of wars generally, and financed the war with N ‘America. It was also involved in funding the Napoleonic wars, hence Richelieu's description . Growth continued throughout the 19th Century. Barings brought Guiness to the market in 1886 and there was some doubt then about the propriety of certain share dealings! Always willing to invest in far-flung places, the bank got its fingers bumed financing, inter alia, a water and sewage treatment company in Argentina (the Pacific Rim of the time); as a result, Barings had to be rescued in 1890 by the B of E (celebrated in a famous "Punch" cartoon: ); the deficit then was about same in real terms as now! (£17m = £450m today). However, the B of E got its money back---eventually. It took four years to clear the debts. ‘There was a loss of pre-eminence thereafter, but Barings remained an aristocratic, “Blue Blood” bank; it numbered the present Quecn among its clients; there were five titles in the extended family. It was known to be old-fashioned, recruiting from "Eton and the Army”. Philanthropic to an extent, it was conservative, aloof, tisk avers, and-bad an established intemal audit function. Income was derived m corporate finance fees, corporate debt funding and asset management. There ‘was a significant “blue chip client base. 2 Duc de Richeliew, French soldier and statesman : "There are six great powers in Europe. England, France, Prussia, Austria, Russia and Baring Brothers.” 1818.Swtzotand -3- “Big Bang" Barings was stil a family-owned bank in the 1980's, with the ordinary shares held by the descendants of the founders and their charitable foundations. There were ‘outside bond holders, many of them private clients of the bank. Operating control lay with the Directors. Much changed in 1984 when, in the run up to "Big Bang”, like many others, Barings acquired a stockbroking business. Henderson Crosthwaite which’ had strong Asian connections, tun by a Christopher Heath, became Barings Securities (BSL). It had been a partnership and therefore had had no outside shareholders to worry about! It had a different ethos and there was a huge cultural gap. Barings’ strong control ethic conflicted with Heath's salesman's approach; there were clashes between the culture of corporate finance versus trading, team players versus individualists, trust and strong relationships versus quick results and "hire and fire” approach. It was Barings’ first involvement in equity securities. Heath ran BSL as a “one man band” with no formal management structures. The system of management and intemal controls known to be weak (certainly as carly as 1992). BSL was driven by the front office and communications between front and back offices were poor. The rapid expansion in personnel, offices and markets was not accompanied by the development of commensurate controls. No internal audit function.was in place until the end of 1992. BSL made big profits in late 1980's on the back of the Tokyo Stock Exchange (TSE) boom. By mid 1992, in a significant market dowatum, BSL was losing money. The Board demanded a new strategy; Heath stepped down following restructuring and left altogether in early 1993 with other senior staff and all the derivatives team. They were replaced by from corporate finance, with no background in this activity. Attempts were made to impose more controls, a matrix ‘management structure was put in and BSL was brought together with Baring Brothers (BB&Co), the ‘banking arm, to form Barings Investment Bank (BIB). Control culture differences remained, and were never fully resolved. In fact the management structure changed three times after 1992; no clarity of responsibility, no stability! There were also a number of serious personal conflicts amongst the senior management, sufficient to affect their operating performance. Following the Kidder, Peabody disaster in New York, the Board had ‘commissioned an internal risk review which concluded that such a problem could not happen in Barings.Hero or villain? Nick Leeson had joined Barings in 1989 to work in the futures and options settlements department ie. “back office’, of BSL, having previously done something similar at Morgan Stanley. His background was far removed from the BB&Co norm, He was a plasterer’s son, educated at a comprehensive, rather than a public, school, leaving with poor A level results. He had ‘entertained ambitions to ‘become ’a dealer and applied for authorisation in the UK. He was tuned down by the Securities and Futures Authority (SFA)? because he had failed to disclose, in his application form, two County Court judgements against him for personal debts. This rejection did not appear to have caused any problems at BSL. In mid 1992, partly because of staff shortages, Leeson was sent to Singapore to take charge of the back office function of Barings Futures Singapore (BFS), a wholly owned subsidiary of BSL. In early 1993, he was appointed General Manager of BFS, thus becoming responsible for dealing as well as settlement. His reporting lines were not clearly defined or understood from the start. In effect there was a "black hole” in the control structure! Leeson then applied to the Singapore Intemational Monetary Exchange (SIMEX) for a license as a trader. No was mention made of his SFA rejection in London, he was authorised, started trading and the rest is history! ‘The Singapore Business ‘The basic business of BFS was equity derivatives trading on behalf of a few clients, including Barings Securities Japan (BSJ); the main extemal client was Banque National de Paris (BNP); trading was in simple derivatives only, not "no rocket science"! There were three main types of derivatives: 10 year Japanese Government bonds (JGBs), Nikkei 225 futures and 3 month Euroyen contracts. All were conducted through recognised and therefor regulated, exchanges. There was no “over the counter” (OTC) dealing. All bargains were to be matched and no pen positions held according to SL's policy. The exchanges used were SIMEX, sake, Stock Exchange (OSE) and TSE. While SIMEX operated on open outcry”, TSE and OSE were computer based, which gave some room for arbitrage because of difering market stuctures. Leeson began to exploit the arbitrage opportunities. 3 The UK regulatory body responsible for authorising and monitoring firms which carry out investment business.‘Trading Activities Eventually Leeson started “proprietary trading", ic. for the bank's own account rather than for clients, and to enjoy success and excellent profits from ‘what was believed in London to be a risk free activity! The likely positive effect ‘on year-end bonuses had been noticed! He was booking trading gains and hiding losses. The abnormal profits were not queried by or investigated during the Deloitte & Touche (D&T) audits for 1992 or 1993 (by which time the concealed losses had reached £23m); these grew to exceed £200m by the end of 1994. The large reported profits made Leeson a “hero” in London, and no-one was anxious to upset him. Following the Kobi earthquake, the Nikkei collapsed Leeson doubled up and chased losses. Huge cash advances were requested from London to meet the SIMEX margin calls. In January and February these rose cumulatively to £700m, or two times Barings’ capital base! All sorts of waming signs had not been picked up, but eventually someone was sent to investigate. Leeson disappeared and the ‘phone call to Peter Baring in London followed! In the meantime the trading floors of SIMEX, TSE and OSE were full of rumours about extent of Barings’ derivatives exposure. SIMEX and the Bank of Intemational Settlements (BIS), Basle asked questions. The responses from London were slow and inadequate, In the meantime, the stories even got to Edinburgh! Nobody in London picked up on it ! ‘The Cover-up and creation of the 88888 account Leeson used a special account (88888) to book transactions which had the effect of disguising the true trading position. He has claimed that this account was opened originally to book genuine errors and only later misused. The London computer system could not pick it up because it was. not on the master list of files. Instead it was put into a suspense account which was never reconciled or analysed!. The cash margin calls by SIMEX were reported as part of “customer advances" on the regular internal bank, balance sheets, but escaped the normal credit checks! London and Singapore numbers didn't match but no reconciliation ‘was carried out. Leeson was the source of all information for London. Internal procedures and controls ‘There had been an intemal audit in Singapore in July 1994 which didn’t pick up the fraud, but recommendations were made which, if followed, would have caught it. Nothing was done by London. No compliance or risk officer was appointed for Singapore because London believed that no risk activity was being carried on! Furthermore, D&T had reported to Coopers & Lybrand (C&L) in London in connection with the 1993 group audit, that there were "no intemal control blems in BFS". Regulators had been fed false or misleading information by Barings, but did very litle independent investigation. The B of E never made an inspection visit, and also allowed Barings to break “25% exposure" rule which limits a banks exposure to any one activity.‘The Collapse Following the failure by the B of E to organise a rescue package, all bell broke loose. ‘A week later ING? bought Barings for £1, retuming it to its Dutch roots! The new ‘Owners assumed all the bank's liabilities, other than those to the bondholders, and no-one in the Far East lost out. The "losses tumed out to be not as bad as originally feared, but still circa £850 million. It was recognised that there was value in the asset management subsidiary, and ING hoped to retain the existing client base of over 70 UK public companies. The bondholders, who were thought to have Jost more than £100 million, were excluded from deal, and had little hope of recovering their money. Leeson was arrested in Germany en route for the UK. Report of the Board of Banking Supervision (BBSR) In July 1995, four months after the collapse, but quick by UK standards, the report of the Board of Banking Supervision was “returned” to the House of Commons, thus enjoying the protection of Parliamentary privilege. There was still no. co- operation from Singapore, while Lecson remained in a Frankfort jail awaiting extradition. Everybody was trying to find a scapegoat. The auditors were critici and there were more demands by politicians for more regulation. Leeson, who wanted to return to the UK, refused to be interviewed by Board of Inquiry. 4 The Board consisted of three senior officers of the B of E, the Governor, his deputy and the Executive Diresctor, and six independent members appointed jointly by the Chancellor of the Exchequer and the Governor of the Bank. 3 A major Dutch Bank.Ho The report_set out in great detail the nature of the unauthorised transactions, and the methods of cover-up. Leeson was alleged to have forged an audit confirmation letter to conceal part of the losses. The report was critical all round, but not too hard on the B of E itselft However, the Board admited that it had boon restricted in its inquiry by the inability to gain access in Singapore to Barings’ employees, the audtore and other wclevent forma, Consequently, the — story remained incomplete, and is likely to remain so pending the report by the Singapore authorities. The report listed a number of missed “indicators” of wrong doing, which it believed Barings’ management should have picked up. It also made some recommendations for management in general, particularly with regard to intemal controls. There were also suggestions as to how regulators in the future, could tighten control and supervision. Interestingly, the extensive press coverage at the time of the collapse, cepecially that by the “FT” and “The Times”, had picked up most of the main point ‘not all the detail; consequently, the report, almost indigestible (at 337 pages), was something of an anti-climax. There followed much analysis and comment in the UK press, inclding wild puns eg. "The Leeson Lesson", "BarINGs without the ING = jail!" and "gallows humour": “Why was Leeson found wandering lost in a Thai wood? He had lost his bearings!", and worse. Inall of this, the fate of bond holders was ignored. At the end of the day, only they and the Barings’ shareholders had lost out. ‘The UK authorities did not appear anxious for Leeson to be tried in London. There was press speculation that the UK authorities, in particular the B of E, had something to hide, or perhaps it was simply a wish on the Government's part to avoid further embarrassment? try and force government to demand Leeson's extradition from to stand {alin England, Resolutely, Singapore insisted that Leeson must face trial for fraud re