Barings Case Study

I think it shows the financial markets world is a good deal less efficient than we believe. If we look at our bank statements, we can see computer errors, for example. And at the same time, there's negligence. A lot of people turned a Nelsonic blind eye to what he (Leeson) was doing because he seemed to be bringing in the profits." 1 - David Frost, Executive Producer, Rogue Trader. "It could happen again because the incentives are the same, if not greater. The rewards are very great and that's a temptation for people." 2 - Neil Wilson, Editor of Futures and Options Week. Introduction On February 26, 1995, Barings Bank (Barings) - the United Kingdom's (UK) oldest and one of its most reputed banks - declared it was bankrupt. The bank with a total net worth of $900 mn had suffered losses in excess of $1 bn. These losses were result of the gross mismanagement of the bank's derivatives trading operations by Nicholas William Leeson (Leeson), the General Manager of Barings Future in Singapore (BFS). BFS had been established to look after the bank's Singapore International Monetary Exchange (SIMEX) trading operations. Leeson's job was to make arbitrage profits by taking the advantage of price differences of similar contracts on the SIMEX (Singapore) and Osaka stock exchanges. In spite of not having the authority, he traded in options and maintained un-hedged positions. He acted beyond the scope of his job, and was able to conceal his unauthorized derivatives trading activities. Due to the senior management's carelessness and lack of knowledge of derivatives trading, the bank landed up in a major financial mess. When Barings finally went into receivership3 on February 27, 1995, it had an outstanding notional futures position on Japanese equities and bonds of US$ 27 bn (US$ 7 bn on Nikkei 225 equity contracts and US$ 20 bn on Japanese government bond (JGB) and Euroyen contracts).4 Analysts said that the situation demanded that banks the world over must tighten their internal control procedures.

Background Note Barings was founded in 1762, by Francis Baring who set up a merchant banking business in Mincing Lane in London, UK. The business grew rapidly during the period 1798 to 1814. It became one of the most influential financial houses during the 1830s and 1840s. The British government paid Barings commissions to raise money to finance wars against the US and France during the mid 1800s. During 1860-1890, Barings raised $500 mn for the US and Canadian governments

and was regarded as London's biggest 'American House.' Barings was also involved in providing loans to Argentina during this period. In 1890, Barings was on the verge of bankruptcy when Argentina defaulted on bond payments. However, the Bank of England and several other major banks in London came forward to bail out the bank. This crisis had a major impact on Barings and led the bank to withdraw all its business on the North American continent. Barings then took up the business of providing consultancy to small firms and wealthy people, including the British royal family. Barings advised the royal family on the management of their assets, and also gave advice to small British firms on investing in stocks and bonds. For the next several decades, the bank grew well and earned significant profits. In the 1980s, the bank started operating in the US again. In 1984, Barings acquired the stock broking arm of Henderson Crosthwaite,5 which later became BSL. Prior to its merger with the banking business (Baring Brothers & Company) in 1993, BSL was run as a separate company (Refer Exhibit I & II for Barings' Organization Chart Pre- and Post-Merger). Incorporated in September 1986, BFS held a non-clearing membership6 of SIMEX. In February 1992, BFS applied for clearing membership7 of SIMEX... Excerpts Events Leading to the Fall Soon after joining BSL, Leeson applied and got a transfer to Jakarta, Indonesia. Due to his excellent performance, Barings management promoted Leeson to General Manager of BFS in Singapore in April 1992. In BFS, Leeson's job was to leverage on the arbitrage opportunities on similar equity derivatives between SIMEX and the Osaka stock exchange (OSE). To take the advantage of the arbitrage opportunity, Leeson had to adopt the following strategy if Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX . The arbitrage trading strategy required Leeson to buy at a lower price on one exchange and sell simultaneously at a higher price on the other, reversing the trade when the price difference had narrowed or become zero. The market risk in arbitrage was minimal because positions were always matched. Leeson was not given any authority to trade in options or maintain any overnight un-hedged positions.

Why Did it Happen? Industry analysts felt that the fall of Barings served as a classic example of poor risk management practices. The bank had completely failed to institute a proper managerial, financial and operational control system. Due to the lack of effective control and supervision, Leeson got an opportunity to conduct his unauthorized trading activities and was able to reduce the likelihood of their detection. Analysts felt that this disaster happened for the following reasons. SEPERATION OF FRONT AND BACK OFFICE DUTIES The back office is responsible for recording and settling trades transacted by the front office, by accepting/releasing securities and payments for trades, and reconciling them with details sent by the bank's counterparties and assessing the accuracy of prices... The End Result The fall of Barings not only shocked the financial markets world over, it also exposed their vulnerability. On February 26, 1995, Barings was declared insolvent under the UK Insolvency Act, 1986. Administrators were appointed to take control of the assets of the bank and its subsidiaries. A week later, all the assets and liabilities of Barings Bank and its subsidiaries (except BFS) were acquired by the Internationale Nederlanden Groep NV (ING). ING was looking to expand its investment banking business especially in Asia, where Barings had an extensive business network involving merchant banking activities such as investment banking, corporate banking, venture capital and capital markets operations, together with securities trading and asset management. ING paid one pound for Barings and took on the responsibility of paying the entire $1 bn debts that Barings had accumulated. Exhibits Exhibit I: Barings Organization Prior to Merging of Banking and Securities Businesses Exhibit II: Barings After the Merger of Banking and Securities Businesses Exhibit III: Graphical Representation and Payoff Table of a Short Straddle Strategy