“The Collapse of Barings Bank”
(Causes and Recommendations)
Introduction:
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 M 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 edge 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 which later became BSL.
Events Leading To Fall:
In February, 1995, Nick Leeson, a “rogue” trader for Barings Bank, UK, single-handedly caused the financial collapse of a bank that had been in existence for hundreds of years. In fact, Barings had financed the Louisiana Purchase between the US and France in 1803.
Leeson was dealing in risky financial derivatives in the Singapore office of Barings. He was the only trader there and was betting heavily on options for both the Singapore (SIPEX) and Nikkei exchange indexes. These are similar to the Dow Jones Industrial Average (DJIA) and the S&P500 indexes here in the US.
In the early 90s, Barings decided to get into the expanding futures/options business in Asia. They established a Tokyo office to begin trading on the Tokyo Exchange. Later, they would look to open a Singapore office for trading on the SIMEX. Leeson requested to set-up the accounting and settlement functions there and direct trading floor operations (different from trading). 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. The London office granted his request and he went to 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 initially, he could only execute trades on behalf of clients and the Tokyo office for “arbitrage” purposes. After a good deal of success in this area, he was allowed to pursue an official trading license on the SIMEX. He was then given some “discretion” in his executions meaning; he could place orders on his own (speculative, or “proprietary” trading).
Even after given the right to trade, Leeson still supervised accounting and settlements. And there was no direct oversight of his “book” and he even set-up a “dummy” account in which to funnel losing trades. So, as far as the London office of Barings was concerned, he was always making money because they never saw the losses and rarely questioned his request for funds to cover his “margin calls”. He took on huge positions as the market seemed to “go his way.” He also “wrote” options, taking-on huge risk.
He was, in fact, perpetuating a “hoax” in his record-keeping to hide losses. He would set the prices put into the accounting system and “cross-trade” between the legitimate, internal, accounts and his fictitious “88888” account. He would also record trades that were never executed on the Exchange.
In January, 1995, a huge earthquake hit Japan, sending its financial markets reeling. The Nikkei crashed, which adversely affected Leeson’s position (remember, he had been selling Options). It was only then that he tried to hedge his positions, but it was too late. By late February, he faxed a letter of resignation, and when his position was discovered, he had lost ($1.4 billion USD).
The fall of Barings not only shocked the financial markets world over, it also exposed their vulnerability.
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 billion debts that Barings had accumulated.
On February 26, 1995, Barings was declared insolvent under the UK Insolvency Act, 1986. Barings, the bank which financed the Louisiana Purchase between the US and France, became insolvent and was sold to a competing bank for $1.00
The Reason for the Failures:
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.
Mr Leeson began to commit several trading errors (selling instead of buying, misunderstanding signals, communication problems, etc.). The costs of these errors were usually charged to the bonus account of the responsible trader. Mr Leeson, however, decided to “cook the books” in order to hide the errors. He dumped his errors to a “stealth account”, using fictitious trade operations, especially future and option contracts. Due to unfavorable market movements and continuous fraudulent behavior.
Several errors committed not only by Mr Leeson but also by the Barings supervisors and the financial supervision in Singapore and London lead to the breakdown. First of all, there was an incentive to hide errors and exercise fraudulent operations since the traders were offered high bonuses at the end of the year for successful trades. In addition, the bank increased the pressure to perform when setting a higher profit goal. Mr Leeson, a quite difficult character, very ambitious and at the same time impatient concerning his career advance (lots of career moves), therefore was very prone to this type of hidden operations. He probably also misjudged the Singaporean business culture.
Barings Bank is also responsible for its breakdown. The office in Singapore was understaffed which lead to stressed traders and more errors. Moreover, Barings wanted to save money and employed only one manager instead of two for an important position. There was a lack of control because settlement and floor operations were not separated from each other so the trader had to be controlled by himself. So far this was unusual practice, maybe because of the bank’s greed and aspiration to easy profits, but not the only reason for the breakdown.
The operation of the matrix-based reporting system within the Barings Group, which had Leeson nominally reporting through different management lines, made responsibility for oversight of his activities ambiguous and ultimately ineffective in practice. With hindsight, it
appeared that no-one carried ultimate responsibility for monitoring Leeson’s activities in Singapore.
Barings management did not question, until it was too late, the apparent high levels of profits being generated out of the authorized, but supposedly low risk, arbitrage activity conducted by Leeson. At one point, it was acknowledged within Barings management that over 60 per cent of the revenues of its worldwide derivatives operations was generated out of Leeson’s arbitrage operations;
Barings management did not question, nor did it control or place limits on, the high, ongoing levels of funding required by BFS from its parent and associated companies. These funding needs jumped sharply towards the end of February 1995. Immediately prior to the collapse, funding to BFS represented twice Barings Group capital; and the recommendations of an internal audit review, conducted on BFS in August 1994, were not acted upon quickly enough, or not at all, by Barings management. The internal audit, in fact, pointed too many of
the weaknesses in both the risk management structure and the controls which were present within the BFS operation.
Recommendations:
- Segregation of the front and back office
- Clear determination of responsibilities for each business and specification of the limits of each operator
- Full knowledge of the business in which the firm operates
- Separation of proprietary trading from agency trading
- Top management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly
- Creation of Internal Risk Management Units
The Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings pointed out the following suggestions for regulators:
The Bank of England should explore ways of increasing its understanding of the non-banking businesses undertaken by those banks for which it is responsible;
It should prepare explicit internal guidelines to assist its supervisory staff in identifying activities that could pose material risks to banks and ensure that adequate safeguards are in place;
It should work more closely with the Securities and Futures Authority, the agency responsible for regulating the domestic operations of British-based securities firms, as well as with regulators from other nations;
It should address deficiencies in the implementation of rules dealing with large exposures.