The Barings Bank collapse

Starring Nick Leeson

(The spectacular fall of Barings in 1995 because of one rogue trader - Nick Leeson)

Praxis Business School

By,Donald White

Introduction

Founded in 1762 by Sir Francis Baring

The oldest mercantile bank in London until its collapse in 1995

Nick Leeson in 1990’s lost $1.4 billion speculating – primarily on futures contracts

Derivative trading by Barings

The chain of events which lead to this banks downfall

The control and risk management lessons to be learnt from this collapse

Takeaways

History

In 1802, it helped finance the Louisiana Purchase

Panic of 1890 – efforts in underwriting got the firm into serious trouble through overexposure to Argentina and Uruguayan debt

Ties with King George V and the British Monarch

WW2 saw the British government using Barings to liquidate assets in the US and elsewhere to finance the war effort

Meaning of derivatives

Financial instruments whose value changes in response to the changes in the underlying variables

Derivatives fall into two major courses OTC derivatives Exchange traded derivatives

Since mid-80 volumes and value of futures, options and swap contracts traded have increased astronomically

The collapse

Barings was brought to its knees by Nick Leeson in a Singapore office

He was employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on the SIMEX and Japan’s Osaka Exchange

Leeson left a $ 1.4 billion hole in Barings' balance sheet due to his unauthorized derivatives speculation, causing the 233yr old banks demise

Who was Nick Leeson ?

He grew up in London’s Watford suburb Worked for Morgan Stanley after graduating

university Leeson then joined Barings(Jakarta) to sort

through back office mess involving 100 million pounds of share certificate.

Successfully rectified the situation in 10 months

Then transferred to Singapore and worked with a lot of power and freedom

Lesson's Activities

Was supposed to be arbitraging

Instead of hedging, gambled on the future direction of the Japanese market

Had long futures position on OSE

Was not short on SIMEX

Kobe earthquake of Jan 1995 led to the crash of Nikkei and his investments

Lesson's Trading

“Arbitrage” futures between SIMEX and OSE

Sell straddles

“Arbitrage” between SIMEX and OSE

Involves going long in one market and short in the other one.

Lesson's went long in Osaka.

(His position was public knowledge since the OSE publishes weekly data)

Leeson should have gone short in Singapore; he went long instead (unauthorized trades)

Selling straddles

Straddle = Sell one put and one call with same strike and maturity

Benefits the seller if prices don’t change much (i.e., the options expire worthless)

Leeson sold straddles on the Nikkei 225

Note: Leeson did not have the authority to sell options

Tough luck

On January 17, 1995, the Kobe earthquake hit Japan, causing the Nikkei to fall below 18,000.

Put options moved deep in-the-money

No rocket science needed here?

When you speculate in long futures and prices drop = you lose

When you sell straddles and prices drop = you lose

Keep in mind: Losses from selling call options are potentially unlimited!

Barings collapsed because it could not meet its obligations:

(Courtesy of Nicholas Leeson)

Over US$7 billion on the Nikkei 225 equity contracts

Over US$20 billion on Japanese bonds and Euro yen contracts

Bottom line

The infamous 88888 account !

Leeson set up an error account - the infamous account 88888 (not known to senior management in UK).

He then engaged into a significant volume of cross trading between account 88888 and other accounts

Cross trading = matching the positions of two accounts belonging to the same client

Ex: If Barings owed US$500m to Daiwa Bank from one type of transaction but also expected to receive US$300 from Daiwa from another type of transaction, it could net the two amounts through a cross trade.

After executing these cross-trades, Leeson would instruct the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices to cause profits to be credited to account 92000, while charging losses to account 88888 account

What appeared to be an arbitrage was in fact a speculation disguised with the help of account 88888.

88888 account discrepancies

Trading discrepancies Short term : settle immediately

Leeson changes software so that trades not reported

He’s running trading and back office Initially Barings Singapore not supposed to

trading for its own account

Lesson's deceptive strategies

Use of cross trade Breaking down the total number of contracts

into several different trades Changed the trade prices thereon to cause

profits Profits credited to ‘switching’ accounts &

losses to be charged to account 8888 Details of this account were never

transmitted to the treasury or risk control offices in London

Doubling strategy

Bet on Japanese stocks rising Every time index falls: Leeson increases his

long positions As stocks continue to fall, Lesson's losses

magnify

Margin calls

Futures markets: marking to market Generate large losses Leeson lies about these

Customer accounts Normal part of futures trading

Should be generally neutral if he is long in one market and short in another

Failure to flag this in London was a big problem

Nikkei continues to fall

July 94-Feb 95: Nikkei falls, and Leeson continues losing money

Fraud increases: Fictitious trades False records

Selling option straddles Payout:

Win if no change in price Lose if the price increases or decreases

Raise cash now, exposed to potential huge losses in the future

Straddle plus Long Future

Gain on rise is reduced Magnifies losses on price fall

Final drop

Kobe earthquake, Jan 17 1995 Nikkei falls below 19,000 Leeson tries to single handedly push it back By Feb 1995, Losses = 830 million pounds Barings goes bankrupt Might have been ok, if could have held to Dec

1995 Also, what if positions were unwound “quietly”?

Regulations in Response

The Board of Banking Supervision conducted an inquiry

Did not necessitate any change to the framework of regulation

Some existing arrangements needed to be improved

Like better understanding of non banking businesses undertaken by the banking groups they were responsible for

Managements failure to control Leeson

Effectively let Leeson settle his own trades by putting him in charge of both the dealing desk and the back office.

He had the final say Payments

Ingoing outgoing confirmations and contracts

Reconciliation statements

Accounting entries

Position reports

Leeson was considered perfectly placed to relay false information back to London

Other red flags

BFS was asked by SIMEX to explain some margin inconsistencies related to account 88888 (Leeson was put in charge of responding to SIMEX)

No one in London knew how Barings acquired a US$83m receivable from Spear, Leeds & Kellogg.

Lesson's cash requests for the first two months of 1995 amounted to US$1.2 billion (No one asked for justifications)

Staff in London could not reconcile funds remitted to BFS to both proprietary in-house and individual client positions

Lessons from Barings

Role of traders Customer trades Arbitrage Position trades

Role of the back office Oversight on trader behavior Needs to be independent of traders

Role of main office Needs to understand and better scrutinize anomalous cash flows

Better understand the derivatives business

Senior management’s part

Mgmt. failed to follow up on the internal audit

Mgmt. had a poor understanding of derivatives

Mgmt. failed to understand the risks of the business

Mgmt. failed to supervise properly

Wishful thinking

Senior mgmt. believed that Lesson's positions were hedged because the alternative was inconceivable

Senior mgmt. should have made sure it was hedged

Probably they also believed in market efficiency and natural selection:They were right, but headed for extinction

Risk Management Message

Operational risk

Fraud Inadequate controls

Would VaR have helped?

Didn’t really need this technology to reveal Lesson's risk exposure

Observations

Management wanted to enter a new market but bank was not prepared for the activity on a derivative market

Stronger competition search additional profits gave so much control only to the one person

Derivatives in recent years a powerful tools in the hands of traders

Strict regulations are needed in order to avoid the next Barings

Conclusion

An unlikely series of events in the market +

One rogue trader +

Incompetent management =

______________________________________________

The demise of one of world’s oldest and most respectable bank

THANK YOU