Praxis Business

The Barings Bank

collapse
Starring Nick Leeson

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

Nick Leeson)
By,
Donald
 Introductio

qFounded in 1762 by Sir Francis Baring

qThe oldest mercantile bank in London

until its collapse in 1995

qNick Leeson in 1990’s lost $1.4 billion

speculating – primarily on futures contracts
 Takeaways
qDerivative trading by Barings

qThe chain of events which lead to this banks

downfall

qThe control and risk management lessons to

be learnt from this collapse
 History

qIn 1802, it helped finance the Louisiana

Purchase

qPanic of 1890 – efforts in underwriting got the

firm into serious trouble through overexposure
to Argentina and Uruguayan debt

qTies with King George V and the British

Monarch

qWW2 saw the British government using

 Meaning of

qFinancial instruments whose value changes in

response to the changes in the underlying
variables

qDerivatives fall into two major courses

ØOTC derivatives
ØExchange traded derivatives

qSince mid-80 volumes and value of futures,

options and swap contracts traded have
increased astronomically
 The

qBarings was brought to its knees by Nick

Leeson in a Singapore office

qHe was employed by Barings to profit from

low risk arbitrage opportunities between
derivatives contracts on the SIMEX and Japan’s
Osaka Exchange

qLeeson 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
?
qHe grew up in London’s Watford suburb
qWorked for Morgan Stanley after graduating
university
qLeeson then joined Barings(Jakarta) to sort
through back office mess involving 100 million
pounds of share certificate.
qSuccessfully rectified the situation in 10
months
qThen transferred to Singapore and worked
with a lot of power and freedom
 Lesson's
Activities
qWas supposed to be arbitraging
qInstead of hedging, gambled on the future
direction of the Japanese market
qHad long futures position on OSE
qWas not short on SIMEX

qKobe 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)
 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!
 Bottom
line
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
 The infamous 88888
account !
qLeeson set up an error account - the infamous account 88888 (not known
to senior management in UK).
qHe then engaged into a significant volume of cross trading between
account 88888 and other accounts
qCross trading = matching the positions of two accounts belonging to the
same client
qEx: 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.
qAfter 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
qWhat 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
qUse of cross trade
qBreaking down the total number of contracts
into several different trades
qChanged the trade prices thereon to cause
profits
qProfits credited to ‘switching’ accounts &
losses to be charged to account 8888
qDetails of this account were never
transmitted to the treasury or risk control
offices in London
 Doubling
strategy
qBet on Japanese stocks rising
qEvery time index falls: Leeson increases his
long positions
qAs stocks continue to fall, Lesson's losses
magnify
 Margin
calls
qFutures markets: marking to market
qGenerate large losses
qLeeson lies about these
Ø Customer accounts
Ø Normal part of futures trading
qShould be generally neutral if he is long in
one market and short in another
qFailure to flag this in London was a big
problem
 Nikkei continues to
fall
qJuly 94-Feb 95: Nikkei falls, and Leeson
continues losing money
qFraud increases:
Ø Fictitious trades
Ø False records
qSelling option straddles
qPayout:
Ø Win if no change in price
Ø Lose if the price increases or decreases
qRaise cash now, exposed to potential huge
losses in the future
 Straddle plus Long
Future
qGain on rise is reduced
qMagnifies losses on price fall
 Final drop

qKobe earthquake, Jan 17 1995

qNikkei falls below 19,000
qLeeson tries to single handedly push it back
qBy Feb 1995, Losses = 830 million pounds
qBarings goes bankrupt
qMight have been ok, if could have held to Dec
1995
Ø Also, what if positions were unwound “quietly”?
 Regulations in
Response
qThe Board of Banking Supervision conducted
an inquiry
qDid not necessitate any change to the
framework of regulation
qSome existing arrangements needed to be
improved
qLike better understanding of non banking
businesses undertaken by the banking
groups they were responsible for
 Managements failure to control
Leeson
qEffectively let Leeson settle his own trades by
putting him in charge of both the dealing desk
and the back office.
qHe had the final say
Ø Payments
Ø Ingoing outgoing confirmations and contracts
Ø Reconciliation statements
Ø Accounting entries
Ø Position reports

qLeeson was considered perfectly placed to

relay false information back to London
 Other red
flags
qBFS was asked by SIMEX to explain some margin
inconsistencies related to account 88888 (Leeson was put
in charge of responding to SIMEX)

qNo one in London knew how Barings acquired a US$83m

receivable from Spear, Leeds & Kellogg.

qLesson's cash requests for the first two months of 1995

amounted to US$1.2 billion (No one asked for
justifications)

qStaff in London could not reconcile funds remitted to

BFS to both proprietary in-house and individual client
 Lessons from
Barings
qRole of traders
ØCustomer trades
ØArbitrage
ØPosition trades

qRole of the back office

ØOversight on trader behavior
ØNeeds to be independent of traders

qRole of main office

ØNeeds to understand and better scrutinize
anomalous cash flows
ØBetter understand the derivatives business
 Senior management’s
part

qMgmt. failed to follow up on the internal audit

qMgmt. had a poor understanding of

derivatives

qMgmt. failed to understand the risks of the

business

qMgmt. failed to supervise properly

 Wishful
thinking

qSenior mgmt. believed that Lesson's

positions were hedged because the alternative
was inconceivable

qSenior 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
q Operational risk
Ø Fraud
Ø Inadequate controls
q Would VaR have helped?
Ø Didn’treally need this technology to reveal
Lesson's risk exposure
 Observation
s
 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
 Conclusio
n
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