Collapsed of Barings Bank

Abstract:

The case discusses how Nicholas William Leeson's (Leeson) unauthorized trading in

derivatives led to the fall of Barings Bank, the oldest and one of the most reputed

banks in the UK.

It describes the complete sequence of events leading to the fall of the bank.

The case also highlights the reasons for the fall, including the lack of proper

managerial supervision and operational control systems, and the mismanagement of

the bank's derivatives operations.

Issues:

The reasons that led to the fall of Barings Bank.

Importance of proper supervision and control systems in a bank to mitigate

risks.

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...

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...