Barings BankThe collapse of 1995

Presentation by:Maria Kaninia

The bank

Barings was oldest merchant bank in London (founded in 1762).• Financed the purchase of Louisiana by the USA from France in 1803

• Had survived trouble in the end of the 19th century (“panic of 1890”)

• The Queen’s bank

The trader: Nick LeesonStarted out as a clerk at Morgan Stanley.He was denied a broker’s license in the UK because of fraud.Was hired by Barings and sent to Indonesia to sort out a bureaucratic and organisational mess. Task was a success.Then he was offered the position in Singapore as a derivatives broker.1992 : appointed general manager for operations in future markets in SIMEX.After the debacle was exposed, he fled Singapore on February 23d 1992.Arrested, extradited back to Singapore, charged with fraud, imprisoned for 6.5 years (time during which he published his autobiography “Rogue Trader”).Currently lives in Ireland, giving lectures and managing a local football club (…not bad…).

The Singapore branch of BaringsBarings had maintained an office in Singapore since 1987:

Baring Securities (Singapore) Limited (BSS) This branch originally focused on equities. The volume of futures

trading on SIMEX was also growing steadily. Leeson arrived in 1992 and had a double role: Head of the back-office

and head trader.

(1) Arbitraging of price differences on futures contracts between:

•Osaka Securities Exchange

•Singapore International Monetary Exchange SIMEX

(2) transacting futures and options orders for clients or

for other firms within the Barings organisation

Types of tradingauthorised for

Singapore branch:

(2) transacting futures and options orders for clients or

for other firms within the Barings organisation

(1) Arbitraging of price differences on futures contracts between:

•Osaka Securities Exchange

•Singapore International Monetary Exchange SIMEX

Arbitraging

“arbitrage”: The practice of taking advantage (for profit-making purposes) of a price difference between two or more markets. Theprofit results from making simultaneous matching deals on both markets.Normal practice in BSS: Simultaneously buying and re-selling (in two different exchanges, Singapore and Japan) a quantity Q of futures contracts at a price-difference of ∆p, resulting in profit π=Q· ∆p. Because ∆p→0, Q →∞ (large quantity) in order to get a substantial profit π.Leeson’s unauthorised practice: Speculation! Held on to the quantity for a certain period of time before re-selling.

Example of risk-free “switching” (by means of identifying and utilising small price differences).

•No risk if the contracts are not retained.

•The variation margin payable to the clearing house in Singapore (SIMEX) should be zero!

Normal practice: example

variation margin = The cash transfer that takes place after each trading day (and sometimes intraday) in most futures markets to mark long and short positions to the market.

leverage required means that switching in volatile markets is potentially dangerous and proper controls should be in place.

[Rogue Trader, 1999]: excerpt for illustration purposes

An example of “legitimate switching”:

Q=200∆P = 590-580 = 10Profit = 200*10 = 2000

Unauthorized practice (example)

The variation margins on the retained contracts were paid through the back-office error account, which was infamously labeled “88888”.

Barings was unaware of Leeson’s speculations.

Manipulation of accounts, cross-trade

Leeson manipulated his books to show a profit on Baring's switching activity.

Cross-trading : Matching the positions of two accounts when these positions belong to the same client.

Secret account where losses were

accumulated

“Legal” account showing profits from legitimate

switching (arbitraging

activities)

Under what conditions did Leeson manage to become “rogue” trader? -1

Internal auditing and risk-management practices were faulty.Suicidal oversight by the management.

Reports sent to London office were tampered with. Actual resultswere hidden (secret error-clearing account, known as “88888”).Conflict of interest: BFS was simultaneously investing on behalf of clients and Barings.Leeson started making losses almost immediately. He had to pay those losses to SIMEX in the form of margin. By using various tricks (p.ex. falsifying documents), he managed to get funding from:

client accountscompanies within the Barings organisation

Under what conditions? -2

Leeson held a double (self-contradictory) role:Floor manager (“open outcry”) for Barings’ trading on the SIMEX (front-office).Head of settlement operations (back-office).

This rule-breaking had been indicated by an internal audit in 1994 (but was subsequently ignored – mainly because was regarded as a “super-trader”, so no further investigation was pursued).Nobody investigated in depth how the profits claimed by Leeson were achieved, although the ratio profits / risk was abnormally high.As head of the back-office, Leeson had the opportunity to hide his trading losses…

Leeson’s “signature” trade: The straddle

Leeson sold short straddles (matching put and call options with the same strike price and maturity).

max profit from a short straddle (when the underlying futures contract is within the straddle limits) = premiummax loss from a short straddle (when the underlying

futures contract is outside the straddle limits) = ∞Unauthorized!

“Short-straddle” position (matching call and put options)

Leeson used this strategy in order to immediately generate income from the premium.

Initially this strategy seemed to work: By July 1993 it had helped him compensate his initial losses.

From the beginning of 1994, Leesonstarting selling Straddles, betting that the Nikkei 225 index would remain (mostly) between 19.000 and 21.000 (or 18.000 and 20.000).

This seemed to be a reasonable bet, because the volatility of the Nikkei 225 was low.

upper and lower limit of Leeson’s Straddles

Collapse - 1: The earthquake in Kobe

By January 16th 1995, Leeson had acquired significant positions in Nikkei 225 index futures, by means of placing “short straddles” in the Singapore and Tokyo stock exchanges. The limits of his straddles were 19.000 (lower) and 21.000 (upper) points.

The Earthquake in Japan on January 17th caused the Asian markets to fall.

Collapse - 2

Leeson’s positions were damaged. Thinking that he could recoup the losses, he started acquiring long positions on Nikkei 225 Index. He actually thought that he would be able to support the Nikkei 225 by himself.

Initially, this increasingly risky strategy seemed to work because at the end of Jan. / beginning of Feb. there was a temporary high of the index. But soon the course downwards became dominant, breaking again the lower limit of 18.000 on 23d Feb. 1995.

After that day, on which £ 65 million was lost, the end was inevitable. Leesonescaped from Singapore.

Subsequently, his actions (and losses) so far were exposed (total losses generated = £ 827 million), to the detriment of the bank.

Reported Actual Cumulative actual

1993 8,83 -21 -231994 28,529 -185 -2081995 18,567 -619 -827

million £

Collapse – 3 : Disclosure of Leeson’s actual positions

February 27, 1995

US$ (million)Nikkei 225 index futures 7.000Japanese government bond futures 20.000

27.000

straddle options sold ("written") 6.680

capital of Barings 615

sum transferred to BSS from Barings London and Tokyo in order to cover margin obligations in Jan.-Feb. 1995 835

Barings' futures positions acquired via Leeson:

Leeson’s positions go in the opposite direction to the Nikkei index

By Dec. 1994:Actual (hidden) result: £200 m losses (£4.8 m in his first three months only).Reported result: £102 million profit (on which tax was paid and bonuses were distributed to employees).

In early 1995, Leeson continued to trade aggressively. By falsifying records, he appeared to be making profits.

Growth of funding to BSS from within Barings. This funding was used by Leeson in order to cover margin payments.

Senior Barings management continued to fund Leeson’sactivities because they thought his positions were secure (hedged).

How did he escape being noticed?Chaotic management! No understanding of derivatives!

Barings was in the midst of a major restructuring, including expansion of their activities (1993).

Hierarchy and responsibilities were not clearly specified.

Accounting systems were not unified and consistent throughout the organisation.

net positions in global derivatives trading were practically unknown to the central office

Management inadequacy…

Example:Famous quote by Peter Baring, Chairman of Barings, in 1993, that

indicates this inadequacy:

“The recovery in profitability has been amazing following the reorganization, leaving Barings to conclude that it was not actually terribly difficult to make money in the securities markets.”

Lessons from Barings-conclusion

Segregation of front and back-officeSenior management involvementAdequate capitalControl proceduresLack of supervision