Whatever Happened at Barings Bank?

Scale of Disaster

• On 27th Feb, 1995 Barings collapsed!• Direct Damage

– On 27th Feb: ₤700 million– But still positions were open– 18th July: ₤827 million and ₤927 million when

positions were closed– ₤827 mn loss in relation to shareholders’ fund

₤354mn

Cumulative Losses by BFS from July 1992 to Feb 1995

Losses from Concealed Transactions Million £

Scale of Disaster

• Indirect Damage– Pound touched lowest ever, DM2.302– Nikkei 225 fell 3.8%, more than 1000 points– FTSE 100 fell 12.4%– Systemic damage to banking system was not much– Speculation about which creditor would suffer the loss

Corporate Structure of Barings PLC

Barings Corporate Strategy

• “Six Great Powers in Europe”, illustrious• Barings was sidelined during London’s Big-

Bang” in 1987.• It could not manage to be an integrated

investment bank• Upto 1984, it was a merchant bank specializing

in corporate finance and debt-trading• In 1984, enters into stockholding business and

Christopher Heath joins Barings

Barings Corporate Strategy

• Cultural differences arises between stockholders and bankers: perception and management of risk

• Heath leaves because of anxieties about the risk positions

• Growth became addictive for bank!• Leeson joins Barings Singapore in March 1992• Started proprietary trading positions only at ₤354

mn shareholders fund, it was a mistake• However, BSF was doing very well during this

period

Who is Leeson?

• Leeson joined BSL settlement in 1989

• Early 1992 he had applied for registration as a dealer with FSA in London and it was canceled

• In April 1992, he was posted to BFS to establish settlement operations and also to be a floor manager at SIMEX

• This was inconsistent with one of the fundamental principles of risk management

• His role was agency business, however, he was heavily engaged in proprietary trading

Leeson’s Business• Authorized to conduct both client and proprietary

trading• The Nikkei 225 contract arbitraging between

SIMEX and OSE• The 10-year JGB contract trading between

SIMEX and TSE• Naming inter-exchange arbitraging as

“switching”• He was involved in “bucketing”, illegal under the

‘Futures Trading Act’.

Leeson’s Business• Bucketing

– Matching client orders in SIMEX– Taking equivalent opposite orders in OSE– Riding on the back of the large client orders if market

moved favorably– If unfavorable, arbitrage between OSE and SIMEX

• Timing differences give rise to some risk of prices moving unfavorably

• Leeson was allowed to have unhedged positions on 200 OSE Nikkei contracts and 100 TSE JGB.

Nikkei 225 Futures Strategy

• Leeson was convinced that the Nikkei Index was going to rise

• This bullish view was very curious as Index had fallen some 35% since mid-1994

• The attitude of the market was almost entirely the opposite which is why Leeson found many sellers in market

• Unhedged continuous / repeated long positions on Nikkei 225 (Fig. 2)

Nikkei March 1995 Close and Cumulative Nikkei Futures P & L from 1 January 1995

JGB Futures Strategy

• Leeson’s view was that JGBs were overvalued• He adopted open short positions in JGB futures• His positions: Oct 93 - 2120 contracts, Nov 94 -

54,325 contracts, 27 Feb 95 – 26,079 contracts• He had taken 85% of the open interest in March

1995 contract and 88% of June contract.• On 23 February alone, he lost ₤61 million on the

day.

JGB March 1995 Close and JGB Cumulative P & L from 1 Jan 1995

Options Strategy

• Leeson was authorized only to trade options on behalf of corporate clients

• However, he took proprietary open positions in options from the end 1992 on Nikkei 225 futures

• His view was that the Index would continue trading in the narrow range – volatility position

• He wrote approx equal numbers of put and call options on index futures – short straddle

• Range bound movement in index would fetch premiums, otherwise unlimited loss

Written Straddle P & L Position

Options Strategy

• Delta could be used as an option price sensitivity to change in underlying asset price

• In fact Delta grew very fast as index deviated to a large extent after “Kobe Earthquake”

• He lost money as all the put-holders were deep in-the-money

• Though Delta risk was substantial, he was never delta hedged.

• His cumulative loss from options portfolio was £51m

Other Position Strategies

• Intra-day unhedged trades– Leeson grossly exceeded the limits of intra-day

unhedged positions– Authorized to maintain open positions of 200 Nikkei

futures, and 100 JGB futures.– Exceeded limits, over 16,000 Nikkei futures and 5,600

JGB futures contracts.

Fraudulent Trading

• Manipulative trading and fraudulent accounting practices

• Transfer/cross trades between BSJ or BSL clients accounts and a secret error account 88888

• He was deterring other traders for the last half minute of trading in SIMEX

• Avoided disclosing unhedged positions and awarded fictitious profits to BSL and BFS

• Leeson also recorded fictitious trades between 88888 and BSL/BSJ, without being executed on SIMEX floor

• These fictitious trades were recorded at profitable prices to the BSL/BSJ accounts

• From Jan 1995 onwards, margin pressure was high

• Leeson started supplying SIMEX with net positions in account 88888 for margin payments

• However, SIMEX requires gross positions on a single account basis

• Offseting long Nikkei positions in 88888 by short JGB positions in BSJ and vice-versa

• Recorded fictitious trades to offset open positions in account 88888 after trading hours and trades were reversed out at the start of the next trading day

Fraudulent Trading

Funding Manipulation

• Losses increased in 88888 from £63m in 1992 to £857m in Feb 1995

• Leeson misrepresented his margin requirements asking for options margins from BSL

• Asked for advance margins required for intra-day margin calls from BSL

• BSL was unable to reconcile remittances of this kind to BFS with client positions

Curious Features• Leeson’s trading positions were subject to

various levels of management control, still• Low-risk arbitraging supposedly contributing

high returns to groups total profit• Continuous calls by BFS to all other subsidiaries

of Barings for funds for margin payment and their silence shows lack of common sense

• SIMEX, OSE and TSE were not looking at his positions as they were getting the margin payments

Poor Judgment or Incompetence?

• Leeson’s net positions were in the opposite of the market direction

• Nikkei Futures, net long in a falling market

• JGB futures, net short in a rising market

• Euroyen, net short in a rising market

• Nikkei Index Option, short straddle in a high volatile market

• In absence of good investment opportunities, where was the potential for Nikkei to grow?

Systems Failure

• Agency trading vs. proprietary trading• Unhedged aggressive trading vs. arbitraging• Conflict between back office and front office• ALCO focused on Leeson’s funding requirement

instead of his risk positions• Funds were given as loans to clients without any

check of creditworthiness by credit control function

• Profitable arbitrage is not persistent in competitive international markets

Systems Failure

• Exposure to SIMEX, TSE and OSE exceeded 75% of Barings capital though restricted to 25%

• BFS had four clients in which three are from Barings group, still there was no reconciliation of funds

• In 1994, BFS was subject to an internal audit, it was ignored

• Barings international structure was not opaque, still Leeson evaded effective supervision

• Conflict between BoE and FSA about regulating BB&C and BSL

Is derivatives trading risky?

• Of course there are many instances of disasters arising from derivatives

• The Economist Intelligence Unit indicates that MNCs are making use of derivatives and its growing rapidly

• Despite knowledge of disasters, only 65% companies had a written policy

• Only 50% policies specified the types of derivatives allowed

Is derivatives trading risky?

• Only 50% imposed limits on the volume and principal amounts of derivatives

• 58% calculated the market value of their derivatives on a regular basis

• Less than 10% reported that derivatives were used for speculative purposes

Thank You!!!