ARTICLES REGARDING THE COLLAPSE OF BARINGS BANK ARTICLE 1 Barings Bank (1762 to 1995) was the oldest merchant banking merchant banking company in London London,, England [1] until
its collapse in 1995 after one of the bank's employees, Nick employees, Nick Leeson , lost $1.4 billion in speculation primarily on futures contracts. contracts.
History Barings Bank was founded in 1762 as the 'John and Francis Baring Company' by Sir Francis Sir Francis Baring. Baring. In 1806 his son Alexander Baring joined Baring joined the firm and they renamed it Baring Brothers & Co., merging it with the London offices of Hope of Hope & Co., Co., where Alexander worked with Henry Hope. Hope. Barings had a long and storied history. In 1802 1802,, it helped finance the Louisiana Purchase, Purchase, despite the fact that Britain was at war with France France,, and the sale had the effect of financing Napoleon financing Napoleon''s war effort. Technically the United States did not purchase Louisiana from Napoleon. Louisiana was purchased from the Baring brothers and Hope & Co.. Co.. The payment for the purchase was made in US bonds, which Napoleon sold to Barings at a discount of 87 1/2 per each $100. As a result, Napoleon received only $8,831,250 in cash for Louisiana. Alexander Baring, Baring, working for Hope & Co., conferred with the French Director of the Public Treasury François Barbé-Marbois in Paris Paris,, went to the United States to pick up the bonds and took them to France. Later daring efforts in underwriting got the firm into serious trouble through overexposure to Argentine and Uruguayan debt, and the bank had to be rescued by a consortium organized by the governor of the Bank of England, England, William Lidderdale, Lidderdale, in the Panic of 1890. 1890. While recovery from this incident was swift, it destroyed the company's former bravado. Its new, restrained manner made it a more appropriate representative of the British establishment, and the company established established ties with King George V, V, beginning a close relationship with the British monarchy that would endure until Barings' collapse. The descendants of the original five male branches of the Baring family were all appointed to the peerage the peerage with the titles Baron Revelstoke, Revelstoke, Earl of Northbrook , Baron Ashburton, Ashburton, Baron Howick of Glendale and Earl of Cromer . The company's restraint during this period would cost it its preeminence in the world of finance, but would later pay dividends when its refusal to take a chance on financing Germany Germany''s recovery from World War I saved it the painful losses experienced experienced by other British banks at the onset of the Great Depression. Depression .
Events leading to Barings Bank's collapse Barings Bank's activities in Singapore between 1992 and 1995 enabled Nick Leeson to operate effectively without supervision from Barings Bank in London. Leeson acted both as head of settlement operations (charged (charged with ensuring accurate accounting) accounting) and as floor manager for Barings' trading on Singapore International Monetary Exchange, Exchange , or SIMEX. This placed Leeson in the position of reporting to an office inside Barings Bank which he himself held. Because of the absence of oversight, Leeson was able to make seemingly small gambles gambles in the futures market and cover for his shortfalls by reporting losses as gains to Barings in London. Specifically, Specifically, Leeson altered the branch's error account, subsequently known by its account number 88888 as the "five-eights account", to prevent the London office from receiving the standard daily reports on trading, price, and status. Using the hidden "five-eights account," Leeson began to aggressively trade in futures and options on SIMEX.. His decisions routinely lost substantial sums, but he used money entrusted to the bank by SIMEX
subsidiaries for use in their own accounts. He falsifed trading records in the bank's computer systems, and used money intended for margin payments on other trading. Barings Bank management in London at first congratulated and rewarded Leeson for what seemed to be his outstanding trading profits. After two years of steady losses covered up by the unknown "fiveeights" error account, Barings Bank auditors finally discovered the fraud, but it was too late. Nick Leeson's activities had generated losses totaling £830 million. Barings collapsed on February 26, 1995 Barings was purchased by the Dutch bank/insurance company ING for the nominal sum of £1 along with assumption of all of Barings liabilities. Barings Bank therefore no longer has a separate corporate existence, although the Barings name still lived on as Baring Asset Management. BAM was split and sold by ING to MassMutual and Northern Trust in March 2005. Nick Leeson wrote an autobiography, entitled Rogue Trader , covering the events leading up to the collapse; it was dramatised in the movie Rogue Trader .
ARTICLE 2
The Collapse of Barings Bank In February of 1995, one man single-handedly bankrupted the bank that financed the Napoleonic Wars, Louisiana Purchase and the Erie Canal. Founded in 1762, Barings Bank was Britain’s oldest merchant bank and Queen Elizabeth’s personal bank. Once a behemoth in the banking industry, Barings was brought to its knees by a rogue trader in a Singapore office. The trader, Nick Leeson, was employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on the Singapore Mercantile Exchange and Japan’s Osaka Exchange. A scandal ensued when Leeson left a $1.4 billion hole in Barings’ balance sheet due to his unauthorized derivatives speculation, causing the 233-year-old bank’s demise. Nick Leeson grew up in London’s Watford suburb, and worked for Morgan Stanley after graduating university. Shortly after, Leeson joined Barings and was transferred to Jakarta, Indonesia to sort through back-office mess involving £100 million of share certificates. Nick Leeson enhanced his reputation within Barings when he successfully rectified the situation in 10 months (Risk Glossary). In 1992, after his initial success, Nick Leeson was transferred to Barings Securities in Singapore and was promoted to general manager, with the authority to hire traders and back office staff. Leeson’s experience with trading was limited, but he took an exam that qualified him to trade on the Singapore Mercantile Exc hange (SIMEX) alongside his traders. According to Risk Glossary: "Leeson and his traders had authority to perform two types of trading: 1. Transacting futures and options orders for clients or for other firms within the Barings organization, and 2. Arbitraging price differences between Nikkei futures traded on the SIMEX and Japan's Osaka exchange. Arbitrage is an inherently low risk strategy and was intended for Leeson and his team to garner a series of small profits, rather than spectacular gains." As a general manager, Nick Leeson oversaw both trading and back office functions, eliminating the necessary checks and balances usually found within trading organizations. In addition, Barings’ senior management came from a merchant banking background, causing them to underestimate the risks involved with trading, while not providing any individual who was directly responsible for monitoring Leeson’s trading activities (eRisk). Aided by his lack of supervision, the 28-year-old Nick Leeson promptly started unauthorized speculation in futures on Nikkei 225 stock index and Japanese government bonds (Risk Glossary). These trades were outright trades, or directional bets on a market. This highly leveraged strategy can provide fantastic gains or utterly devastating losses; a stark contrast to the relatively conservative arbitrage that Barings had intended for Leeson. Nick Leeson opened a secret trading account numbered 88888 to facilitate his furtive trading. Risk Glossary says of Leeson:
He lost money from the beginning. Increasing his bets only made him lose more money. By the end of 1992, the 88888 account was under water by about GBP 2MM. A year later, this had mushroomed to GBP 23MM. By the end of 1994, Leeson's 88888 account had lost a total of GBP 208MM. Barings management remained blithely unaware. As a trader, Leeson had extremely bad luck. By mid February 1995, he had accumulated an enormous position—half the open interest in the Nikkei future and 85% of the open interest in the JGB [Japanese Government Bond] future. The market was aware of this and probably traded against him. Prior to 1995, however, he just made consistently bad bets. The fact that he was so unlucky shouldn't be too much of a surprise. If he hadn't been so misfortunate, we probably wouldn't have ever heard of him. Betting on the recovery of the Japanese stock market, Nick Leeson suffered monumental losses as the market continued its descent. In January 1995, a powerful earthquake shook Japan, dropping the Nikkei 1000 points while pulling Barings even further into the red. As an inexperienced trader, Leeson frantically purchased even more Nikkei futures contracts in hopes to gain back the money already lost. The most successful traders, however, are quick to admit their mistakes and cut losses. Surprisingly, Nick Leeson effectively managed to avert suspicion from senior management through his sly use of account number 88888 for hiding losses, while he posted profits in other trading accounts. In 1994, Leeson fabricated £28.55 million in false profits, securing his reputation as a s tar trader and gaining bonuses for Barings’ employees (Risk Glossary). Despite the staggering secret losses, Leeson lived the life of a high roller, complete with his $9,000 per month apartment and earning a bonus of £130,000 on his salary of £50,000, according to “How Leeson Broke the Bank.” The horrific losses accrued by Nick Leeson were due to his financial gambling, as he placed his trades based upon his emotions rather than by taking calculated risks. After the collapse of Barings, a worldwide outrage ensued, decrying the use of derivatives. The truth, however, is that derivatives are only as dangerous as the hands they are placed in. In this case, Nick Leeson was reckless and dishonest. Derivatives can be tremendously useful if used for hedging and controlling risk or even careful trading. After a series of lies, cover ups and falsified documents, Leeson and his wife fled Singapore for Kuala Lumpur, Malaysia. By then, Barings’ senior management had discovered Nick Leeson’s elaborate scheme. The total damage suffered by Barings was £827 million, or $1.4 billion. In February 1995, England’s oldest, most established bank was unable to meet SIMEX’s margin call, and was declared bankrupt. Leeson and his wife were arrested in Frankfurt, Germany on March 3rd , 1995. That same day, the Dutch bank, ING, purchased Barings for a mere £1 and assumed all of its liabilities (eRisk). Nick Leeson was placed on trial in Singapore and was convicted of fraud. He was sentenced to six and a half years in a Singaporean prison, where he contracted cancer (Risk Glossary). He survived his cancer, and while imprisoned, wrote an autobiography called “Rogue Trader”, detailing his role in the Barings scandal. “Rogue Trader” was eventually made into a movie of the same name. Nick Leeson
was released from prison in July 1999 for good behavior.
Article 3 Unlearnt lessons from Barings
The derivative trading is not as easy
as perceived. Here is a case which shows the instincts of how risky the business is. The chain of events which led to the collapse of Barings, Britain's oldest merchant bank, is a demonstration of how not to manage a derivatives operation. The control and risk management lessons to be learnt from this collapse apply as much to cash positions as they do to derivative ones. The leverage and liquidity offered by futures contracts brings down an institution with lightning speed which is in contrast to bad loans or cash investments whose illeffects takes years to ruin an institution. The activities of Nick Leeson on the Japanese and Singapore futures exchanges led to the downfall of Barings. The build-up of the Nikkei positions took off after the Kobe earthquake of January 17, 1995. Leeson's positions went in the opposite direction to the Nikkei - as the Japanese stock market fell. Before the earthquake, Nikkei traded in a range of 19,000 to 19,500. Leeson had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange. A few days after the earthquake, Leeson started an aggressive buying programme which culminated in a high of 19,094 contracts reached about a month later. Barings collapsed as it could not meet the enormous trading obligations, which Leeson established in the name of the bank. When it went into receivership on February 27, 1995, Barings had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 bn on the Nikkei 225 equity contract and US$20 bn on Japanese government bond (JGB) and Euroyen contracts. Leeson sold 70, 892 Nikkei put and call options with a nominal value of $6.68 bn. The nominal size of these positions is breathtaking; their enormity is all the more astounding when compared with the banks reported capital of about $615 million. But Leeson's Osaka position reflected only half of his sanctioned trades. If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX. Because Leeson's official trading strategy was to take advantage of temporary price differences between the SIMEX and OSE Nikkei 225 contracts. This arbitrage, which Barings called 'switching', required Leeson to buy the cheaper contract and to sell simultaneously the more expensive one, reversing the trade when the price difference had narrowed or disappeared. This kind of arbitrage activity has little market risk as the positions were always matched. But Leeson was not short on SIMEX, infact he was long approximately the number of contracts he was supposed to be short. These were unauthorised trades which he hid in an account named Error Account 88888. He also used this account to execute all his unauthorised trades in Japanese Government Bond and Euroyen futures and Nikkei 225 options: together these trades were so large that they ultimately broke Barings. The most striking point is the fact that Leeson sold 70,892 Nikkei 225 options worth about $7 bn without the knowledge of Barings London. In industry parlance, Leeson sold straddles. i.e. he sold put and call options with the same strikes and maturities. Leeson earned premium income from selling well over 37,000 straddles over a fourteen month period. Such trades are very profitable provided the Nikkei 225 is trading at the options' strike on expiry date since both the puts and calls would expire worthless. If the Nikkei is trading near the options' strike on expiry, it could still be profitable because the earned premium more than offsets the small loss experienced on either the call (if the Tokyo market had risen) or the put (if the Nikkei had fallen). The strike prices of most of Leeson's straddle positions ranged from 18,500 to 20,000. He thus needed the Nikkei 225 to continue to trade in its pre-Kobe earthquake range of 19,000 - 20,000 if he was to make money on his option trades. The Kobe earthquake shattered Leeson's options strategy. On the day of the quake, January 17, the Nikkei 225 was at 19,350. It ended that week
slightly lower at 18,950 so Leeson's straddle positions started to look shaky. The call options Leeson sold looked worthless but the put options became very valuable to their buyers if the Nikkei continued to decline. Leeson's losses on these puts were unlimited and totally dependent on the level of the Nikkei at expiry, while the profits on the calls were limited to the premium earned. When the Nikkei dropped 1000 points to 17,950 on January 23, 1995, Leeson found himself showing losses on his two-day old long futures position and facing unlimited damage from selling put options. Leeson, tried single- handedly to reverse the negative post-Kobe sentiment that swamped the Japanese stock market. On 27 January, account '88888' showed a long position of 27,158 March 1995 contracts. Over the next three weeks, Leeson doubled this long position to reach a high on 22 nd February of 55,206 March 1995 contracts and 5640 June 1995 contracts. Leeson was also engaged in unauthorised activities almost when he started trading in Singapore in 1992. He took proprietary positions on SIMEX on both futures and options contracts. Leeson lost money from his unauthorised trades almost from day one. Yet he was perceived in London as the wonder boy and turbo-arbitrageur who single-handedly contributed to half of Barings Singapore's 1993 profits and half of the entire firm's 1994 profits. In 1994 alone, Leeson lost Barings US$296 million; his bosses thought he made them US$46 million, so they proposed paying him a bonus of US$720,000. How was Leeson able to deceive everyone around him? How was he able to post profits on his 'switching' activity when he was actually losing? The vehicle used to effect this deception was the cross trade. A cross trade is a transaction executed on the floor of an Exchange by just one Member who is both buyer and seller. If a Member has matching buy and sell orders from two different customer accounts for the same contract and at the same price, he is allowed to cross the transaction (execute the deal) by matching both his client accounts. A cross- trade must be executed at market-price. Leeson entered into a significant volume of cross transactions between account '88888' and account '92000' (Barings Securities Japan - Nikkei and JGB Arbitrage), account '98007' (Barings London - JGB Arbitrage) and account '98008' (Barings London - Euroyen Arbitrage). After executing these cross-trades, Leeson instructed the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices thereon to cause profits to be credited to 'switching' accounts referred to above and losses to be charged to account '88888'. Thus while the cross trades on the Exchange appeared on the face of it to be genuine and within the rules of the Exchange, the books and records of BFS, maintained in the Contac system, a settlement system used extensively by SIMEX members, reflected pairs of transactions adding up to the same number of lots at prices bearing no relation to those executed on the floor. The bottom line of all these cross-trades was that Barings was counterparty to many of its own trades. Leeson bought from one hand and sold to the other, and in so doing did not lay off any of the firm's market risk. Barings was thus not arbitraging between SIMEX and the Japanese exchanges but taking open (and very substantial) positions, which were buried in account '88888'. It was the profit and loss statement of this account which correctly represented the revenue earned (or not earned) by Leeson. Details of this account were never transmitted to the treasury or risk control offices in London, an omission which ultimately had catastrophic consequences for Barings shareholders and bondholders. The management of Barings broke a cardinal rule of any trading operation - they effectively let Leeson settle his own trades by putting him in charge of both the dealing desk and the back office. This is tantamount to allowing the person who works a cash-till to bank in the day's takings without an independent third party checking whether the amount banked it at the end of the day reconciles with the till receipts. The back-office records, confirms and settles trades transacted by the front office, reconciles them with details sent by the bank's counterparties and assesses the accuracy of prices used for its internal valuations. It also accepts/releases securities and payments for trades. Some back offices also provide the regulatory reports and management accounting. In a nutshell, the back office
provides the necessary checks to prevent unauthorised trading and minimise the potential for fraud and embezzlement. Since Leeson was in charge of the back office, he had the final say on payments, ingoing and outgoing confirmations and contracts, reconciliation statements, accounting entries and position reports. Thus Leeson was considered perfectly placed to relay false information back to London.
Links to other Barings Bank Collapse Pages
Risk Glossary: Nick Leeson and Barings Bank eRisk: Barings Case Study References:
"Barings Case Study." eRisk.com. February 2004. eRisk. 12 March 2005. “How Leeson Broke the Bank.” BBC Online. June 22, 1999. British Broadcasting Company. 12 March 2005. "Nick Leeson and Barings Bank." RiskGlossary.com. January 1996. Contingency Analysis. 12 March 2005.
See also • • •
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Leonard Ingrams, former Managing Director and founder of Garsington Opera. "High Speed Money", a movie about the bank the broker Leeson. Rogue Trader (1996, hardcover) ISBN 0-316-51856-5; (1997, softcover) ISBN 0-7515-17089, Book by Nick Leeson giving his account of the Barings Bank collapse. Rogue Trader 1999 film starring Ewan McGregor. Nick Leeson Official Website of the Barings Rogue Trader http://www.numa.com/ref/barings/ http://www.nytimes.com/books/first/f/fay-collapse.html
