Case Report on The Fall of Barings Bank
Submitted to : Prof. AG Mendhi
Submitted By;
Vineet Sharma Roll No. 1026 KIAMS, Pune
1. What went wrong with Barings Futures Singapore?
Ans. Leeson used to trade in derivates but he was not given any authority to trade in options or maintain any overnight un-hedged positions. However, Leeson acted beyond his authority. He traded on derivatives that were of different types and in so me cases were of mismatched amounts. Although Leeson¶s control over back office operations explains how he was able to initiate the fraud, weaknesses in internal and e xternal oversight explain how the fraud escaped detection over so long a period. In principle, the Baring Gro up¶s risk positions, trading limits, trading performance and the allocat ion of funding were monitored each day by an Asset and Liability Committee (ALCO). Since Leeson¶s mounting losses had to be funded from elsewhere in the group, BFS was ultimately drawing funds that exceeded its total assets. But apparently the ALCO meetings focused on how to meet Leeson¶s funding requirements rather than why the requirements were so large. As late as February 20, 1995, t he Chief Executive Officer of the Barings Group is reported to have informed ALCO that he concurred with Leeson that his positions should not be reduced. One
might also have expected the Financial Controls Department to have discovered account 88888. But the Department viewed its responsibility as furnishing management with daily reports of profits and losses rather than ascertaining whether these reports reflected the true profitability of the activities of the Baring Group. Leeson¶s intention to open account 88888
seems to be with different idea. In the first month of its opening itself, a large number of transactions were booked through the account. Normally, error account should have fewer entries and should be used only for reconciling small value differences. Further, the error account should be closed on daily basis and net difference ± positive (gain) or negative (losses) should be recorded as profit or loss. However, account number 88888 was used to put through a large number of transactions on daily basis from the beginning itself. In other words, the account did not seem to be intended to serve as an error account. The error account itself was operated as a regular trading account. Leeson gave specific instructions to his staff, right in the beginning of the opening of µerror¶ account, to modify the office software to exclude transactions in account 88888 from the system and from all market activity reports. The
bank was not maintaining the Capital Adequacy Ratio (CRAR) norms. The bank had not imposed trading limits such as value-at-risk and stop-loss limits. There was no segregation in front and back office operations. In April 1992 Leeson was posted to Baring Futures Singapore Ltd (BSL) to establish settlement operations and also to be a floor manager at the Singapore International Monetary Exchange (SIMEX). This was clearly inconsistent
with one of the most fundamental principles of risk management ± separation of the trading function from the clearing and settlement function and presumably justified as a defensible economy measure in a small office far from headquarters. . It was an error of judgment on the part of the
bank¶s management to entrust both types of activities to Mr Leeson, who later brought down the bank through unauthorized dea ls and became known as the ³rogue trader´ Leeson started keeping unmatched positions (whenever they went wrong i.e. whenever they could have incurred a loss) open for a long time. He was also able to conceal such unauthorized open positions for over a year. Even when Leeson showed huge profits through arbitrage, the management did not become alert or think that substantial risks were taken. Large profits, which are usually not possible in arbitrage, failed to alert the senior management about the accumulated open positions on futures contracts. On the contrary, they believed that Nick Leeson was making low risk profit and held only matched positions on the SIMEX and the OSE and hence was making a low-risk profit. However, the reality was altogether different. Though Leeson started with arbitrage profits, he had started keeping his loss making positions open for a long time. Not only this, he started trading derivatives contracts on the two exchanges that were of different types or in mismatched amounts. For example, he resorted to a trading strategy known as a "straddle," with the objective of making a profit by selling put and call options on the same underlying financial instrument i.e. Nikkei 225 Index. it also means that you are taking unlimited risks (while selling call options) and almost unlimited risks while selling put options. The
senior management was unaware o f what was going on in the organisation and was not taking accountability. Also they did not have any knowledge of the working of trading in derivatives since they were from merchant banking field. There was lack of Information Security Committee which oversees strategy and implementation of information security policies and procedures for the entire Bank. Lack of strong management team with vast experience in diverse fields, well defined processes, standard operating manuals and job cards, transaction verification and authorization systems, d istributed processing, staff training and an effective internal audit process. The international corporate structure was also a reason o f the operational risk.
2.
Did Barings bank do something to check / detect fraud at BFS?
Ans . Yes, it had undertaken few measures to check/detect the fraud but it was a last minute reaction because by that time Barings Bank had already faced huge financial losses. In July ± August 1994, an internal auditor was sent to BFS to investigate the unusually large profits reported in 1992 & 1993. The auditor actually identified the weakness of internal control measures at BFS and recommended segregation of operational charge between trading and accounting. Consequently, a financial manager in their Hong Kong office was entrusted with the part-time responsibility for watching the back o ffice functions of BFS. It was, however, not enough. At the same time in August 1994, the bank had set up an integrated group treasury and risk function management division and an Asset ± Liability Committee ( ALCO ) and asked the former to report all treasury related operations to the newly set up ALCO. However this happened to be a last minute effort of no consequence as we know that the bank had already gone deep in red.
3.
What lessons can we learn from Barings bank f ailure?
Ans. The lessons to be learnt from Barings bank failure are as follows: a) First of all there should be proper well defined reporting standards, roles and responsibilities of each job undertaken by a person. A business like that of Baring Bank should not be a one man show. There should be segregation of departments like front and back office operations. b) There should be proper supervision of employees. We have seen in the case that although Leeson had never held a trading license prior to his arrival in Singapore, there was little oversight of his activities and no individual was directly responsible for monitoring his trading strategies. c) The business should not be inclined towards o nly achieving profits through unethically means and the employees and the top management should not be greedy. It should involve all the stakeho lders and should work toward wealth maximisation of all the stakeholders and for t he good of the society as well as per its corporate social responsibility. Since in most of the financial institutes in US and EU the salary of the employees is linked to t heir performance and how much profits they generate. So to get huge bonuses they become greedy to generate profits which should not be the case. d) The top management should be well educated and knowledgeable. They should possess skills / knowledge of diversified fields. e) There should be an individual to monitor any and all anomalies in the company's policies. f) There should be frequent internal and external audits at regular time intervals: say quarterly to detect and reduce/ minimize any fraud .Once an
internal/external audit has been completed, assign an individual to make sure audit recommendations are implemented.
4.
Should a bank like Barings Bank have a separate Risk Management cell?
Ans. Yes a bank like Barings Bank should have a separate Risk Management cell which would take care of all the risks involved. This RMC should be an independent department and should be accountable to the top management as well as to the government in a sense that no person can influence the cell for their personal interests and greed. There should be an independent director on board of this cell who doesn¶t have any stake in the business but all the key officials involved in th is task should be highly qualified and should possess diversified skills apart from their domain knowledge. As per the Basel norms a bank like Barings Bank should mitigate/minimize market risks and operational risks involved in their business. RMC should make sure that the company invest in global risk-monitoring systems, encompassing both sophisticated risk models and sufficient computer and communications capacity to handle highvolume, high speed transactions in all their financial and legal complexity. There should be an effective internal control system requires a major commitment to: Hire, support and retain employees throughout the management system with appropriate training and background in trading, modelling, information technology and other required skills. Several key risk management and supervisory control lessons emerge: A. Setting the Right Tone from the Top: Senior Management and Boards Must Encourage a Culture of Compliance and Responsible Risk Taking . Collectively, these rogue trader cases and the subsequent analyses of them underscore the importance of setting the right ³tone from the top.´ In particular, senior management and boards o f directors should emphasize integrity, and compliance concerns must be raised to independent functions within the firm and investigated and resolved ± regardless of who is involved and how profitable the business unit appears to be. This policy should be communicated to all employees In addition to emphasizing compliance and control, senior management and boards should play an active role in encouraging responsible risk taking. B. Senior Managers Must Understand the Complexities of the Products Their Firms Trade.
Perhaps
the most obvious, but fundamental, lesson is that proprietary trading is a high-risk activity, and not just for market risk reasons. The potential operational and market risks may outweigh the potential market returns, perhaps greatly Given these risks, it is critical that supervisors understand their traders¶ strategies, the quantitative models, and mathematics of the products they trade ± particularly before allocating more of the firm¶s capital to tho se traders. Trading management should discuss trading rationale and strategy on a regular basis with traders. Also, directors should be adequately knowledgeable about derivatives and risk management to appreciate the risks that might lead to material trading losses. C. Strong Business Line Supervisory Controls Are Essential . Business supervisors are the frontline defense against any aut horized, fraudulent, or excessively risky trading. In that regard, the Ludwig Report recommended a number of supervisory controls to help detect and prevent such trading, including: (i) daily review of trades by a registered and qualified supervisor (which include not only the summary of the profit and loss in each ledger, but also the actual trade tickets or a computerized summary of the information that would include all pertinent information on a trade ticket); (ii) reviews of exception reports, which would show unusually large transactions, large profit and loss (³P&L´) swings, unusual settlement terms, and major counterparty activity; and (iii) procedures for the creation, monitoring, and enforcement o f position and trading limits (and intraday monitoring to ensure that traders stay within these guidelines). D. Risk Managers Should Be Encouraged to Challenge Traders¶ Valuations . Risk managers and other persons charged with verifying traders¶ positions should be encouraged to question those valuations when they appear idiosyncratic ± regardless of whether or not the trader is successful. Some commentators recently have noted that an industry culture of deference by risk managers to successful traders may contribute to pricing failures and overly op timistic valuations on firms¶ books. E. Operations, Risk Management, and Compliance Reporting Lines Should Be Separate from the Business Lines . A key to a successful reporting structure is the complete segregation of duties from the front and back offices. One framework or organizational structure for overseeing trading activities should involve three distinct groups ± the front office, the back office, and compliance. F. Dual or Matrix Reporting Lines Must Be Clear . The relationship between parent companies and overseas units needs to be clear. If there are dual reporting lines or a matrix reporting structure, there must be unambiguous accountability,
so that issues do not fall through the cracks and employees cannot exploit ambiguities in reporting structures. For example, with Barings, the Bank of England Report noted that no one appeared to carry out his or her responsibility to supervise Leeson in Baring¶s Singapore office, due in part to the absence of clear lines of authority
5.
Suggest measures that could have been initiated by Barings Bank senior
Management well in advance to prevent the f ailure of a bank that was once known for its integrity. Suggest an appropriate structure and reporting system and relevant reporting procedures for treasury department of a bank like
Barings Bank. Ans.
"Barings was a complete mishmash of systems and relied heavily on manual processes and was therefore incapable o f assessing the risk accurately". No one was able to put all the information together, so no one understood what was really happening, and that is why Leeson was never challenged. The closure could have been avoided by taking following measures: Segregation
of front and back office -would have effectively reduced the kind of activities that Leeson was involved in. Should have imposed position limits on the proprietary trading activities on the BSF. Should have imposed trading limits such as value-at-risk and stop-loss limits. Assign an individual to monitor any and all anomalies in the company's policies. Once
an internal/external audit has been completed, assign an individual to make sure audit recommendations are implemented.
Force
all employees to take a vacation (Allows other individuals within the company to be cross trained in that individuals job and enables the company to keep tabs on that job functions activities.
Establish
investment guidelines and educate a ll traders as to the proper investments.
If
there had been systems in place to share information across the organisation, the situation that led to the bank's collapse would never have arisen. Never invest in any financial instrument you do not understand, cannot explain, or determine the company's pot ential downside risk.
Once
an investment has been made, assign an individual, preferably someone not involved in making the investment, to monitor its performance.
Rotate
responsibilities within the company. (Allows for cross training opportunities and helps deter potential dishonesty.)
Adequate
capital-the institution was in funding risk due to enormous unhedging positions. Appropriate CAR (capital adequac y ratio) should have been maintained on regu lar basis as per the international standards. Involvement of senior management - it seemed that the management was satisfied with the short term profit, they were unaware o f important activities of the companies. A third party or an external audit co mmittee should have been appointed to make that adequate corporate governance measures have been taken. A new committee should be formed after every 3 years on rotational basis. Tougher poor control procedures -one of the main reasons as to why this entire debacle happened was because the management was not accountable to certain activities. A strong senior management team with vast exper ience in diverse fields should have been made. Also the senior management should have been made accountable Should have Implemented MIS and SIT. Should have adopted Basic Indicator Approach for operational risk
