What Can We Learn From Financial Disaster
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The collapse of Baring Bank
The 200-year-old Barings Bank was brought to its knees in 1995 in one month, when the rouge trader, Nicholas W. Leeson, gambled $29 billion speculating on the price of Japanese stocks and bonds using derivatives. By March 2 1995, Barings had lost over $1 billion and shortly after the UK’s second oldest bank at the time collapsed due to the weight of its short term obligations. To understand and learn lessons from the collapse, we should study not only Leeson’s actions, but also Barings’ history, culture and management leading up to the events of 1995.
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(a) Cause, process and consequences of the case | [Introduction]
While the end for Barings Bank started when Leeson began to commit fraud at Barings Futures Singapore (BFS), the seeds were sown many years ago with the inception of Barings Securities. Barings tasked Christopher Heath, a financier, with its creation, and he enjoyed much success investing heavily in equity warrants ties to the Nikkei. Because of this his success, Heath and Barings Executives shared in the profits enjoying substantial bonuses for years to come. Heath was ousted at the end of the decade when the Japanese equity market stalled, leaving a problem for Baring Executives; where would they find a new source of profits for the bonuses they had become accustomed to?
Then came Nicholas W. Leeson who, starting from 1992 began to make unauthorised speculative trades that at first lead to huge gains for Barings; in 1993 his profits represented 10% of the banks total profit. Leeson became the source of new profits Barings executives were looking for, and in turn they gave him their trust believing he could do no wrong. Leeson’s direct boss in London Michael Killian, even said in February 1995: “That guy is a turbo arbitrageur!”
Leeson himself began his career at Barings Securities as a bookkeeper in London, a back-office function. When Barings began operations in Singapore, Leeson moved a became a derivatives operations manager. Later that year he would became a trader after passing the test. Even though he had become a trader, due to managerial oversight stemmed from Barings poor organisational structure, Leeson did not have someone directly overseeing his actions and therefore also continued his old back-office role.
Because he both traded and cleared his accounts and positions, Leeson could report figures that made him seem like nothing but a successful trader, concealing the true picture of his trades. Management believed that it had occupied a niche where it takes advantage of its presence in OSE and SIMEX, making virtually riskless profit through executing a client’s order in the cheapest market between the two. The end began when the Nikkei plunged after the Kobe earthquake on 17 January 1995. Leeson, who speculated heavily on the Nikkei for the last 2 and a half years, had exposed Barings to “unlimited potential loss” (RBA Implications of the Barings Collapse – Nov 1995).
Leeson’s positions included.
Long positions in Nikkei futures
Short positions in Japanese Government Bonds
Short Volatility position in Nikkei exchange traded option.
When the Nikkei fell the prices of the long positions and short volatility positions fell as well, leading to massive losses incurred and subsequent collapse of Barings Bank.
In the aftermath Barings Shareholders’ lost x amountBarings was bought up by peer ING, a Dutch bank for a measly 1 pound. Bank of England decided not to bail out Barings Bank
To avoid another catastrophe like this, the Singaporean government made an amendment to Futures trade act, which gave the Monetary Authority of Singapore more autonomy and power in checking activities of traders selling futures contracts, which commenced shortly after the collapse in April 1995.
Nikkei 225 Index Chat
(b) What we can learn from the financial disaster? | [Body]
– Draw references and guidelines from chapter 36, incorporate content from the textbook with the case. Then with that in mind answer “what can we learn from this case” DO NOT SUMMARISE CHAPTER 36 WITHOUT CONNECTION TO CASE…… 0 MARKS FOR DOING SO
500 words at least, bulk of assignment marks allocated here (7 marks)
Do Not Assume You Can Outguess the Market & Diversification & Make Sure a Hedger Does Not Become a Speculator Monitoring Traders Carefully
“He was the breadwinner for the entire operation, they left him alone because he was doubling everyone’s bonuses.” – Former Baring Equity Saleman
On 1 August 1994 there was an internal Audit report warning of non-segregated duties in Singapore. The report pointed to many of the weaknesses in both the risk management structure and the control which were present in BFS’s structure. However, no change was made by Barings management to resolve this weakness.
Barings Bank transferred USD$835 million to its Singapore office so that they could meet their margin obligations. The Barings Bank golden trader could do no wrong
As the Nikkei fell due to the Kobe earthquake Leeson heavily speculated that the market had overreacted and thought that the index would readjust. He went on an aggressive buying spree, adding up to 19,094 contracts by 17 February 1995 on top of his already huge positions in the Japanese market. This bet proved to be wrong, subsequently leading to the collapse of the 200-year-old bank. It is important to understand that speculation is guesswork, and that
Separate Front Office, Mid Office and Back Office
There was a lack of separation between front and back office in BFS. Leeson effectively had control over both sides of the trading operation. From his position, he was able to conduct unauthorised trading and subsequently manipulate the number and details of the transactions in which he engaged, concealing them from management in London. He opened secret accounts which he designated famously as error Account “88888” and used them to hide his losses arising from unauthorised transactions. In fact, using his role as a back office manager, Leeson changed the software to exclude Account 88888 from all market activity reports and the information was only used to calculate SIMEX margins.
In addition, Leeson at the height of his activities controlled 49% of the Nikkei 225 March 95 contracts. Barings’ board and executives claimed to be unaware of his activities even though the bank had to finance margin calls as they lost money due to Leeson’s activities.
Make Sure a Hedger Does Not Become a Speculator