The Collapse Of Barings Bank Essay, Research Paper

THE COLLAPSE OF BARINGS BANK

GROUP IV

This story begins with a former back office clerk being promoted to a derivatives trader for Barings Bank?s Singapore Branch and ends with the collapse of a 232-year old banking empire. As we began researching this assignment, we all asked the same question, ?How does a 28 year old trader bring about the collapse of a 232-year old banking empire??

To understand how this debacle came about, one must have a basic understanding of the nature of a derivative and what they are designed to do. Initially, derivatives were designed to provide an investor/trader with a type of insurance against unexpected movements in prices which could devastate an investment portfolio. These derivatives take the form of futures and options:

A future is an agreement for the future delivery of a certain commodity/

financial instrument at a price set at the time of the contract.

An option gives the purchaser the right, but not the obligation, to buy/sell

a certain quantity of a specific asset at a fixed price at, or before,

a future date.

In this instance, Nick Leeson, a 28 year old trader at Barings Bank, made a bet that the Nikkei 225 would not drop below 19,000. During the morning of January 17, 1995, the city of Kobe, Japan was hit with a major earthquake. As a result, the Nikkei 225 plunged 7% in a week. Unbeknownst to senior management, Lesson had no hedge to protect the bank against an unexpected event such as this. The losses resulting from these transactions resulted in the loss of almost a billion dollars and wiped out the capital of Barings Bank. This event occurred through a mixture of corporate greed and a lack of internal controls.

One of the most unusual aspects of this case was the fact that Barings Bank allowed Nick Leeson to settle his own trades. At most banks, trading and settlement are handled by two people. Allowing one person to handle both sides of the transaction was a recipe for disaster: an unscrupulous trader, such as Leeson, has a way to hide the risks he was taking and/or the money he was losing. This lack of control provided Leeson with the opportunity to undertake unauthorized trading and reduce the likelihood of its detection.

Although there were few internal controls monitoring Leeson?s activities, a number of warning signs were present which, had they been properly addressed, should have enabled Barings to detect the unauthorized activities and the losses that they were generating. These warnings signs were ignored because individuals in a number of different departments failed to face up to, or follow up on, identified problems. Also, due to inadequate communication between departments and the individuals within them, many of Leeson?s supervisors failed to act or ignored the irregularities in his trading activities. Had these managers acted upon information readily available to them (through internal audits and irregularities in trading activities), the collapse of Barings Bank may have been prevented.

Our group saw a number of areas which contributed to the enabling of Nick Leeson and which Barings could have acted to prevent Leeson?s unauthorized trading:

Internal problem #1 Lack of segregation of Leeson’s duties:

The fact that Leeson was permitted throughout to remain in charge of both

front office and back office at BFS was a most serious failing.

In any internal control system, adequate separation of duties is essential. Duties of individuals that deal with financial instruments should be clearly defined and no individual should be assigned incompatible duties. (The more tasks done by one individual, the greater the opportunity for errors and dishonesty.

Internal problem #2 Supervision of BFS:

Leeson?s immediate supervisor, a Director of BFS, failed to implement the suggestions of a company internal audit which recommended a separation of duties. Also, the Director of BSS/Regional Manager of the South Asian Region, failed to see that the recommendations of the company?s internal audit were carried out.

This power vacuum left Leeson virtually unsupervised and allowed Leeson to continue to engage in activities which brought about the collapse of Barings Bank.

Internal problem #3 Failure to act upon relevant information

In many instances, Barings senior management were notified of potential problems arising from the activities of Nick Leeson. Had senior management acted upon all of the information available to them, the collapse of Barings Bank could have been averted.

Internal problem #4 Failure to understand the transactions and the risks they entailed.

Senior management was under the impression that the investments Leeson was involved in were virtually riskless. Due to the fact that Leeson?s trading activities contributed significantly to the bank?s profitability, senior management seemed blissfully unaware of the risks Leeson?s activities posed to the health of the institution. Few in the organization questioned how such ?riskless investments?

were able to generate such tremendous profits.

These internal problems contributed to the ultimate downfall of a 232-year old banking empire. Although procedures were in place to prevent the activities, they were ignored. Our group would make several recommendations to prevent something like this from occurring in any organization in which we were employed:

1. Assign an individual to monitor any and all anomalies in the company?s policies.

2. Once an internal/external audit has been completed, assign an individual to make sure audit recommendations are implemented.

3. 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.

4. Establish investment guidelines and educate all traders as to the proper investments

allowed under these guidelines.

5. Never invest in any financial instrument you do not understand, cannot explain, or

determine the company?s potential downside risk.

6. Once an investment has been made, assign an individual, preferably someone not

involved in making the investment, to monitor its performance.

7. Rotate responsibilities within the company. (Allows for cross training opportunities and

helps deter potential dishonesty.)

Implementation of the above objectives could help prevent a disaster occurring in any

organization; however, without proper follow through and internal controls, any organization is

susceptible to a situation similar to the collapse of Barings Bank.

www.numa.com The Bank of England Report into the Collapse of Barings Bank

www.time.com TIME Magazine, March 13, 1995 Vol. 145. No 10, Chua-Eoan, Howard,

?Going for Broke?

www.cnnfn.com

www.newsweek.com