Financial Engineering
Barings Collapse
The history
Barings Bank was founded in 1762 as the John and Francis Baring Company by Francis Baring.
Barings gradually diversified from wool into many other commodities, providing financial services
necessary for the rapid growth of international trade.
In 1802, Barings was called on to facilitate the largest land purchase in history - the Louisiana
Purchase. This was accomplished despite the fact that Britain was at war with France and the sale
had the effect of financing Napoleon's war effort.
The company established ties with King George V, beginning thus a close relationship with the
British monarchy that would endure until 1995.
During the Second World War, the British government used Barings to liquidate assets in the
United States and elsewhere to help finance the war effort. After the war, Barings was overtaken in
size and influence by other banking houses, but remained an important player in the market until
1995.
The collapse
At the beginning of 1995, the chief trader for the Far East markets, Nick Leeson, took a long
position over the Japanese stock market.
At that time, Leeson was supposed to be arbitraging, seeking to profit from differences in the prices
of Nikkei 225 futures contracts listed on the Osaka Securities Exchange in Japan and the Singapore
International Monetary Exchange. Such arbitrage involves buying futures contracts on one market
and simultaneously selling them on another at a higher price. Since everyone tries to take advantage
of a price difference on a publicly traded futures contract, the margins on arbitrage trading are small
or even wafer thin. Consequently, the volumes traded by arbitrageurs must be very large to gain any
meaningful profit. In arbitrage, one is buying something at one market while selling the same goods
in another market at about the same time. Consequently, almost all risks are hedged and the strategy
is not very risky. Certainly it would not have bankrupted the bank.
For example, one could buy a futures contract on Nikkei worth $100 million on one day and at the
same time sell the same product in Singapore for say $100,001,000. Though a person would have
bought and sold nearly 200 million, their profit is only $1,000, that is 1,000 dollars for a 100
million dollar investment. However, instead of buying on one market and immediately selling on
another market for a small profit, the strategy approved by his superiors, Leeson bought on one
market then held on to the contract, gambling on the future direction of the Japanese markets. If one
uses the above example, one could buy $100 million worth of Nikkei futures contracts then hope
that the contract price goes up in future. In this instance, even a percentage change of the price
would create 1 million dollar worth of profit or loss.
Moreover, Leeson wrote (sold) put options, so to get the premium in order to increase the long
futures position.
Due to a series of internal and external events, his unhedged losses escalated rapidly.
Internal auditing
Under Barings Futures Singapore's management structure through 1995, Leeson doubled as both the
floor manager for Barings' trading on the Singapore International Monetary Exchange and head of
settlement operations. In the latter role, he was charged with ensuring accurate accounting for the
unit. The positions would normally have been held by two different employees. By allowing
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Financial Engineering
Leeson, as trading floor manager, to settle his own trades, Barings short-circuited normal
accounting and internal control/audit safeguards. In effect, Leeson was able to operate with no
supervision from London—an arrangement that made it easier for him to hide his losses. After the
collapse, several observers, including Leeson himself, placed much of the blame on the bank's own
deficient internal auditing and risk management practices.
Corruption
Because of the absence of oversight, Leeson was able to make seemingly small gambles in the
futures arbitrage market at Barings Futures Singapore and cover for his shortfalls by reporting
losses as gains to Barings in London. 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. Leeson claims
the losses started when one of his colleagues bought contracts when she should have sold them,
costing Barings £20,000. By December 1994, Leeson had cost Barings £200 million. He reported to
British tax authorities a £102 million profit. If the company had uncovered his true financial
dealings then, collapse might have been avoided as Barings still had £350 million of capital.
Kobe earthquake
Using the hidden five-eights account, Leeson
began to aggressively trade in futures and
options on the Singapore International
Monetary Exchange. His decisions routinely
resulted in losses of substantial sums, and he
used money entrusted to the bank by
subsidiaries for use in their own accounts. He
falsified trading records in the bank's computer
systems, and used money intended for margin
payments on other trading. As a result, he
appeared to be making substantial profits.
However, his luck ran out when the Kobe
earthquake sent the Asian financial markets
into a tailspin. Leeson bet on a rapid recovery
by the Nikkei, which failed to materialize
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Financial Engineering
Discovery
On 23 February 1995, Leeson left Singapore to fly to Kuala Lumpur. Barings Bank auditors finally
discovered the fraud around the same time that Barings' chairman, Peter Baring, received a
confession note from Leeson. Leeson's activities had generated losses totalling £827 million
(US$1.3 billion), twice the bank's available trading capital. The collapse cost another £100 million.
The Bank of England attempted an unsuccessful weekend bailout. Employees around the world did
not receive their bonuses. Barings was declared insolvent on 26 February 1995 and appointed
administrators began managing the finances of Barings Group and its subsidiaries. The same day,
the Board of Banking Supervision of the Bank of England launched an investigation led by Britain's
Chancellor of the Exchequer and their report was released on 18 July 1995. Lord Bruce of
Donington, in the House of Lords debate on the report, said:
"Barings' collapse was due to the unauthorised and ultimately catastrophic activities of, it appears,
one individual (Leeson) that went undetected as a consequence of a failure of management and
other internal controls of the most basic kind".
"as a consequence of a failure of management and other internal controls of the most basic kind".
"Relevant internal controls, including independent risk management, have to be established for all
business activities".
"Top management and the Audit Committee have to ensure that significant weaknesses, identified to
them by internal audit or otherwise, are resolved quickly".
Bail out
ING, a Dutch bank, purchased Barings Bank in 1995 for the nominal sum of £1 and assumed all of
Barings' liabilities, forming the subsidiary ING Barings
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