The Collapse of Baring Bank

Abstract

Barings Bank (established 1792) was Britain’s oldest merchant bank. It collapsed in 1995 after 28-year-old employee Nick Leeson lost over $1.3 billion in unauthorised trades from their Singapore office. For almost three years, derivatives trader Nick Leeson was able to deceive Baring Bank by appearing to earn extraordinary profits, whilst in reality incurring catastrophic losses (Drummond, 2002, p.232). This disaster was spurred by the use of financial derivative instruments as well as improper actions by employees and management. Several things can be learnt from this catastrophic collapse, which should be acknowledged by financial institutions and policy makers in order to avoid similar problems in the future. This essay will focus on three of these major lessons. These are the need to monitor traders carefully, to separate the front, middle and back offices, and to beware of easy profits. This financial crisis also highlights the potential danger associated with the trading of derivatives, and how losses can escalate to disastrous levels.

Introduction

The collapse of Baring Bank provided valuable lessons to the financial world. This crisis showed how it was possible for such a large bank to become bankrupt primarily from the actions of just one trader and the use of derivatives. This essay will first examine the key causes, processes and consequences of the collapse of Baring Bank. The essay will then analyse what we can learn from this financial crisis.

Baring Bank

Nick Leeson arrived at Baring Bank (Singapore Office) in 1992. He was tasked to exploit the low-risk arbitrage opportunity arising from the small price differences between the Nikkei 225 futures contracts in the Osaka Securities Exchange and the Singapore International Monetary Exchange.

Leeson reported massive profits from this strategy, however in reality he started trading unauthorised options with hopes to make a larger profit by betting that the index would remain above 19,000 points (Hull, 2018, p.839). In June 1993, matters became further complicated when Leeson took control of both the front and back offices (Mun, 2009). This enabled him to hide his losses and unauthorised trades in an account he opened for “error trades made by inexperienced staff” called ‘88888’ (Mun, 2009).

On 17-January 1995, an earthquake struck Japan. This resulted in the dramatic fall of the Nikkei index to 17,785 points by 23-January. Upon losing money, Leeson took bigger risks and larger bets to produce new premiums to hide his losses. Since Leeson’s accounts showed these premiums as pure profit, the more he lost, the better his trading seemed to Barings. In truth, his exposure was so volatile that each point the index changed made a £100,000 difference in Baring’s positions (Drummond, 2002, p.232). Reputable investment banks also started to warn customers against using Baring Bank as a counter-party.

Tony Railton (a financial-controller) found Leeson’s 88888 account and further discrepancies in the Singaporean accounts. On 23-Febuary, Leeson disappeared when called into a meeting to explain the problem (Drummond, 2002, p.235). Railton found that every contract of Leeson’s was losing money, culminating in the largest losing bet in history at over $1.3billion (twice the bank’s available trading capital), with no caps on additional losses (Fox, 1995, p.12). By 23-February 1995, the Nikkei was at 17,580 points. The cumulative losses totalled to over $2.2billion in losses at the time of Baring’s collapse on 26-February 1995. Even rescue efforts by the Bank of England could not save Barings from insolvency. Leeson was sentenced to six and a half years imprisonment for two counts of fraud and forgery.

Learning from the Crisis

Monitor Traders

The collapse of Baring Bank taught us that traders should be monitored carefully and held accountable by their superiors.  It is essential to clearly define limits regarding financial risks and to ensure that culturally, risk limits are taken seriously (Hull, 2018, p.831). This means enforcing the limits, even when profits are made – because high profits usually indicate high risks. Such actions are necessary to ensure that low-risk traders/hedgers do not become speculators.

Ignoring this lesson could lead to a situation such as Leeson’s where he doubled his bets in order to recover losses, and management did not oversee the unreasonably high risks he took.  Despite the signs of malfeasance, no directors at Barings were alert enough to impose their policies until it was too late. If the managers had monitored him more closely, then the crisis may have been averted.

Some stakeholders clearly learned from this crisis. For example, in Singapore the Futures Trading (Amendment) Act was passed on 1-April 1995 in order to prevent similar incidents from happening again. This allowed the Monetary Authority of Singapore to more closely monitor the activities of traders selling futures contracts.

Separate Offices

Nick Leeson controlled both the front and back office and was therefore able to hide the catastrophic results of his trades for years. The scale of the crisis therefore reaffirmed the lesson that it is essential for the front office (traders), middle office (risk-managers) and back office (accounting) to be held separate (Hull, 2018, p.833). By December 1994, an external audit found that disparities in Leeson’s accounts had grown to more than £100million. Since Leeson controlled both offices, he could give elusive explanations and make up facts – for example, deeming losses as “uncollected debt from a sold option” (Drummond, 2002, p.234).

Baring Bank was in fact warned prior by an audit report that they were exposed to significant risks by letting Leeson take charge of both offices (Mun, 2009). However, management in London did not act upon this advice and instead trusted Leeson, accepting the wild profits he was making (as much as 133% of Baring’s profits in January 1995) (Drummond, 2002, p.234). They also attributed any mistakes he made to being overburdened by workload, not because of fraud. This proves the lesson of the importance to separate the offices, even if lacking in staff numbers.

Beware ‘Easy Profits’

The first warning sign that Baring Bank should have noticed was that Leeson’s trades were apparently not only wildly profitable, but also risk-free (Drummond, 2002, p.232). This goes against fundamental laws in finance theory which says that a higher return equates to higher risk. As a risk-averse bank, they were blinded by Leeson’s claims and believed his profits mirrored previous successes in different markets in previous years.

Once directors accepted the notion of risk-free profits, the danger signs were rationalised to fit the expectations of a trader exploiting a bubble of profit. They believed Leeson was overburdened so mistakes were to be expected (the fact that he controlled both front and back offices even more-so proved this). They were also able to rationalise his evasive answers as wanting to cover up the chaos in the back office. Furthermore, London directors assumed that Leeson’s positions in Japan were equally and oppositely matched in Singapore, and not naked positions. This groupthink assumption became a “known”, and these such assumptions caused Baring’s downfall.  In the end, it was Leeson’s disappearance, not the lost money and huge margin calls, which alerted them to danger – because they could not rationalise it to fit their expectations (Drummond, 2002, p.235).

Conclusion

The Baring Bank crisis was primarily caused by the massive losses from the unauthorised trading by Nick Leeson. This disaster taught us multiple lessons, including the need to monitor traders carefully, to separate the offices, and to beware of easy profits. If Baring Bank had adopted these strategies, then the crisis could have potentially been averted. Overall, this case showed the degree of risk that the use of financial derivatives can produce, and that these instruments need to be treated carefully.

References

Drummond, H. (2002). Living in a Fool’s Paradise: The Collapse of Barings’ Bank. Management Decision, 40(3), 232-238.

Fox, J., & Horricks, D. (1995). The Collapse of Baring. International Financial Law Review, 14(4), 12.

Hull, C. J. (2018). Options, Futures, and Other Derivatives (9th Edition). Essex: Pearson Education.

Mun Y. K. (2009). Collapse of Barings. National Library Board Singapore. Retrieved from http://eresources.nlb.gov.sg/infopedia/articles/SIP_1531_2009-06-11.html