Barings Bank PLC

Barings Bank PLC was a blue-blooded British merchant bank founded in 1762 by Sir Francis Baring.150 The bank catered to royalty and was at the pinnacle of the London financial world. Among its many endeavors over the centuries, Barings financed the Louisiana Purchase in 1803, the Napoleonic Wars, and England’s wars against rebellious America (1775–83). The bank was also responsible for floating Guinness® stock in 1886, making it the first brewery to be incorporated on the London Stock Exchange; but the road to success was not always smooth. Barings survived wars and depressions and nearly went bankrupt in 1890 because of imprudent investments in Argentina, surviving only because of a last-minute bailout organized by the Bank of England.151 Despite occasional moments of turmoil, Barings was always one of the best-placed and highly regarded players in London’s financial hub. How ironic that this centuries-old bank would be toppled by one man operating out of Barings’ remote Singapore office!

During the 1990s, Barings’ operations focused on banking, asset management, and securities brokering, which created an internal culture clash that led to conflicts and back-office politics. Barings’ bankers and asset managers emphasized caution, deliberation, and long-term relationships over short-term gains. By contrast, its brokers were more adventuresome and spontaneous, with short-term gains uppermost in their minds. These two factions fought to allocate Barings’ limited capital. The bank’s decision to expand globally was divisive because its capital could not support equal expansion of all business lines. As a result, Barings decided in 1993 to merge its capital reserves to support all lines of business instead of allocating capital separately to each one. Unfortunately, this decision removed a major source of control over Leeson’s activities.

Incessant bickering among Barings’ senior managers in London and backbiting between executives in London and Singapore caused petty office politics to get in the way of good decision-making and weakened traditional lines of authority. Leeson reported, in theory, to managers in London, Singapore, and Tokyo, but no one took responsibility for him. Internal discussions did not conclusively distinguish whether Leeson was in charge of settlements, compliance, arbitrage, proprietary trading, or just executing customer orders. In reality, he was doing all these jobs, as well as taking unauthorized futures and option positions.

Nick Leeson: From London to Jakarta to Singapore

Nick Leeson came from humble origins compared to most of Barings’ officers. He had no family ties to the nobility, did not attend Eton, and did not serve in the Coldstream Guards. The son of a Watford plasterer, Leeson’s first job at Barings (1989) was in the back office, settling futures and option trades, but he rose swiftly. His big break came in 1990 when he was sent to Barings’ Indonesia office in Jakarta to sort out a tangled mess in the back office.

The Indonesia office had built a worrisome £100 million exposure in stocks and bonds that local operations could not reconcile. Trading volume on the Indonesian stock exchange had grown so fast that Barings’ procedures for delivering stock and bond certificates could not keep up with the volume. The bank had hundreds of small discrepancies between the certificates it held and the certificates it was supposed to hold. As a result, Barings was in possession of securities worth millions of pounds that should have been paid for and delivered to customers. A team of four, including Leeson, was sent to sort out the problems. Within ten months, the team had reduced the Jakarta exposure to a tenth of its original size. Leeson returned to London in 1991, and in the following year, was rewarded with the position of chief trader and head of settlements for Barings Futures (Singapore) (BFS). Later that same year, Leeson was promoted to assistant director and general manager.

Barings Securities Singapore (BSS) was incorporated in 1986 and granted non-clearing membership on the Singapore International Monetary Exchange (SIMEX). At first, BSS’ activities focused mainly on stock market transactions; but during the early 1990s, Barings decided to expand the bank’s worldwide activities in Southeast Asia to take advantage of the region’s relatively rapid growth and reduce its emphasis on Japan’s waning stock and warrant markets. In 1992, Barings applied for and received clearing membership for a newly established company called Barings Futures (Singapore).152 Leeson’s appointment to BFS was the ingredient needed to activate Barings’ three seats on SIMEX.

What Was Leeson Supposed to Be Doing at BFS?

In a monumental lapse of good judgment, Barings decided to make Leeson, who was only twenty-five years old and had no previous trading experience, the chief trader and floor manager for BFS on SIMEX, as well as the head of trade settlements.153 You may ask, “What well-managed bank would allow its chief trader to be in charge of the back office?”

Initially, BFS was supposed to execute orders placed exclusively by Barings’ affiliates worldwide on behalf of their customers, an activity called “agency trading.” As a result, supervisors reasoned that any loss of control resulting from putting Leeson in charge of both the front and back offices would be insignificant compared to the cost savings from having one person perform both jobs.

But as competition became keener, Leeson’s (and BFS’) responsibilities expanded. By 1993, Leeson could trade options for clients and conduct inter-exchange arbitrage (“switching”). Most of his arbitrage activities involved simultaneous purchases and sales of financially identical futures contracts, which were offered at different prices on two exchanges (i.e., “futures arbitrage”); but he also engaged in “cash-futures arbitrage,” which involved trading large baskets of stocks in the cash markets and contracts in the futures markets.

Even though these arbitrage transactions exposed Barings’ equity to potential risk, the threat was considered minimal because the time gap between buy and sell orders could be measured in seconds. Therefore, Barings would have an almost continuous stream of offsetting contracts trading simultaneously on two exchanges.

In 1994, Leeson landed a very large customer (Philippe Bonnefoy) and was given permission by senior management to trade for his account.154 Bonnefoy worked for the Bahamas-based European Trust and Banking Company and was known to trade more than 5,000 contracts per day. In a good month, Leeson could earn commissions of $100,000 or more from this business. To Leeson’s supervisors, trading for Bonnefoy’s account posed no major security breach because the bank’s equity was not at risk. Only if BFS took independent positions would Barings be exposed, and such positions were prohibited by the bank’s internal rules.

Leeson focused his arbitrage activities on three index futures contracts: the Japanese Nikkei 225 stock index,155 ten-year Japanese government bonds (JGB),156 and three-month Euroyen deposits.157 The Nikkei 225 futures contract was traded simultaneously on SIMEX and the Osaka Stock Exchange (OSE); the JGB futures contract was traded simultaneously on SIMEX and the Tokyo Stock Exchange (TSE), and the three-month Euroyen futures contract was traded simultaneously on SIMEX and the Tokyo International Financial Futures Exchange (TIFFE).158

Throughout the day, Leeson would communicate the futures prices quoted on SIMEX to Barings’ traders on the Japanese exchanges. For example, if the Nikkei 225 stock index futures contract159 was trading at 18,000 on SIMEX and 18,100 on OSE, Leeson would buy in Singapore and the OSE trader would simultaneously sell in Osaka to lock in a profit. These deals were simple and safe and the profit from each one was small. If Leeson had only been doing arbitrage trades of that sort, he would probably never have caused any disturbance; but he was also engaging in outright “naked” speculation, and that was how he lost more than $1 billion. How was he able to evade his managers, as well as internal and external auditors for so long?

Five Eights Account

Barings’ internal guidelines required affiliates to post discrepancies and trading mistakes to an Errors Account linked to corporate headquarters in London.162 That way, the bank’s books would balance, discrepancies would be isolated and dealt with separately, and the bank could make its regulatory filings without delay. Barings expected any open positions, which resulted from trading mistakes and separated in this way, to be closed and the resulting losses (or profits) charged to Barings’ earnings. The bank intended for these discrepancies to be handled within a short period (e.g., a day).

Brokers, like BFS, and banks, like Barings, normally have error accounts because traders make mistakes, back-office settlements are not always synchronous, and some trades are disputed. In the melee of SIMEX’s open outcry trading sessions, it is easy for traders to occasionally buy when they should have sold, execute trades at incorrect prices or maturities, and make mistakes recording transactions.

When BFS began trading SIMEX contracts on July 1, 1992, it already had an errors account called the “99905 Account,” which was linked directly to Barings in London. During the first two days of trading, Leeson’s team made a bevy of small errors and unreconciled trades, which were dutifully recorded in the errors account and reported to headquarters. Inundated with the workload caused by BFS’ tiny mistakes and perhaps concerned about attracting greater regulatory scrutiny, headquarters asked Leeson (on July 3, 1992) to set up a second errors account not linked directly to London. In this way, BFS’ mistakes could be reconciled in Singapore. The Chinese consider the number “8” to be lucky; so Leeson named the new errors account the “88888 Account” (the “Five Eights Account”).163

Leeson put himself into the role of guardian and proprietor of his newly discovered door to fortune and fame. During the first week of trading, he had the computer software (i.e., the CONTAC system) changed so that transactions booked to 88888 Account almost vanished from the daily reports sent to London. Specifically, Leeson deleted the system’s daily trade feed, which listed all the trades BFS executed on behalf of its customers. He did not, however, delete a crucial report that was created from BFS’ daily margin feed. This report listed the margin calls for all of BFS’ customers, and it included the 88888 Account as a line item. From his experiences in Jakarta and in Barings’ London back office, crafty Leeson knew that the margin feed report posed no problem because it was neither reviewed by Barings’ senior managers nor merged into London’s broadly used reporting system (called First Futures).

Shortly after Leeson created the 88888 Account, headquarters informed him they had installed a new computer system, which was capable of handling any and all of BFS’ errors. He was instructed to close the 88888 Account and book all future errors in the 99905 Account; but Leeson did not follow orders, and no one in the Barings organization checked to ensure that he had.

The 88888 Account was the keystone of Leeson’s financial fraud and deception. Without it, his reckless trades could not have been executed, and this ignominious financial disaster would have been avoided. He used the account to make unauthorized trades in futures and options, falsify reports to headquarters, misstate BFS’ profits, record invented trades, and create fictitious accounting entries. Barings had strict trading limits and believed that it was diligently monitoring all its traders to make sure they did not exceed their limits, but the bank’s systems were not good enough to catch the deception and misrepresentation Leeson committed.

Leeson’s turbocharged use of the 88888 Account began soon after it was created.164 Between July 1992 and the end of the year, he booked numerous transactions to this account, causing BFS’ hidden losses to grow from £20,000 to £2 million. When his arbitrage activities began in 1993, Leeson was able to report strikingly large profits, and a major source of these profits came from cross-trades booked in the 88888 Account. Cross-trades occur when a broker matches customers’ buy and sell orders internally rather than using the exchange floor. These trades must be for financially identical contracts that have the same total value.165 Leeson increased his reported profits by recording fictitious buy and sell orders in the 88888 Account at prices guaranteed to be profitable. He also transacted legitimate business for Barings’ worldwide affiliates and crossed these transactions with fictitious trades in the 88888 Account. As a result, it seemed as if he was making arbitrage profits, but many of these were fabricated and only a small part of the trades he was posting to the 88888 Account. The unreported losses in that account exceeded the arbitrage gains he was reporting.

To protect himself from being caught, Leeson often requested BFS’ back office to divide his large cross-trades into many smaller deals, to make it seem as if they had been transacted in different amounts and at different times throughout the day. In this way, his trades and positions would not arouse the suspicions of Barings’ supervisors and auditors. Because he controlled the 88888 Account, Leeson was able to assign any trades he desired to it—and he did. As a result, an inspection of Leeson’s normal trading showed robust profits and moderate amounts of futures contracts with positions and activity within authorized trading limits.

Leeson’s Trading Strategy: Doubling

Leeson quickly acquired a reputation as a hotshot trader, and success gave him credibility with his managers and colleagues.166 As a result, his trades and positions were not scrutinized the way they should have been. He made enormous bets on the movement of Japanese stock prices and interest rates. Instead of neutralizing or closing his position when the market turned against him, Leeson viewed every disadvantageous move in the market as an opportunity to recoup his losses. This led him to the fatal strategy of doubling. Doubling requires a trader to double his bets each time he loses. It is a do-or-die strategy that required Leeson to multiply the size of his bets in the 88888 Account so that any favorable movement in Japanese stock prices or interest rates would recover his losses.

Leeson used his doubling strategy to recoup significant losses in the 88888 Account. Meanwhile, he continued to report profits in his regular trading account. After one brush with disaster during the summer of 1993, when the 88888 Account was £6 million in the red, Leeson managed to bring it back to about zero and swore to himself (and to his wife) that he would never use the account again; but like a moth attracted to a flame, Leeson could not resist the twin lures of temptation and access to a seeming limitless supply of funding. After only a weekend’s hiatus, he was back at it, with transactions on a larger and grander scale. Leeson had become addicted to fame, which meant he needed to keep his reputation as a brilliant trader. To accomplish that, he had to earn large profits for the bank, which translated into higher bonuses for everyone at Barings, including Leeson and his supervisors.167

In 1993, Leeson’s Singapore operations reported earnings equal to £8.8 million, but his losses amounted to more than £21 million.168 During 1994 and the first two months of 1995, his losses increased exponentially. For Leeson, it became an all-or-nothing game. Determined to trade his way out of this predicament, he doubled, redoubled, and then doubled again his positions; but repeatedly, the market turned against him. By the end of 1994, BFS’ reported profits equaled £28.5 million, but Leeson’s actual losses were £185 million, and cumulative losses had reached £208 million.169

In 1995, the situation got worse—much worse. By February 24, Leeson had lost £600 million, and on February 27 (just three days later), when Barings filed for bankruptcy, his estimated losses had reached £827 million.170 As for the power of doubling, had Leeson’s activities been identified and stopped just one month prior to the Barings collapse (i.e., stopped at the end of January 1995 rather than the end of February 1995), total losses would have been less than one quarter as large, and the bank would have survived. Had he been stopped just one week prior to the end, losses would have been approximately half.

Funding Margin Calls

As the losses in Leeson’s 88888 Account grew, he faced a problem. The purchase or sale of futures contracts required him to deposit funds in margin accounts with the exchanges on which he was placing his trades. Adverse movements in prices required Leeson to deposit additional variation margin payments because his positions were marked to market every day. Leeson had to be careful because, if his positions got too large, he would not be able to raise the cash needed to meet the margin calls.

At first, losses in the 88888 Account were small enough for Leeson to fund by diverting BFS’ commissions and using client deposits; but as the required payments grew larger, he searched in desperation for other funding alternatives and found four: (1) increasing commission income by offering deals at non-market prices, (2) using the financial resources of Barings as his cash cow, (3) booking fictitious trades and falsifying records, and finally, (4) selling options.172

One way to better understand the corner into which Leeson painted himself and the bets he was making is by diagramming the profit/loss profile of his combined positions. The graphic explanation in the next section illustrates what really went wrong at Barings. His futures and options positions in the Nikkei 225 stock index serve as the basis for this explanation.

Net Profit/Loss Profile of Leeson’s Exposures

Leeson’s Long Futures Positions

From mid-1992 (when Leeson began at BFS) to mid-1994, the Nikkei 225 Index rose and fell with market forces (see Figure 6.1). During this period, Leeson varied his positions in Nikkei 225 futures contracts from long to short and back again. For example, if he was long and the market moved persistently against him, he would occasionally reverse his entire position and, out of desperation, go short. Figure 6.1 shows how it was possible for Leeson to have been on the wrong side of rising and falling markets. This analysis begins in mid-1994 because that was the fatal period before the Barings collapse.

In June 1994, Leeson bet the Nikkei 225 Index would rise; so he built a sizeable long position in Nikkei 225 futures contracts. As Figure 6.1 shows, Leeson missed the market trend. Rather than rising, the Nikkei 225 Index fell strongly from mid-June 1994 to the end of February 1995—and beyond.

The payoff profile of a long futures position is upward-sloping, and as Figure 6.2 shows, any decline in the underlying asset’s price (in this case, the Nikkei 225 Index) causes losses. Leeson was long on both OSE and SIMEX. As a result, a falling Nikkei 225 Index forced him to pay variation margin to both exchanges. At first, he tapped BFS’ commission income, customer deposits, and the financial resources of Barings’ London and Tokyo offices, but as his margin calls grew, he relied increasingly on the sale of options and in particular, on the sale of straddles.

Leeson’s Short Straddles

From November to December 1994, Leeson financed a large portion of his margin calls with unauthorized short straddles, and he hid these transactions in the 88888 Account. A short straddle is the hybrid derivative created when a put and a call with the same strike price and expiration are simultaneously sold. Figure 6.3 shows a short put and short call with strike prices of ¥19,000 and premiums of ¥1,000. The only way a short straddle can earn profits is if the price of the underlying asset does not move substantially in either direction (i.e., remains between ¥17,000 and ¥21,000). A straddle looks like an iceberg, with most of its mass underwater (i.e., below zero). Notice how little of the straddle is above zero, compared to the total profit/loss profile. The portion of the short straddle that is above zero depends on the size of the premium relative to the total exposure.

Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract

The short straddle positions taken by Leeson were not in isolation. As Figure 6.4 shows, he also combined his short straddles with long futures positions.

For every straddle he sold, Barings got cash which Leeson used to pay the required initial margin on new trades and to meet the escalating margin calls on his existing futures positions. Figure 6.4 shows an example where the strike and futures prices are both ¥19,000. To profit from his long futures position, the Nikkei 225 Index had to rise above the futures price of ¥19,000;175 but every yen gained on his futures position would have been offset by losses on the short straddle (or more specifically, on the short call portion of the straddle).

On the downside, the situation was much riskier. A drop in the Nikkei 225 Index caused simultaneous losses on his futures position and on his straddle position (or more specifically, on the short put portion of the straddle). The only thing standing in the way of losses at every lower price level was the premium Leeson collected up front, at the time he sold the straddle.

Figure 6.5 shows the profit/loss profile created when one short straddle and one long futures position are combined. It looks like a short put, but there is a big difference. The upward-sloping portion of the hybrid straddle’s profit/loss curve is steeper than a single short put because the long futures contract incurs losses as the stock index falls below the futures price, and the short straddle incurs losses as the stock index falls below the strike price. Notice in Figure 6.5 how the gains from a short put position are capped. By contrast, the potential losses could be enormous if the Nikkei 225 Index fell—and it did.

Profit/Loss Profile: Combining a Long Futures Position and “Numerous” Short Straddles

The profit/loss profile from combining one short straddle and one long futures position gives the illusion that Leeson had a viable trading strategy, and he just guessed wrong in terms of price direction. Figure 6.5 shows a large span of prices to the right of the strike price, which offers, at least, a glimmer of hope that profits could be earned. Unfortunately, this was not the case. In fact, Barings would have been lucky if Leeson had put the bank in such a position. Leeson’s need for large sums of cash to fund his margin calls forced him to sell disproportionate numbers of short straddles for each long futures position he took. Figure 6.5 shows the results if one long futures contract were combined with one short straddle, but this one-for-one combination was not what Leeson did. Rather, he combined numerous short straddles with each long futures position.

Figure 6.6 shows the profit/loss profile when numerous (in this case, three) short straddles are combined with one long forward contract. The hybrid profit/loss profile looks, again, like an iceberg (“Leeson’s Iceberg”) because 90 percent or more is underwater (i.e., in the red). The only outcomes that could have been even slightly profitable were if the Nikkei 225 Index hovered within a narrow range. For example, if the Nikkei 225 Index rose slightly, Leeson’s long futures contracts would have generated small gains, and his puts (and possibly some calls) would have expired out-of-the-money, leaving him with the premiums; but if stock prices rose too much, the losses on Leeson’s mountain of short calls would have overwhelmed the gains on his futures contracts. By contrast, if stock prices fell, losses on Leeson’s long futures contracts would have been amplified by the losses on his mountain of short puts.

Beyond Irony: The Barings Failure in a Broader Time Frame

As enormous as his losses were after the stunning drop in Japanese stock prices, Leeson’s strategy still could have earned considerable profits if Barings had been able to hold his positions until the end of the year. Figure 6.7 shows that, between February 27, 1995 (when Barings failed) and the end of December 1995, the Nikkei 225 stock index rose more than 3,000 points. Due to the colossal number of Nikkei 225 futures contracts he had purchased during January and February 1995, trying to keep the Nikkei 225 Index at 19,000, Leeson’s Iceberg (Figure 6.6) had been transformed into Leeson’s Hockey Stick (Figure 6.8). His new position had a sharply sloping downside, reflecting the losses he would incur on his short straddle and long futures positions if the Nikkei 225 Index fell; but if prices rose, he would have benefited because the earnings from his mountain of long futures positions would now have overpowered the losses on his short straddles.

A Bank for a Pound

It was not until SIMEX issued its mega-margins calls in January and February 1995 that Barings’ directors in London suspected that Leeson’s trading was not arbitrage and that he was not a star trader. Barings sent auditors to Singapore, but by the time the team exposed the reckless trader, it was too late. Losses had mounted and exceeded the bank’s net worth. Barings had no way to recover, and efforts to extricate itself from financial ruin failed. Unlike the near bankruptcy of 1890, no white knight came to the rescue. The choice for Barings was simple: bankruptcy or sale. In the end, a Dutch bank, Internationale Nederlanden Groep (ING), purchased Barings for £1 (about $1.50) and assumed all the bank’s liabilities.178 SIMEX immediately liquidated all of Barings’ positions, using the deposited margin to repay all counterparties.179

Leeson tried desperately to get back to England so he could be tried in an English court. If he were imprisoned, Leeson wanted to be close to his family and not in a foreign jail. From Singapore, he and his wife fled to Malaysia and from there to Brunei, Bangkok, Abu Dhabi, and finally Frankfurt, where the police apprehended him as he disembarked from a plane. London’s Serious Fraud Office (SFO) was not interested in extraditing Leeson to England to stand trial. Even though his crimes had been against an English bank, they had occurred in Singapore, and it was difficult for British lawyers to find charges on which to build their case. The SFO could have tried Leeson for theft, but this charge was considered trivial compared to his reprehensible deeds; therefore, the SFO was happy to have Leeson stand trial in Singapore.

After losing a seven-month battle to be tried in an English court, Leeson accepted extradition to Singapore, where he pleaded guilty to two charges of fraud.180 His penalty for misreporting contracts worth £300 million (February 1, 1995) was a six-year sentence in Singapore’s Changi jail, and his penalty for forgery was six months in the same jail. Leeson’s imprisonment was backdated to account for the time he spent in Germany’s Hoechst Prison. While in prison, he was diagnosed with colon cancer that had spread to his lymph nodes, and his marriage dissolved. In July 1999, Leeson was released from prison on good behavior, after serving about four and a half years of his six-and-a-half-year sentence.

Aftermath of the Barings Failure

Peter Baring, Chairman of Barings Bank PLC, was convinced that the failure of his bank was the work of a conspiracy much broader than Nick Leeson’s involvement alone. After all, if Leeson bought so many Nikkei 225 futures contracts, someone must have sold them. Leeson was certain that his phone had been tapped and he was the victim of competitors who unfairly beat him to the market and robbed him of profitable trades. Still others were sure that Leeson had a “pot of gold” hidden away for after he was released from jail. When the smoke cleared, virtually all the conspiracy theories either were disproved or carried little credibility. The failure of Barings shocked the financial industry into realizing just how powerful one trader’s undiscovered and unsupervised transactions could be. Because of this catastrophe and others that occurred in the 1990s, the financial industry set its sights on the target of implementing new and improved risk management measures. Today, financial tools and approaches to risk management, such as value at risk (VaR) and enterprise risk management, have grown in popularity due to the lessons learned in the 1990s.

Because ING purchased Barings and assumed all its losses, none of Barings’ depositors, bank creditors, or customers was hurt by the collapse, and only a minority (about 1,200) of Barings’ employees lost their jobs. Nevertheless, shareholders and bondholders suffered terribly.181 As for the financial markets, the Barings failure turned out to be little more than a speed bump on the global financial turnpike. For a short time, market volatility and transaction costs (i.e., bid-ask spreads) increased marginally, but they returned to normal after a few months, as the markets shrugged off this financial debacle.182

How Could Barings Have Caught Leeson Sooner?

It is difficult to understand why Barings London did not discover and stop Leeson’s reckless trading far sooner than it did, but then everything seems simple with 20:20 hindsight. A large part of the problem was that Barings’ control systems were ineffective and toothless, aggravated by management’s inability or unwillingness to act on information and warning signs. In July and August 1994, a Barings auditor spent two weeks in Singapore and occupied the chair next to Leeson but did not discover the unauthorized positions in his 88888 Account.

There were plenty of advance warnings, but they were either disregarded or not taken seriously. Leeson’s excessive margin calls were not challenged when they should have been. Warning bells should have rung loudly when his daily requests for funds were evenly split between Barings’ house account and customers’ accounts—an occurrence that probabilistically should not have occurred even once, let alone almost every day. How difficult should it have been to expose this rogue trader? Regrettably, the answer is “not very difficult.” For instance, consider the following.

Table 6.1 compares the trades Leeson reported to London at the end of February 1995 with the actual trades booked in the 88888 Account. Barings London assumed that Leeson’s SIMEX trades were offset by equally valued positions on OSE. Furthermore, the bank’s internal rules limited traders’ intraday positions in the Nikkei 225, Japanese government bonds, and three-month Euroyen contracts to 200, 100, and 500 contracts, respectively. These same internal rules also prohibited traders from taking proprietary positions (i.e., positions using Barings as a counterparty), such as selling options or holding unauthorized positions overnight.

Table 6.1: Reported and Actual Trades of Barings Futures (Singapore) on February 27, 1995

* Contracts are measured in terms of SIMEX contracts, which are half the size of OSE and TSE contracts.

Source: Bank of England, Board of Banking Supervision, Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings London (ordered by the House of Commons), (July 1995).

Leeson was in gross violation of all these limits. At the end of February 1995, he stood to gain or lose more than $30.5 million with each 100-point movement of the Nikkei index184 and more than $28 million for each 100-point change in Japanese government bond prices.185 His positions were so large that they violated Bank of England protocols. To control credit risk, English banks were required to report to the Bank of England all customer exposures that exceeded 10 percent of the bank’s shareholders’ equity and to notify the central bank before exposure exceeded 25 percent. Yet during 1994 and 1995, Barings had persistent exposures to SIMEX, OSE, and TSE that were each more than 25 percent. In February 1995, when Barings failed, its exposures to OSE and SIMEX were 73 and 40 percent, respectively.186

Conclusions

The Barings failure was a spectacular calamity providing valuable lessons. Effective risk management requires a clear line of demarcation between the responsibilities of front-office and back-office managers and staff. Otherwise, there will always be temptation to fix the books to enhance performance. Without this separation, control systems that monitor risks, such as trading limits, creditworthiness, liquidity, and cash flows, lose most of their significance. Barings allowed Nick Leeson to settle his own trades, by giving him authority over both the front and back offices. As a result, he could manipulate accounts at the Singapore branch, while reporting fraudulent totals that appeared accurate. Giving Leeson authority over front- and back-office functions was letting the fox guard the chicken coop.

Perhaps the most embarrassing aspect of the Leeson-Barings catastrophe was the role played by senior management (i.e., Leeson’s direct supervisors, the bank’s management committee, and the Board of Directors), whose errors were of omission rather than commission. Barings management gave too much autonomy to Leeson, who was in many ways far beyond the scrutiny of his supervisors. From the start, there were no clear reporting lines in Barings’ highly political matrix organization. As a result, there was a gaping lack of understanding throughout Barings of exactly what Leeson was doing.

Barings’ controls proved to be pathetically ineffective. No one in the bank seems to have fully understood the risks Leeson was taking. He was thought to have the Midas touch and too much restraint would cramp his trading style. Therefore, no one posed the hard questions that should have been asked. Even routine tasks, such as reconciling margin payments with customers’ accounts and verifying information sent from BFS to headquarters, were not performed in a professional way. Barings’ management committee should have set up reporting systems to ensure that important information on operational risks reached it, and the Board of Directors should have put the management committee under constant pressure to formulate these risk-reporting systems.

Barings management thought Leeson was hedging and it funded his margin calls without demanding a full explanation. Had Leeson been fully hedged, the margin calls on one exchange would have been offset by gains in the other. When he earned 20 to 50 percent of Barings’ worldwide annual profits on riskless trades, alarm bells should have sounded immediately.187 Yet no one from Barings investigated the source of these absurdly high profits. Instead of scrutinizing them, Barings management convinced itself that the source of the BFS’ competitive advantage over rivals came from its large customer base, ability to arbitrage the Japanese and Singapore exchanges, and having the wisdom to hire Leeson, the golden boy of arbitrage trading.

Senior Barings managers ignored internal audit reports, as well as inquiries from the Bank of England and Bank for International Settlements. They even ignored (for a while) the cold reality of Leeson’s call for cash, when trading losses required Barings to borrow the needed funds and wire them to Singapore. The bank had rules and regulations in place that were supposed to stop traders (including Leeson) from exceeding intraday trading limits, carrying open overnight positions, and exposing the bank to excessive customer risk, but rules are useless if they are not obeyed or enforced.

From all their years of trading and security dealing, banks, like Barings, should have learned from their successes and failures how to control positions of their employees; but control is an elusive goal when banking activities have so many dimensions and when each trading operation and new instrument offers its own secret passageways to the bank vault. Derivatives involve huge degrees of leverage, and their net risks can be masked by joining them in countless combinations, permutations, and variations. Nevertheless, almost no twisting and turning can reverse the fact that many levels of management above and around Leeson failed to function properly. Whatever arguments Leeson’s supervisors concocted to absolve themselves were invalid and shallow. Leeson was only twenty-five years old and had no previous trading experience when he became BFS’ chief trader and head of settlements. It is sobering to think how many individuals with brilliant minds and the opportunity to study at prestigious universities, like Oxford and Cambridge, were duped by a lone rogue trader in Singapore.

Review Questions

Bibliography

Bank of England. Board of Banking Supervision. Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings London (ordered by the House of Commons) (July 1995).

BBC Online Network. “Business: The Economy How Leeson Broke the Bank.” Tuesday, June 22, 1999. Available at http://news.bbc.co.UK/2/hi/business/375259.stm. Accessed on December 24, 2007.

Brown, Stephen J. and Steenbeek, Onno W. “Doubling: Nick Leeson’s Trading Strategy.” Pacific-Basin Finance Journal 9 (2001), 83–99.

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