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This lecture discusses the collapse of Barings Bank due to the fraudulent activities of Nick Leeson and highlights the deficient internal auditing and risk management practices that contributed to the bank's downfall.
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"Bankers who hire money hungry geniuses should not always express surprise and amazement when some of them turn around with brilliant, creative, and illegal means of making money." “The quotation is from a speech by the financial thriller writer on the Psychology of Risk, Speculation and Fraud, at a conference on EMU in Amsterdam.
Barings Bank collapsed when one of the Singapore based employees of London's Barings Bank, Nick Leeson, lost £827 million (US$1.4 billion) - primarily on futures contract speculation. Leeson's actions led the oldest merchant bank to default on its debts.
The bank's collapse is considered a pivotal turning point in the history of banking and has become a textbook example of accounting fraud.
The way that Barings Bank's activities in Singapore were organized between 1992 and 1995 enabled Leeson to operate effectively without supervision from Barings Bank's head office in London.
Leeson acted both as head of settlement operations (charged with ensuring accurate accounting) and as floor manager for Barings' trading on Singapore International Monetary Exchange (SIMEX).
Normally the positions would have been held by two employees. This concentration of functions placed Leeson in the position of reporting to an office inside the bank which he himself held. Several observers, including Leeson, placed much of the blame on the bank's own deficient internal auditing and risk management practices.
Because of the absence of oversight, Leeson was able to make seemingly small gambles in the futures market at Barings Futures Singapores (BFS) 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. By December 1994 Leeson had cost Barings £200 million but 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 had capital of £350 million
Using the hidden "five-eight account," Leeson began to aggressively trade in futures and options on SIMEX. His decisions routinely lost substantial sums, but 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.
Barings Bank management in London at first congratulated and rewarded Leeson for what seemed to be his outstanding trading 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 Stock Average which failed to materialize.
Appointed administrators began managing the finances of Barings Group and its subsidiaries on 26 February 1995. On 26 February, the Board of Banking Supervision launched an investigation led by Britain's Chancellor of the Exchequer.
The Chancellor released his report on 18 July. By 27 February, Leeson had cost the bank £827 million. The collapse itself cost the bank another £100 million.
Barings Bank auditors finally discovered the fraud, around the same time that Chairman Peter Barings received a confession note from Leeson, but it was too late. Leeson's activities had generated losses totaling £827 million (US$1.4 billion), twice the bank's available trading capital.
