Barings Bank and Nick Leeson

1. Barings Bank andNick Leeson 2020-01-01

2. Barings Bank and Nick Leeson • Nicholas Leeson was a rogue trader who reduced the value of the venerable Baring Brothers & Co. (BB&Co) Bank from roughly $500 million dollars to $1.60. Lesson traded futures contracts on the Nikkei 225 and on Japanese government bonds without authorization while management at Barings, the Singapore International Monetary Exchange,the Osaka Stock Exchange, and other governing bodies in Britain and Singapore disregarded or failed to recognize the potential for financial disaster. The failure of Barings Bank provides a lesson in the risks and responsibilities involved in organizing and monitoring derivatives trading.

3. Barings Bank and Nick Leeson

4. Barings Bank and Nick Leeson • Baring Brothers History • Baring Brothers had a long history in the London financial district, with the distinction of having gone global with its operations in the eighteenth century. Founded in the late 1700s, the bank was turned into a general-banking and mercantile operation by Sir Francis Baring. During his tenure, the bank developed several lines of business: underwriting bonds, accepting deposits, and trading commodities. Baring Brothers reached the height of its reputation after the Napoleonic Wars in Europe. The bank led the funding of the French reparations to the victors and was lauded, in 1812 by the French Duc de Richelieu,

5. Barings Bank and Nick Leeson

6. Barings Bank and Nick Leeson as the "sixth power in Europe," after Great Britain, France, Russia, Austria, and Prussia. Baring Brothers helped finance the Louisiana Purchase for the United States, underwrote railroad construction in Canada, and financed other projects throughout the Americas. One of those other projects was underwriting a 1,2 million share issue for the Buenos Aires Water Supply and Drainage Co. in 1890. The issue did not sell, but Baring Brothers had already sent the money and was on the brink of failure when the Bank of England organized a consortium to bail it out. Thereafter, it was known as Baring Brothers & Co.

7. Barings Bank and Nick Leeson • For all its long history in cross-border transactions, the bank never grew along with the size of the markets it served. In 1995, Baring Brothers & Co. remained a small, family controlled bank ranked 474th in the world banking market. Barings entered the securities market in 1984 when it acquired the Far East department of Henderson Crothwaite (British stockbrokers). This new entity at Barings was called Baring Securities Ltd. (BSL). Christopher Heath, a specialist in Japanese instruments, managed to maintain independent control of Baring Securities until 1993.

8. Barings Bank and Nick Leeson During eight consecutive profitable years, everyone at Barings became accustomed to large bonuses, largely funded by profits in Baring Securities. In 1989, BSL provided £5O million of £65 million total profit for Barings. Unfortunately, the losses incurred in 1992 led to Heath being asked to resign in March 1993. • Nicholas Leeson • Nicholas Leeson was two days shy of his twenty-eighth birthday when his trading activities forced Baring Brothers into bankruptcy. Leeson left a note on his desk saying "I'm 'sorry" and boltedto Kuala Lumpur with his wife following shortlythereafter.

9. Barings Bank and Nick Leeson

10. Barings Bank and Nick Leeson Nick Leeson was born in Watford, England, just outside of London. His father was aplasterer and his mother was a nurse. He was the oldest of four children. Leeson did not attend university; instead, he went directly to work in London upon completion of high school. He worked with a British bank, Coutts & Co., and then Morgan Stanley, before moving to Barings Securities London in 1989.

11. Barings Bank and Nick Leeson Nick Leeson was twenty-two years old when he was hired for the position at Baring Securities London (BSLL). BSLL was looking to fill a position settling trades completed in Japan. Leeson, who had experience at Morgan Stanley settling futures and options in Japan, was a good replacement. He worked hard, kept to himself, and was known as someone anxious to learn and eager to please. He was subsequently selected as a member of a team of four people assigned to straighten out back office problems in Jakarta.

12. Barings Bank and Nick Leeson In 1992, he was selected to run the back office for the new Baring Futures Singapore (BFS), a subsidiary that would trade futures and options. His exact responsibilities were somewhat unclear, although they did include responsibility for both the back office accounting and control functions as well as for executing clients’ orders. This was when Leeson's unauthorized trading activities began. On his initiative, Leeson sat for and passed the futures-trading exam to become registered as an associated person with the Singapore International Monetary Exchange (SIMEX).

13. Barings Bank and Nick Leeson He did not need the license to fulfill his responsibilities, but he did need it to execute trades. To meet his Baring's responsibilities, he only needed to take orders from clients, and pass them to a trader for execution. In 1992, Leeson established the error account 88888 (eight is considered a lucky number by the Chinese), which, according to SIMEX investigators, he immediately began using to conceal unauthorized trading activities. While a legitimate error account, numbered 99002, was known to BSLL, the 88888 account did not show on files or statements transmitted from Singapore to London.

14. Barings Bank and Nick Leeson Account 88888 was known to SIMEX, but as a customer account, not as an error account. Leeson had to represent it differently to each group because he could not hide the existence of 88888 from SIMEX, and he could not explain its volume and balance to BSLL (but he could hide it from them).

15. Barings Bank and Nick Leeson • Derivatives • Since the early 1970s, derivatives have increasingly been used by firms to manage their exposure to risks. When a derivative is purchased, only part of the value of the underlying asset is at risk, while the opportunity to benefit from favorable price fluctuations is retained. Derivatives can offer potentially enormous gains, which can lead to their use as speculative instruments. They also offer potentially debilitating losses, depending on the positions taken.

16. Barings Bank and Nick Leeson Nick Leeson was trading futures and options on the Nikkei 225, an index of Japanese securities. Leeson was long Nikkei 225 futures, short Japanese government bond futures, and short both put and call options on the Nikkei index. He was betting that the Nikkei index would rise. He was wrong and ended up losing $1.39 billion. For Leeson to suffer losses of this magnitude in futures positions during January and February of 1995, he had to have held approximately one quarter of the entire open interest on the Osaka and Singapore stock exchanges. Unfortunately, since management had given such free rein to Leeson by allowing him to control both front and back office operations, this level of investment went undetected by the firm.

17. Barings Bank and Nick Leeson Leeson offset any losses incurred on his long positions in Nikkei futures by writing Nikkeioptions. That is, when Leeson purchased futures contracts, he was required to pay cash, a margin of 15% of the contract's value to SIMEX, and when the losses on the contracts accumulated, additional margin was required because futures contracts are marked-to-market on a daily basis. However, when he wrote the options, he received cash, in the form of premiums. The premiums from the Nikkei options served two purposes: (1) they were used to hide losses created by the futures, which would otherwise have shown in BFS financial statements,

18. Barings Bank and Nick Leeson and (2) the premiums served to cover the margin calls on the futures. Leeson was able to do this due to the nature of the Japanese futures market at this time. In Japan, margin is posted on a net basis for all customers. Therefore, if many customers were short index futures, the firm can take long positions without having to post cash margin. In addition, daily settlement was one-sided. That is, losers must cover their losses daily, but winners were not permitted to withdraw gains. Therefore, it was possible to cover the firm's losses with customer gains.

19. Barings Bank and Nick Leeson Another aspect of the Japanese futures market, which enabled Leeson to do this, was that the exchange did not require a separation between customer and proprietary funds. Therefore, it was impossible to distinguish between the firm's and the customers' positions. The Nikkei 225 experienced an extended bull run throughout the late 1980s, reaching a height of close to 40,000 in 1989. By mid 1994, Leeson was convinced that since the Nikkei had fallen to half of its 1989 high, and interest rates were low, it would likely recover in the near future.

20. Barings Bank and Nick Leeson He was convinced it would not fall below 19,000 and he was willing to put a lot of Barings’ money at risk based on that belief. However, a rise in interest rates would hurt him and, accordingly, be took short positions in Japanese government bonds futures contracts that would pay off if interest rates rose. Leeson's options positions were founded on his belief that volatility would be low. In fact, he had traded enough contracts by the time of the collapse that he was causing volatility to remain low. Increasingly, he had to write a larger volume of options in order to get the same amount of premiums.

21. Barings Bank and Nick Leeson When it became increasingly difficult for the options' premiums to cover the margin calls on the futures, Leeson requested money from London. By February 23, 1995, BSLL had sent approximately $600 million to BFS. BSLL funded his request with little information, and with the understanding that a portion of the money was "loans to clients," as portrayed on the BFS balance sheet.

22. Barings Bank and Nick Leeson • The Losses • Leeson began trading futures in July 1992 and by the end of the month, he had bought and sold 2,051 Nikkei futures, suffering a loss of approximately $64,000 immediately. By the end of the year, his losses in account 88888 were more than $3.2 million. The numbers turned somewhat in his favor by mid-1993 when the losses amounted to only $40,000. Unfortunately, Leeson intended to keep trading until his numbers were positive. By the end of 1993, the losses were approximately $30 million.

23. Barings Bank and Nick Leeson At this point, Leeson wrote options for approximately $35 million to offset the futures losses and to avoid suspicion from London and the auditors. Throughout this time period, Leeson was reporting record profits, and was being heralded as a superstar. • By the end of 1994, the Nikkei had fallen to just under 20,000 and Leeson's losses approached $330 million. Meanwhile, Barings executives were expecting an estimated $20 million in profits from BFS for 1994.

24. Barings Bank and Nick Leeson Leeson's activities in the first few months of 1995 were like those of any self-respecting speculator. On January 13, 1995, the Nikkei reached 19,331 and Barings was long 3,024Nikkei futures contracts. But, on January 17, 1995, an earthquake measuring 7.2 devastated the Japanese city of Kobe. The Nikkei plummeted below 18,840 by January 20, at which point Leeson doubled his contracts to 7,135. This process continued as the Nikkei fell to 18,000 on February 23, 1995, and Leeson's exposure grew to more than 55,399 unhedged Nikkei futures.

25. Barings Bank and Nick Leeson Compounding the problem, interest rates did not rise as Leeson had expected and he was losing on the Japanese government bond futures as well. • By Friday, February 24, 1995, Barings and the world discovered that Leeson had incurred losses approaching $1.1 billion, more than double the capitalization of the bank. The bank was headed toward bankruptcy. When the markets opened in Singapore and Osaka on Monday, the exchanges would declare Barings in default on its margins.

26. Barings Bank and Nick Leeson Throughout that weekend, the Bank of England hosted meetings in London to try to form a consortium to bail out Barings. Barclays Bank assumed the leadership role and was able to attain commitments for $900 million for three months. Unfortunately for Barings, no one would assume the contingent risk of additional, but as yet undiscovered losses, and the efforts failed. At the time, it was already known that on Monday, February 27, 1995, there would be an additional $370 million in losses from Barings positions, bringing the total loss to $1.39 billion. Barings was bankrupt.

27. Barings Bank and Nick Leeson 1. What was Nick Leeson's strategy to earn trading profits on derivatives?

28. Barings Bank and Nick Leeson • He dealt in 6 mainfinancial futures and some options on them, as follows: • 1. Nikkei 225 contract traded on SIMEX in Singapore; • 2. Nikkei 225 contract traded on OSE (Osaka Stock Exchange) in Japan; • 3. 10-year JGB (Japanese government bonds) contract traded on SIMEX in Singapore; • 4. 10-year JGB contract traded on TSE (Tokyo Stock Exchange) in Japan; • 5. 3-month Euroyen contract traded on SIMEX in Singapore; • 6. 3-month Euroyen contract traded on TIFFE (Tokyo Financial Futures Exchange) in Japan. • Around 1993 arbitrage business began to be an important part of Baring’s Far Eastern operations.

29. An arbitrage • An arbitrage is a type of transaction or portfolio. Actually, the term is used in two different ways, so it refers to either of two very different types of transactions or portfolios. People also speak of arbitrage as an activity—the activity of seeking out and implementing either of the two types of arbitrage transactions or portfolios. An arbitrageur is an individual or institution who engages in such arbitrage.

30. An arbitrage • In finance theory, an arbitrage is a "free lunch"—a transaction or portfolio that makes a profit without risk. Suppose a futures contract trades on two different exchanges. If, at one point in time, the contract is bid at USD 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02.

31. A short straddle • Short straddle A short straddle is a non-directional options trading strategy that involves simultaneously selling a put and a call of the same underlying security, strike price and expiration date.

32. A short straddle

33. A short straddle The profit is limited to the premiums of the put and call, but it is risky if the underlying security's price goes up or down much. The deal breaks even if the intrinsic value of the put or the call equals the sum of the premiums of the put and call.

34. A short straddle • A short straddle position is highly risky, because the potential loss is unlimited, whereas profitability is limited to the premium gained by the initial sale of the options. The Collar is a more conservative "opposite" that limits gains and losses.

35. Barings Bank and Nick Leeson • 1. What was Nick Leeson’s strategy to earn trading profits on derivatives? • Answer: Nick Leeson was trading futures and options on the Nikkei 225, an index of Japanesesecurities. He was long Nikkei 225 futures, short Japanese government bond futures, and • short both put and call options on the Nikkei Index. He was betting that the Nikkei index • would rise, but instead, it fell, causing him to lose $1.39 billion.

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37. Barings Bank and Nick Leeson 2. What went wrong that caused his strategy to fail?

38. Barings Bank and Nick Leeson + The beginning of the end occurred on January 16, 1995, when Leeson placed a short straddle in the Stock Exchange of Singapore and Tokyo stock exchanges, essentially betting that the Japanese stock market would not move significantly overnight. However, the Kobe earthquake hit early in the morning on January 17, sending Asian markets, and Leeson's investments, into a tailspin. Leeson attempted to recoup his losses by making a series of increasingly risky new investments, this time betting that the Nikkei Stock Average would make a rapid recovery. But the recovery failed to materialize, and he succeeded only in digging a deeper hole.

39. Barings Bank and Nick Leeson • What went wrong that caused his strategy to fail? • Answer: Nick Leeson’s strategy failed because the Nikkei 225 index kept falling while hecontinued to bet that it would rise.

40. Barings Bank and Nick Leeson 3. Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed?

41. Barings Bank and Nick Leeson • Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed? • Answer: Nick Leeson established a bogus error account (88888) when a legitimate account (99002)already existed in order to conceal his unauthorized trading activities. While the legitimateerror account was known to Barings Securities in London, the bogus account was not.However, the bogus account was known to SIMEX as a customer account, not as an erroraccount. In this way Leeson could hide his balances and losses from London—but notSingapore. One the other hand, SIMEX thought the bogus error account, 88888, was alegitimate customer account rather than a proprietary Barings account.

42. Barings Bank and Nick Leeson 4. Why did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading?

43. Barings Bank and Nick Leeson • Why did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading? • Answer: Internal Reasons. Leeson engaged in unauthorized trading, as well as fraud. However, itis clear that he was hidden in the organized chaos that characterized Barings. “There wereno clearly laid down reporting lines with regard to Leeson, through the management chainto Ron Baker [Head of Financial Products Group for Barings]” (Bank of England, p. 235).In fact, it seems there were several people responsible for monitoring Leeson’sperformance, each of whom assumed the other was watching more closely than he.

44. Barings Bank and Nick Leeson • In August 1994, James Baker completed an internal audit of the Singapore office. Hemade several recommendations that should have alerted Barings executives to thepotential for unauthorized trading: (a) segregation of front and back office activities—afundamental principle in the industry, (b) a comprehensive review of Leeson’s fundingrequirements, and (c) position limits on Leeson’s activities. None of these had been actedupon by the time of the bank’s collapse.With regard to the first concern, Simon Jones, Director of BFS and Finance Director ofBSS, in Singapore, offered assurances that he would address the segregation issue.

45. Barings Bank and Nick Leeson However, he never took action to segregate Leeson’s front and back office activities. TonyHawes, Barings Treasurer in London agreed to complete a review of the fundingrequirements within the coming year. Ian Hopkins, Director and Head of Treasury andRisk in London, placed the issue of position limits on the risk committee’s agenda, but ithad not been decided when the collapse occurred.

46. Barings Bank and Nick Leeson According to the Bank of England report, senior management in London considered Jonesa poor communicator and were concerned that he was not as involved as he should havebeen in the affairs of BFS. In fact, Peter Norris, the chief executive officer for BaringSecurities Limited wanted to replace Jones. Jones, however, was protected by James Bax,Managing Director of Baring Securities Singapore, who was well liked in London.The Bank of England also found fault with the process of funding Leeson’s activities fromLondon. First, there was no clear understanding of whether the funds were needed forclients or for Baring’s own accounts, making reconciliation impossible.

47. Barings Bank and Nick Leeson Second, given thelarge amounts, credit checks should have been completed as well. The report places theresponsibility for the lack of due diligence with Tony Hawes, Ian Hopkins, and theChairman of the Barings Credit Committee.The issue of proper reconciliation arose as early as April 1992 when Gordon Bowser, therisk manager in London, recommended that a reconciliation process be developed.Unfortunately, Bowser left Simon Jones and Tony Dickel, who had sent Leeson toSingapore, to agree on a procedure.

48. Barings Bank and Nick Leeson With internal conflict over who was responsible forLeeson’s activities, no agreement was reached between those two, and Leeson was left toestablish reconciliation procedures for himself.There are numerous similar examples of internal conflict benefitting Leeson’s coverttrading throughout the three years. But one of the late failures occurred in January 1995when SIMEX raised concern over Barings’ ability to meet its large margins. In a letterdated January 11, 1995, and addressed to Simon Jones, SIMEX officials noted that thereshould have been an additional $100 million in the margin account for 88888.

49. Barings Bank and Nick Leeson Jonespassed the letter to Leeson to draft a esponse.External Reasons. In January 1995, SIMEX was getting close to Leeson’s activities, buthad not yet managed to determine what was happening. In response to a second letterdated January 27, 1995 and sent to James Bax in Singapore, SIMEX expressed concernsregarding Barings’ ability to fund its margin calls. Bax referred the letter to London, andSIMEX received reassurance that opposite positions were held in Japan. Unfortunately,SIMEX officials did not follow up with the Osaka Stock Exchange to verify the existence of those positions.

50. Barings Bank and Nick Leeson 5. Why did none of the regulatory authorities in Singapore, Japan, and the United Kingdom discover the true use of the error account?