Power Markets I HS2014

Case Study2 - Barings Bank

Source: C. Bergschneider, M. Karasz, R. Schuhmacher. Risikomanagement im Energiehandel. SchafferPoeschel Verlag Stuttgart, 1999.
Read the case study carefully and answer the questions below.
1. Which derivative transactions did Nick Leeson in 1994?
2. On which market development did Leeson speculate? Where are the risks of this strategy?
3. What triggered the disaster?
4. Why was the bank confronted with such high liabilities in the end?
5. What principles were violated that led to losses on this scale?
6. Which simple measures could have prevented this?

The most spectacular example of inadequate management of operational risk is the case of Barings
Bank in 1995. A single trader, Nick Leeson, caused a bankruptcy of a 233-year-old British bank.
Especially, this disaster due to unauthorized trades by Leeson provides an example of risk related to
employees. The problems could occur in this extent, because simultaneously many components of
operational risk were not or were only insufficiently considered. The main reason for the collapse of the
bank was in the fundamental shortcomings of the internal monitoring system.
The disaster developed at the background during a rapidly implemented reorganization of the bank when
the bank expanded the business. Management changes were common. This resulted in unclear
leadership. Managers believed that others were responsible for certain businesses. The others, however,
denied this responsibility later. Due to a non-uniform accounting system, the bank was unable to
determine the net positions of their worldwide activities in the derivatives business.
One at that time in, a Japan based Barings employee recalls: "We were way back in the Stone Age. The
accounts produced in London never matched our figures. They switched accounting methods every time
the management changed. We had to rely on guesstimates for... most of our costs. It was a farce. You
could have hidden anything in those books, absolutely anything."
Nick Leeson worked since 1992 for Barings Futures in Singapore, where he rose quickly to the general
manager. Leeson acted personally on the Singapore International Monetary Exchange (SIMEX) both as a
broker on behalf of clients as well as Barings Barings itself.
The proprietary trading should be limited to index arbitrage for the Japanese Nikkei 225 stock index,
which is traded on both the SIMEX and on Japanese stock exchanges (Tokyo and Osaka). The so called
index arbitrage was the utilization of common but often very short-term price differences between Nikkei
futures prices on the SIMEX and similar contracts on the Japanese stock markets. Since the Japanese
exchanges are computer exchanges while SIMEX a floor exchange, Leeson and his staff were constantly
informed of any price change in Japan. Leeson was able to immediately exploit price differences by
entering directly opposite positions in Japan and SIMEX. This action, which is also called, switching ", is
regarded as almost risk-free. If the market moved in his favor, Leeson's kept open position for a longer
time. In each case the team ensured, that at the end of the trading day, all Long - and short positions
were balanced.
Within Barings there was some discussion regarding the conflict of interest which may be caused by
simultaneous action for customers and for its own account. This discussion, however, drew from only
from the real problem, which was that Leeson was also responsible for the back office. An internal audit
in 1994 pointed out the violation customary golden rule that responsibilities for front and back office must
be separate: "The audit found that while the individual controls over FSO's [Baring Futures (Singapore)]
systems and operations are satisfactory, there is a significant general risk that the controls could be overridden by the general manager [Nick Leeson]. He is the key manager in the front and the back office and
Malthus can initiate transactions on the Group's behalf and then Ensure that they are settled and
recorded according to his own instructions."

Power Markets I HS2014

The Barings management was aware of the fundamental problem of the organizational structure in
Singapore, however they assumed that problem could wait. This certainly goes along with the great
reputation and trust that Leeson had acquired since 1992.
Neither top management nor Leeson's superiors really understood what was happening in Singapore.
Many Barings employees wondered how it was possible to achieve over the years considerable profits by
almost risk-free arbitrage. In 1994, Leeson made 10 million profit in one week.
Although these results disagreed with the usual risk/earnings ratios, no one looked into the matter. It
turned out that the profits were not earned through arbitrage. Rather Leeson used from the beginning on
of his work the possibility to manipulate the accounts of executed transactions.
How did the collapse of Barings Bank happen exactly?
During his first three months Leeson scored a loss of 4.8 million by unauthorized trading with Nikkei
futures. These transactions were settled, as well as all future unauthorized transactions on SIMEX, on an
alleged account. To compensate for these losses, Leeson started trading with options on Nikkei futures
225. By the simultaneous sale of puts and calls, he took a so-called short straddle position. This strategy
results in an immediate income in the height of the option premiums, with no payment at the end of the
option run time, as long as the Nikkei index is within a certain range, namely, the index levels where the
put and call options were sold. However, the strategy is highly speculative. For an unfavorable evolution
of the indexes, the losses are theoretically unlimited. At first, the strategy proved to be successful for
Leeson; in July 1993 the losses on the account were compensated. This success is likely to have given
Leeson a feeling of security, which later proved to be fatal. In the early 1994, Leeson started to sell
straddles again and thus bet that the indexes will stay within a narrow band. He increased his positions
for several months. At that time the Japanese stock markets were very inactive and the volatility of the
Nikkei 225 was very low. As long as it stayed within 19,000 to 21,000 points, Leeson was on the winning
side. At the beginning of the year 1995 the index approached the lower limit. But due to the still very low
liquidity and volatility the Japanese stock market, there no danger unless either the investor behavior
changed fundamentally or if the market was shaken up by an external shock. The unimaginable
happened: On 17 January 1995, the earthquake occurred in the industrial heartland around Kobe and
Osaka and this lead to the misfortune of Barings. Initially, the Nikkei index fell relatively little, from 19,350
points on the day of the earthquake to 18,950 points on Friday, the 20th January. Over the weekend,
however, it became increasingly clear that the damage was much larger than assumed first. On Monday
23 January, the Nikkei index fell to 17,785 - Leeson started to panic. Under the absurd assumption that
he could stop alone the development on the Japanese stock market during the greatest catastrophe of
postwar Japanese history, Leeson bought Nikkei 225 futures to support their course.
Within four weeks, he built up the gigantic position of 55,399 March contracts and 5640 June contracts.
After an interim high in late January / early February, the index went continuously downwards. On 23
February, the index broke through the 18,000 point mark again. Leeson lost on that day alone 65
million. Leeson left Singapore in a hurry.
When the market on the 27th of February opened, an additional 880 points lower, the collapse of Barings
Bank was sealed. Leeson's losses accumulated finally to 827 million.
In retrospect, it is difficult to understand that the Barings' London-based headquarters gave these sums
to finance margin calls of customers, without examining or understanding how this sum of money was
used. Any steps to verify the identity or creditworthiness of these customers were not taken.