CHAPTER 3: BARINGS BANK COLLAPSE – OWEN GREGORY

This study analyses the collapse of Barings Bank and will demonstrate both the failure of internal controls and the problems initiated by deregulation within the financial industry. The infamous failure of the bank in 1995 was by no means the first time it had courted disaster.

In 1762 Francis Baring established a merchant bank in Mincing Lane, in the City of London, trading in cochineal, copper and diamonds. Barings Bank also became an ‘acceptance house’, guaranteeing the supplier would be paid by the buyer through the provision of Bills of Exchange.

After surviving near financial disaster in 1774 and 1787 Barings grew to become one of the finest merchant banks in Europe, even helping to broker the Louisiana Purchase in 1802. In 1890, however, a scheme involving buying large sums of Argentinian debt went badly wrong when the Revolución del Parque caused the South American country to default on its payments, and lack of confidence in Barings almost caused its foreclosure.

‘There was no getting away from the almost unthinkable consequences if Barings did go down, not only would the failure of the City’s leading acceptance house inevitably bring down a host of other firms, including all the discount houses, but the very status of the bill on London would be threatened, and thus the pre-eminence of the City as an international financial centre.’ – David Kynaston (Fay, 1996, p. 11).

Barings was saved by the intervention of the Governor of the Bank of England, William Lidderdale. This earlier event provides a useful insight into the events that caused the collapse of Barings some 105 years later – the Barings collapse of 1995 started with a ‘Big Bang’ and ended with an earthquake.

Big Bang Day

27 October 1986 was named ‘Big Bang Day’ in the City of London, because the deregulation of the financial markets on that day affected almost every financial institution. The deregulation ended the role of the specialist financial institutions that concentrated on specific tasks in the financial system and would:

‘. . . allow for the existence of financial institutions that could engage in a wide variety of activities and in a variety of types of markets, thus having a much greater customer appeal than that hitherto associated with small niche players such as Barings.’ – (Stein, 2000, p. 1217).

At the time of the Big Bang Day, the author was working as an IT developer for Union Discount Company of London Limited (Union). From his first-hand experience, he recalls that the level of reporting insisted upon by the regulatory authorities increased hugely. An automation of risk reporting from organisations was required to allow membership of the deregulated institutions. In line with this, Union was required to create near real-time reporting as part of the regulatory controls. This constituted a method of electronic transfer for risk and exposure measurements which were electronically sent to the regulators on a frequent basis throughout the trading day.

The information in the new exposure-control system was also to be monitored within the organisation to ensure that no exceptional risks were attributable to trading. This included exposure in positions taken in all trading including the derivatives market. The system seemed to be sound as, although companies recorded losses and gains in their year-end statements, nothing untoward really occurred that would worry the financial regulators of the institutions in the City.

In July 1989 Baring Securities employed a new member of the back office staff, settling futures and options contracts. His name was Nick Leeson. In early 1992 Leeson was given the opportunity to manage the Baring Securities back office in Singapore despite wild excesses outside of work, as he impressed bosses at the bank with his diligence.

Soon after his arrival in Singapore Leeson requested that the company should apply for him to be licensed as a front office derivatives trader as well. The majority of Leeson’s trading took place on the Nikkei-225 stock market using a technique called arbitraging, which involves taking advantage of the difference in prices by buying contracts listed on one exchange (e.g. Osaka Securities Exchange) and selling them on another (e.g. the Singapore Monetary Exchange). This method reduces the risk of encountering large losses in a single position. It is also known as hedging. One such gamble on the Nikkei-225 allegedly earned Barings US$150 million in the final quarter of 1994.

On the 23 January 1995 the Kobe earthquake occurred while Leeson was in a derivatives position that required the market to remain in the 18,500–19,500 range. The Tokyo stock market fell 1,000 points to under 17,800 and in attempts to redeem his positions Leeson:

‘. . . went on a massive buying spree in the hope that it would push up the Nikkei futures market, but to no avail. Leeson’s huge losses seem to have arisen as a result of his failure to hedge his positions. Instead, gambling on a rise in the Nikkei-225 stock market average. . . when the nature and scale of his operations became known, he had incurred a loss of nearly £1 billion, which exceeded the bank’s capital.’ – (Bhalla, 1995, p. 660).

On 28 February 1995 Peter Baring observed that while the arbitraging continued, ‘It was in principle a low-risk business.’ The management of the risk associated with a single operative having both dealing and settlement capabilities did nothing to control trading risk, however – in fact it generated a risk for which no control was in place.

James Bax, a director of Barings Singapore, warned London in March 1992, shortly after Leeson was granted the dealing license, that:

‘We are setting up a structure which will subsequently prove disastrous.’ (Bhalla, 1995, p. 660).

It was management failure that did not terminate the risk. The failure of information systems and reporting is also to be blamed for an unacceptable trading position not to be recognised. The Barings directors claimed that Leeson withheld information by posting losses to a ‘settlement errors account’, number 88888 – but any true consolidation of the Singapore accounts should have included account 88888 in its calculation and allowed immediate treatment of the situation.

This shortfall in the reporting information displays a lack of accountability, supervision and control. In October 1993 Peter Baring had noted that, ‘derivatives need to be well controlled and understood’ – clearly the intent was unmatched by the control.

Year end 1994 saw Leeson reporting a £102 million profit to the British tax authorities although in reality he had cost the bank £200 million. Had Barings been aware of the true extent of its exposure, the subsequent collapse may well have been avoided as the bank still had around £350 million of capital.

It seems highly likely that deregulation resulted in a greater level of stress being generated, furthering the drive for the production of profits for investors and greater dividends for shareholders. Bonus payments were also tied to the performance of the banking departments and, for the purpose of profit-making, increasing the risk in trading was regarded as the norm. Baring’s risk taking, especially in the case of the Singapore operation, was a case that quickly went out of control with devastating effects. The Bank of England refused to bail out Barings, as it had done 105 years before.

Barings was declared insolvent on 26 February 1995, and KPMG were appointed as administrators. At the same time, the Bank of England commenced its own investigation and their findings were published in July of the same year. Lord Bruce of Donington remarked that:

‘Barings’ collapse was due to the unauthorised and ultimately catastrophic activities of, it appears, one individual (Leeson) that went undetected as a consequence of a failure of management and other internal controls of the most basic kind. . . . . . . . . Management teams have a duty to understand fully the businesses they manage.’ – Lord Bruce of Donington (Hansard, 1995).

The majority of Barings Bank was sold to ING, a Dutch financial group, for £1 sterling and over 200 years of banking history was ended.

With the benefit of hindsight, a number of commentators and, indeed, Leeson himself, credited much of the responsibility and autonomy that he attained on the bank’s own inadequate internal risk management practices. Those who raised concerns about his status and modus operandi were invariably ignored.

Lessons learned

The lessons that can be taken from the collapse of Barings can primarily be sub-divided into three factors – human, operational and technical failings. The human factors that were prevailing and contributed towards the situation included:

• Post-deregulation opportunity for higher earnings, in a growing market, for successful job candidates.
• Success of individuals in gaining profit for organisation increased personal bonus prospects (bonus related to profitability), leading to a trading risk increase.
• Demand from investors to receive greater returns in deregulated trading.
• Fast moving jobs market led to employees ‘jumping ship’ for better opportunities to earn.
• Loss of knowledge base as employees moved to other opportunities.

From an operational perspective the following observations were made:

• Growth of organisations operating in the City of London stretched the regulatory capabilities of the Bank of England.
• Survival-of-the-fittest mentality, defining successful organisations as those able to produce returns and quickly adjust to the change in the market conditions.
• Mergers, take-overs and acquisitions rife.
• Evolving market requiring changes to the method of operations.
• New investment types requiring new risk and control methods.
• Globalisation permitting round the clock operations, requirement for subsidiary organisations to be geographically distributed.
• Globalisation leading to geographically distant events affecting performance of local markets away from the event origin.
• Allowing the same individual to deal and settle trades; including the rejection of a director’s concern over such.
• Rejection of internal audit reports.
• Manager of the derivative business based in London while trading carried out in Singapore.
• Removal of restrictive practices leading to additional competitiveness and subsequent greater risk taking in a newly overcrowded market.
• Pressure from increasing numbers of foreign banks needing a presence in the London market.
• Movement out of historically ‘niche’ markets into new investment types – leading to companies operating outside of their ‘comfort zone’ and expertise.
• Risks of external influence on the markets not anticipated.

Finally, the following technical observations were made:

• Increasing use of, and dependence on, information technology – still then an emerging technology.
• Evolving markets needing evolving information systems – markets growing faster than the control capabilities.
• Capability to hide true positions on a trading account from management.

What could have been done better

• Senior management did not heed warnings about the introduction of new risks.
• Failure of reporting meant that they not recognise the serious financial trouble the bank was in. Had they been made aware at year end 1994, they could have acted to prevent a collapse.

What did not go well

• Deregulation, combined with financial incentives for risky behaviour, made a disaster more likely.
• The internal risk management practices at Barings proved completely inadequate.

Conclusion

The analysis of risk, and any mitigation of the risks that can be identified, is the primary function involved in either business continuity management or emergency planning.

In the case study above the absence of levels of risk management either caused or increased the impact of the particular event.

Barings Bank collapsed due to a risk introduced by the management of the company. Despite warnings from a local director in Singapore three years prior to the eventual demise of Barings, no actions were taken to treat or terminate the risk. In this case the blame must lie with poor management, creating a situation that would eventually cause the downfall of a respected banking institution. Nick Leeson was provided with the means to adversely affect the operation of the bank and did so with disastrous consequences.

The conclusion is that risks must be constantly monitored to ensure that the correct actions can be carried out for their immediate mitigation. As part of risk mitigation a sound business continuity plan, emergency plan or combination of the two must be in place to cover both the public and private interests as necessary.