Barings - In Leeson's custody

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Profits are typically seen as a good thing, particularly at financial firms. The collapse of Barings Bank, caused by the actions of Nick Leeson, should serve as a warning that outsized profits can also be an indicator of unrecognized risk and should be met with as much inquisitiveness as happiness.

 

In 1992, Nick Leeson moved to Singapore and became the local head of operations for Barings Bank, a centuries-old British financial institution founded in 1762. As part of his role, Leeson executed client trades on the Singapore International Monetary Exchange (SIMEX). Expanding his remit, he received authorization to execute an arbitrage trading strategy designed to exploit price disparities between Nikkei futures contracts listed on the SIMEX and those listed on the Osaka Securities Exchange (OSE). Rather than follow this arbitrage strategy, which involved offsetting trades in the two markets, Leeson instead built speculative positions by buying in one market and holding onto the contracts. His approach quickly generated huge losses.

 

In addition to his trading authorization, Leeson also controlled the Singapore back office and he used this dual-role to hide his losses. Using a reconciliation account, Leeson converted an actual 1994 loss of GBP 200 million into a reported sizable profit of GBP 102 million. Deepening his subterfuge, Leeson managed to have the reconciliation account excluded from the reports sent to the main office in London. By late 1994, the outsized amount of Leeson's profits began to attract the attention of Barings' risk controllers. Their inquiries to Leeson's superiors were rebuffed, however, who cited Barings' "unique ability to exploit this arbitrage." (It's possible that the extra bonuses his superiors received on the back of Leeson's reported profits may have clouded their judgement.) The risk controller's suspicions were raised again in January 1995 after Leeson reported a one-week profit of GBP 10 million in January 1995, and once more their concerns were dismissed. Had his superiors investigated the source and plausibility of the profits, simple calculations would have shown that it would have been impossible for Leeson to have made these profits in the manner he claimed, as that would have required trading four times that week's total volume for the Nikkei futures contracts on both the SIMEX and the OSE. By the time Barings discovered Leeson's rogue trading, the losses he had accumulated had grown too large and the bank was forced to liquidate. Eventually, ING, a Dutch bank, acquired Barings Bank for the ignominious sum of GBP.

 

A main lesson from the Barings collapse is that reporting and monitoring of positions and risks (i.e., back-office operations) must be separated from trading (i.e., front-office operations). Another basic lesson is that outsized or strangely consistent profits (think Bernie Madoff as well) should be independently investigated and rigorously monitored in order to verify that they are real, generated in accordance with the firm's policies and procedures, and not the result of nefarious or unacceptably risky activities. More broadly, it is incumbent upon risk managers to determine if the reported business profits seem logical with respect to the positions held.

Note that Barings' downfall could have been avoided under regulations implemented just a few years later. In addition to setting capital adequacy requirements for market risk, the Basel Committee set limits on concentration risks. Linder the 1996 amendment, banks are required to report risks that exceed 10% of their capital and cannot take positions that exceed 25% of their capital. Had these rules been in effect in 1994, or had the bank developed and enforced prudent guidelines similar to these rules, Barings would have been prohibited from amassing such large positions and one of the world's most infamous rogue trading scandals might have been avoided. 

 

Large trading volumes and revenues typically result in large bonuses for senior managers. In turn, this compensation framework encourages managers to trust the traders that report to them. Their reports may not be given proper scrutiny by risk managers or other key individuals who might be able to properly question the veracity of the purported profits. One difficulty is that traders can use their superior knowledge of pricing models, or claims of profound market insights, to confound their internal critics. The antidote to this problem is for senior managers to engage with a healthy skepticism models and strategies that claim to deliver above-market returns and to insist that all models be transparent and independently vetted. It should be remembered that immediate revenues from a transaction (e.g., ten-year credit default swap) cannot be recognized as economic profit. Rather, a transaction's profitability depends on its performance over its life. Unfortunately, accounting procedures can be used to misre- port profits for risky derivative instruments.