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Barings Bank

Christian ThornæsGlobal Association of Risk Professionals

March 2014

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Barings Securities Singapore – Experience with Japan

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BFS during Nick Leeson’s Tenure

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Kobe Earthquake Impact on the Nikkei225 Index

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A Trader’s View of the Nikkei225 – to end 1992

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A Trader’s View of the Nikkei225 – to end 1993

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A Trader’s View of the Nikkei225 – to end 1994

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A Trader’s View of the Nikkei225 – to end 1995

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A Trader’s View of the Nikkei225 – in context

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The oldest UK merchant bank still trading – founded in 1762

Barings Bank baled out by the Bank of England in 1890 over credit losses in Argentina

In 1984 Barings purchased Stockbrokers Henderson Crosthwaite in order to expand into securities trading

With this acquisition came Christopher Heath, who would expand Barings into Asia

Merges culture of Merchant Bank and Broking/Trading firm

The Position of Barings Bank in 1995

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Barings Organization Chart - 1984

Barings Plc

Barings AssetManagement

Baring Bros. & Co. Ltd.(BB & Co)

Baring Securities Ltd(BSL).

Baring Securities(London) Ltd.

(BSLL)

Baring Securities(Japan) Ltd

(BSJ)

Baring Securities(Singapore) Ltd.

(BSS)

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Mr. Heath joined Optima in 1998, after serving as Chairman of Caspian Securities, Inc. and Chief Executive Officer of Caspian Securities, Ltd. which he founded in 1995.

Previously, he spent nine years as Managing Director, and then Chairman of Baring Securities Limited, which he founded in 1984 and built into one of the world’s most successful securities firms before his departure in 1993.

He has over 40 years of investment experience including being a partner in the stock broking firm of Henderson Crosthwaite & Co. and various positions in Imperial Chemical Industries. In addition, Mr. Heath is a Fellow of the Securities Institute.

Apart from senior management appointments, Mr. Heath has been active as a business developer in many parts of the world, particularly Japan.

Christopher J. Heath, Partner, Managing Director

http://www.optima.com/OurTeam.aspx

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Barings Group Structure before Reorganisation

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Barings Group Structure after Reorganising

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Barings Group Structure on the Final Day

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Barings New Organization Chart - after 1993 Reorganization

Barings Plc

Barings Asset Management

Baring Bros. & Co. Ltd.(BB & Co.)

Baring Securities Ltd.(BSL)

Baring Securities(London) Ltd.

(BSLL)

Baring Securities(Japan) Ltd.

(BSJ)

Baring Securities(Singapore) Ltd.

(BSS)

Exit Christopher Heath

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Established in 1987 as a securities trading and broking business

Purchased a seat on SIMEX futures exchange under a new subsidiary, Barings Futures Singapore (BFS)

Bought in new managers, traders and operational staff

Baring Securities (Singapore) Ltd.

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Nick joined Barings in London as an Operations Clerk

Transferred to the Jakarta office of Barings in 1991 to sort through GBP 100 million stock certificate mismanagement

His success at sorting the problems in Jakarta brought him to the attention of the Singapore management

Nick Leeson

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Nick Leeson is chosen to manage BFS in 1992 because of his operational skills

BFS business plan is to engage only in arbitrage for other Barings businesses and for customers

Arbitrage trades are limited to Nikkei 225 contracts on SIMEX and OSE Osaka, or to JGB contracts

No significant market risk limits are established, small intra-day limits are established but no overnight limits are set and there are no limits for trading in options products –futures limits only

Barings Futures Singapore

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Nick Leeson had full management authority over BFS, including trading, settlements, reconciliation, management reporting and funds disbursal

Nick Leeson expands arbitrage operations to include “switching”

Nick Leeson’s reporting line on a product basis is to two managers, and on an operational basis to two other managers

BFS Start-up

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In 1992, a trader caused a GBP 20,000 loss by executing a sell contract for a customer rather than a buy contract

Nick Leeson orders the creation of an error account 88888, as a customer account, to book this loss (rather than post a sundry loss)

Nick Leeson instructs Systems Support to remove the error account from reports to management

First Step to Fraud

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Successful recovery of the GBP 20,000 loss results in Leeson beginning to use the 88888 account to book other losses due to operational errors

Rather than making good the losses they build and by the end of 1993 the account was running a GBP 23 million cumulative loss

Leeson hides any trading losses due to his cross trades on SIMEX by putting them in the 88888 account whilst putting gains in the public accounts

In 1993 BFS shows a (false) profit of GBP8.8 million, he gets a good bonus!

The 88888 Account Grows

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As losses mounted in the 88888 account, Leeson had to post equivalent value in margin calls on SIMEX

Leeson obtained funds from BSL Group Treasury London, claiming most of the margin was “top-up” balances needed for customers

London Credit Committee began receiving reports of growing size of margin payments for customers

Funding Error and Account Losses

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Nikkei 225 Option “Straddle” trading strategy – profit and loss profile.

Sold Calls at Nikkei index strike price of 20,000

Sold Puts at 18,000 strike price

Use of Options to Generate Funds

Loss Loss

Profit

14k 18k 20k 24kNikkei

+

-

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In 1994 SIMEX sends two letters to BSS asking for assurance that margin calls will be met, and suggesting BFS violated exchange rules

Barings London receives inquiry from the Bank for International Settlements on BFS

Bank of England gives informal consent for Barings Plc to violate 25% capital rule

The Regulators

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C & L refuses to give a clean audit without details on a missing USD 78 million equivalent JPY payment

The payment is actually a margin requirement for the exchange, but Leeson invents a story about a position he entered into for a customer and where the settlement was misdirected

Leeson forges a document purportedly from Spear, Leeds & Kellogg asserting they will remit the USD 78 million equivalent in JPY for their customer

C & L issues a clean audit for Barings Plc in 1994

Coopers & Lybrand and the 1994 Audit

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By early 1995 Leeson is running out of room to generate more funds for margin calls

He doubles up his positions to try to recover all losses, but ends up doubling his losses to USD 1.4 billion equivalent

The equity capital of Barings is only USD 615 million equivalent

Lacking any further ability to meet margin calls, Barings enters receivership on 27th February 1995, and is sold to ING Group for GBP 1.00

Collapse of Barings

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Nick Leeson flees, with his wife, to Kota Kinabalu and then to Germany, where he is arrested

Tried and convicted of fraud in Singapore, he serves a portion of a 61/2 year sentence at Changi Prison

Released in 1999, he now delivers lectures to bank associations about risk management

Flight and Capture

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Collapse of Barings is a classic example of malfeasance and fraud, combined with gross dereliction of responsibility by management

Prior to 1995, many managers at Barings had clues and warnings that would have allowed them to save the firm

After January 1995, when Leeson doubled up on trading, it was too late to save Barings

Leeson had become such an important part of Barings’ revenue stream and bonus pool, many managers wanted to believe his performance was legitimate, despite some evidence this was not so

No one individual manager oversaw Leeson’s activity under Barings matrix management structure

No manager truly understood the futures business and many looked down on it as a tradesman business

No manager wanted to admit their stupidity and ask basic questions about BFS

Barings Lessons Learned - Institutional Flaws

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Nick Leeson was ambitious with poor ethical standards

He had a gift for lying and made imaginative use of his operation’s experience to cover his tracks

He had a gift for preying on managers ignorance of his business

He did not hesitate to trade despite not having either experience or authority

He ordered systems consultants to alter reports to hide the 88888 account from senior management

Barings Lessons Learned - Nicholas Leeson

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He exploited his management of both the front and back office by ordering the back office to falsify transactions, accounting records and reports to management, regulators and exchanges

He consistently violated the spirit and letter of exchange rules on cross trades (trades across exchanges)

He fraudulently concocted a confirmation from Spear, Leeds & Kellogg covering a missing USD 78 million equivalent margin call

He was not lucky 1995

– Jan. 17, Osaka, Kyoto, and Kobe, Japan: 5,500 killed and 36,800 injured. Magnitude: 6.9. The OSE fell precipitously

Barings Lessons Learned - Nicholas Leeson

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Barings violated a prime rule of trading by allowing Leeson to manage both the front and back office

When auditors objected to this arrangement in 1994, management failed to rectify the problem

Error reports were reconciled monthly in London, this practice was never applied to the 88888 error account (as it was not a sundry loss account)

Barings Lessons Learned - Segregation of Front and Back Office

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BSLL had ample opportunity to get to the bottom of margin payments and reconciliation discrepancies but never fully pressed for answers

Global Treasury never understood SIMEX margin rules or the “advance margin call” process, which was simply a fictitious invention of Nick Leeson

Barings Lessons Learned - Funding and Capital

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Barings Credit Committee never checked BFS customer list against growing amounts of margin demanded to cover customer needs

The Credit Committee never asked that credit limits be established for these customers – nor for the BFS subsidiary itself!

The Credit Committee never explored why these customers had only 10% collateral held by the bank to support these loans

The Credit Committee never investigated the USD 78 million loan to Spear, Leeds & Kellogg

Any one of these potential actions would have exposed the fraud

Barings Lessons Learned - Credit Risk

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The ALCO never questioned how BFS could earn so much revenue on such a low margin business like arbitrage

No-one compared the growing open positions on SIMEX and the Osaka Stock Exchange (OSE)

ALCO instructed BFS in 1994 to reduce their market activity, but never followed up to see that it was done

Barings never established a risk control office in Singapore

Leeson was supposed to trade within intraday position limits, but he routinely violated those limits

There were no limits on the notional amount of arbitrage or switching business, no limits on contract size or open positions on exchanges, and no limits on margin call amounts posted

When Leeson admitted to taking an open position in 1995, no-one investigated whether this was the only such violation

Barings Lessons Learned - ALCO and Market Risk

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Singapore management left Leeson to operate on his own because they really did not understand his business

Management did not follow up on 1994 audit recommendation to separate front and back office management

Management did not directly deal with SIMEX concerns, but sent these back to Leeson to handle

Barings Lessons Learned - Singapore Management

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London management never expressed real concern that the small BFS operation was generating 50% of the firm’s net income

Senior Management never wondered how such large profits could be produced from a low margin business

Senior management praised Nick Leeson’s performance as worthy of emulation and gave him protected status as a superstar employee; “you don’t question prophets, you believe in them”

Matrix management allowed Leeson to operate without any real supervision

Barings Lessons Learned - Senior Management

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The Bank of England allowed Singapore authorities sole oversight responsibility, removing a double check on BFS

The Bank of England allowed Barings Plc to violate the 25% rule, when this might have halted the position doubling in 1995

Internal audit of 1994 failed to expose the 88888 error account positions

Coopers and Lybrand failed to notice the alleged Citibank confirmation fax was actually sent from Leeson’s home

Barings Lessons Learned - Regulators and Auditors

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