BARINGS – A CASE STUDY IN RISK MANAGEMENT AND INTERNAL CONTROLS
In 1995 Britain’s oldest merchant bank of two hundred years came to a dramatic and fatal halt. The bank was Barings. The demise of the bank was brought about as a result of the actions of a derivative trader, Nick Leeson, stationed in Singapore. Without a careful and considered review one may be tempted to conclude that the blame rests solely on Nick Leeson. But if you think with analytical mind, you will ask: how is it possible that this one man was able to cripple a financial giant? What was the role of senior management in this situation and did they contribute to the demise? How effective were the internal control systems, Risk management system and was the Singapore operations managed effectively?
The answer to these and similar questions would be indeed interesting and insightful in analyzing the debacle of Baring Bank. Reported on very widely in the nineteen- nineties, this bank collapse still holds significant lessons for those involved in the management of financial institutions.
The objective here is not to prove definitively the exact cause of the collapse but to show, by way of a very narrow discussion, how certain deficiencies in internal controls and risk management systems impacted the bank and ultimately led to its collapse.
When Barings collapsed it had a capital of approximately $600 million. Contrast this with notional futures position of Japanese equity and interest rates of $27 billion, Nikkei 225 equity contracts of $20 billion and put and call options with nominal values of over $6 billion that the bank held. Given the level of capital it is incomprehensible that the bank could have created this level of exposure. It is certainly worth asking where were the mechanism and limits that should ordinarily be in place to signal that its capital was at severe risk.
In an analysis (see http://newrisk.ifci.ch) on the incident the author stated: “Numerous reports have come out over the last three years (back in the nineties) with recommendations on best practices in risk management. Barings violated almost every [such] recommendation. Because its management singularly failed to institute a proper managerial, financial and operational control system, the firm did not catch on, in time, to what Leeson was up to. Since the foundations for effective controls were weak, it is not surprising that the firm's system of checks and balances failed at a number of operational and management levels and in more than one location”.
Barings was founded in 1762, by Francis Baring who set up a merchant banking business in Mincing Lane in London, UK. Barings, also known as the Queen's bank since it was used by Elizabeth II. The business grew rapidly during the period 1798 to 1814. It became one of the most influential financial houses during the 1830s and 1840s. The British government paid Barings commissions to raise money to finance wars against the US and France during the mid-1800s. During 1860-1890, Barings raised $500 mn for the US and Canadian government sand was regarded as London's biggest 'American House.' Barings was also involved in providing loans to Argentina during this period. In 1890, Barings was on the verge of bankruptcy when Argentina defaulted on bond payments. However, the Bank of England and several other major banks in London came forward to bail out the bank. This crisis had a major impact on Barings and led the bank to withdraw all its business on the North American continent. Barings then took up the business of providing consultancy to small firms and wealthy people, including the British royal family. Barings advised the royal family on the management of their assets, and also gave advice to small British firms on investing in stocks and bonds. For the next several decades, the bank grew well and earned significant profits. In the 1980s, the bank started operating in the US again....
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