Derivatives & Risk Control
The Collapse of Barings: The Events and The Aftermath
Written Report Case: The Collapse of Barings Executive Summary Barings Bank after two centuries of successful operations became a victim of a rogue trader. US$1.3 billion in losses outweighed bank’s own capital of US$850 million. Management negligence, lack of internal controls, poor risk management and excessive risk-taking strategy brought the bank to its ultimate collapse in Feb 1994. Throughout his tenure from 1992 to early 1995, the star-trader-turnedrogue, Nick Leeson, was consistently misleading the senior management to believe that his entire strategy was based on arbitrage between Simex and Osaka stock exchanges. It turned out he was taking leveraged bets on the Japanese Index, Nikkei 225. A single event, Kobe earthquake on January 1995, a black swan event of a kind, triggered the index to fall by 1,000 points, the opposite direction to what Mr.Leeson was heavily betting for. Ironically, Leeson followed the suit of traders’ common mistake by doubling his bets hoping to recover losses. The collapse of Barings is an example of a crash due to market risk and fraud. There are several reasons that are worth mentioning for understanding what happened: Reliance on a single trader: the 28 year old Nick Leeson was profiting of a relevant freedom to engage in risky trading strategies due to his previous performance (in 1994, the revenue attributed to Leeson were about £28.5 millions), specifically: o Engaging in a speculative strategy (instead of the approved arbitrageur strategy) o Requesting funds to supposedly close temporary differences in clients’ accounts in between trades that were actually used to cover losses on the margin account of the Bank (neither of the two practices were allowed by the exchanges) Lack of internal control: the organizational structure lacked clear accountabilities (Leeson was to report ad interim to the Head of South Asia, who preferred not to be involved in the BFS business, so that Leeson eventually reported to the regional manager in Tokyo and the head office in London) Lack of appropriate risk measurement policies: o No separated risk management function for BFS: front office (trading desk) and backoffice (futures and options settlement) management roles were both covered by Leeson o No limits on transactions notional amounts o ALCO (a risk management committee) was established only at the end of Nov 1994 Lack of guidelines in the use of derivatives: o Management did not interfere in Leeson’s work because of its own lack of knowledge on the topic and a complete misunderstanding of the firm risk exposure o Leeson was literally holding a “one man show”, exceeding risk limits Market risk which brought to: o Losses due to sales of short positions on straddles on the Nikkei (bet on a stable Japanese stock market) o Large exposures to Nikkei futures As it was subsequently discovered, the blame is partially on exchanges. Singapore stock exchange, the rising financial hub of Asia, turned a blind eye on the large trades carried out by Mr. Leeson.
Written Report Case: The Collapse of Barings Case Discussion Nick Leeson was an employee of Barings Bank in the Singapore office in the period 1992-1995. After obtaining a trading license at SIMEX (Singapore International Monetary Exchange) in 1992, his first trading job at BFS (Barings Futures Singapore) was about implementing an arbitrage strategy developed by a colleague (Gueler, who used it in Tokyo but then stopped trading due to an increased exposure to risk and lack of matching contracts). Such strategy would profit from price differences for the Nikkei-225 index on the OSE (Osaka Stock Exchange) and SIMEX. Such strategy was possible thanks to the information advantage that Barings had from its large customer base and to the size of the exchanges, time zone difference and the...