Barings bank collapse

1. Baringsbankcollapse ErjonaMimini AgelaBaze

2. Baringsbankcollapse French Foreign Minister (1818) said: “There are six great powers in Europe: England, France, Prussia, Austria, Russia and Baring Brothers.” Areas and Countries of its activities: • 1762 Founded and practiced its activity in UK • 1880-1890 large loans to Argentina and Uruguay • 1933-1945 involved in the Second World War • 1980s- expanded on the emerging markets • 17 September 1986- established Barings Future Pte, Ltd in Singapore • 21 February 1992 Clearing membership in SIMEX (first trading 1stJuly 1992)

3. HowdidLeesongainhisseat in Barings Reputationof the Bank: Corporate finance, strong investment management, trading for the best clients of London (including the Royal Family). • £100 million involved in stock certificates and bearer bonds, most of them purchased on behalf of clients, which were not in a deliverable form. By the time they became deliverable, the market had declined. Therefore, the clients were trying to avoid taking delivery, complaining that certificates were in the wrong denomination, not properly documents or in physically unacceptable condition. Leeson succeeded in making deliveries in about 10 months. • Increasing volume of future trades on the SIMEX thus, necessity of a seat in Singapore March 1992, Leeson relocated in Singapore as the Head Office.

4. Nick Leeson’s activities Authorised Unauthorised • Arbitraging (on swaps) with the Nikkei 225 in SIMEX and OSE • Arbitraging on the exchangedtraded derivatives in SIMEX and TSE and SIMEX and TIFFE • Trading on futures and options on behalf of Barings Group clients’ (seemed riskless) Accumulated a Japanese portfolio in stock index futures on Nikkei 225 • Contracts in SIMEX on long futures linked to Nikkei 225 • He went short on futures written on the JGB and on the Euroyen exchange rates • Leeson sold straddles with the same maturity based on a stable market expectation Huge losses after the market fall (due to the earthquake)

5. Howwasheabletohide the unauthorisedtrade and cover the loss? ObtainedfundsfromBaringsjustifyingthemas: • a SIMEX requirement – “ anintradayadvancedmargincalls” • Need to anticipate money for clients’ trades because of time and place differences • Need of large trading volumes in arbitrage trades because of the small gain from every trade (true). Used the Error account, the “88888” veryuncommonfor a trader, to: 1) MakeCross trading between the “88888” and “92000” accounts (Barings Securities Japan account –used for the Nikkei and Japanese bonds arbitrage), “98007” and “98008” accounts ( Barings London for Japanese Gov. Bonds arbitrage and the account for EuroYen arbitrage) and transferred them into the Error account before the market closed.

6. Howwasheabletohide the unauthorisedtrade and cover the loss? The second step was to split the contracts into different smaller trades and to change the trade prices in a way so they could avoid disclosure of unhedged positions and register profits into Barings accounts, increasing the loss of the “88888 account” instead. 2) Record not real trades between the bank’s accounts and the “88888” on Nikkei and Japanese futures. The idea was to transfer the positions that had not been hedged during the working day to the “88888” account when they had not really been executed. The effect: The reduction of call margins Increasing losses of the “88888” account £ 208 million of losses recorded by the end of 1994

7. “As the market soared in July [1993] my position translated from a £6 million loss back into glorious profit. I was so happy that night I didn’t think I’d ever go through that kind of tension again. I’d pulled back a large position simply by holding my nerve ... but first thing on Monday morning I found that I had to use the 88888 account again ... it became an addiction.” - Leeson, 1996. • November 1994 - 24% of the volume of SIMEX Japanese government bond futures. • December-January – increased the unhedged positions in JGB up to 28.000 contracts. • Leeson was continuously betting in only one direction: the increase of the Japanese index and interest rates. • January 17, the Kobe Earthquake – substantial decline of the Japanese market resulting in huge losses for Leeson. • Leeson’s answer was aggressive long positions on the NIKKEI futures, doubling his previous long positions. • What really happened, the market went down for more than 15%, Barings lost even more and it was not able to pay for the exchanges made on its name. • 26 February 1995 was declared insolvent.

8. Leeson’s Doublingstrategy LEESON’S EXPECTATIONS MARKET REALIZATIONS • Increasing prices of the Nikkei ( return to the pre-earthquake levels) • Low volatility • High Japanese interest rates. • The market declined by 1000 basis more initially and continued declining • There was high volatility • Low Japanese interest rates

9. RESULTS OF THE STRATEGY Before the earthquake Nikkei was trading in a range between 19.000 – 19.500, but the post-earthquake levels where 18.950 declining up to 17.950 on 23/01 and so on… Staddles caused further losses since after just 2 days, as concequence of the earthquake, puts went ITM and deep ITM…

10. Risk factors • Collapse was due to Operational Risk: The risk that deficiencies in information system or internal controls result in unexpected losses. • There were also problems of: • The credit risk of the client was significant if the total funds remitted to Singapore was to meet genuine client margin calls. Yet the Credit risk department did not question why Barings was lending over US$500 million to its clients to trade on SIMEX, and collecting only 10% in return. It did not seem to have an idea of who these clients were, yet Barings' financial losses would have been significant if some of these clients defaulted. • Market risk:  Barings had no independent unit checking the accuracy of the reports, the market risk reports generated by Barings' risk management unit were inaccurate. • Unlimited Gross Positions: Barings did not impose any gross position limits on Leeson's proprietary trading activities because it felt that there was little market risk attached to arbitrage trades since at the close of business, the position must be flat. 

11. Lessons to be learnt • Segregation of the front and back office • Clear determination of responsibilities for each bussiness and specification of the limits of each operator • Full knowledge of the bussiness in which the firm operates • Separation of proprietary trading from agency trading • Top management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly • Creation of Internal Risk Management Units

12. Lessons to be learnt The Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings pointed out the following suggestions for regulators: • The Bank of England should explore ways of increasing its understanding of thenon-banking businesses undertaken by those banks for which it is responsible; • It should prepare explicit internal guidelines to assist its supervisory staff in identifying activities that could pose material risks to banks and ensure that adequate safeguards are in place; • It should work more closely with the Securities and Futures Authority, the agency responsible for regulating the domestic operations of British-based securities firms, as well as with regulators from other nations; • It should address deficiencies in the implementation of rules dealing withlarge exposures.