Barings bank collapse

Report
BARINGS BANK COLLAPSE
1
Erjona Mimini
Agela Baze
BARINGS BANK COLLAPSE
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 1st July 1992)
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HOW DID LEESON GAIN HIS SEAT IN BARINGS
Reputation of 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.
Stock/contract
Market where it was trades
Nikkei 225 contract
SIMEX in Singapore
Nikkei 225 contract
Osaka Stock Exchange in Japan
10-year JGB contract
SIMEX in Singapore
10-year JGB contract
Tokyo Stock Exchange in Japan
3-month EuroYen contract
SIMEX in Singapore
3-month EuroYen contract
Financial Futures Exchange in Japan
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NICK LEESON’S ACTIVITIES
Authorised
Unauthorised

Arbitraging (on swaps) with the
Nikkei 225 in SIMEX and OSE

Contracts in SIMEX on long
futures linked to Nikkei 225

Arbitraging on the exchanged
traded derivatives in SIMEX
and TSE and SIMEX and
TIFFE
Trading on futures and options
on behalf of Barings Group
clients’ (seemed riskless)

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

Accumulated a Japanese portfolio in stock
index futures on Nikkei 225
Huge losses after the market fall
(due to the earthquake)
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HOW WAS HE ABLE TO HIDE THE UNAUTHORISED
TRADE AND COVER THE LOSS?
Obtained funds from Barings justifying them as:

a SIMEX requirement – “ an intra day advanced margin calls”

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” very uncommon for a trader, to:
1) Make Cross 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.
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HOW WAS HE ABLE TO HIDE THE UNAUTHORISED
TRADE 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
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“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
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.
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.
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LEESON’S DOUBLING STRATEGY
LEESON’S EXPECTATIONS

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Increasing prices of
the Nikkei ( return to
the pre-earthquake
levels)
Low volatility
High Japanese
interest rates.
MARKET REALIZATIONS
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The market declined
by 1000 basis more
initially and continued
declining
There was high
volatility
Low Japanese interest
rates
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RESULTS OF THE STRATEGY
Before the earthquake Nikkei
was trading in a range between
19.000 – 19.500, but the postearthquake 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…
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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:

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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.
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LESSONS TO BE LEARNT
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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
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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 the non-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 with large exposures.

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