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Case study of Baring bank & Nick Leeson

Nov 29, 2014

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Nicholas Leeson and Baring Brother & Co. (BB&C) BankCase study of risk managementBy Mr. Surachai ID:09200025 Ms. Srisuda Booraphanon ID: 09200027

The Barings Bank collapse

Starring Nick Leeson

(The spectacular fall of Barings in 1995 because of one rogue trader - Nick Leeson)

Introduction

History

Meaning of derivativesFinancial instruments whose value changes in response to the changes in the underlying variables

Derivatives fall into two major coursesOTC derivativesExchange traded derivatives

Since mid-80 volumes and value of futures, options and swap contracts traded have increased astronomically

Who was Nick Leeson ?

He grew up in Londons Watford suburbWorked for Morgan Stanley after graduating universityLeeson then joined Barings(Jakarta) to sort through back office mess involving 100 million pounds of share certificate.Successfully rectified the situation in 10 monthsThen transferred to Singapore and worked with a lot of power and freedom

Barings was brought to its knees by Nick Leeson in a Singapore office

He was employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on the SIMEX and Japans Osaka Exchange

Leeson left a $ 1.4 billion hole in Barings' balance sheet due to his unauthorized derivatives speculation, causing the 233yr old banks demise

The collapse

Lesson's ActivitiesWas supposed to be arbitragingInstead of hedging, gambled on the future direction of the Japanese marketHad long futures position on OSEWas not short on SIMEX

Kobe earthquake of Jan 1995 led to the crash of Nikkei and his investments

Lesson's Trading Arbitrage futures between SIMEX and OSE

Sell straddles

Arbitrage between SIMEX and OSE Involves going long in one market and short in the other one.

Lesson's went long in Osaka. (His position was public knowledge since the OSE publishes weekly data)

Leeson should have gone short in Singapore; he went long instead (unauthorized trades)

Selling straddles Straddle = Sell one put and one call with same strike and maturity

Benefits the seller if prices dont change much (i.e., the options expire worthless)

Leeson sold straddles on the Nikkei 225Note: Leeson did not have the authority to sell options

On January 17, 1995, the Kobe earthquake hit Japan, causing the Nikkei to fall below 18,000.

Put options moved deep in-the-money

When you speculate in long futures and prices drop = you lose

When you sell straddles and prices drop = you lose

The infamous 88888 account ! Leeson set up an error account - the infamous account 88888 (not known to senior management in UK).He then engaged into a significant volume of cross trading between account 88888 and other accountsCross trading = matching the positions of two accounts belonging to the same clientEx: If Barings owed US$500m to Daiwa Bank from one type of transaction but also expected to receive US$300 from Daiwa from another type of transaction, it could net the two amounts through a cross trade.After executing these cross-trades, Leeson would instruct the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices to cause profits to be credited to account 92000, while charging losses to account 88888 accountWhat appeared to be an arbitrage was in fact a speculation disguised with the help of account 88888.

Baring Bank

Barings collapsed because it could not meet its obligations:(Courtesy of Nicholas Leeson)

Over US$7 billion on the Nikkei 225 equity contractsOver US$20 billion on Japanese bonds and Euro yen contracts

Futures markets: marking to market

Generate large losses

Leeson lies about these Customer accountsNormal part of futures trading

Should be generally neutral if he is long in one market and short in another

Failure to flag this in London was a big problem

Risk Management MessageOperational riskFraudInadequate controlsWould VaR have helped?Didnt really need this technology to reveal Lesson's risk exposure

ConclusionThe demise of one of worlds oldest and most respectable bank

Nicholas Leeson: Case QuestionsWhat was Nick Leesons strategy to earn trading profits on derivatives?Nick Leeson was trading futures and options on the Nikkei 225, an index of Japanese securities. He was long Nikkei 225 futures, short Japanese government bond futures, and short both put and call options on the Nikkei Index. He was betting that the Nikkei index would rise, but instead, it fell, causing him to lose $1.39 billion.

What went wrong that caused his strategy to fail?Nick Leesons strategy failed because the Nikkei 225 index kept falling while he continued to bet that it would rise he just didnt know when to quit and take his losses.

Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed?

Nick Leeson established a bogus error account (88888) when a legitimate account (99002) already existed in order to conceal his unauthorized trading activities.

While the legitimate error account was known to Barings Securities in London, the bogus account was not.

However, the bogus account was known to SIMEX as a customer account, not as an error account. In this way Leeson could hide his balances and losses from London but not Singapore.

One the other hand, SIMEX thought the bogus error account, 88888, was a legitimate customer account rather than a proprietary Barings account.

Nicholas Leeson: Case Questions

Nicholas Leeson: Case QuestionsWhy did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading?Internal Reasons. Leeson engaged in unauthorized trading, as well as fraud. However, it is clear that he was hidden in the organized chaos that characterized Barings. There were no clearly laid down reporting lines with regard to Leeson, through the management chain to Ron Baker [Head of Financial Products Group for Barings] (Bank of England, p. 235). In fact, it seems there were several people responsible for monitoring Leesons performance, each of whom assumed the other was watching more closely than he. In August 1994, James Baker completed an internal audit of the Singapore office. He made several recommendations that should have alerted Barings executives to the potential for unauthorized trading: 1) segregation of front and back office activitiesa fundamental principle in the industry, 2) a comprehensive review of Leesons funding requirements, and 3) position limits on Leesons activities. None of these had been acted upon by the time of the banks collapse.With regard to the first concern, Simon Jones, Director of BFS and Finance Director of BSS, in Singapore, offered assurances that he would address the segregation issue. However, he never took action to segregate Leesons front and back office activities. Tony Hawes, Barings Treasurer in London agreed to complete a review of the funding requirements within the coming year. Ian Hopkins, Director and Head of Treasury and Risk in London, placed the issue of position limits on the risk committees agenda, but it had not been decided when the collapse occurred.

Nicholas Leeson: Case QuestionsWhy did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading? (continued)According to the Bank of England report, senior management in London considered Jones a poor communicator and were concerned that he was not as involved as he should have been in the affairs of BFS. In fact, Peter Norris, the chief executive officer for Baring Securities Limited wanted to replace Jones. Jones, however, was protected by James Bax, Managing Director of Baring Securities Singapore, who was well liked in London.The Bank of England also found fault with the process of funding Leesons activities from London. First, there was no clear understanding of whether the funds were needed for clients or for Barings own accounts, making reconciliation impossible. Second, given the large amounts, credit checks should have been completed as well. The report places the responsibility for the lack of due diligence with Tony Hawes, Ian Hopkins, and the Chairman of the Barings Credit Committee. The issue of proper reconciliation arose as early as April 1992 when Gordon Bowser, the risk manager in London, recommended that a reconciliation process be developed. Unfortunately, Bowser left Simon Jones and Tony Dickel, who had sent Leeson to Singapore, to agree on a procedure. With internal conflict over who was responsible for Leesons activities, no agreement was reached between those two, and Leeson was left to establish reconciliation procedures for himself.

Nicholas Leeson: Case QuestionsWhy did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading? (continued)There are numerous similar examples of internal conflict benefitting Leesons covert trading throughout the three years. But one of the late failures occurred in January 1995 when SIMEX raised concern over Barings ability to meet its large margins. In a letter dated January 11, 1995, and addressed to Simon Jones, SIMEX officials noted that there should have been an additional $100 million in the margin account for 88888. Jones passed the letter to Leeson to draft a response. External Reasons. In January 1995, SIMEX was getting close to Leesons activities, but had not yet managed to determine what was happening. In response to a second letter dated January 27, 1995 and sent to James Bax in Singapore, SIMEX expressed concern

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