Lecture # 44. "Bankers who hire money hungry geniuses should not always express surprise and amazement when some of them turn around with brilliant, creative,

Lecture # 44

• "Bankers who hire money hungry geniuses should not always express surprise and amazement when some of them turn around with brilliant, creative, and illegal means of making money." “The quotation is from a speech by the financial thriller writer on the Psychology of Risk, Speculation and Fraud, at a conference on EMU in Amsterdam.

Baring Bank

• Barings Bank collapsed when one of the Singapore based employees of London's Barings Bank, Nick Leeson, lost £827 million (US$1.4 billion) - primarily on futures contract speculation. Leeson's actions led the oldest merchant bank to default on its debts.

• The bank's collapse is considered a pivotal turning point in the history of banking and has become a textbook example of accounting fraud.

Internal auditing

• The way that Barings Bank's activities in Singapore were organized between 1992 and 1995 enabled Leeson to operate effectively without supervision from Barings Bank's head office in London.

• Leeson acted both as head of settlement operations (charged with ensuring accurate accounting) and as floor manager for Barings' trading on Singapore International Monetary Exchange (SIMEX).

• Normally the positions would have been held by two employees. This concentration of functions placed Leeson in the position of reporting to an office inside the bank which he himself held. Several observers, including Leeson, placed much of the blame on the bank's own deficient internal auditing and risk management practices.

Corruption

• Because of the absence of oversight, Leeson was able to make seemingly small gambles in the futures market at Barings Futures Singapores (BFS) and cover for his shortfalls by reporting losses as gains to Barings in London.

• Specifically, Leeson altered the branch's error account, subsequently known by its account number 88888 as the "five-eights account," to prevent the London office from receiving the standard daily reports on trading, price, and status.

• Leeson claims the losses started when one of his colleagues bought contracts when she should have sold them. By December 1994 Leeson had cost Barings £200 million but he reported to British tax authorities a £102 million profit. If the company had uncovered his true financial dealings then, collapse might have been avoided as Barings had capital of £350 million

Kobe Earthquake

• Using the hidden "five-eight account," Leeson began to aggressively trade in futures and options on SIMEX. His decisions routinely lost substantial sums, but he used money entrusted to the bank by subsidiaries for use in their own accounts. He falsified trading records in the bank's computer systems, and used money intended for margin payments on other trading.

• Barings Bank management in London at first congratulated and rewarded Leeson for what seemed to be his outstanding trading profits. However, his luck ran out when the Kobe earthquake sent the Asian financial markets into a tailspin. Leeson bet on a rapid recovery by the Nikkei Stock Average which failed to materialize.

Discovery

• Appointed administrators began managing the finances of Barings Group and its subsidiaries on 26 February 1995. On 26 February, the Board of Banking Supervision launched an investigation led by Britain's Chancellor of the Exchequer.

• The Chancellor released his report on 18 July. By 27 February, Leeson had cost the bank £827 million. The collapse itself cost the bank another £100 million.

• Barings Bank auditors finally discovered the fraud, around the same time that Chairman Peter Barings received a confession note from Leeson, but it was too late. Leeson's activities had generated losses totaling £827 million (US$1.4 billion), twice the bank's available trading capital.

• The Bank of England attempted a weekend bailout but it was unsuccessful. Barings was declared insolvent 26 February 1995. The collapse was dramatic and employees around the world were denied their bonuses.

Aftermath

• ING, a Dutch bank, purchased Barings Bank for the nominal sum of £1 and assumed all of Barings liabilities. Barings Bank therefore no longer has a separate corporate existence, although the Barings name still lived on as Baring Asset Management. BAM was split and sold by ING to Mass Mutual and Northern Trust in March 2005.

Nick Leeson fled Singapore but was arrested in Germany and extradited back to Singapore, where he was convicted of fraud and imprisoned for six years. Upon release, he wrote an autobiography, Rogue Trader, covering the events leading up to the collapse. A film maker later dramatized the book in the film Rogue Trader.

Black WednesdayClassical Corporate Scandal in Europe

• In British politics and economics, Black Wednesday refers to 16 September 1992 when the Conservative government was forced to withdraw the Pound from the European Exchange Rate Mechanism (ERM) due to pressure by currency speculators—most notably George Soros who made over US$1 billion from this speculation. In 1997 the UK Treasury estimated the cost of Black Wednesday at £3.4 billion.

• The trading losses in August and September were estimated at £800m, but the main loss to taxpayers arose because the devaluation could have made them a profit. The papers show that if the government had maintained $24bn foreign currency reserves and

• the pound had fallen by the same amount, the UK would have made a £2.4bn profit on sterling's devaluation (Financial Times 10 February 2005). The papers also show that the Treasury spent £27bn of reserves in propping up the pound; the Treasury calculates the ultimate loss was only £3.4bn.

The Currency Speculators'

Attack

• The fundamental sterling problem in September 1992 was that the dollar was rapidly depreciating against the deutschmark. Tied as it was to the ERM, the pound was hence appreciating to unsustainable levels against the US currency. With a large proportion of British exports priced in dollars, a pound/dollar correction was well overdue.

• ERM membership was preventing this from happening. In anticipation of the inevitable dam-bursting, speculators hastened the process by borrowing pounds (and also lire) and selling them for DM, in the expectation of being able to repay the loan in devalued currency and to pocket the difference.

• On September 16 the British government announced a rise in the base interest rate from an already high 10% to 12% in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15%, dealers kept selling pounds, convinced that the government would not stick with its promise.

• By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12%.

• EU economists' analysis of this event concluded that stable exchange rates are the result, not the cause, of a common approach to economic management, resulting in the Stability and Growth Pact that underpins ERM II and subsequently the Euro single currency.

Treasury Bond Scandal

• In 1991, Salomon was caught submitting false bids to the U.S. Treasury by Deputy Assistant Secretary Mike Basham, in an attempt to purchase more Treasury bonds than permitted by one buyer between December 1990 and May 1991.

• It was fined 290 million dollars, the largest fine ever levied on an investment bank at the time, weakening it and eventually leading to its acquisition by Travelers Group. The scandal is covered extensively in the book Nightmare on Wallstreet.

• After the acquisition, the parent company (Travelers Group, and later Citigroup) proved culturally averse to the volatile profits and losses caused by proprietary trading, instead preferring more slow and steady growth.

• Salomon suffered a $100 million dollar loss when it incorrectly bet that MCI Communications would merge with Sprint instead of Worldcom. Subsequently, most of its proprietary trading business was disbanded.

• For some time after the mergers the combined investment banking operations were known as Salomon Smith Barney, but reorganization has renamed this entity as Citigroup Global Markets Inc. The Salomon Brothers name, like the Smith Barney name, is now a division and service mark of Citigroup Global Markets.

Sandstorm report

• In March 1991, the Bank of England asked Price Waterhouse to carry out an inquiry. On June 24, 1991, using the codename "Sandstorm" for BCCI, Price Waterhouse submitted the Sandstorm report showing that BCCI had engaged in "widespread fraud and manipulation".

Support of terrorism

• The Sandstorm report, parts of which were leaked to The Sunday Times, included details of how the Abu Nidal terrorist group had held accounts at BCCI's Sloane Street branch, near Harrods in London. Britain's internal security service, MI5, had signed up two sources inside the branch to hand over copies of all documents relating to Abu Nidal's accounts. One source was the Syrian-born branch manager, Ghassan Qassem, the second a young British employee.

• The Abu Nidal link man for the BCCI accounts was an Arab based in Iraq named Samir Najmeddin or Najmedeen. Throughout the 80s, BCCI had set up millions of dollars worth of letters of credit for Najmeddin, largely for arms deals with Iraq. Qassem later swore in an affidavit that Najmeddin was

• often accompanied by an American, whom Qassem subsequently identified as the financier Marc Rich. Rich was later indicted in the U.S. for tax evasion and racketeering in an apparently unrelated case, fled the country, and received a controversial pardon from Bill Clinton on January 20, 2001.

• Qassem also told reporters that he had once escorted Abu Nidal, who was allegedly using the name Shakir Farhan, around town to buy a tie, without realizing who he was. This revelation led in 1991 to one of the London Evening Standard's best-known front-page headlines: "I Took Abu Nidal Shopping."

Closure of the bank?

• On July 5, 1991, the Bank of England closed down BCCI. Around a million investors were affected. Amongst the customers of the bank at this time was Garrards and Mappin & Webb, the jewellers responsible for maintaining the crown jewels and makers of the trophy for the America's Cup.

• In 1992, United States Senators John Kerry and Hank Brown co-authored a report on BCCI, which was delivered to the Committee on Foreign Relations. The BCCI scandal was one of a number of crimes and disasters that influenced thinking leading to the Public Interest Disclosure Act of 1998.

• The report found that former Defense Secretary Clark Clifford and his business partner Robert A. Altman had been closely involved with the bank from 1978, when they were introduced to BCCI by Bert Lance, to 1991.

• Clifford and Altman testified to the committee that they had never observed any suspicious activity. The federal government brought indictments against Clifford and Altman and proposed barring them from banking for life, but did not pursue Clifford due to his age and deteriorating health.

• Altman, however, was indicted and ultimately tried in New York by the office of District Attorney Robert Morgenthau. Despite a failure to convict in the New York trial, Altman nevertheless agreed to be banned from banking under threat of prosecution by the Securities and Exchange Commission.

• The British government also set up an independent inquiry, chaired by Lord Justice Bingham, in 1992. Its House of Commons Paper, Inquiry into the Supervision of the Bank of Credit and Commerce International, was published in October of that year.

• Following the report, the bank's liquidators launched the Three Rivers vs. Bank of England case, on behalf of thousands of BCCI creditors who are suing the Bank of England for its failure to properly oversee the bank.

• The BCCI creditors sought £850m in damages, claiming that the Bank of England was guilty of misfeasance in public office. The case collapsed in November 2005, with the Bank of England seeking to re-claim legal bills. The cost of the case to the creditors could be as high as £100m

• However, in 2002, Denis Robert and Ernest Backes, former number three of Clearstream, described as a "bank of banks" which practices "financial clearing", discovered that the BCCI had continued to maintain its activities after its official closure, with "microfiches" of Clearstream's illegal unpublished account