The expanding global market has created both staggering wealth for some and the promise of it for others. Business is more competitive than ever before, and every business, financial or product-based, regardless of size or international presence is obligated to operate as efficiently as possible. A major factor in that efficient operation is to take advantage of every opportunity to maximize profits. Many multinational organizations have used derivatives for years in financial risk management activities.
These same actions that can protect multinational organizations against interest rate futures and currency fluctuations can be used to create profits for those same organizations. At the time of its collapse, Baring Brothers & Co. , Ltd was the longest established merchant banking business in the City of London. Since the foundation of the business as a partnership in 1762 it had been privately controlled and had remained independent. In 1890 Barings Brothers was founded. In November 1985, Barings plc acquired the share capital of Barings Brothers and became the parent company of the Barings Group.
In addition to Barings Brothers, the other two principal operating companies of Barings plc were Barings Asset Management Limited (BAM), which provided a wide range of fund and asset management services, and Baring Securities Limited (BSL), itself a subsidiary of Barings Brothers, which generally operated through subsidiaries as a broker dealer in the Asia Pacific region, Japan, Latin America, London and New York. Barings Brothers acquired Barings Securities Limited from Henderson Crosthwaite in 1984.
BSL was incorporated in the Cayman Islands, although its head office, management and accounting records were all based in London. BSL had a large number of overseas operating subsidiaries including two, Baring Futures (Singapore) (BFS) and Baring Securities (Japan) Limited (BSJ). At the time of its collapse, Barings Bank had a reported capital of $615 million. This was in sharp contrast to its trading obligations, thanks to Nicholas Leeson. Nicholas Leeson was responsible for trading in the global financial markets to maximize his employer’s bottom-line results.
In February 1995, a financial reporter was curious enough about his financial trading activities to question him “about rumors that the Englishman was making huge purchases on the Japanese and Singapore exchanges on behalf of his London-based investment bank. Nicholas Leeson coolly explained that he was ‘buying Nikkei futures here and selling them there’ . On February 27, 1995, Barings had outstanding theoretical futures positions of $27 billion on Japanese equities and interest rates, $7 billion of the Nikkei 225 equity contract, and $20 billion on the Japanese Government Bond and Euroyen contracts.
One of the problems with the use of various financial trading instruments is the accounting methods and conventions used to track these instruments. Accounting shortcomings gave managers opportunity to mask much of their financial trading activity and resulting losses by providing the means by which liabilities could appear as assets and debts could be posted in records as equity. The derivative instrument allowed Leeson to steer Barings into collapse. Leeson used derivatives to trade Japanese futures and option contracts in both Japan and Singapore, creating profits “by taking advantage of small price differences between the two exchanges” .
Leeson invested Barings capital – in “long” contracts, which would have further increased Barings profits if Japan’s Nikkei had increased in value; however, the true value of those contracts sharply eroded, however, when the Tokyo stock market drastically fell at a time that Leeson did not expect. From late 1992 to the time of the collapse BFS’s General Manager and Head Trader was Nick Leeson. Nicholas Leeson was hired in 1989 in the London office. He was a back office clerk doing settlement work, making sure all transactions were accounted and paid for.
As the bank continued to ponder its commitment to derivatives, he focused on them. By 1992, Nicholas Leeson had helped set up offices, troubleshoot problems and investigated allegations of internal fraud. At the time the Singapore International Monetary Exchange was trying to set itself up as Asia’s hot new trading floors. Barings wanted a presence – and Leeson was put on the team assigned to help get it. At first he did settlements as he had done in London. Then, because Barings was short staffed, Leeson began executing trades himself. Before long Leeson was bringing in millions of dollars.
When the Asian markets were sagging, he was thought to have made $20 million to $36 million for Barings. In Singapore he developed a following. His immediate boss in Singapore was so fascinated of Leeson’s success that the young man operated virtually without supervision. According to internal documents obtained by The Financial Times, Leeson had already built up an $80 million deficit at the end of 1994, the year in which he supposedly earned huge profits for Barings and had become known unofficially as the Nikkei king on the SIMEX floor.
His reputation was based on his ability to spot tiny differences in the value of Nikkei futures on the exchanges of Singapore and Osaka, Japan, and make millions by exploiting the spread, buying where the price was low and immediately selling where it was high. One former Barings analyst says of the Tokyo office in the early 1990s, “‘There was much more freedom and a lot less compliance’ … That kind of volatility, however, flustered the old-line Baring executives who wanted to put the derivatives business under the watchful eye of one of their risk-averse sales experts”.
There was no one in Barings top management who understood derivatives and the top brass was weary, but the money being made kept the bank from pulling out altogether. In addition to the problem was the fact that the Tokyo office of Barings had been through four senior managers in three years. There was no continuity or official policies and procedures. Investment traders largely could operate on their own with little if any accountability at all, which is precisely what Leeson chose to do. Wilson and Ervin (1996) write that identifying one specific cause for Barings’ failure is difficult, that Leeson alone is not fully responsible.
However, it has been widely reported that there were a number of fundamental weaknesses in the authority and accountability structures, management reporting, and the ongoing evaluation of corporate risks. These weaknesses combined with a lack of awareness of the potential risks at the most senior levels allowed one individual to pursue his own personal interests at the expense of the institution” . Nicholas Leesons activities were based in Singapore and it was a Singapore court that ultimately sentenced him to 6 years in prison for the collapse of Barings Bank.
In total, Barings Banks loss was more than 1. 25 billion dollars. Britain’s sedate financial sector was deregulated in the 1980s and suddenly the aggressive Americans came crashing in with giant salaries embellished with even more gigantic bonuses for star traders. Young, ambitious people like Nicholas Leeson were swept up in the hunger for money and power, and Barings was for the first time managing a new kind of investment. Traders were made overnight and the managers did not have time to train them properly.
Nicholas Leeson picked up a little bit of knowledge and used it as his entry into Barings. The inexperience and aggressiveness of youth may have been Nicholas Leesons undoing. He may have known his stuff, but he had no experience with the seriousness of his position. He didn’t have the courage – or the experience – to go to the boss and admit failure and ask how to get out of it. Due to the inexperience of Nicholas Leeson and the lack of official policies and oversight to its employees, the oldest bank in the world was bankrupt and sold to ING for the decidedly nominal amount of $1.
The Nikkei 225 and JGB futures contracts traded by Leeson were the simplest of derivative instruments. They were also the most transparent – since they were listed contracts, Leeson was required to pay or receive daily margins and so needed funds from London. In January and February 1995 alone, he asked for $835 million. Although Barings fate was only sealed in the final weeks of February, its destruction began when senior management entered new businesses without ensuring adequate support and control systems.
