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Nick Lesson Case

In: Business and Management

Submitted By kelsiang88
Words 1780
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Overview
This article looks into the details with regards to the collapse of one of world’s oldest (~233 years old) and most respectable bank in London, Barings Bank on 26 Feb 1995 due to uncontrolled and well-concealed derivatives trading arising from ethical improprieties of a person called Nick Leeson in their Singapore office. End result is ~$1.4 billion in losses. On the surface, we may be tempted to conclude that the blame rests solely on him but an in-depth & analytical mind would ask the simple question on “how is it possible that this one man was able to cripple a financial giant?” Further possible questions which would pop up would be “What was the senior management’s role in this situation and did they contribute to the demise? How effective were the internal control systems and was the Singapore operations managed effectively? etc” In short, for this incident to happen, it involved more than one factor and similarly for this to be avoided, it also involved more than one lapse or system to be further reinforced and closed. As such, let’s take a deeper look into these aspects in the subsequent paragraphs.

Factors behind the collapse of Barings Bank
Nick Leeson started well as a star trader and was tasked as SIMEX floor manager by Barings to manage the Singapore trading operations to profit from low risk arbitrage opportunities with derivatives contracts between SIMEX and Japan’s Osaka Exchange. Arbitrage involves going long in one market and short in the other one and thus making the differences as profits to Barings. In 1993, he singlehandedly contributed ~10% of the banks’ profits, which was worth about £10 million. This resulted with a £130,000 bonus on to top of his base salary of £50,000. Of course, with this success, his management team will get similar or even higher recognitions and rewards too. His ability for generating profits essentially earned him the trust of the top management team back in London who thought what he was doing was pretty normal. Eventually, Leeson went on to take control of the back office as well besides the front-end trading operations. In fact, this is one MAJOR factor resulting in the unfortunate fiasco because in this way, there’ll not be a check and balance element within the Singapore operations if he controlled both the frond-end and backend operations. This is equivalent to not having an independent and neutral party within the local organization to prevent such fraud events from happening.
Coming from a settlements background, Nick knew exactly how the back office worked. Therefore, he went beyond his tour of duty and set up an infamous bogus error settlement account (88888) when a legitimate account (99002) already existed & known to Barings Securities in London in order to conceal his unauthorized trading activities and speculative losses. The bogus account was not known to the London’s office but to SIMEX, it was known as a customer account whereby Nick used to hide his balances and losses from London. He would then engage in significant volume of cross-trading with other accounts. After executing these cross-trades, he would then instruct the settlements staff to break down the total number of contracts into several different trades and changing the trade prices to cause profits to be credited to account 92000 while charging all losses to account 88888. In this way, he was able to report continued profits from Singapore’s operations which delighted the head office and indirectly caused the complacency of the management team which is another MAJOR factor behind the downfall too. Therefore, what appeared to be an arbitrage was in fact a hugely speculative activity disguised with the help of account 88888.
With the above descriptions on how Nick engaged in unauthorized trading and fraud, one would wonder why such blatant practices were not discovered on time to prevent the disaster both internally and externally. This is another area of focus which needs to be analyzed in more details and from the lessons learnt, we can then probably work on corrective and preventive measures to prevent such disaster from happening in the similar context.
Internally, it all boiled down to Barings' flawed internal controls and channels of accountability coupled with lack of due diligence from their management team. Firstly, Nick was responsible for both the trading and the settlement sides of the Singapore operations, which made it easier for him to conceal his contracts from his superiors. This is a fundamental principle in this industry to segregate the front and back office activities as we explained earlier but it was not practiced diligently in Barings at that time. Secondly, he was able to mobilize large amount of funds from London and not much limits were put upon him purely from the fact that his operations were bringing in significant profits for the bank and senior management officials were not familiar with this new derivative trading instrument then. It was still early days in derivatives trading and the bankers at the top were used to simpler and more traditional products. This is another fundamental flaw in the lack of management’s expertise and understanding of the risks whereby the bank is under-going with these derivatives trading activities. A simple logic of risk management and sensitivity was not present as they did not really question why such high profits can be generated from low risk arbitrage trading between two stock exchanges. In investment terms, high risk usually generates high returns and vice versa, high return implicitly means high risk which they should be more conscious and careful in terms of huge funds transfer and risk management. Last but not least, there were no clearly laid down reporting structures with regards to Nick’s hierarchy structure based in Singapore whereby it seems there were several people responsible for monitoring his performance and each of whom assumed the other was watching more closely. Thus, this is equivalent to no monitoring of his activities so long as he generates profits for the firm. In fact, according to sequence of events, an internal audit was conducted in August 1994 with some of the above feedbacks and recommendations on possible loopholes for fraud being highlighted but the senior management team didn’t act on it till the time of the bank’s collapse. The delay in terms of response towards audit findings is another MAJOR factor which should be improved to mitigate the risk and gaps in system.
Externally, it was evident that SIMEX should have done better in this case. Before the bank’s collapse, SIMEX has raised concerns over Barings’ ability to fund its margin calls for the bogus account 88888. However, owing to their assumptions of Barings’ reputation for being a conservative firm and assurances given from management staff in London, they did not pursue further to verify with Osaka Stock Exchange. Different forms of derivatives trading were newly available in the financial industry at that time but not much regulations was in-placed in terms of risk management so long as the banks kept to their traditional requirements of liquidity ratio etc. As such, regulatory bodies in different countries had failed to communicate with each other to a degree sufficient enough to reduce the information asymmetry between the different markets. At that time, the competitive nature of the relationship between the Osaka Stock Exchange in Japan and the SIMEX exchange in Singapore also prevented a sharing of information about Barings' exposures that would have led to earlier curbs on Nick's activities.

Recommendations
In summary, the collapse of the Barings Bank identified few fundamental shortcomings as mentioned in earlier paragraphs that had to be addressed in order to avoid or minimize future re-occurrences of similar context. Upon reviewing those key factors resulting in this unfortunate event, some basic fundamentals need to be further reinforced and complied in terms of recommendations as follows: 1. Management teams have a duty to understand fully the businesses they managed. If they failed in this function, shareholders and customers’ interests would be compromised because they relied on capable and effective management team to understand and uphold the business model; 2. Internal controls have to be more robust and effective in terms of clear segregation of duties between front and back end operations. Having same person to be in charge of both operations is a clear and blatant weakness which results in not having a check and balance function within the organization against frauds or miss-operations; 3. Top management and audit committee have to ensure that significant weakness identified and reflected during internal audits or otherwise are resolved quickly. Internal audits must be treated as important as external audits because they’re revealing tell-tale signs of possible gaps and weakness to be closed before any major event or disaster happens; 4. Various stock exchanges around the world must open up and share information in this world of transparency so as to minimize risk of defaults. Asymmetrical information usually results in potential risk exposure even though it’s a form of competitive advantage too in this financial industry. As such, regulators would have to step in to smoothen out the rules and regulations to comply with and stern penalties to be enforced for any non-compliance; 5. Last but not least, greater controls must be in-placed and stiff punishments must be enforced for any dishonest behavior or fraud from any individuals and even to the organization level. This type of “rogue trading” will continue unless there’re stronger and tougher deterrent actions to prevent such monetary fraud cases from happening because the lure behind the potential high returns is just too high.

Conclusions:
All things being equal, one person should not be able to take down an institution. As seen above, the popular perception that one person, Nick Leeson was responsible for Barings’ demise maybe a fallacy and a rather myopic view. What happened at Barings was plainly and simply a breakdown in fundamental systems which should have protected the bank. These included effective compliance, robust internal controls, proactive risk management, sound oversight, timely remedial actions, knowledgeable management and by extension good corporate governance. These factors all represent extra costs for any organization but, if implemented properly, they are necessary and important utilization of resources. Having them properly embedded in the organizational culture, influencing how business is done is very important to the long term viability of an organization. They are not intended to retard profitability or restrict returns but in fact are geared at enhancing the longevity and sustainability of an organization while providing a framework within which business objectives can be achieved without endangering the interest of shareholders and other stakeholders.…...

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