Whatever Happened at Barings Bank?

Scale of Disaster
On 27th Feb, 1995 Barings collapsed! Direct Damage
On 27th Feb: 700 million But still positions were open 18th July: 827 million and 927 million when positions were closed 827 mn loss in relation to shareholders fund 354mn

Cumulative Losses by BFS from July 1992 to Feb 1995

Losses from Concealed Transactions

Million

Scale of Disaster
Indirect Damage
Pound touched lowest ever, DM2.302 Nikkei 225 fell 3.8%, more than 1000 points FTSE 100 fell 12.4% Systemic damage to banking system was not much Speculation about which creditor would suffer the loss

Corporate Structure of Barings PLC

Barings Corporate Strategy

Six Great Powers in Europe, illustrious Barings was sidelined during Londons BigBang in 1987. It could not manage to be an integrated investment bank Upto 1984, it was a merchant bank specializing in corporate finance and debt-trading In 1984, enters into stockholding business and Christopher Heath joins Barings

Barings Corporate Strategy

Cultural differences arises between stockholders and bankers: perception and management of risk Heath leaves because of anxieties about the risk positions Growth became addictive for bank! Leeson joins Barings Singapore in March 1992 Started proprietary trading positions only at 354 mn shareholders fund, it was a mistake However, BSF was doing very well during this period

Who is Leeson?
Leeson joined BSL settlement in 1989 Early 1992 he had applied for registration as a dealer with FSA in London and it was canceled In April 1992, he was posted to BFS to establish settlement operations and also to be a floor manager at SIMEX This was inconsistent with one of the fundamental principles of risk management His role was agency business, however, he was heavily engaged in proprietary trading

Leesons Business
Authorized to conduct both client and proprietary trading The Nikkei 225 contract arbitraging between SIMEX and OSE The 10-year JGB contract trading between SIMEX and TSE Naming inter-exchange arbitraging as switching He was involved in bucketing, illegal under the Futures Trading Act.

Leesons Business
Bucketing
Matching client orders in SIMEX Taking equivalent opposite orders in OSE Riding on the back of the large client orders if market moved favorably If unfavorable, arbitrage between OSE and SIMEX

Timing differences give rise to some risk of prices moving unfavorably Leeson was allowed to have unhedged positions on 200 OSE Nikkei contracts and 100 TSE JGB.

Nikkei 225 Futures Strategy

Leeson was convinced that the Nikkei Index was going to rise This bullish view was very curious as Index had fallen some 35% since mid-1994 The attitude of the market was almost entirely the opposite which is why Leeson found many sellers in market Unhedged continuous / repeated long positions on Nikkei 225 (Fig. 2)

Nikkei March 1995 Close and Cumulative Nikkei Futures P & L from 1 January 1995

JGB Futures Strategy

Leesons view was that JGBs were overvalued He adopted open short positions in JGB futures His positions: Oct 93 - 2120 contracts, Nov 94 54,325 contracts, 27 Feb 95 26,079 contracts He had taken 85% of the open interest in March 1995 contract and 88% of June contract. On 23 February alone, he lost 61 million on the day.

JGB March 1995 Close and JGB Cumulative P & L from 1 Jan 1995

Options Strategy
Leeson was authorized only to trade options on behalf of corporate clients However, he took proprietary open positions in options from the end 1992 on Nikkei 225 futures His view was that the Index would continue trading in the narrow range volatility position He wrote approx equal numbers of put and call options on index futures short straddle Range bound movement in index would fetch premiums, otherwise unlimited loss

Written Straddle P & L Position

Options Strategy
Delta could be used as an option price sensitivity to change in underlying asset price In fact Delta grew very fast as index deviated to a large extent after Kobe Earthquake He lost money as all the put-holders were deep in-the-money Though Delta risk was substantial, he was never delta hedged. His cumulative loss from options portfolio was 51m

Other Position Strategies

Intra-day unhedged trades
Leeson grossly exceeded the limits of intra-day unhedged positions Authorized to maintain open positions of 200 Nikkei futures, and 100 JGB futures. Exceeded limits, over 16,000 Nikkei futures and 5,600 JGB futures contracts.

Fraudulent Trading
Manipulative trading and fraudulent accounting practices Transfer/cross trades between BSJ or BSL clients accounts and a secret error account 88888 He was deterring other traders for the last half minute of trading in SIMEX Avoided disclosing unhedged positions and awarded fictitious profits to BSL and BFS Leeson also recorded fictitious trades between 88888 and BSL/BSJ, without being executed on SIMEX floor These fictitious trades were recorded at profitable prices to the BSL/BSJ accounts

Fraudulent Trading
From Jan 1995 onwards, margin pressure was high Leeson started supplying SIMEX with net positions in account 88888 for margin payments However, SIMEX requires gross positions on a single account basis Offseting long Nikkei positions in 88888 by short JGB positions in BSJ and vice-versa Recorded fictitious trades to offset open positions in account 88888 after trading hours and trades were reversed out at the start of the next trading day

Funding Manipulation
Losses increased in 88888 from 63m in 1992 to

857m in Feb 1995 Leeson misrepresented his margin requirements asking for options margins from BSL Asked for advance margins required for intraday margin calls from BSL BSL was unable to reconcile remittances of this kind to BFS with client positions

Curious Features
Leesons trading positions were subject to various levels of management control, still Low-risk arbitraging supposedly contributing high returns to groups total profit Continuous calls by BFS to all other subsidiaries of Barings for funds for margin payment and their silence shows lack of common sense SIMEX, OSE and TSE were not looking at his positions as they were getting the margin payments

Poor Judgment or Incompetence?

Leesons net positions were in the opposite of the market direction Nikkei Futures, net long in a falling market JGB futures, net short in a rising market Euroyen, net short in a rising market Nikkei Index Option, short straddle in a high volatile market In absence of good investment opportunities, where was the potential for Nikkei to grow?

Systems Failure
Agency trading vs. proprietary trading Unhedged aggressive trading vs. arbitraging Conflict between back office and front office ALCO focused on Leesons funding requirement instead of his risk positions Funds were given as loans to clients without any check of creditworthiness by credit control function Profitable arbitrage is not persistent in competitive international markets

Systems Failure
Exposure to SIMEX, TSE and OSE exceeded 75% of Barings capital though restricted to 25% BFS had four clients in which three are from Barings group, still there was no reconciliation of funds In 1994, BFS was subject to an internal audit, it was ignored Barings international structure was not opaque, still Leeson evaded effective supervision Conflict between BoE and FSA about regulating BB&C and BSL

Is derivatives trading risky?

Of course there are many instances of disasters arising from derivatives The Economist Intelligence Unit indicates that MNCs are making use of derivatives and its growing rapidly Despite knowledge of disasters, only 65% companies had a written policy Only 50% policies specified the types of derivatives allowed

Is derivatives trading risky?

Only 50% imposed limits on the volume and principal amounts of derivatives 58% calculated the market value of their derivatives on a regular basis Less than 10% reported that derivatives were used for speculative purposes

Thank You!!!