Team 13

Mike Essling, Bryan Frame, Reena George, Vandana Mahtani and Gary Rich

BARINGS BANK: AN EXAMPLE OF HOW FINANCIAL RISK MANGEMENT CAN GO WRONG

Introduction Barings Bank. The story of how one rouge trader brought down a 233 year old bank in the matter of a few months. It is also known as the greatest example in how financial risk management could go wrong. Though, the collapse of Barings could have been avoided if proper internal controls were in place as well as following a strategy to segregate duties performed by employees. Throughout this paper, we will discuss a brief history on Barings Bank as well as rouge trader, Nick Leesons actions that caused the collapse of this financial Institution. Next we will discuss some of the major issues that were present at Barings Bank which allowed Leesons behavior to go undetected and our recommendations that could have prevented this disaster. Known as the Queens Bank (3), Barings had an illustrious history and participated in a number of key historical events. Whether it was financing Britains military campaigns during the Napoleonic wars to helping broker the Louisiana Purchase, Barings has always been looked upon with great prestige. But before participating in these deals, Barings had a humble beginning by originally trading wool and later venturing off into providing financial services. It wasnt until the late 1800s where Barings began to deal with international securities and in particular, investments in North American railroads. The Nick Leeson Story Nick Leeson began his career in 1980 as a clerk for the Royal Bank Coutts and was able to make a quick impression on his supervisors (5). He later found himself working at Barings bank where, after initial success, was promoted to supervisor of the new operations in futures markets on the Singapore Monetary Exchange (SIMEX). Leeson made millions for Barings Bank
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by placing bets on the direction of the Nikkei Index. Though this strategy would later backfire on him and be the catapulting event that led to Barings collapse. Leesons main trading strategy dealt with taking advantage of temporary price differences between the SIMEX and OSE (Osaka Stock Exchange) Nikkei 225 contracts. This strategy is known as switching where Leeson bought the cheaper contract while concurrently selling the more expensive contract and then reversing the trade when the arbitrage opportunity disappeared. On the other hand, some of Leesons irresponsible behavior began to seep out as only half of his Osaka trades were reported and accounted for. As depicted in the graph below, Leeson sold 70,892 Nikkei 225 options which were worth about 7 billion dollars that Barings had no knowledge of. He did this by selling straddles where he sold put and call options with the same strike and call price. This issue signals the poor reporting structure at Barings that we will discuss in the upcoming paragraphs. Table 10.1

Fantasy versus Fact: Leeson's Positions as at End February 1995. Number of contracts1 nominal value in US$ amounts Reported3 Actual4

Actual position in terms of open interest of relevant contract2

Futures Nikkei 225 30112 $2809 million long 61039 $7000 million 49% of March 1995 contract and 24% of June 1995 contract.

The Kobe Disaster On January 17th, 1995, the Kobe Earthquake struck Japan and sent a wave throughout all of the Japanese stock exchanges. At this point in time the Nikkei Index began the day at about
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19,350 and closed at 18,950 (4). Leesons derivatives strategy was only profitable if the Nikkei 225 Index was in the 19,000-20,000 range. Then on January 23rd, Nikkei 225 dropped 1000 points to 17,950 (as depicted in the graph below) and Leeson began to see losses on his future positions and unlimited losses from the put options he was selling from the straddle strategy. Lesson began to hide the losses in the infamous error account 88888 (5) and tried to reverse the effects of the Kobe earthquake by continuing to buy more contracts in the bleak hopes of making a profit. As a result of this failed salvation attempt, Barings suffered losses of 1.4 billion dollars and could never truly recover from these events. Leeson then fled the country where he was later captured in Frankfurt, Germany and sentenced to 6 years in prison.

The real question is how Leeson was able to trick everyone and singe-handedly destroy Barings Bank from a Singapore office. One of the things that should have alerted Barings was the fact that Leeson was the general manager, head trader, and de-facto head of the back office. In addition to these conflicts of interest, Leeson and his team also had the authority to
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complete two different kinds of trades: transacting futures and options orders for clients or for other firms within the Barings organization and attempting to achieve those arbitrage opportunities by trading on SIMEX and the Osaka stock exchange. The cross trading that Leeson was doing also fooled Barings management because he was hiding his losses in the 88888 account (5). Therefore, management believed that Leeson was making them money but in reality, he was losing hundreds of millions of dollars.

Issues at Barings Bank

Barings Bank had a number of internal issues that went undetected which allowed a 28year old trader to come through and wipe out a 233 year old financial institution. For instance, Barings used both internal and external auditors to check their controls and provide advisory assistance. These auditors provided a number of recommendations for Barings that were never followed up upon. One of those recommendations was the separation of roles and not allowing one person to complete an end-to-end task. As mentioned before, Leeson was the de-facto head of the back offices and the head trader. Clearly there should have been some type of segregation of duties strategy that could have prevented Leesons risky behavior.

The reporting structure at Barings was also very poor. Only half of Leesons trades on the Osaka Stock Exchange were reported and losses were swept under the rug. This is why Barings management was oblivious to what Leeson was truly doing. One of our recommendations for Barings was to improve their organizational reporting structure. That way, the right people will be getting the right information and there would be more supervision

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that can prevent fraudulent activities. In the Barings situation, no one felt that they were accountable for Leeson and felt that they didnt have to report or check up on him. We will go into more depth on our recommendations for the rest of this paper.

Our Recommendation In any firm, there must be an understood segregation of duties for the different stakeholders of the company. It is especially important within the banking and trading industry and how a bank such as Barings could neglect to identify and prevent these conflicts of interest are the reason why they do not exist today. Barings employees, from the senior management to entry-level employees, should have known that no individual should have the right to place trades for customers and also settle the financial reporting of those same trades. Our recommendation would call for a strict SoD framework to directly approach risky conflicts of interest, such as the ones that ultimately lead to their failure and insolvency. Utilizing the framework below, Barings should have established their main objectives with segregation of duties. By defining critical business responsibilities of each business process and their risk aversion level, they should have established a series of conflicting roles among different positions and processes. Our suggested framework also identifies the need to recognize and prioritize sensitive transactions, creates a conflict (or SoD) matrix, and most importantly remediation and continued retesting of the framework and controls.

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Recommended Segregation of Duties Framework

Identify key responsibilities in each business process Determine level of risk management is willing to take
Define Sensitive Transactions

Determine SoD Objectives

Determine critical transactions Analyze processes that drive the business

Prioritize Transactions

Extract data Perform SoD conflict matrix analysis

Create Conflict Matrix

Extract data Perform SoD conflict matrix analysis

Remediate, Retest, Roll Forward

Remediation plan Resolve SoD issues/identify compensating controls Re-perform application SoD testing

With this framework, Barings would have established a system to test, identify, and correct the conflicts of interest that were ultimately their reason for failure. Within this framework, Barings should have utilized consultants to develop a segregation of duties framework to define conflicting responsibilities such as the one below.

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The X marks indicate areas that represent conflicts of interests between two responsibilities that no employee should have the ability to execute together. They should have queried their databases and found how many employees were capable of performing in each Xed area and determined how to remediate these conflicts with general and IT controls. The IT controls could be adopted through best in class practices and utilization of proven application access control governor software offered by top software producing companies such as Oracle, SAP, or Peoplesoft. Costs of purchasing and integrating these systems would be significant; however, they are miniscule in comparison to the costs that result in large fraud cases. We estimated that licensing costs and implementation of these systems into a business the size of Barings would be around $530,000 initially, with an additional $300,000 annually for support and improvements. General controls could be implemented in a number of ways, one of the most effective being through a more rigid reporting structure through Barings. The reporting system that Barings initially followed gave Nick Leeson a very flexible structure to communicate to various
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higher-ups and allowed him to conceal information, while his superiors were all convinced that his trading procedures were not under their jurisdiction. The following model shows Leesons communication structure of reporting.

Under our suggested structure, Leeson and all other employees of Barings would have had a more directly linear chain of reporting. Specifically, Rob Baker, the Head of Financial Products Group, would have assumed more responsibilities in the reporting structure that he should have had to begin with. Also, Leeson would have had to report to Fernando Gueler, the Head of Equity Derivatives Proprietary in Tokyo, who would have overseen his transactions and also reported those to Baker. Our suggested reporting chain can be seen below.

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One of the biggest areas of negligence within Barings Bank was the failure to thoroughly use their best judgment and insights of their company to analyze internal controls. Deloitte & Touche was found negligent in its auditing of Barings, however neither Deloitte nor Barings took initiative when obvious alerts of unauthorized trading showed up in the banks financial statements. The largest area of negligence in this case is the lack of proactive measurements of Barings, one of the most established merchant banks in London, within their organization. Barings should have had well-established procedures and continual testing of internal controls in order to prevent major issues such as the one involving Leeson. Establishing thorough segregation of duties models and standardized reporting structures can only hinder issues if the controls put in place are continually tested and evaluated. Barings blatantly neglected all segregation of duties that they could have established by allowing Nick Leeson to maintain two positions with directly conflicting responsibilities. In reflection, Barings Bank had many deficiencies that lead to its eventual demise. Although the bank was able to solidify itself as a stable leader through World Wars and the
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Great Depression, internal failures proved to be a bigger threat to Barings than the outside economy. Putting Nick Leeson in a position of power, especially after his previous complications with credibility proved to be a devastatingly poor decision. Barings lack of a thorough reporting system, a standardized segregation of duties structure, and adequate internal and IT controls to carry-out these established safeguards was its biggest and most impactful flaw. Had the bank taken a more proactive stance in targeting these deficiencies, rather than a reactive stance, they might still be a leader in the banking world. By following our recommendations, Barings could have limited Leesons control over trading on the Singapore International Monetary Exchange and remained solvent to this day. Barings, as well as their outside auditors, should have recognized a more thorough segregation of duties system and tested for conflicts continually. Barings should have kept better tabs on Leesons trading strategies with a more rigid and linear reporting system in order to make him responsible for his actions. The bank also should have implemented and consistently tested their controls, both general and IT, to identify flaws in their systems and correct these problems. Overall, a more proactive stance on controls and segregation of duties is critical for success in all businesses and especially, as proven by this case, in the banking industry

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Works Consulted 1. "Barings Bank's Collapse." KARVY :: Bringing Industry, Finance and People Together :: Stock Broking Company India, Online Share Trading, Stock Broking Franchise. Web. 14 Nov. 2011. <http://www.karvy.com/articles/baringsdebacle.htm>.

2. "Barings Debacle." RiskGlossary.com. Web. 14 Nov. 2011. <http://www.riskglossary.com/link/barings_debacle.htm>.

3. "Barings PLC -- Company History." Find Funding with Banks, Investors, and Other Funding Sources | FundingUniverse. Web. 14 Nov. 2011. <http://www.fundinguniverse.com/company-histories/Barings-PLC-companyHistory.html>.

4. "Japan's Stock Market Post Kobe Earthquake In 1995." Bespoke Investment Group - Think BIG. Web. 14 Nov. 2011. <http://www.bespokeinvest.com/thinkbig/2011/3/11/japans-stock-market-postkobe-earthquake-in-1995.html>.

5. Nick Leeson - Official Website. Web. 14 Nov. 2011. <http://www.nickleeson.com/biography/index.html>. 6. How Leeson Broke Barings. Web. 14 Nov. 2011 <http://riskinstitute.ch/137560.htm>.

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