2013

The Barings Bank Collapse

The Spectacular Fall of Barings Bank on 26 February 1995 was because of one rogue trader- Nicholas "Nick" William Leeson

By: Ishan Abrol Saahil Khanna Karan Chauhan Khushali Nanavati Pritish Sareen 12/8/2013

BackgroundBarings was founded in 1762, by Francis Baring who set up a merchant banking business in Mincing Lane in London, UK. The business grew rapidly during the period 1798 to 1814. It became one of the most influential financial houses during the 1830s and 1840s. The British government paid Barings commissions to raise money to finance wars against the US and France during the mid 1800s. During 1860-1890, Barings raised $500 million for the US and Canadian governments and was regarded as London's biggest 'American House.' Barings was also involved in providing loans to Argentina during this period. In 1890, Barings was on the verge of bankruptcy when Argentina defaulted on bond payments. However, the Bank of England and several other major banks in London came forward to bail out the bank. This crisis had a major impact on Barings and led the bank to withdraw all its business on the North American continent. Barings then took up the business of providing consultancy to small firms and wealthy people, including the British royal family. Barings advised the royal family on the management of their assets, and also gave advice to small British firms on investing in stocks and bonds. For the next several decades, the bank grew well and earned significant profits. In the 1980s, the bank started operating in the US again. In 1984, Barings acquired the stock broking arm of Henderson Crosthwaite which later became BSL (Barings Security Limited). Prior to its merger with the banking business (Baring Brothers & Company) in 1993, BSL was run as a separate company. Incorporated in September 1986, BFS held a non-clearing membership (A membership which qualifies a firm to trade only on the stock exchange) of SIMEX (Singapore International Monetary Exchange).

Introduction about the Scam On February 26, 1995, Barings Bank (Barings) - the United Kingdom's (UK) oldest and one of its most reputed banks - declared it was bankrupt. The bank with a total net worth of $900 million had suffered losses in excess of $1 bn. These losses were result of the gross mismanagement of the bank's derivatives trading operations by Nicholas William Leeson, the General Manager of Barings Future in Singapore. BFS had been established to look after the bank's Singapore International Monetary Exchange (SIMEX) trading operations. Leeson's job was to make arbitrage profits by taking the advantage of price differences of similar contracts on the SIMEX (Singapore) and Osaka stock exchanges. In spite of not having the authority, he traded in options and maintained un-hedged positions. He acted beyond the scope of his job, and was able to conceal his

unauthorized derivatives trading activities. Due to the senior management's carelessness and lack of knowledge of derivatives trading, the bank landed up in a major financial mess.

Events leading to fall Leeson's trading activities mainly involved three futures markets: Futures on the Japanese Nikkei 225 stock index, futures on 10-year Japanese Government bonds (JGB futures) and Euroyen futures. These products are all traded simultaneously and in similar design on SIMEX and on a Japanese exchange. Leeson's main assignment was to arbitrage between SIMEX and the exchanges in Japan and tries to capitalize on small price differences between the futures contracts. In reality, however, he was taking massive speculative positions, financing SIMEX margin requirements by selling options and borrowing huge amounts of money from Barings head office in London. By the end of February 1995, the losses had become too large and Barings bank went bankrupt. Soon after joining BSL, Leeson applied and got a transfer to Jakarta, Indonesia. Due to his excellent performance, Barings management promoted Leeson to General Manager of BFS in Singapore in April 1992. Leeson would play a major role, i.e. arbitrage trading of the Nikkei futures contract between SIMEX and the OSE. Apparently, large price differences existed between the two contracts that were very similar in design. The profits from exploiting such price differences between exchanges are small and therefore trading volumes tend to be large. Still, the risks are low, because every long position on one exchange is offset by a short position on the other. In addition to arbitrage trading, Leeson developed an even more lucrative activity, namely switching. As Barings was able to trade in Japan as well as in Singapore, it could select the cheapest market to execute a clients order. For example, it could tell a client it would buy 1000 Nikkei futures contracts in Osaka, while in reality it made the purchase on SIMEX, where at that moment the price was lower. Barings would charge the client the price quoted on the OSE or slightly better, which was still worse than the price in Singapore. The difference meant extra profit for Barings. This selection of the more profitable location of the two to do business was referred to as switching. The market risk in arbitrage was minimal because positions were always matched. Leeson was not given any authority to trade in options or maintain any overnight un-hedged positions. Betting on the recovery of the Japanese stock market, Nick Leeson suffered monumental losses as the market continued its descent. In January 1995, a powerful earthquake shook Japan, dropping the Nikkei 1000 points while pulling Barings even further into the red. As an inexperienced trader, Leeson frantically purchased even more Nikkei futures contracts in hopes of winning back the money that he had already lost. Most successful traders, however, are quick to admit their mistakes and cut their losing trades.

Surprisingly, Nick Leeson effectively managed to avert suspicion from senior management through his sly use of account number 88888 for hiding losses, while he posted profits in other trading accounts. In 1994, Leeson fabricated 28.55 million in false profits, securing his reputation as a star trader and gaining bonuses for Barings employees. Due to the lack of effective control and supervision, Leeson got an opportunity to conduct his unauthorized trading activities and was able to reduce the likelihood of their detection. Analysts felt that this disaster happened for the following reasons. Leesons Trading Strategy Leeson quickly acquired a reputation as a hotshot trader. Even during his first few months at Singapore, he made profits for the bank. Asian stocks and currencies were in fashion, and they rose. In violation of Barings internal rules, Leeson traded using leverage and he rode Asias rising wave of stock market appreciation. Success gave Leeson credibility with his managers and colleagues, and so his trades were not scrutinized the way they should have been. Doubling Strategy After the other Asian stock markets cooled down in 1994, Leeson concentrated his trading on Japanese stock index futures and Japanese government bond futures. He bet that Japanese stocks and interest rates would rise at precisely the time Japanese market was sinking. Share prices and interest rates plummeted. Instead of selling to neutralize his position, Leeson viewed every dip in the Nikkei average as a buying opportunity. As a result, his losses piled up in the 88888 Account. To recoup his losses, he began the fatal strategy of doubling, which requires a trader to double his bets each time he loses. Doubling is a do-or-die strategy that called for Leeson to multiply the size of his bets in the 88888 Account so that any slight recovery in Japanese stocks would bring him back to even. Doubling strategies are dangerous for two major reasons. First, they can quickly result in gigantic losses, which have to be doubled once again just to break even or to make a small gain. Betting wrong at such high speculative altitudes can threaten the solvency of even the well-capitalized institutions. The second, and perhaps most frightening, reason the doubling strategy is so dangerous is because evidence has shown that, up until the end, individuals who use it often appear to be conservative, talented traders who earn relatively stable investment returns. As a result, they are relatively unsupervised, which means that when this strategy goes wrong (i.e., when there are repeated losses), the financial roof falls in virtually overnight and the common reaction of supervisors is one of shock and utter surprise.

Leeson used his doubling strategy several times to recoup significant losses in the 88888 Account. Meanwhile, he continued to report profits in his regular trading account. After one brush with disaster in 1993, when the 88888 Account was 6 million in the red, Leeson managed to bring it back to zero. Through his deception and Barings carelessness, Leeson was able to pursue the doubling strategy of recouping losses by piling up long positions in Nikkei 225 futures contracts and short positions in Japanese government bond futures. In 1994 and 1995, Leeson had increased his positions in Nikkei futures and Japanese government bond futures to approximately 8% and 24% of SIMEXs total trading volume, respectively.14 But Japanese stock prices kept falling, with only occasional rallies. During these rallies Leeson recovered slightly, but never enough to satisfy his needs. Exhibit 7.3 shows the daily closing quotes for the Nikkei index, the barometer of Japanese stock prices, and the roller-coaster ride that took Leeson and Barings to ruin between July 1994 and February 1995. In fact, the Nikkei fell almost continuously until July 1995, but that was overkill, because in February 1995, Barings had already failed. The chronic weakness of Japanese stock prices pushed the 88888 Account deeper into the red each time, and Leeson kept buying more futures contracts, so that when (and if) Japanese stock prices ever rallied, the 88888 Account would be pulled back up to zero. LEESONS TRADING POSITION: THE NET PROFIT-AND-LOSS PROFILE OF HIS EXPOSURES 1. Leesons Sales of Short Straddles 2. Combining a short straddle and long futures contract 3. Combining a long futures position and Numerous short puts The activities of Nick Leeson on the Japanese and Singapore futures exchanges led to the downfall of Barings. The build-up of the Nikkei positions took off after the Kobe earthquake of January 17, 1995. Leeson's positions went in the opposite direction to the Nikkei - as the Japanese stock market fell. Before the earthquake, Nikkei traded in a range of 19,000 to 19,500. Leeson had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange. A few days after the earthquake, Leeson started an aggressive buying programme which culminated in a high of 19,094 contracts reached about a month later. Barings collapsed as it could not meet the enormous trading obligations, which Leeson established in the name of the bank. When it went into receivership on February 27, 1995, Barings had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 bn on the Nikkei 225 equity contract and US$20 bn on Japanese government bond (JGB) and Euroyen contracts. Leeson sold 70, 892 Nikkei put and call options with a nominal value of $6.68 bn. The nominal size of these positions is breathtaking; their enormity is all the more astounding when compared with the banks reported capital of about $615 million.

But Leeson's Osaka position reflected only half of his sanctioned trades. If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX. Because Leeson's official trading strategy was to take advantage of temporary price differences between the SIMEX and OSE Nikkei 225 contracts. This arbitrage, which Barings called 'switching', required Leeson to buy the cheaper contract and to sell simultaneously the more expensive one, reversing the trade when the price difference had narrowed or disappeared. This kind of arbitrage activity has little market risk as the positions were always matched. But Leeson was not short on SIMEX, infact he was long approximately the number of contracts he was supposed to be short. These were unauthorised trades which he hid in an account named Error Account 88888. He also used this account to execute all his unauthorised trades in Japanese Government Bond and Euroyen futures and Nikkei 225 options: together these trades were so large that they ultimately broke Barings. The most striking point is the fact that Leeson sold 70,892 Nikkei 225 options worth about $7 bn without the knowledge of Barings London. In industry parlance, Leeson sold straddles. i.e. he sold put and call options with the same strikes and maturities. Leeson earned premium income from selling well over 37,000 straddles over a fourteen month period. Such trades are very profitable provided the Nikkei 225 is trading at the options' strike on expiry date since both the puts and calls would expire worthless. If the Nikkei is trading near the options' strike on expiry, it could still be profitable because the earned premium more than offsets the small loss experienced on either the call (if the Tokyo market had risen) or the put (if the Nikkei had fallen). The strike prices of most of Leeson's straddle positions ranged from 18,500 to 20,000. He thus needed the Nikkei 225 to continue to trade in its pre-Kobe earthquake range of 19,000 - 20,000 if he was to make money on his option trades. The Kobe earthquake shattered Leeson's options strategy. On the day of the quake, January 17, the Nikkei 225 was at 19,350. It ended that week slightly lower at 18,950 so Leeson's straddle positions started to look shaky. The call options Leeson sold looked worthless but the put options became very valuable to their buyers if the Nikkei continued to decline. Leeson's losses on these puts were unlimited and totally dependent on the level of the Nikkei at expiry, while the profits on the calls were limited to the premium earned. When the Nikkei dropped 1000 points to 17,950 on January 23, 1995, Leeson found himself showing losses on his two-day old long futures position and facing unlimited damage from selling put options. Leeson, tried single- handedly to reverse the negative post-Kobe sentiment that swamped the Japanese stock market. On 27 January, account '88888' showed a long position of 27,158 March 1995 contracts. Over the next three weeks, Leeson doubled this long position to reach a high on 22nd February of 55,206 March 1995 contracts and 5640 June 1995 contracts. Leeson was also engaged in unauthorised activities almost when he started trading in Singapore in 1992. He took proprietary positions on SIMEX on both futures and options contracts. Leeson lost money from his unauthorised trades almost from day one. Yet he was perceived in London as the wonder boy and turbo-arbitrageur who single-handedly contributed to half of Barings Singapore's 1993 profits and half of the entire firm's 1994

profits. In 1994 alone, Leeson lost Barings US$296 million; his bosses thought he made them US$46 million, so they proposed paying him a bonus of US$720,000. LEESON ACCUMULATES LOSSES By 31 December 1994, Leeson had accumulated losses of 208 million. Japanese stocks never rose above 19,000, there was an earthquake in Kobe on 17 January 1995, and Japans long-awaited recovery was pushed farther and farther into the future. After the earthquake, the Nikkei Index fell to 18,950, forcing Leeson to engage in an even more frantic and massive operation that looked, in retrospect, like a single-handed effort to hold Japanese stock prices at the 19,000 level. Over the next five trading days, Leeson bought a total of more than 20,000 futures contracts, and by 22 February 1995 his aggregate position was over 61,000 futures contracts. Despite his frantic buying, Japanese common stocks fell sharply, and on Monday, 23 January 1995, the Nikkei index fell 1,000 points to 17,950. For Leeson, the end was near. By February 1995, his losses had reached an astounding 830 million. As enormous as his losses were after the stunning drop in Japanese stock prices, Leesons strategy could still have worked if he had been able to buy enough contracts to pull the index back up above 19,000, and it was for this reason that Leeson continued to sell straddles.

AFTERMATH OF THE BARINGS FAILURE The failure of Barings Bank PLC shocked the financial industry into realizing just how powerful one traders undiscovered and unsupervised transactions could be. As a result of this catastrophe and others that occurred in the 1990s, the financial industry set its sights

on the target of implementing new and improved risk-management measures. Today, measures and systems such as Value at Risk and enterprise risk management have grown in popularity due to the lessons learned in the 1990s. Although it is true that ING Bank eventually purchased Barings and none of the depositors or creditors was hurt by the collapse, shareholders and loan note holders still suffered terribly.