CASE STUDY

ON
BARINGS NICHOLAS LEESON

Submitted To: Submitted By:

Ms. Neeti Sanan Ankit Gupta

PG20090005
Q1. What was Nick Leeson’s strategy to earn trading profits on derivatives?

 He was speculating wildly and completely without authorization, in massive amounts on

movements in the Japanese stock and bond markets.
 Most of his trading was a bet on the volatility of the Tokyo stock and bond markets. In
his futures positions, he was betting that the Tokyo stock market would rise and the bond
market would 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 European futures.
 Leeson executed a trading strategy known as a "straddle," with the objective of making a
profit by selling put and call options on the same underlying financial instrument, in this
case, the Nikkei 225 Index. A straddle will generally produce positive earnings when
markets are stable but can result in large losses if markets are volatile.
 He planned his strategy taking into consideration the Japanese futures market as in Japan
the margin is posted on a net basis for all costumers and if there are customers who are in
short position, firm can take long position without any need to pay the call margin. He
utilized this opportunity through his bogus erroe account 88888 and companies account
99002.
Q2. What went wrong that caused his strategy to fail?

 Nick Leeson’s strategy failed as he was taking into consideration that market has
experienced an extended bull run throughout the late 1980’s and after that it has fallen to
half of its 1989 high and he was thinking that it has fallen enough and from now it will
only go up and second thing he thought is that the interest rates are also low at the
moment and if they are going to rise they will hurt him as more of the investors will
move towards the safe earning through the high interest rate returns making the
investment into market to reduce and hence to make himself on the safer side he invested
into government bonds futures.
 Nick Leeson’s strategy failed because the Nikkei 225 index kept falling while he
continued to bet that it would rise – he just didn’t know when to quit and take his losses.
Leeson increased the size of his open positions even as his losses increased due to
volatility in the markets. He did nothing to hedge his position - to lay off his potential
losses if the markets did move the wrong way. In effect, Leeson was accepting unlimited
liability.
 Also, he was relying on the bank interest rate that it would decrease but eventually the
exact opposite thing happened and the interest rate increased to a high.
Q3. Why did Nick Leeson establish a bogus error account (88888) when a legitimate
account (99002) already existed?

 Nick Leeson established a bogus error account (88888) when a legitimate account
(99002) already existed in order to hide his unauthorized trading activities.
 While the legitimate error account was known to Barings Securities in London, the bogus
account was not.
 It was a loophole he exploited to set up bogus accounts for non-existent clients to mask
mounting debts.
 This account enabled Leeson to take advantage of the rules of Japanese Futures market at
that time. In Japan margin was posted on net basis for all customers. Therefore if many
customers were short index futures, the firm can take long position without having to post
cash margin.

Q4. Why did Barings and its auditors not discover that the error account was used by
Leeson for unauthorized trading?

 Barings and its auditors were unable to discover that the error account was used by
Leeson for unauthorized trading as the account did not show on files or statements
transmitted from Singapore to London. There was no clue from which they have gained
any information about the existence of this account.
 Moreover this account was known to SIMEX as a customer account rather than a error
account.
 There was no proper segregation between front and back office as both were under the
control of leeson so making it easier for him to keep tracking and modifying the contents
as per his utilization so that his own activities keep going without any disclosure.
 Also, Leeson was able to do this due to the nature of japanese future market at that time.
As the exchange there did not require a separation between customer and the proprietary
funds and hence making it difficult to differentiate between the funds and the position of
the firm and the customer.
Q5. Why did none of the regulatory authorities in Singapore, Japan, and the United
Kingdom not discover the true use of the error account?

 Nick Leeson was clever and adept enough to hide the true cause of the use of the error
account 88888. None of the regulatory authorities in Singapore, Japan and U.K was able
to discover the true use of error account as it was visible to them as a customer account
 The speculative position of Barings was hidden due to use of a bogus account to clear
trades. With a bogus account, the identity of the broker’s customers is hidden from the
exchange and the clearinghouse.
 The other reason was the solo-consolidation of Baring Securities Ltd and Baring Brothers
& Co. This allowed them to be treated as one entity for capital adequacy and large
exposure purposes. This meant Leeson had access to a larger amount of capital.

Q6. Why was Barings Bank willing to transfer large cash sums to Barings Futures
Singapore?

Barings Bank believed that the large cash sums transferred to Barings Futures Singapore was for
loans to customers as portrayed on the Barings Futures Singapore balance sheet. The key aspect
of Japanese Future market was that exchange did not require a separation between customer and
propriety funds. Therefore it was impossible to distinguish between the firm's and the customer
position.
Q7. Why did the attempt by the Bank of England to organize a bailout for Barings fail?

The attempt by the Bank of England to organize a bailout for Barings failed because no one
would assume the contingent risk of additional, but as yet undiscovered losses. Bank of London
made a huge effort to organize a bailout for Barings bank. The bailout failed because Barings
bank reached to the position where losses amounted more than the double the capitalization of
the bank. Further losses were inevitable and thus there was no one ready to assume the
contingent risk of additional but yet undiscovered losses. The bank was trapped in such a
situation that the amount of future losses was unknown and unrevealed due to the unauthorized
dealing by Nick Leeson.

Q8. Suggest regulatory and management reforms that might prevent a future debacle of
the type that bankrupted Barings.

 Management teams have a duty to understand fully the businesses they manage
 Responsibility for each business activity has to be clearly established and communicated.
 Clear segregation of duties is fundamental to any effective control system.
 Relevant internal controls, including independent risk management, have to be
established for all business activities.
 Top management and the Audit Committee have to ensure that significant weaknesses,
identified to them by internal audit or otherwise, are resolved quickly.
 Understanding of the Business: Top management should understand the business they are
dealing in. For example in the present case Leeson was reporting huge profits but
Arbitraging is a low risk and hence low profit business so how was he reporting such
huge profits. Thus it is very necessary that management has sufficient knowledge and
should be adept enough to understand the complexities of business and its fundamental
concept.

 Lack of internal checks and balances: The power given to the Lesson was uneven just
because of his knowledge and no inquiry was done on the trading lesson was doing just
because the company was running in profit.
 If Barings' auditors and top management had understood the trading business, they would
have realised that it was not possible for Leeson to be making the profits that he was
reporting without taking on undue risk, and they might have questioned where the money
was coming from.

 Poor supervision of employees: Although Leeson had never held a trading license prior
to his arrival in Singapore, there was little oversight of his activities and no individual
was directly responsible for monitoring his trading strategies.

 Lack of a clear reporting line: Leeson's fraud may have been facilitated by the
confusion caused by two reporting lines: one to London, for proprietary trading, and
another to Tokyo for trading on behalf of customers.