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Photo: Bloomberg
Photo: Bloomberg

Opinion | Lessons we’ve forgotten 25 years after the fall of Barings

We have better controls but bankers have continued to take gambles at the cost of taxpayers

In 1872, when Phileas Fogg, Jules Verne’s enigmatic character, wagered with his whist partners at London’s Reform Club, including an assistant governor of the Bank of England, to travel around the world in eighty days, he issued a cheque for £20,000, drawn on Baring Brothers. That was sufficient, as his cheques were paid on sight, and he had joined the club on the recommendation of Baring Brothers, which had given him an unlimited overdraft facility.

The 25th anniversary of the collapse of Barings went past in February this year. Nick Leeson, a 28-year-old star trader, brought down this venerable British institution through unauthorized and concealed trading that resulted in losses of around £830 million. Established in 1762, Barings was Britain’s oldest merchant bank, banker to royalty, and by the 19th century, one of the six big powers of Europe, alongside England, France, Prussia, Austria and Russia. It had financed the 1803 purchase of Louisiana, doubling US territory through the biggest real estate deal in history. The family also boasted of five separate hereditary peerages.

Leeson was supposed to be doing low-risk arbitrage between the Singapore and Osaka exchanges. This should have generated only low profits. But, Leeson was actually engaged in more risky positions. His “straddle" strategy, selling put and call options on Nikkei-225, was a bet on the volatility of this index. The Kobe earthquake turned the index volatile, resulting in huge losses for Leeson, who started doubling his bets.

Being in charge of both the trading and back offices helped Leeson cover up losses. Segregation of front and back offices is a basic risk management requirement that was audit-mandated but never implemented.

The incentive structure had an inherent asymmetry, creating a bias towards risk-taking. Thus, when Leeson was making profits for the bank, he received a bonus, expecting £450,000 in 1994. But he did not have to share the losses. As large profits can come only from greater risks, the incentives were towards putting the whole bank at risk.

In the bank’s complex matrix organization, he was reporting to both London, for proprietary trading, and Tokyo, for customer transactions. Managerial confusion and poor monitoring of Leeson’s activities also contributed to the collapse. Poor internal controls allowed Leeson to create an error account, 88888, which was used to hide losses. Fictitious transactions, falsified reports, and fraudulent accounting also helped conceal losses. He violated guidelines on overnight positions. Auditors’ questions were ignored or brushed aside. Warning signals were not acted upon as different departments acted in silos.

One director famously declared that they did not understand derivatives, which contributed significantly to profits. This lack of understanding extended to not even knowing that higher profits come from higher risks. As long as the bank’s directors were getting bonuses upward of £1 million, they did not ask any questions.

The collapse was also a result of not taking regulators seriously. The Singapore Exchange had raised concerns about Leeson, while making calls for additional margins, going up to £300 million. The exchange’s letters were given to Leeson himself for replies. When London transferred funds, they did not probe why low-risk activity required huge funds. The argument that credit business required large funds was not cross-checked with the credit function.

Barings could not be saved because the transaction counterparties were too many and spread out for any meaningful negotiations. Moreover, the derivative losses were quantifiable only on future dates. The bank was eventually bought by ING Bank for £1.

Leeson was sentenced in 1995 to six-and-a-half years in prison, but released in 1999 after being diagnosed with cancer. Leeson now writes books. The first, Rogue Trader, written in prison was made into a movie. He also lectures—on risk, conduct, compliance and corporate governance.

Barings has passed into banking folklore. It is also a landmark case in the history of banking supervision. But, were any lessons learnt? The Basel Committee on Banking Supervision issued guidelines on supervision of financial conglomerates, cross-border banking, and capital for market risk. It brought out its Core Principles for Effective Banking Supervision, followed by a framework for internal controls, and a new focus on operational risk while issuing a consultative paper on Basel-II in 1999.

However, key lessons remained unlearnt, resulting in the global financial crisis of 2007-09. New risks, such as high leverage and global interconnectedness, emerged or became stronger. Many older risks remained unaddressed or ignored. Bankers continued to deal in complex products of which their top managements were clueless. The asymmetry in risk got scaled up to sectoral and global levels, with bankers sharing profits and taxpayers picking up huge tabs for losses. Cultural conflicts in hasty takeovers are at the root of many compliance issues. Risks posed by employee incentives continue to put banks at greater risk.

Today, Phileas Fogg might be able to travel around the world in a day. But, if he were to issue a cheque, it could raise a few eyebrows. No one knew where he was from or where he made his fortune. Even Barings had done no KYC (know your customer) checks on him. Moreover, one day is a long time in banking today.

G. Sreekumar is a former central banker.

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