Lesson Learnt The derivate trading is not as easy as perceived.

Here a case which shows the instincts of how risky the business is. The chain of events which led to the collapse of Baring Bank, Britains oldest merchant bank, is a demonstration of how not to manage a derivative operation. Numerous reports have come out with recommendations on best practices in risk management. Barings violated almost every recommendation. Because its management singularly failed to institute a proper managerial, financial and operational control system, the firm did not catch on, in time, to what Leeson was up to. Since the foundations for effective controls were weak, it is not surprising that the firm's system of checks and balances failed at a number of operational and management levels and in more than one location. After the collapse of Barings, appropriate steps were taken by investment houses, which announced measures to tighten oversight of their traders. Regulators also bolstered their defenses and for example SIMEX, where Leeson traded, formed a Regulatory and Risk Management Division and set up information-sharing arrangements with other bourses. To sum up, it can indicate the major lesson of the collapse of Barings: 1. Lack of internal checks and balances Even when segregation of duties was suggested by internal audit, the concentration of power in the Leeson's hands was scarcely diluted. 2. Lack of understanding of the business If Barings' auditors and top management had understood the trading business, they would have realized 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. Arbitrage is supposed to be a low risk, and hence low profit business, so Leeson's large profits should have inspired alarm rather than praise. Given that arbitrage should be cash-neutral or cash-rich, additional alarms should have gone off as the Bank wired hundreds of millions of dollars to Singapore. 3. 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. 4. 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.

Conclusion The Barings collapse is another reminder of the serious problems which can arise within banks. In this instance, the difficulties led to the failure of a banking group with a history spanning over 230 years. Contrary to initial and popular reactions to the collapse, however, the Barings experience says less about the problems with banks use of derivatives than about the problems that arise when risk management systems and practices and accounting procedures are ineffective. The experience also demonstrates the particular problems that can arise where there is deceptive activity and fraud on the part of senior bank staff. Barings over many years was considered as a rather conservative bank and therefore the bankruptcy served as a wake-up call for financial institutions all over the world. The disaster has revealed an amazing lack of control at Barings where Leeson had control over both the trading desk and the back office. The function of the back office is to confirm trades and check that all trading activity is within guidelines. In any serious bank, traders have limited amount of capital they can deal with and are subject to closely supervised position limits. To avoid conflicts of interest, the trading and back office functions are clearly delineated. In addition, most banks have a separate risk-management unit that provides another check on traders, but in the case of Barings it looked different. In my humble opinion, the management board wanted to enter a new market but in reality the Bank was not prepared to the activity on a derivate market. On the other hand, stronger competition in the banking sector induced the board to search additional profits in different business areas and from this reason it gave so much control only to the one person. Derivates have become in recent years a powerful tool in the hands of traders and after some confusion at the beginning I think it can notice that financial institutions are aware of the fact that strict regulations are needed in this area in order to avoid the next Barings. For its part, the Reserve Bank has been acutely aware of the problems posed by the lack of appropriate risk management controls within banks. Many of the banking difficulties of the late 1980s and early 1990s in Australia were the product of less than adequate credit risk management systems. As part of its ongoing response to such issues, the Bank has been developing its supervisory capabilities, particularly in relation to the assessment and analysis of risk management methodologies and practices within banks. Associated with this has been greater input from and review of banks internal audit functions. For over two years asset quality teams from the Bank have been visiting banks to help assess the effectiveness of banks systems for monitoring and controlling creditrisk, and their consistency with

good industry practice. More recently, similar groups have been involved in the analysis of methodologies and practices used by banks in relation to the identification and measurement of market risk. These visit programs will be a continuing feature of bank supervision in Australia and will help to minimise the possibility of problems occurring at banks. In the final analysis, however, no amount of supervision can absolutely guarantee against serious problems.