Insights of the Case

In February of 1995, one man single-handedly bankrupted the bank that financed the Napoleonic
Wars, Louisiana Purchase and the Erie Canal. Founded in 1762, Barings Bank was Britains oldest
merchant bank and Queen Elizabeths personal bank. Once a behemoth in the banking industry,
Barings was brought down by a rogue trader in a Singapore office. The trader, Nick Leeson, was
employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on
the Singapore Mercantile Exchange and Japans Osaka Exchange. A scandal ensued when Leeson left
a $1.4 billion loss in Barings balance sheet due to his unauthorized derivatives speculation, causing
the 233-year-old banks demise.
Nick Leeson grew up in Londons Watford suburb and worked for Morgan Stanley after graduating
from university. Shortly after, Leeson joined Barings and was transferred to Jakarta, Indonesia to sort
through a back-office mess involving 100 million of share certificates. Nick Leeson enhanced his
reputation within Barings when he successfully rectified the situation in 10 months.
In 1992, after his initial success, Nick Leeson was transferred to Barings Securities in Singapore and
was promoted to general manager, with the authority to hire traders and back office staff. Leesons
experience with trading was limited, but he took an exam that qualified him to trade on the Singapore
Mercantile Exchange (SIMEX) alongside his traders. Leeson and his traders had authority to perform
two types of trading such as transacting futures and options orders for clients or for other firms within
the Barings organization, and arbitraging price differences between Nikkei futures traded on the
SIMEX and Japans Osaka exchange.
As a general manager, Nick Leeson oversaw both trading and back office functions, eliminating the
necessary checks and balances usually found within trading organizations. In addition, Barings senior
management came from a merchant banking background, causing them to underestimate the risks
involved with trading, while not providing any individual who was directly responsible for monitoring
Leesons trading activities. Due to his lack of supervision, the 28-year-old Nick Leeson promptly
started unauthorized speculation in Nikkei 225 stock index futures and Japanese government bonds.
These trades were outright trades or directional bets on the market. This highly leveraged strategy can
provide fantastic gains or utterly devastating losses a stark contrast to the relatively conservative
arbitrage trading that Barings had intended for Leeson to pursue.
Nick Leeson opened a secret trading account that was numbered 88888 to facilitate his surreptitious
trading. He lost money from the beginning. Increasing his bets only made him lose more money.
Barings management remained blithely unaware. By mid-February 1995, he had accumulated an
enormous positionhalf the open interest in the Nikkei future and 85% of the open interest in the
JGB [Japanese Government Bond] future. 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 Kobe, Japan, dropping the Nikkei 1000 points while pulling Barings even further
into the red zone. As an inexperienced trader, Leeson frantically purchased even more Nikkei futures
contracts in hopes of winning back the money that he had already lost.

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. Despite the staggering secret losses,
Leeson lived the life of a high roller, complete with a $9,000 per month apartment and
earning a bonus of 130,000 on his salary of 50,000.The horrific losses accrued by Nick
Leeson were due to his financial gambling as he placed his trades based upon his emotions
rather than through taking calculated risks... Barings sent a team of auditors to Singapore, but
it was too late. The losses continued to mount, and soon exceeded the banks net worth of
$500 million. Barings had no way to recover, and efforts to extricate itself from financial ruin
failed. Unlike the near bankruptcy of 1890, no organization was willing to help. In the end,
ING Bank in the Netherlands bought Barings for 1. Leesons trip to Malaysia turned from a
vacation into a pathetic attempt to escape. He went into hiding by traveling to Borneo and
then on to Frankfurt, where he was apprehended and extradited to Singapore. Leeson pleaded
guilty to fraud and spent three-and-a-half years of a six-and-a-half year sentence in a
Singapore jail.Nick Leeson was released from prison in July 1999 for good behavior.
Issues or Problems
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.
Barings internal guideline was to post discrepancies to a special account, called the 88888 Account.
That way, the banks books would balance, discrepancies would be isolated and dealt with separately,
and the bank could make its regulatory filings without delay. The bank intended for these
discrepancies to be recorded and closed out within a day, but Leeson realized that Barings internal
guidelines were not followed. While in Singapore, Leeson focused his trading activities on futures
contracts in three major markets: the Japanese Nikkei 225 stock index, 10-year Japanese government
bonds, and euro-yen deposits. Because they were traded simultaneously on the Osaka Securities
Exchange (OSE) and the Singapore International Monetary Exchange (SIMEX), Leesons job
eventually became one of taking advantage of arbitrage opportunities between the two markets. While
he was working on reconciling the discrepancies in Indonesia, Leeson learned that the discrepancies
account (the 88888 Account) did not appear in reports used to control traders. Not surprisingly, they
did go into other reports, such as position statements to the exchanges for margin5
calculations, but internally, this information was prepared less frequently, and it went through
different channels to employees at the bank who had little familiarity with trading. Even if these
imbalances arise and are resolved in the normal course of business, they can still do harm.
Discrepancies introduce delays in rec-cognizing exposures, but equally important, they create
opportunities for clever and unscrupulous employees to figure out how to take advantage of the
permissive treatment of temporary imbalances. Nick Leeson was certainly both clever and
unscrupulous. Barings had strict trading limits and believed that it was diligently monitoring all its
traders to make sure they did not exceed their limits, but the banks systems were not prepared for the
level of fraud and misrepresentation that Leeson committed, and Barings was not aware of the secret
ways of Leeson. From the perspective of Barings London, there was nothing suspect about Leeson
setting up the 88888 Account. After all, a separate account for settling transaction discrepancies was
normal, but what went on in this account was apparently off the radar screen of Leesons managers in
London

and Singapore. Leeson set himself the goal of becoming the protector of his newly discovered door to
fortune and fame. Within a week of opening the 88888 Account, he had its reporting software changed
so that transactions in the account did not appear on the daily internal performance reports. initially,
Barings Singapore branch was supposed to be executing orders placed exclusively by Barings
affiliates worldwide on behalf of their customers. It was some time afterward that BFS also began to
conduct independent arbitrage transactions, but from the standpoint of Barings London, this new line
of business posed no major security breach. BFS was not supposed to be involved in any trading for
the houses account, so Barings management might have reasoned that any loss of control by putting
Leeson in charge of the front and back offices was offset by the cost savings of having one person
cover two tasks. Since Leeson controlled the 88888 Account, he was able to assign any trades he
desired to it and he did. As a result, an inspection of Leesons normal trading activity showed
moderate amounts of futures contracts with positions and activity within authorized trading limits.
Leeson used the 88888 Account in two major ways. Whenever he traded more contracts than his
limits allowed and whenever he had losing trades that would have blemished his reputation as a
brilliant trader, Leeson assigned the extra trades and the losing transactions to the 88888 Account. He
also used the account to conceal the fact that he was speculating and not arbitraging. 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. To cover his tracks, Leeson convinced Barings London that the margin calls were
not a problem. He fabricated a story that the transfers were needed mostly to meet the margin calls of
Barings customers, many of whom lived in different time zones and had trouble clearing checks in
time. He also convinced Barings London that part of the large margin calls was a normal counterpart
of his profitable arbitrage trading activities. Leeson argued that arbitrage transactions, in general, earn
so little profit per transaction that he needed large gross positions to conduct his deals. Barings
London was unable to expose Leeson far earlier than it did. For instance, his explanation that the
excessive and growing margin payments were due to customers in different time zones should have
been questioned immediately, because the only exclusive third-party client that BFS had was Banque
Nationale de Paris (Tokyo). All of BFSs other clients were existing customers of Barings London
and Tokyo offices. Barings London never asked Leeson to substantiate his requests for margin
funding. 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. The need for cash to meet margin calls drove Leeson
to desperation. He began to record fictitious trades, falsify internal transfer records, and sell straddles
on the Nikkei index. All of these actions were clearly and explicitly outside his authority to transact.
He pretended to transfer and trade large blocks of stocks between the accounts of the various Barings
affiliates and the 88888 Account. In this way, Leeson gave the impression that his net exposures were
small and his profits were high. As well, he duped exchanges into charging him less margin than he
should have paid.
Corporate governance of the bank
Banks are in the business of trading financial instruments, such as currencies, bonds,
common stocks, and many other financial assets, including derivatives. This trading can
be done as a service to clients and/or to earn outright trading profits. For auditing and
control purposes, the difference is
important. Trading that is done only as a service for customers requires the bank to have
strict rules concerning account management and credit risk management for individual
customers. By contrast, trading done for the house requires strict exposure limits on the

banks traders, because this type of trading puts the banks equity directly at risk. In
either case, derivative trading requires top management to have a clear idea of how
profits are earned and the risks associated with such returns. On both counts, the
managers at Barings Bank were deficient. Traders profit by taking advantage of small
movements in market prices. Because there are so many different markets and so many
different instruments, these traders tend to specialize and become experts in their own
narrow segments of the financial world. Sometimes this depth of knowledge leads traders
to believe that they can actually predict in which direction the market will move. Such
confidence can be dangerous, because there is no room for self-delusion or ego trips.
When they suffer losses, traders have to close out their losing positions quickly before
the losses get too large, and then move onward, with their self-assurance as strong as
ever. In other words, they have to have an unshakable conviction that their superior
knowledge and trading skills will make them net winners in the long run, but they also
have to pay due homage to the capricious and inscrutable movements of the market.
Because the risks of carrying open trading positions can be very high, most traders need
special permission from their managers at the end of each day to carry an unbalanced
position overnight. The activities of traders have to be controlled closely, which means
their positions have to be strictly monitored and audited; yet, within a bank, there is also
another type of employee whose activities are supposed to be much more benign. This is
the arbitrager. Arbitrage is the simultaneous buying and selling of assets to earn profits.
Because assets are simultaneously bought and sold, arbitragers net positions at the end
of the day, and for most points within a day, are supposed to be balanced (i.e., flat), and
therefore the risks of arbitrage trading are supposed to be small or non-existent. Nick
Leeson was in charge of arbitrage trading for Barings Futures Singapore (BFS), but his
positions were nowhere close to being flat at the end of each day, and the losses from
these positions caused the eventual bankruptcy of Barings. From all their years of trading
and security dealing, one would expect the bank to have learned from their successes
and failures how to control the positions of their employees. But control is an elusive goal
when banking activities have so many dimensions and when each trading operation and
each new instrument offers its own secret passageways to the bank vault. In short,
controlling bank-trading operations is harder than it sounds, and this task is made even
more difficult by rogue traders who actively search for ways to evade controls and
exceed their trading authority.
Studying the Barings fiasco reveals that no one, not the traders, bank management,
board of directors, or Bank of England was adequately supervising Barings derivative
risks. The breakdown inside Barings was partly because Leesons derivatives transactions
were complicated, but the heart of the breakdown was much more elementary. In a
nutshell, there was no effective oversight at Barings, and as a result, Leeson was able to
circumvent the banks internal checks and balances. The managers and directors in
London did not know exactly what Leeson was doing, and neither did his supervisors in
Singapore or Tokyo. Due to the 88888 Account, only a part of Leesons trading results
showed up in the banks routine tabulations of trading activities, and warnings from
internal auditors as well as external auditors and regulators were largely ignored. It
seemed that, so long as Leesons performance was stellar, there was no urgency to ask
hard questions. The attitude within the bank was that Leeson had the Midas touch, and
too much restraint would cramp his style and hold down the profits his trading could
bring. Most things are obvious in retrospect, but for Leeson and his managers, one aspect
is unclear if he was truly supposed to be conducting only arbitrage trades, why were
there no red flags waving and alarms sounding when Leeson reported such large profits.
In 1993, Leesons office brought in about 20% of Barings worldwide profits, and during
the first half of 1994, it was responsible for about 50% of the banks earnings. By year
end 1994, Leesons reported profits were 500% of his budgeted estimate. Instead of
critical scrutiny, Barings management seems to have convinced itself that the source of
the banks competitive advantage over rivals came from its simultaneous membership
on the Japanese and Singapore exchanges. Management also seemed to have prided
itself for having the wisdom to hire Leeson, the golden boy of arbitrage trading. It was
not until the Singapore futures exchange issued a mega-margin call in January and
February 1995 that Barings directors in London realized that Leesons trading was not
arbitrage and that he was not a star trader.

Impact of the case

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. The
Barings-Nick Leeson story is a spectacular anomaly that provides some valuable lessons.
Effective risk management requires a clear line of demarcation between the back office
(i.e., the individuals responsible for recording, confirming, settling, reconciling, and
reporting transactions) and the front office (i.e., the traders). Otherwise, there will always
be temptation to fix the books to enhance performance. Without this separation, control
systems that monitor risks, such as trading limits, credit, liquidity, and cash flows, lose
most of their significance. Barings allowed Nick Leeson to settle his own trades, by giving
him authority over both the front and back office, and as a result he could manipulate
accounts at the Singapore branch, while reporting fraudulent totals that appeared
accurate. The most embarrassing aspect of the Barings-Leeson catastrophe was the role
played by senior management (i.e., Leesons direct supervisors, the banks management
committee, and the board of directors), whose errors were ones of omission rather than
commission. Simply put, there was a gaping lack of management control that gave too
much autonomy to Leeson, who was, in more ways than one, far beyond the scrutiny of
his supervisors. The directors in London thought Leeson was arbitraging, when, in reality,
he was taking outright positions and un-hedged puts and calls, both of which were clear
violations of Barings rules. No one in the bank seems to have fully understood the risks
that Leeson was taking, and because he was reporting such large profits, no one posed
the hard questions that should have been asked. Leesons supervisors should have had
direct and immediate knowledge of his activities. Barings management committee should
have set up reporting systems to ensure that important information on operational risks
reached them, and the board of directors should have put the management committee
under constant pressure to formulate these risk reporting systems. Senior Barings
managers ignored internal audit reports, as well as inquiries from the Bank for
International Settlements. They even ignored (for a while) the cold reality of Leesons call
for cash, when trading losses required Barings London to borrow the needed funds and
wire them to
Singapore. Barings management thought Leeson was arbitraging, and therefore, it
funded his margin calls without demanding full explanations. Arbitrage traders are not
supposed to earn enormous profits. Rather, they should be earning small profits on
numerous trades with almost zero net exposures. When an arbitrage trader begins to
earn 20% to 50% of a multinational banks annual profits on riskless trades, as Leeson
claimed to be doing, warning bells and sirens should sound immediately. Had Leeson
been fully hedged, then the margin calls on one exchange would have eventually been
offset by gains on the other. To be sure, he would have needed to post larger and larger
amounts to his margin accounts as his positions expanded, but they would have been

nowhere near the level of funding he requested. The truth is that Leesons supervisors
seemed to bend over backwards looking for reasons to believe that he was staying within
the banks guidelines and the eye-popping trading profits he was generating were
legitimate. Whatever arguments Leesons supervisors concocted, they were invalid and
shallow. Barings had rules and regulations in place that were supposed to stop traders
(including Leeson) from activities such as carrying open overnight positions, exposing the
bank to any one customer for more than 25% of the banks capital, and selling options.
Almost no twisting and turning can reverse the fact that many levels of management
above and around Leeson failed to function properly.