Barings Bank and

Nick Leeson

Introduction
I would like to present the case of Barings Bank, one of the most famous histories in
the world when one man led to the bankruptcy the oldest British bank. Barings collapsed on
February 26, 1995, due to the activities of one trader, Nick Leeson, who lost almost $1.4
billion. The loss was caused by a large exposure to the Japanese stock market, which was
achieved through the futures market. Leeson, the chief trader for Barings Futures in
Singapore, had been accumulating positions in stock index futures on the Nikkei 225, a
portfolio of Japanese stocks. As the market fell more than 15 percent in the first two months
of 1995, Barings Futures suffered huge losses, which were made even higher due to the sale
of options, which implied a bet on a stable market. As losses mounted, Leeson increased the
size of the position, in a stubborn belief he was right. Finally, on 25 February 1995 he walked
away, when he realized that bank was unable to make the cash payments required by the
exchanges. Later, he sent a fax to his superiors, offering “sincere apologies for the
predicament that I have left you in.”
Nick Leeson had totally wiped out the venerable 233-year-old Baring Investment
Bank, which proudly counted Queen Elizabeth as a client. He left behind huge liabilities
totaling $1.4 billion, more than the entire capital and reserves of the British institution. This
situation - and a similar scam at the New York branch of Japan's Daiwa Bank in October 1995
- shocked all people, not only the financial world. In the aftermath of the activity of Leeson,
Barings collapsed and was purchased by the Dutch bank/insurance company ING for the
nominal sum of £1. How it was possible? In my essay I try to answer this question and I will
explain what exactly happened at Baring and how the board might have avoided this situation.

Brief history of the Bank

Barings Bank, the oldest merchant banking company in England, was founded in
1762. Barings was an illustrious name what confirm the words of the French Foreign

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Minister, Duc de Richelieu, who in 1818 said: “There are six great powers in Europe:
England, France, Prussia, Austria, Russia and Baring Brothers.” This accolade did not apply
so well eighty years later, when in 1890 it faced bankruptcy in the aftermath of a significant
amount of investment lost in South America following the Argentinean revolution. However,
at that time, they had been bailed out by the Bank of England and other London banks.
From then on, however, Brings continued in traditional merchant banking, building up
a reputation based on corporate finance, strong investment management, and the trading it did
for one of the best clients in London, including the Royal Family. In 1984 it acquired the
stockholding business of small stock broking company, Henderson Crosthwaite, with a staff
of 15 based in London, Hong Kong and Tokyo. Baring Brother and Company (BB and Co)
then established Baring Securities Limited (BSL), as a separately and liberally managed
business within the group. BSL was very successful, enjoying the fruits of the 1980s Tokyo
Stock Market boom, and specialized in Japanese equity warrants – bonds sold with warrants
exercisable into shares. Growth of business in emerging markets together with expansion of
securities induced Barings to consolidate BB and Co and BSL.
Board of the Bank was very satisfied with the presence on the Asian market and in
order to develop much faster it perceived in the field of derivates a good source of profits and
therefore decided to establish Baring Futures (Singapore) Pte Ltd ("BFS") which was
incorporated on 17 September 1986 and shortly after, applied for and was granted non-
clearing membership by the Singapore International Monetary Exchange Ltd ("SIMEX"). On
21 February 1992, BFS applied for clearing membership of SIMEX and this was subsequently
granted. BFS commenced trading on SIMEX on 1 July 1992.

The meaning of derivatives

Generally speaking, derivatives fall into two major categories. One consists of
customized, privately negotiated derivatives, which are known generically as over-the-counter
(OTC) derivatives or, even more generically, as swaps. The other category consists of
standardized, exchange-traded derivatives, known generically as futures. In addition, there are
various types of product within each of the two categories. Since the mid-80s the volumes and
value of futures, options and swaps contracts traded have increased astronomically all over
the world what is well illustrated by the table and graph below:

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Markets for selected Derivate Financial Instruments:
Notional Principal Amounts Outstanding (US$ Billions)
North Europe Asia-Pacific Other Total
America
1986 518,1 13,1 87,0 0,0 618,2
1990 1268,5 461,2 560,5 0,2 2290,4
1991 2151,7 710,1 657,0 0,5 3519,3
1992 2694,7 1114,3 823,5 1,8 4634,3
1993 4358,6 1777,9 1606,0 28,7 7771,2
1994 4819,5 1831,7 2171,8 39,5 8862,5
1995 4849,6 2241,6 1990,1 106,8 9188,1
1996 4839,7 2831,7 2154,0 59,3 9884,7
Source: IMF, International Capital Market, November 1997

Historical OTC Market Derivates Activity

(outstandings, US$ billions)

$60 000

$50 000

$40 000

$30 000

$20 000

$10 000

$0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Source: International Swaps & Derivates, http://isda.org/

Simultaneously, with the rapid growth of the use of derivates, many analysts were
aware of the lack of procedures of management risk A report prepared by the Economist
Intelligence Unit after the collapse of Barings, indicated that 95% of the international

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companies wanted still to maintain their favourable attitude to derivates, with 52% regarding
derivates as “an essential and regularly utilised tool.”
On the other hand, a company Touche Ross, in one of its study from 1995 concerning
the use of derivates by 26 companies in the London FTSE 100 Index found that only 65% of
companies surveyed had a written policy on the use of derivates, and in many of these, the
policies were inadequate. Only 50% said their policies specified the types of derivates
allowed, and 50% had policies which imposed limits on the volume and principal amounts of
derivates transacted. Only 58% of companies calculated the market value of their derivates on
a frequent basis. However, less than 10% reported that derivates were used for speculative
purposes.

Activity of Nick Leeson on the Asian market

The Barings board decided to send to Asia in 1992 a young trader from a humble
background, Nick Leeson, who seemed to know how to deal in derivatives, a quite new game
that few in the financial fraternity really understood. The Bank wanted to become one of the
first active banks in this region of the world and also from this reason the board gave a trader
a lot of freedom in his activity. In 1993, Nick Leeson was appointed general manager of the
bank's Barings Futures subsidiary in Singapore.
Trader was authorized to conduct both proprietary and clients account trading on Far
Eastern exchanges, on behalf of other Barings companies, specifically, Baring Securities
Limited (Singapore), Baring Securities Limited (London), Baring Securities (Japan), Baring
Securities Hong Kong Limited and Banque Nationale de Paris (Japan). He dealt in 6 main
financial futures and some options on them, as follows:
1. Nikkei 225 contract traded on SIMEX in Singapore;
2. Nikkei 225 contract traded on OSE (Osaka Stock Exchange) in Japan;
3. 10-year JGB (Japanese government bonds) contract traded on SIMEX in Singapore;
4. 10-year JGB contract traded on TSE (Tokyo Stock Exchange) in Japan;
5. 3-month Euroyen contract traded on SIMEX in Singapore;
6. 3-month Euroyen contract traded on TIFFE (Tokyo Financial Futures Exchange) in
Japan.

Around 1993 arbitrage business began to be an important part of Baring’s Far Eastern
operations. Initially this took the form of cash/futures arbitrage in Tokyo, and soon after the
rapid build-up of arbitrage between SIMEX and OSE on Nikkei 225 futures contracts. The

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Barings’ management called this authorized business “switching”, although it would normally
be known as a form of inter-exchange arbitrage. Leeson would buy and sell Nikkei 225
futures contracts simultaneously on SIMEX and OSE, benefiting from small differences in
identical contracts – buying at the cheaper price and selling at the higher. These opportunities
existed because OSE and SIMEX have different market conditions – OSE has local business,
SIMEX mostly “off-shore” business, and OSE conducts business more slowly than SIMEX.
Leeson also “switched” JGB futures contacts on SIMEX and TSE. This arbitrage
market provided good opportunities since the JGB market was rather volatile. He also did
arbitrage business on SIMEX and TIFFE Euroyen contracts.
In this moment it can ask what exactly happened at Barings if arbitrage is theoretically
risk-free since orders are matched? The problem was here – Leeson kept unmatched position
and he was able to conceal his unauthorised trading activities for over a year because he
managed both the trading and back office functions. The senior managers at Barings came
primarily from a merchant banking background and knew very little about trading. Even in
the face of large profits, which should have tipped management off to the fact that substantial
risks were being taken, they continued to believe that Leeson held matched positions on the
SIMEX and the OSE, and hence was making a low-risk profit.
In fact, Leeson was trading derivatives contracts on the two exchanges that were, in
some cases, of different types and, in some cases, in mismatched amounts. For example, he
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.
Leeson created an error account numbered “88888” as a holding area for any
premiums or losses that he made. A trader claimed that he initially had opened the account to
conceal a single loss of 20,000 pounds sterling that had resulted from an accounting error
until he could make up the difference through trading. However, he continued booking
various losses on the account and also continued to increase his volume of trading and level of
risk taking.
Leeson increased the size of his open positions even as his losses increased due to
volatility in the markets. When an earthquake (23 January 1995) in Japan caused a steep drop
in the Nikkei 225 equity index, Leeson's unauthorised trading positions suffered huge losses
and his operation unravelled. On March 3, 1995, the Dutch bank ING purchased Barings for
the princely sum of £1, providing the final chapter in the story of the 223-year-old bank. The

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immediate damage to markets was less than might have been expected – mostly resulting
from falls in confidence. Nikkei 225 dropped by 5% on 27 February when markets re-opened
while the London Stock Exchange Index (FTSE 100) lost only 12,4 points on 28 February.
These rather small slopes were caused mainly because of the fact that Barings was a tiny
player in international banking in comparison with the huge American and Swiss banks.
Barings’ £354 million plus capital resources (assets £5,9 billion) were dwarfed by banks
whose resources ran into several billions as Barclays.
To sum up the activities of Nick Leeson, it can indicate three major features of his
operations:
1. His supposedly low-risk arbitraging with Nikkei 225 and JGB futures produced
apparently large returns, quite out of proportion to the type of business involved, even
taking into account the large number of contracts. From account disclosed for 1994,
“switching” business contributed £28,5m to the Barings Group operating profits, about
8% of total profits, and nearly as great as the Banking Group’s operating profit which
was at the level of £36,9m. Of this switching activity, £23,4m was generated solely
from JGB arbitrage.
2. Continuing call by BFS on the rest of the Group for funds for margin payments. By 24
February 1995, this cumulative funding represented well over the reported capital of
the Barings Group. This astonishing situation was allowed to develop as the result of
no reconciliation of the funding with client records. This fact confirms also that
management board of Barings had not the vaguest idea about trading of derivates.
Common sense suggests that margin cash should have been received in large amount,
not paid if Leeson’s arbitrage was successful.
3. Leeson was building up substantial long position on SIMEX and short position on
TSE. In the first two months of 1995 it was common knowledge among SIMEX, OSE
and TSE traders that BFS had enormous open positions in the exchanges and it
assumed there must have been some proprietary and unmatched trades.

BFS was very active on the SIMEX in the months of January and February 1995 when
Leeson took dramatic steps in order to save the position of the Bank. During these months
BFC was the largest trader holding between 8 and 12 percent of SIMEX comparing with this
data:
1992 – 26th position
1993 – 9th position

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 In December 1993 it held about 2 percent of outstanding contracts on Nikkei 225
futures traded on SIMEX, and in January 1995, 34 percent.
In January 1993 it held 1 percent of outstanding contracts of Nikkei 225 options traded
on SIMEX, and in January 1995, 35 percent.

Consequences
When Nick Leeson realized that his operations came to light he walked away, but he
was arrested in March while on a stop-over in Germany. He and his wife Lisa were flying to
London from Malaysia, where they said they had been holidaying. On December 2, 1995, a
Singapore court sentenced him to six-and-a-half years in prison but he was released from a
Singapore jail after serving three-and-a-half years of a sentence for fraud.
As one of the further consequence of the collapse of Barings Bank, a syndicate at the
Lloyd’s of London insurance market announced on 2 February 1998 that it had sold its first
insurance policy covering banks for the risk of “rouge trader”. SVB Syndicates, a managing
agency, launched the policy in October 1997 and the first buyer was – as the agency said –
“large New York based financial institution with global operations.” SVB’S policy provides
cover for a trading loss which has been concealed by a trader or falsely recorded. The cover of
up to $300m extends to commitments in excess of permitted limits, trading in unauthorized
instruments and trading with unapproved counterparties. To qualify, banks will have to show
they have the necessary internal controls in place.

What are lessons from Leeson case?

What is crucial to underline in the mid-90s the financial world observed several
significant collapses of various companies which were very active in the filed of derivatives
and securities. It is interesting to mention here only about the most painful:

• 1993 – Metallgesellschaft
The German industrial company lost about $660 million on mismatches between its
derivates hedges and long-term oil contracts with customers.

• April 1994 – Kidder Peabody (KP)

KP dismisses a trader, Joseph Jett, and accuses him of recording phantom profits of
$350 million on trades involving derivates created by stripping the interest and principal
from bonds and selling them separately.

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 • September-October 1994 – Bankers Trust (BT)
BT is sued by Gibson Greetings and Procter&Gamble over derivates losses, which
amounted to $21 million for Gibson and a $200 million settlement for P&G.

• December 1994 – Orange County (OC)

OC reports a $1,5 billion loss, largely because of investment in derivates, leading to the
resignation of the county’s treasurer, Robert L. Citron, and lawsuits against Merrill
Lynch, among others.

• September 1995 – Daiwa (12th largest bank in Japan)

This case provides a striking counterpart to the Barings disaster. The bank announced
that a trader in New York, Toshihide Igushi, had accumulated losses estimated as $1,1
billion. A man concealed more than 30 000 trades over 11 years starting in 1984, in U.S.
Treasury bonds. A trader had - as Leeson - control of both the front and back offices.

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 defences 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 reasons 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.

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 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.

Summary
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: 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.

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References:

1. Jane E. Hughes and Scott B. MacDonald, International Banking, Addison Wesley

2002
2. Report of the board of banking supervision inquiry into circumstances of the collapse
July of Barings 18 July 1995 - http://www.numa.com/ref/barings/bar00.htm
3. Web site of International Swaps and Derivatives Association –
https://www.isdadocs.org/index.html
4. Web site of ERisk company –
http://www.erisk.com/Learning/CaseStudies/ref_case_barings.asp

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