The 1995 Failure of Barings PLC
In 1995, Barings PLC was a 233 year old institution (chartered in 1762), that was Britain's oldest merchant bank. With a stellar history, Barings financed the 1803 Louisiana Purchase which doubled the land in the United Stated. In addition, the bank help finance the British government battle against Napoleon by loaning and raising money to pay soldiers, buy equipment, and maintain the overall war effort. Barings almost collapsed in 1890 when it sustained enormous losses in Argentina but Bank of England bailed it out.
Nick Leeson, a 28 year old derivatives trader in the banks Singapore office located in Singapore office lost over $1.4b betting on Nikkei futures, wiping out the bank's equity capital and making it technically bankrupt. The trader, Nicolas Leeson was trading futures based on the movement in the Nikkei-225, an index of leading Japanese stocks. He traded on the Osaka futures market and the Singapore International Monetary Exchange.
Initially, Leeson had been buying options contracts on the Simex and selling on Osaka in a strategy designed to take advantage of price differentials between equivalent contracts listed on the two exchanges. Mr Leeson was supposed to be "arbitraging" , seeking to profit from the differences in the prices of Nikkei 225 futures contracts listed on the Osaka Securities Exchange (OSE ) in Japan and the Singapore Monetary Exchange ( SIMEX ). Such arbitrage involves buying futures contracts on one market and simultaneously selling them on another.
Mr Lesson's trading strategy seems, however, to have evolved well beyond arbitrage. Instead of hedging his positions, he gambled on the future direction of the Japanese markets. Mr Leeson began doing this at the end of January 1995. His unhedged positions escalated rapidly. By February 23rd , Mr Leeson had bought some $7 billion worth of stock index futures and sold $20 billion worth of bond and interest rate futures contracts. Most of Barings losses came from the stock market futures.
But Leeson started gambling when he decided simultaneously to buy and sell stock index futures on the Nikkei 225. These deals, known as "straddles" make profits for the for the seller of the options provided that the market proves less volatile than the option prices predict. Mr Leeson sold up to 40,000 such option contracts. For it to pay off, Mr Lesson's strategy required that the Nikkei had to stay in the 18,500 - 19,500 range. When the Kobe earthquake struck on January 17th, 1995, the Nikkei wobbled
Worried that the market would fall below 18,500 , Mr Leeson seems to have bought Nikkei futures on a huge scale in an attempt to push it up. This was not easy: the Tokyo stockmarket is the worlds second largest. And on January 23rd disaster struck: the Tokyo stockmarket plunged 1000 points to under 17,800. Hence his increasingly desperate attempts in February to buy enough Nikkei futures to force the market up. And hence, when he failed, the huge losses that sank the bank. When the crisis broke , Barings exposure on the OSE was eight times as big as its nearest rival's; it's position on SIMEX was even bigger.
In the wake of the disaster the major question asked is why did Barings not control Mr Lesson's activities before it was too late? The answer was that in effect, he was Barings Futures Singapore. Leeson was sent out in 1992 as head of settlements, before moving on to become head of trading. He seemed successful; in 1994, Barings profits from futures trading rose from S$2million , ( $1.2 million ) to S$20 million.
Astonishingly, the bank did not require him to give up his job as head of settlements when he became head of trading. At most other banks the two functions are segregated. Allowing a trader to settle his own deals makes it simpler for him to hide the risks he is taking, or the amounts of money he is losing. The bank also lacked an independent risk management unit to provide another check on Mr Leeson.
None of this explains why Barings managers failed to spot the huge amount of cash that Baring Futures had to pay out to both SIMEX and OSE to support its futures positions. Firms that deal on a futures exchange must first deposit a lump sum (called the initial margin ) with the clearing house that backs the exchange. If the value of their contracts falls, they are required to top that sum up daily with additional margin calls. A rogue trader should thus be quickly spotted on a futures exchange. Traders at rival firms were astonished by the growth of Barings positions. When the crisis broke , the banks exposure on the OSE was eight times as big as its nearest rival's; it's position on SIMEX was even bigger.
The old-style bankers who dominated Barings' senior management have long looked down their aristocratic noses at the traders who run the banks securities operations. Management became too thinly spread across the banks' activities. This flaw caused the bank grief long before Mr Leeson.
The banks last hope was for a repeat of 1890: a rescue package put together by the bank of England. The Bank certainly tried. Over the weekend of February 25th to 26th, leaders of several British clearing and investment banks were summoned to Threadneedle Street in a bid to raise enough private money to recapitalise Barings before the Tokyo market reopened. The bankers, fearful that they too might suffer if a revered British merchant bank went under , were willing to help , to the tune of 600m ( the potential rescuers apparently included the Sultan of Brunei, the worlds richest man). But the package failed because of the size of Barings' positions in Japanese derivatives contracts, many of them still open and so liable to incur bigger losses still. No bank was willing to take on those contracts without a fat fee - or a guarantee from the central bank that it would cover further losses. The Bank of England says that this fee might have been another $700m; it was not prepared to risk taxpayers money.
The exchanges probably could have done better. Neither the Osaka nor the Singapore markets emerges from this affair covered in glory. They failed to ferret out why Baring Futures was racking up unusually large positions. They asked for information; but the firm seems to have responded with a few fictitious client names. Nor are the exchanges good at sharing information. This is because OSE is cross that SIMEX stole its business after the Japanese authorities forced it to raise its margin rates to the highest in the world. Yet neither exchange can hope to prevent firms going bust - and this putting their members capital at risk - if they do not pool information.
The addition of Baring Brothers to the list of those felled by derivatives seems to make a stronger case for tighter regulation or even an outright ban. Yet the Barings case does not support such arguments at all. Two popular fears are of derivatives traded over the counter, not on recognized exchanges; and of complex derivatives designed by rocket scientists that managers cannot comprehend. But Barings came unstuck over exchange traded derivatives of the simplest possible kind. The fault lay in internal supervision and control, not in the instruments being used.
The fact is that banks have found it remarkably easy to lose huge sums of money without using derivatives at all, especially now that they trade so much on their own account. Look at the losses incurred by most of the worlds big banks in the 1980's on Latin American debt; at more recent losses on property lending; or at bond trading losses in 1994. Nor are derivatives the only way to leverage exposure. They may be easier and quicker to use; but that is precisely where their advantage lies. The speed with which banks can take on risk using derivatives mirrors the ease with which others can lay it off. That is why the use of derivatives has grown so fast; and why investors ranging from fund managers to farmers have been increasingly able to hedge the risk that the prices of their assets might fall.