Background – what happened
In the early 90s, after establishing a Tokyo office to start trading on the Tokyo Exchange, Barings also decided to open a Singapore office to trade on the SIMEX. In April 1992, Nick Leeson went to Singapore to direct trading floor operations and set up the accounting and settlement functions there. Based on his excellent performance, Leeson soon got the right to place orders on his own but was still able to supervise accounting and settlements.
Due to the lack of direct supervision on Leeson, he created an error account, “88888”, to hide his trading losses. Given the fact that Baring’s senior management came from a merchant banking background and underestimated the risks involved within trading, the management team mistakenly believed that Leeson was always making money.
And then in 1995, with the increasing size of his open positions and losses in the market, Leeson tried to gamble with the Japanese debt and equity markets to recover existing losses, but ended in exposing Baring’s $29-billion capital and losing more than 1 billion of it. (1)
Culture, Governance, Conflicting Objectives, Regulatory Filings
Without developed risk management concepts during that time, Barings didn’t have effective guidance on risk awareness, risk-taking, and risk management. The successful trades and incredible profits made by Leeson disguised the management and made them never pose any question on him, let alone knew those huge risks incurred by the bank. On the basis of the fact that nothing was detected by statutory auditors and control interns, Barings’ account regulation procedures were incredibly inefficient.
Same as Societe Generale, Barings had the conflicts of interest between stakeholders and traders: traders like risks, which are directly connected to the profits and their compensations; however, on the other hand, shareholders are conservative and risk-averse, and they prefer a safer way to maximize their stock values.
About regularity filings, since it’s been long time ago, I can’t find any supporting document related to this case.
Control Factors – consequences, limits, risk appetite, metrics, models, compensation
As mentioned above, Barings didn’t have advanced risk management concept at that time. The lack of risk limits and risk appetite during that time made Barings vulnerable to threats. But the fall of Barings was largely due to its poor internal controls. And one typical flawed internal control was the non-segregation of duties. Leeson himself operated in both the trading desk and the back office, owning excessive rights to manipulate transactions and records. Without proper metrics and models, it was hard for Barings to identify existing control weaknesses and then to strengthen their control environment. Besides, it seemed that there was no communication to Barings’ external auditors, aggravating the vulnerability of internal control. (6)
As for the compensation part, similar to Societe Generale’s compensation plan, Barings’ plans were closely related to trades, which could lure traders to take illegal bets on the market and make fictitious trades.
Risk Framework – how was it established, was it followed?
Gaps in 1st, 2nd and 3rd lines of defense
In 1995, Barings Bank didn’t establish their risk framework. The three lines of defenses would play a key role in assuring the effectiveness of risk management. Lack of three LODs reduced the effectiveness of existing monitor and control processes, leaving whole corporate vulnerable.
From the case of Barings, we need to know that a culture of compliance and responsible risk taking is needed. The first and foremost thing to do is to set the clear and right “tone from the top”, and then make sure all employees understand it to prevent excessive risk-taking. Whenever compliance concerns occur, we need to investigate them and quickly respond to them regardless of who or what is involved.
Also, our company needs to build risk governance guidelines. It is necessary to identify roles and responsibilities of different parts of the firm for managing and addressing risk. Enlightened by Barings, our senior managers must be knowledgeable about the products our firm trades and the risk appetite of those products.
Another interesting lesson we can also learn from Barings is that a sudden huge amount of profit might also be a red flag. Most of the time, it is not only a single trader but also a whole problematic system casing the collapse.
As for the compensation part, the compensation structure should support long-term goals and not incentivize risk-taking.
Last but not least, our organization should prevent the situation that someone could get reach of both trading and back office functions. Segregation of duties is important in every part of business.