1. Nicholas Leeson and Baring Brother & Co. (BB&C) Bank Case study of risk management By Mr. Surachai ID:09200025 Ms. SrisudaBooraphanon ID: 09200027

2. The Barings Bank collapse Starring Nick Leeson (The spectacular fall of Barings in 1995 because of one rogue trader - Nick Leeson)

3. Introduction

4. History

6. Derivatives fall into two major courses

7. OTC derivatives

8. Exchange traded derivatives

11. Worked for Morgan Stanley after graduating university

12. Leeson then joined Barings(Jakarta) to sort through back office mess involving 100 million pounds of share certificate.

13. Successfully rectified the situation in 10 months

15. He was employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on the SIMEX and Japan’s Osaka Exchange

17. Instead of hedging, gambled on the future direction of the Japanese market

18. Had long futures position on OSE

19. Was not short on SIMEX

21. “Arbitrage” between SIMEX and OSE Involves going long in one market and short in the other one. Lesson's went long in Osaka. (His position was public knowledge since the OSE publishes weekly data) Leeson should have gone short in Singapore; he went long instead (unauthorized trades)

22. Selling straddles Straddle = Sell one put and one call with same strike and maturity Benefits the seller if prices don’t change much (i.e., the options expire worthless) Leeson sold straddles on the Nikkei 225 Note: Leeson did not have the authority to sell options

23. On January 17, 1995, the Kobe earthquake hit Japan, causing the Nikkei to fall below 18,000. Put options moved deep in-the-money When you speculate in long futures and prices drop = you lose When you sell straddles and prices drop = you lose

25. He then engaged into a significant volume of cross tradingbetween account 88888 and other accounts

26. Cross trading = matching the positions of two accounts belonging to the same client

27. Ex: If Barings owed US$500m to Daiwa Bank from one type of transaction but also expected to receive US$300 from Daiwa from another type of transaction, it could net the two amounts through a cross trade.

28. After executing these cross-trades, Leeson would instruct the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices to cause profits to be credited to account 92000, while charging losses to account 88888 account

32. Generate large losses

33. Leeson lies about these

34. Customer accounts

35. Normal part of futures trading

36. Should be generally neutral if he is long in one market and short in another

37. Failure to flag this in London was a big problem

39. Fraud

40. Inadequate controls

41. Would VaR have helped?

44. He was long Nikkei 225 futures, short Japanese government bond futures, and short both put and call options on the Nikkei Index.

46. While the legitimate error account was known to Barings Securities in London, the bogus account was not.

47. However, the bogus account was known to SIMEX as a customer account, not as an error account. In this way Leeson could hide his balances and losses from London – but not Singapore.

49. In August 1994, James Baker completed an internal audit of the Singapore office. He made several recommendations that should have alerted Barings executives to the potential for unauthorized trading: 1) segregation of front and back office activities—a fundamental principle in the industry, 2) a comprehensive review of Leeson’s funding requirements, and 3) position limits on Leeson’s activities. None of these had been acted upon by the time of the bank’s collapse.

51. The Bank of England also found fault with the process of funding Leeson’s activities from London. First, there was no clear understanding of whether the funds were needed for clients or for Baring’s own accounts, making reconciliation impossible. Second, given the large amounts, credit checks should have been completed as well. The report places the responsibility for the lack of due diligence with Tony Hawes, Ian Hopkins, and the Chairman of the Barings Credit Committee.

54. In addition, the speculative position of Barings was hidden due to use of an omnibus account to clear trades. With an omnibus account, the identity of the broker’s customers is hidden from the exchange and the clearinghouse.

55. Several incidents in London also made Leeson’s activities easier to manage and hide. The Bank of England had a Large Exposure rule where a bank could not lend more than 25% of its capital to any one entity. However, Barings had requested that an exception be made, arguing that an exchange should not be treated as one entity.

57. This allowed them to be treated as one entity for capital adequacy and large exposure purposes. This meant Leeson had access to a larger amount of capital.

59. The Bank of England wrote a report describing how the losses occurred, why they went unnoticed within and outside Barings, and lessons learned. How the losses occurred and why they went unnoticed has already been explained. The Bank produced five lessons from the bankruptcy. They are (Bank of England Report):Management teams have a duty to understand fully the businesses they manage Responsibility for each business activity has to be clearly established and communicated; Clear segregation of duties is fundamental to any effective control system; Relevant internal controls, including independent risk management, have to be established for all business activities; Top management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly

61. SIMEX, like the other exchanges in the world, implemented changes to decrease default and counterparty risk as well as systemic risks.

62. These changes were made as a direct result of the Barings collapse. SIMEX joined with other exchanges to share information about similar positions participants held on different exchanges.