Barings Bank was the oldest Merchant Bank in theWorld. It was highly trusted and risk averse.TheQueen was a customer. It had financed the LouisianaPurchase, helped fund most of the US railways, and washeavily involved in overseas operations. The bank was still in family hands but was owned by acharity foundation for tax purposes.
The Barings Foundation Trust was established in 1969. It removed tax implications but also removed equityfrom the family. This was compensated by a very rewarding bonusscheme, which handed out 50% of profits. The family and staff soon became accustomed to thebonus rewards.
The Barings Bank that most people knew was themerchant banking side. However there was anotherside to the bank, Baring Securities. Barings Bank was located at 8 Bishopgate, London Barings Securities was located at America Square,London.
Barings Bank was formed in 1762, and highlyrisk averse. It looked at long term relationshipsto make modest profits. Barings Securities was formed in 1984, andhad a high risk appetite. It looked to short termhigh value transactions to make large profits.Barings BankOldConservativeRisk AverseLong term profitsTightly regulatedBarings SecuritiesYoungBrashRisk takersShort term profitsLoosely regulated
By 1989 the traditional Baring Bank equitybroking activity was bringing 19 million poundsprofit compared to 78 million from BaringsSecurities trading. The bank was sharing the profits from Securitiesacross the entire bank operations. In the 6 yearsof its existence to 1990 Barings Securities hadmade 82% of Barings total profits. Despite this, very few in Barings Bankunderstood or cared about the Securities tradingactivities.
The 1990s saw the original hard nosed securitiestraders being usurped and replaced bytechnocrats, whom they nicknamed “techno-peasants”. These technocrats were mathematicians andscientists, used to calculating risk and findingopportunities buried in numbers. Barings Bank, who already didn’t understand orcare about Securities trading, had no realunderstanding how these technocrats found andexploited opportunities.
Barings Securities originally made vast profits fromtrading Warrants, especially Japanese share warrants,which were seriously mispriced in the 1980s. By the 1990s the Warrants mispricing had disappeared,however a similar opportunity was discovered inJapanese Equity Futures and Options.
By the early 1990s most of the profits were beingmade by a very small number of highly skilledspecialists like Khoo and Gueler, making vastprofits in esoteric and complex trades. Su Khoo – a highly rated Malaysianmathematician, made over 16 million pounds inone month by exploiting opportunities. Fernando Gueler - a Harvard Economist, wasmaking similar profits.
So by the 1990s a small number of highly skilledspecialists within Barings Securities were making avast percentage of the Barings Bank profits, and no oneelse understood how they were doing it.Large number of gungho tradersSmall number oftechnocratsWarrant Trading Futures and OptionsGrowing reliance on Barings Securities profitsGrowing lack of understanding on how the profits aremade1980s 1990s
Bearings Bank required minimal capital to operate, and hadassets of around 300 million pounds. Prior to 1990 Barings Securities had been self funding, usingthe income from warrant trading. The 170 million pounds profit generated by BaringsSecurities in the last 6 years had been used to prop upBarings Bank and paid out as bonuses, and was not availableto support trading operations. The move to futures and options trading created a gap infunding and a demand for capital. It was needed to “buy”seats in trading systems, and to pay security bonds fortrading, together with capital to support the trading.
When Barings Bank proved unable to provide the finance,Bearings Securities formed Barings Securities FinancialServices and Barings securities International Holdings toraise capital on the world markets. By 1990 it had used BSFS and BSIH to raise 31 million poundsfrom 10 banks, and desperately needed a further 33 millionto support growth. By late 1990 Barings Securities estimated it needed 120million pounds to continue and expand trading, which theyestimated could generate 45 million pounds a year inprofits.
Barings Bank didn’t understand Securities but it did understand Capital. It realised that the massive profits from warrant trading were ending. It knew that Barings Securities were prone to over spending. Barings Bank forced Securities to downsize, losing over 100 staff in 1992,and in 1993 it executed a coup, replacing most of the top staff withBarings Bank staff. Barings then forced Securities to work within its means, only allowingborrowing to fund margin calls that would be repaid by the client.Thisassumed there really was a client who would pay the call. By 1995 Barings had borrowed 740 million pounds to fund margin calls forwhich there was no customer.
Six years in back office settlements No degree. Straight into banking from school Twenty eight years old Sent overseas to run a trading office – with no priorexperience of trading. Desperate to become a trader - resigned from MorganStanley because they refused to let him trade.
Nick Leeson was involved in two Nikkei tradingoperations, SIMEX in Singapore and Osaka FuturesExchange in Japan. SIMEX was “Open Cry”, with traders standing in a pit inclose physical proximity, buying and selling off eachother. Osaka used electronic screen trading.
Osaka electronic screen trading allowed multipleconcurrent transactions. This meant that a large purchase of contracts could bemade simultaneously from multiple sellers without anyof the other sellers realising the overall volume of thethe transaction.
SIMEX open cry meant that multiple concurrenttransactions were difficult to achieve, and tradestended to be a smaller groups of sales or purchases. These smaller non simultaneous transactions signaledbuyers or sellers intentions to the market and affectedprices. SIMEX was also smaller, and purchases were easilynoticed.
Both SIMEX and demanded margin payments. Osaka demanded 9% initial margin, followed by aseries of margin calls 3 to 4 days after marketmovement of the securities. SIMEX had a similar system but the margin paymentswere much smaller, attracting customers.
In 1990 the Japanese government commenced pricekeeping actions, buying Nikkei futures to keep theprice up.This led to excessive trading in Nikkei futures. To reduce trading activity the margins in Osaka wereraised from 9% to 15% and then 20%. In additiontrading hours were shortened. Osaka introduced rules limiting contract pricemovement to 0.2% every 5 minutes. A 5% fall wouldshut the trading for 2 hours. These rules did not apply on the SIMEX floor.
Leeson noticed that large purchases on SIMEXinvariably pushed the price of the security up, as othertraders watched the activity. This was reported to Osaka, and the price was reflectedon the electronic trading screens. He realised that he could purchase contracts in Osakaat the current price before placing his customerspurchases, which would then drive up the price. Hecould then sell at Osaka at a profit.
Leeson spotting the Nikkei opportunity led Barings tothink that he was another Techno-Peasant. Amathematically gifted opportunist who could find andexploit opportunities for Barings Securities. In fact he had a very basic education, and had spentmost of his career in back office settlements.
Leeson wasnt a technocrat. He had wanted to get intotrading 4 years before when it was full of gung ho “barrowboy” traders, now it was a different workplace full ofmathematicians and MBAs. He was out of his depth. Barings Bank didn’t understand the Securities industry andcould not monitor Leeson. But they were addicted to thebonus payments that came from Barings Securities. Barings Securities had been milked of operating capital bythe Barings bonus scheme. They were desperate togenerate profits to fund expansion. Everyone wanted people like Leeson to succeed.
Driven by a desire to be a star trader, Leeson tried to influence themarket by trading in long futures. Initially successful, he began to lose money due to inexperience.He adopted the gamblers strategy of doubling up, hoping thatsooner or later it would balance out. This collapsed with the Kobi earthquake in January 1995.TheNikkei went into freefall, and Leesons position became a disaster. All of his attempts to extricate himself for the position from then onwere unsuccessful. No matter how much of Barings money hespend the Nikkei continued to fall. On 23rd February 2005 Leeson quietly slipped out of Singapore.He left Barings owing 827 million pounds.