The Role of the Regulators in the Collapse of Barings

Publication Date01 February 1995
Date01 February 1995
AuthorShiraz Mahmood
SubjectAccounting & finance
Journal of Financial Crime Vol. 3 No. 1 Financial Fraud
The Role of the Regulators in the Collapse of
Shiraz Mahmood
The failure of Barings Brothers occurred because
Mr Nicholas W. Leeson1 conducted trading which
at one point extended Barings' positions on Nikkei
225 futures contracts to a total nominal value of
£27bn.2 When Mr Leeson's strategy proved wrong
Barings was unable to support these positions and
collapsed. Mr Leeson's authorised activity was
arbitrage. He was supposed to exploit marginal
ferences between the prices of stocks and bonds on
the Tokyo and Osaka markets by simultaneously
buying on one exchange and selling on the other.
The arbitrage carried out by Mr Leeson was largely
on futures contracts for the Nikkei index of the
225 leading stocks in the Tokyo Market. Appar-
ently Mr Leeson abandoned his authorised activity
of arbitrage, which is a low risk form of trading,
towards the end of January3 and starting taking
part in transactions known as straddles. A straddle
is effectively a bet that a market will not rise or fall
outside a certain range. Mr Leeson bet that Nikkei
prices would remain within the 18,500-19,500
range and sold an equal number of 'puts' and
A seller of calls is speculating that the mar-
ket will fall, while a seller of puts is speculating
that the market will rise; if the market rises sharply
the seller loses money on the calls, if the market
falls sharply, as it did in Mr Leeson's case, the
seller loses money on the puts. A straddle is only
profitable if market prices remain within a speci-
fied narrow range.
Two events, however, led to the downfall of Mr
Leeson's strategy. First, the Kobe earthquake on
17th January caused ripples on the Nikkei and Mr
Leeson, worried that the Tokyo market would
drop below 18,500 points, began buying huge
quantities of Nikkei futures in an effort to boost
the market. The second event that effectively
sealed the fate of Barings was a decline in the
Tokyo stock market which dropped 1,000 points to
17,800.5 The latter event led Mr Leeson to stop
selling contracts and he took a 'long' position by
buying large quantities of futures contracts, betting
that the Nikkei 225 would rise.6 Mr Leeson also
bought a great number of futures contracts in Jap-
anese government bonds and he took a 'short'
position by betting that prices would fall and inter-
est rates would rise.7 Unfortunately for Barings, all
Mr Leeson's predictions proved to be wrong. The
Nikkei dropped between mid-January and mid-
February, thus leading to a loss in the value of Mr
Leeson's 'long' futures contracts while a fall in
interest rates led to a drop in the value of Mr
Leeson's 'short' bond futures contracts. Towards
the end of February the nominal value of Mr Lee-
son's irremediable trading position was £4.66bn of
shares and £14.66bn of bonds,8 a trading position
Barings was unable to sustain. Mr Leeson was able
to conduct such risky trading due to his being in
charge of both the front and back office of Barings
Futures Singapore (BFS), ie he controlled both
dealing and trade settlement which allowed him to
initiate transactions and to ensure that those trans-
actions were settled and recorded in accordance
with his own instructions.9
It appears that Barings were forewarned of the
lack of internal controls on two separate occasions.
The first warning took the form of a letter dated
25th March, 1992, from Mr James Bax (Barings'
most senior executive in Singapore) to Mr Andrew
Fraser (head of Barings' brokerage and trading
group in London).10 The letter stated: 'My con-
cern is that once again we are in danger of setting
up a structure which will subsequently prove to be
disastrous and with which we will succeed in los-
ing either a lot of money or client good will or
probably both'.11 The second warning was given
by an internal audit conducted in August 1994.
The audit found that '. .
while the individual con-
trols over BFS' systems and operations are
satisfactory, there is significant general risk that the
controls could be overridden by the general man-
ager (Mr Leeson). He is the key manager in the
front and the back office and can thus initiate
transactions on the group's behalf and then ensure
that they are settled and recorded according to his
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