Ben Dubow
This year marks 25 years since the failure of Barings Bank. On Sunday 26 February 1995, the 200-year old merchant bank blew up thanks to derivatives trading, which it believed was both risk-free and highly profitable. It was neither of these things. The firm’s star trader was illicitly pursuing a strategy akin to ‘picking up pennies in front of a steam-roller‘. The steamroller arrived in the form the Kobe earthquake. The star trader’s losses ballooned and he doubled up on his bets, unsuccessfully. Barings went bankrupt. The episode captured the public imagination, and helped lead to the creation of a new regulator in the UK.
The world has moved on since then. Banks, supervisors and policymakers around the world drew lessons in wake of Barings, and have drawn many more lessons from the global financial crisis. These lessons are now helping supervisors through the economic turmoil of a global pandemic. So why should supervisors know the story of this small bank’s failure, which took place in a different world over two and a half decades ago? Because, as the Parliamentary Commission on Banking Standards pointed out, historical awareness can help avoid the mistakes of the past. “Supervisors [should] have a good understanding of the causes of past financial crises so that lessons can be learnt from them,” the Commission recommended.
Now, Barings did not precipitate a financial crisis. Uncertain as to what the impact of a bankruptcy would be, over a fraught final weekend, the Bank of England worked on plans to avoid one. In the final hours, the Bank of England’s Court of Directors discussed the ‘systemic’ risks should those plans not succeed. They did not succeed, but when markets opened the next day, turmoil was limited. The bank was not big enough to impact the financial system: its balance sheet ranked 32nd among UK banks. However, some of the weaknesses seen at Barings have also shown themselves at systemically important firms. And had Baring’s failure occurred alongside other fear-inducing events, perhaps it might have tipped markets over into panic. So the story is worth knowing and these are some of the morals for supervisors present and future, in the UK and elsewhere.
Firstly, Baring’s collapse reminds supervisors to be wary of complex, new and incredibly profitable businesses, especially when conducted far from head office. In the late 1980’s competition became tougher in the City of London. After Big Bang in 1986, larger foreign firms expanded their London presence and acquired most of the old British merchant banks. More competition put Barings’ profitability under pressure and the bank began to take more risk. Seeking lucrative growth opportunities, Barings rapidly expanded its Asian securities business. In 1992, among its new ventures, Barings sent Nick Leeson to Singapore to start a derivatives trading business. Leeson’s authorised business was arbitraging small price differences between futures contracts trading on the Singapore exchange and the near-identical contracts trading in Tokyo. This business went on to become a huge success, apparently generating 10% of the entire group’s profits for 1994.
In reality, Leeson was running an unauthorised business, secretly selling options — a one way bet that markets would remain stable. Markets moved by more than Leeson expected and the strategy lost money. Leeson hid the losses, which, in the end, reached £827 million — twice the firm’s capital. Ironically, Barings may be the only bank to have illustrated twice the dangers of growing complex, far-flung businesses: in 1890 Barings was bailed out after an ill-fated move into Argentinian infrastructure finance.
Barings’ collapse also bears out the need for good controls. The idea that one man’s crime single-handedly broke a bank is far from the truth. In reality, Leeson’s activities were enabled by a litany of horrendous control failings, laid out in detail in a report by the Board of Banking Supervision (BoBS). The problems begin with the fact that management entrusted the monitoring of Leeson’s trading activities to Leeson himself. When the Baring’s Internal Auditors found out, they ordered this to stop. The management of the Singapore office said it had stopped. It had not. No one ever checked.
Management and oversight of Leeson was light touch and ambiguous. The BoBS report forensically dissects the evidence on who actually managed Leeson, with all involved denying it was them. Meanwhile, an understanding of derivatives was lacking among the heirs to 200 years of tradition who ran Barings. Management in London did not question why Leeson’s supposedly profitable trading required increasing amounts of cash to be sent to Singapore: £221 million by the end of 1994 growing to £742 million by the end. But it can be career-limiting to question a rain maker too closely, and hence the most ‘profitable’ parts of a firm may be the least well controlled.
Poor controls at the regulator played their part, too. Barings was granted a waiver by the Bank of England, which removed the limit on the amount of cash Barings Bank in London was able to send to its securities trading business in Singapore. This waiver was precedent-setting: no securities trading business had received such a waiver before. Yet the waiver did not go to a committee of senior management for scrutiny as it would today. Barings reminds supervisors why this needs to be so, and why we cannot give firms the benefit of the doubt when granting formal concessions.
Barings also reminds supervisors that, until you can trust a firm’s risk management and controls, you cannot trust its numbers. The problems at Barings were not at all apparent in the firm’s all-important capital, leverage and liquidity ratios. According to the Bank of England’s Historical Banking Returns Database, Baring’s prudential ratios were higher than peers’. But these numbers did not reflect Leeson’s hidden trades. Regulatory data cannot always be taken at face value. If a firm’s risk management and financial controls are poor, it will be a case of ‘rubbish in, rubbish out’.
A final reminder is that, when failings are widespread, the root cause surely lies at the top. Baring’s Board would not have met the expectations of today’s investors or bank supervisors. The Board lacked a Chief Risk Officer or Chief Financial Officer or truly independent Non-Executive Directors experienced in commercial banking, much less derivatives trading. The Senior Managers Regime, established after the financial crisis, gives supervisors many more powers to address good governance than existed back then. Barings collapse serves as an example of why those powers are important.
Ben Dubow works in the Prudential Regulation Authority’s International Banks Directorate.
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I watched this unfold and the damage it caused. Barings is an Excellent Example of the Damage Derivatives can cause. Weapons of Mass Financial Destruction. We call them worthless toxic paper to the last person holding them.
We have seen other such cases after Barings where Derivatives have financially destroyed companies, such as Ashanti Mining and others.
Its not just the controls its also how these Derivatives are constructed there are flaws and are subject to the unexpected event.