Nick Leeson grew up in London’s Watford suburb and worked for Morgan Stanley after graduating from university. Shortly after, Leeson joined Barings and was transferred to Jakarta, Indonesia to sort through a back-office mess involving £100 million of share certificates. Nick Leeson enhanced his reputation within Barings when he successfully rectified the situation in 10 months (Risk Glossary).
In 1992, after his initial success, Nick Leeson was transferred to Barings Securities in Singapore and was promoted to general manager, with the authority to hire traders and back office staff. Leeson’s experience with trading was limited, but he took an exam that qualified him to trade on the Singapore Mercantile Exchange (SIMEX) alongside his traders. According to Risk Glossary:
“Leeson and his traders had authority to perform two types of trading:
1. Transacting futures and options orders for clients or for other firms within the Barings organization, and
2. Arbitraging price differences between Nikkei futures traded on the SIMEX and Japan’s Osaka exchange.
Arbitrage is an inherently low risk strategy and was intended for Leeson and his team to garner a series of small profits, rather than spectacular gains.”
As a general manager, Nick Leeson oversaw both trading and back office functions, eliminating the necessary checks and balances usually found within trading organizations. In addition, Barings’ senior management came from a merchant banking background, causing them to underestimate the risks involved with trading, while not providing any individual who was directly responsible for monitoring Leeson’s trading activities. Aided by his lack of supervision, the 28-year-old Nick Leeson promptly started unauthorized speculation in Nikkei 225 stock index futures and Japanese government bonds (Risk Glossary). These trades were outright trades or directional bets on the market. This highly leveraged strategy can provide fantastic gains or utterly devastating losses, a stark contrast to the relatively conservative arbitrage trading that Barings had intended for Leeson to pursue.
In February of 1995, one man single-handedly bankrupted the bank that financed the Napoleonic Wars, Louisiana Purchase and the Erie Canal. Founded in 1762, Barings Bank was Britain’s oldest merchant bank and Queen Elizabeth’s personal bank. Once a behemoth in the banking industry, Barings was brought to its knees by a rogue trader in a Singapore office. The trader, Nick Leeson, who was employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on the Singapore Mercantile Exchange and Japan’s Osaka Exchange. A scandal ensued when Leeson left a $1.4 billion hole in Barings’ balance sheet due to his unauthorized derivatives speculation, causing the 233-year-old bank’s demise.
In December 1994, Orange County stunned the markets by announcing that its investment pool had suffered a loss of $1.6 billion. This was the largest loss ever recorded by a local government investment pool, and led to the bankruptcy of the county shortly thereafter.
This loss was the result of unsupervised investment activity of Bob Citron, the County Treasurer, who was entrusted with a $7.5 billion portfolio belonging to county schools, cities, special districts and the county itself. In times of fiscal restraints, Citron was viewed as a wizard who could painlessly deliver greater returns to investors. Indeed, Citron delivered returns about 2% higher than the comparable State pool.
Citron was able to increase returns on the pool by investing in derivatives securities and leveraging the portfolio to the hilt. The pool was in such demand due to its track record that Citron had to turn down investments by agencies outside Orange County. Some local school districts and cities even issued short-term taxable notes to reinvest in the pool (thereby increasing their leverage even further). This was in spite of repeated public warnings, notably by John Moorlach, who ran for Treasurer in 1994, that the pool was too risky. Unfortunately, he was widely ignored and Bob Citron was re-elected.
The investment strategy worked excellently until 1994, when the Fed started a series of interest rate hikes that caused severe losses to the pool. Initially, this was announced as a “paper” loss. Shortly thereafter, the county declared bankruptcy
SIMILAR PROBLEMS THAT LEAD TO THE COLLAPSE OF THE ABOVE INSTITUTIONS
Unauthorised Trading Activities
Unauthorised trading activities of the head of Baring Financial Securities (BFS), Nick Leeson. Leeson was authorised to engage in active trading out of Singapore, but only as part of a ‘switching’ (or arbitrage) operation between the Singaporean and Osaka futures exchanges. These activities were viewed as low-risk operations by Barings management, given that they did not involve outright, open positions on the exchanges. It is now known, however, that Leeson had engaged, for a period of two and half years, in unauthorized position taking in Nikkei futures and Japanese Government Bond (JGB) futures on SIMEX and Osaka futures exchanges.
Similarly to orange county Citron was able to increase returns on the pool by investing in derivatives securities and leveraging the portfolio to the hilt and as a result he extended his trading in more risky trading activities (swap) in derivatives without the authorization from management.
Lack of Division of Labour
Again, there was a lack of separation between the front and back offices within Baring Financial Securities (BFS). As general manager of the company, Leeson effectively controlled both sides of the trading operation. From that position, he was able to conduct unauthorized trading and subsequently manipulate the number and details of the transactions in which he had engaged, concealing them from Barings management. Secret accounts were used to park losses arising from the unauthorised transactions;
Similarly to Orange County, Citron was solely responsible for investing several of the county’s funds which totals about 7.5 billion US dollars. He was the jack of all trade despite having any strong educational background in trading financial instruments.
Lack of Management Supervision
Aided by his lack of supervision, the 28-year-old Nick Leeson promptly started unauthorized speculation in Nikkei 225 stock index futures and Japanese government bonds (Risk Glossary). These trades were outright trades or directional bets on the market. This highly leveraged strategy can provide fantastic gains or utterly devastating losses, a stark contrast to the relatively conservative arbitrage trading that Barings had intended for Leeson to pursue.
The failings at Barings could not be attributed to the complexity of the business carried out within Baring Financial Securities, but were primarily a failure on the part of management within the Barings Group to do their supervisory jobs properly. Leeson was able to act without authority and without detection of his act by any management.
Similarly to orange county, The losses was as a results of lack of management supervision on investment activities of Bob Citron, the County Treasurer, who was entrusted with a $7.5 billion portfolio belonging to county schools, cities, special districts and the county itself.
Inadequate Systems to Measure, Monitor and Manage Risk
Barings did not fail because Leeson bought derivatives. Barings failed because its managers were incompetent and did not properly put any system to monitor and manage risky activities of the young trader. This made Barings management, for the most part comprised of experienced bankers, failed so dramatically in their duties. A second issue is why the risk management and detection structures, which in theory at least existed within the Barings Group of companies, proved to be so inadequate.
Also orange county management placed a very risky financial trading in the hands of unprofessional Citron without putting adequate system to measure, monitor and manage risk. Despite of repeated public warnings, notably by John Moorlach, that the pool was too risky, unfortunately, he was widely ignored and Bob Citron continued his risk trading without any system to monitor and manage the risk
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 account is hidden from the exchange and clearing house. On the other hand Citron did not hide any accounts in his derivative trading but rather his dealings was obvious to some members of the institution that is why John Moorlach repeated public warning that the pool was too risky.
The municipality, through its treasurer Robert Citron, speculated that interest rates would stay the same or fall. Into the bargain, he leveraged his position with a factor 3. The means for the speculation were repos on bond. When the interest rates went through the roof (from 5,25% to 8% = + 52%), the value of the collateral (the bonds) for his position fell (with a factor 3). He got a margin call, but couldn’t pay it. The biggest part of the investment (held by FBCS) was liquidated with a phenomenal loss.
First of all, every financial institution or sectors must insist on more rigorous education and training for financial professionals. Leeson, who failed his maths A Level, admits to having little qualification for his job at Barings other than a burning desire to make money. Standards may well have improved, but why do we insist on would-be doctors, vets and lawyers studying their subject at university for several years, and yet happily allow young people to walk into a job in the City or whole county without any formal background in finance?.
Also, one Lesson that can be learned from county exercise is the use of VAR. Had value at risk been measured before 1994, the Orange County fiasco could very well have been avoided. It is fair to say that, had the Treasurer announced that there was a 5 percent chance of losing more than $1.1 billion over a year, many investors would have thought twice about rushing into the pool. In addition, investors would not have the excuse that they did not know what they were getting into, which would have limited the rash of ensuing lawsuits.
Again greater use should be made of information which could be obtained from banks or financial institutions internal audits. We recommend that, as part of that process, the central bank meet regularly with the chairman of the major banks’ audit committees to discuss internal audit, control and related issues and to ask whether there were matters which should be brought to the attention of the central banks in order to stabilize the financial activities in the country.
Furthermore, reports of the collapse of these two institutions gives more insight about how e-criminals, hacktivists or even hostile foreign government agencies could inflict serious damage on our banking or financial systems. While the external threats are real and make for great news copy, it should be remembered that the worst systemic failures affecting banks have come from shortcomings in internal controls and oversights, especially around identity and access management and therefore management of financial institutions must take note.
Moreover, one major lesson is that banks and other major financial organisations must insist on the highest ethical standards. Financial professionals continue to succumb to the same temptations that proved Leeson’s and Citron’s undoing.
Finally, every serious financial related institution must stop idolising “star” performers. Leeson was revered by his peers and also his managers and Citron also was making good monies for the county, which made them convinced that they had found a money making machine. It is human nature to look for heroes and but care must be taking to keep eyes on activities of those we so called stars this is because in reality there are very few genuine stars in financial markets.
A number of important lessons for senior banks and financial managers including
• the importance of internal controls & audit processes
Our group also think the following should be avoided by banks or any financial sector.
• Lack of internal checks and balances
• Lack of understanding of the business
• Poor supervision of employees
• Lack of a clear reporting line