Course: Treasury Management NIBM, Pune

Demise of Barings Bank

At the time of its demise in February 1995, Barings PLC was the oldest merchant bank in
Great Britain. Founded in 1762 by the sons of German immigrants, the bank had a long and
distinguished history. Barings had helped a fledgling United States of America arrange the
financing of the Louisiana Purchase in 1803. It had also helped Britain finance the
Napoleonic Wars, a feat that prompted the British government to bestow five noble titles
on the Baring family.

Although it was once the largest merchant bank in Britain, Barings was no longer the
powerhouse it had been in the nineteenth century. With total shareholder equity of £440
million, it was far from the largest or most important banking organization in Great Britain.
Nonetheless, it continued to rank among the nation’s most prestigious institutions. Its
clients included the Queen of England and other members of the royal family.

Barings had long enjoyed a reputation as a conservatively run institution. But that
reputation was shattered on February 24, 1995, when Peter Baring, the bank’s chairman,
contacted the Bank of England to explain that a trader in the firm’s Singapore futures
subsidiary had lost huge sums of money speculating on Nikkei-225 stock index futures and
options. In the days that followed, investigators found that the bank’s total losses exceeded
US$1 billion, a sum large enough to bankrupt the institution.

Barings had almost failed once before in 1890 after losing millions in loans to Argentina,
but it was rescued on that occasion by a consortium led by the Bank of England. A similar
effort was mounted in February 1995, but the attempt failed when no immediate buyer
could be found and the Bank of England refused to assume liability for Barings’s losses. On
the evening of Sunday, February 26, the Bank of England took action to place Barings into
administration, a legal proceeding resembling Chapter 11 bankruptcy-court proceedings in
the United States. The crisis brought about by Barings’s insolvency ended just over one
week later when a large Dutch financial conglomerate, the Internationale Nederlanden
Groep (ING), assumed the assets and liabilities of the failed merchant bank.

What has shocked most observers is that such a highly regarded institution could fall
victim to such a fate. The ensuing account examines the events leading up to the failure of
Barings, the factors responsible for the debacle, and the repercussions of that event on
world financial markets.19 This account is followed by an examination of the policy
concerns arising from the episode and the lessons these events hold for market
participants and policymakers.

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Course: Treasury Management NIBM, Pune

Unauthorized Trading Activities

In 1992, Barings sent Nicholas Leeson, a clerk from its London office, to manage the back-
office accounting and settlement operations at its Singapore futures subsidiary. Baring
Futures (Singapore), hereafter BFS, was established to enable Barings to execute trades on
the Singapore International Monetary Exchange (SIMEX). The subsidiary’s profits were
expected to come primarily from brokerage commissions for trades executed on behalf of
customers and other Barings subsidiaries.

Soon after arriving in Singapore, Leeson asked permission to take the SIMEX examinations
that would permit him to trade on the floor of the exchange. He passed the examinations
and began trading later that year. Some time during late 1992 or early 1993, Leeson was
named general manager and head trader of BFS. Normally the functions of trading and
settlements are kept separate within an organization, as the head of settlements is
expected to provide independent verification of records of trading activity. But Leeson was
never relieved of his authority over the subsidiary’s back-office operations when his
responsibilities were expanded to include trading.

Leeson soon began to engage in proprietary trading—that is, trading for the firm’s own
account. Barings’s management understood that such trading involved arbitrage in Nikkei-
225 stock index futures and 10-year Japanese Government Bond (JGB) futures. Both
contracts trade on SIMEX and the Osaka Securities Exchange (OSE). At times price
discrepancies can develop between the same contract on different exchanges, leaving room
for an arbitrageur to earn profits by buying the lower-priced contract on one exchange
while selling the higher-priced contract on the other. In theory this type of arbitrage
involves only perfectly hedged positions, and so it is commonly regarded as a low-risk
activity. Unbeknownst to the bank’s management, however, Leeson soon embarked upon a
much riskier trading strategy. Rather than engaging in arbitrage, as Barings management
believed, he began placing bets on the direction of price movements on the Tokyo stock
exchange.

Leeson’s reported trading profits were spectacular. His earnings soon came to account for a
significant share of Barings total profits; the bank’s senior management regarded him as a
star performer. After Barings failed, however, investigators found that Leeson’s reported
profits had been fictitious from the start. Because his duties included supervision of both
trading and settlements for the Singapore subsidiary, Leeson was able to manufacture
fictitious reports concerning his trading activities. He had set up a special account—
account number 88888—in July 1992, and instructed his clerks to omit information on that
account from their reports to the London head office. By manipulating information on his
trading activity, Leeson was able to conceal his trading losses and report large profits
instead.

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Figure 1 shows Leeson’s trading losses from 1992 through the end of February 1995. By
the end of 1992—just a few months after he had begun trading—Leeson had accumulated a
hidden loss of £2 million. That figure remained unchanged until October 1993, when his
losses began to rise sharply. He lost another £21 million in 1993 and £185 million in 1994.
Total cumulative losses at the end of 1994 stood at £208 million. That amount was slightly
larger than the £205 million profit reported by the Barings Group as a whole, before
accounting for taxes and for £102 million in scheduled bonuses.

Figure 1: Concealed Trading Losses

A major part of Leeson’s trading strategy involved the sale of options on Nikkei-225 futures
contracts. Figures 2a and 2b show the payoff at expiration accruing to the seller of a call or
put option, respectively. The seller of an option earns a premium in return for accepting the
obligation to buy or sell the underlying item at a stipulated strike price. If the option
expires “out-of-themoney,” the option premium becomes the seller’s profit. If prices turn

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out to be more volatile than expected, however, an option seller’s potential losses are
virtually unlimited.

Figure 2: Payoffs to selected option trading strategies

Some time in 1994, Leeson began selling large numbers of option straddles, a strategy that
involved the simultaneous sale of both calls and puts on Nikkei-225 futures. Figure 5c
shows the payoff at expiration to a sold option straddle. Option prices reflect the market’s
expectation of the price volatility of the underlying item. The seller of an option straddle
earns a profit only if the market proves less volatile than predicted by option prices. As is
evident in Figure 2c, Leeson’s strategy amounted to a bet that the Japanese stock market
would neither fall nor increase by a great deal—any large movement in Japanese stock
prices would result in losses. By January 1, 1995, Leeson was short 37,925 Nikkei calls and
32,967 Nikkei puts. He also held a long position of just over 1,000 contracts in Nikkei stock
index futures, which would gain in value if the stock market were to rise.

Disaster struck on January 17 when news of a violent earthquake in Kobe, Japan, sent the
Japanese stock market into a tailspin. Over the next five days, the Nikkei index fell over
1,500 points—Leeson’s options positions sustained a loss of £68 million. As stock prices
fell, he began buying massive amounts of Nikkei stock index futures. He also placed a side
bet on Japanese interest rates, selling Japanese government bond futures by the thousands
in the expectation of rising interest rates

This strategy seemed to work for a short time. By February 6, the Japanese stock market
had recovered by over 1,000 points, making it possible for Leeson to recoup most of the
losses resulting from the market’s reaction to the earthquake. His cumulative losses on that
date totaled £253 million, about 20 percent higher than they had been at the start of the
year. But within days the market began falling again—Leeson’s losses began to multiply. He
continued to increase his exposure as the market kept falling. By February 23, Leeson had
bought over 61,000 Nikkei futures contracts, representing 49 percent of total open interest
in the March 1995 Nikkei futures contract and 24 percent of the open interest in the June

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contract. His position in Japanese government bond futures totaled just over 26,000
contracts sold, representing 88 percent of the open interest in the June 1995 contract.
Leeson also took on positions in Euroyen futures. He began 1995 with long positions in
Euroyen contracts (a bet that Japanese interest rates would fall) but then switched to
selling the contracts. By February 23 he had accumulated a short position in Euroyen
futures equivalent to 5 percent of the open interest in the June 1995 contract and 1 percent
of the open interest in both the September and December contracts

Barings faced massive margin calls as Leeson’s losses mounted. While these margin calls
raised eyebrows at the bank’s London and Tokyo offices, they did not prompt an immediate
inquiry into Leeson’s activities. It was not until February 6 that Barings’s group treasurer,
Tony Hawes, flew to Singapore to investigate irregularities with the accounts at BFS.
Accompanying Hawes was Tony Railton, a settlements clerk from the London office.

While in Singapore, Hawes met with SIMEX officials, who had expressed concern over
Barings’s extraordinarily large positions. Hawes assured them that his firm was aware of
these positions and stood ready to meet its obligations to the exchange. His assurances
were predicated on the belief that the firm’s exposure on the Singapore exchange had been
hedged with offsetting positions on the Osaka exchange. He was soon to learn that this
belief was incorrect.

Leeson’s requests for additional funding continued during February, and Barings’s London
office continued to meet those requests—in all, Barings had committed a total of £742
million to finance margin calls for BFS. Meanwhile, Tony Railton, the clerk Hawes had
dispatched to Singapore, found that he could not reconcile the accounts of BFS. Particularly
disturbing was a US$190 million discrepancy in one of BFS’s accounts. For over a week,
Railton attempted to meet with Leeson to resolve these discrepancies. Leeson had become
hard to find, however. Railton finally tracked him down on the floor of the Singapore
exchange on Thursday, February 23, and persuaded Leeson to meet with him that evening.
When the meeting began, Railton began asking a series of difficult questions. At that point
Leeson excused himself, stating that he would return shortly. But he never did return.
Instead, he and his wife left Singapore that evening. The next day, Leeson faxed his
resignation to Barings’s London office from a hotel in Kuala Lumpur, stating in part, “My
sincere apologies for the predicament I have left you in. It was neither my intention nor aim
for this to happen.”

After Leeson failed to return, Railton and others at Barings’s Singapore office began
investigating his private records and quickly discovered evidence that he had lost
astronomical sums of money. Peter Baring, the bank’s chairman, did not learn of the bank’s
difficulties until the next day, when he was forced to call the Bank of England to ask for
assistance. Ironically, this was the same day that Barings was to inform its staff of their

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bonuses. Leeson was to receive a £450,000 bonus, up from £130,000 the previous year, on
the strength of his reported profits. Baring himself expected to receive £1 million.

The Bank of England’s Board of Banking Supervision (1995) subsequently conducted an

inquiry into the collapse of Barings. According to the Board’s report, total losses
attributable to Leeson’s actions came to £927 million (approximately US$1.4 billion),
including liquidation costs; an amount far in excess of Barings total equity of £440 million.
Most of the cost of the Barings debacle was borne by its shareholders and by ING, the firm
that bought Barings. Barings was a privately held firm; most of its equity was held by the
Baring Foundation, a charity registered in the United Kingdom. Barings’s executive
committee held the firm’s voting shares, which constituted a small fraction of the firm’s
total equity. Although ING was able to buy the failed merchant bank for a token amount of
£1, it had to pay £660 million to recapitalize the firm. SIMEX subsequently reported that
the funds Barings had on deposit with the exchange were sufficient to meet the costs
incurred in liquidating its positions It is not known whether the OSE suffered any losses as
a result of Barings’s collapse. Leeson was later detained by authorities at the airport in
Frankfort, Germany, and was extradited to Singapore the following November. In
Singapore, Leeson pleaded guilty to charges of fraud and was sentenced to a 61⁄2-year
prison term.

Acknowledgement: Case sourced from ‘Derivatives debacles: Case Studies of Large Losses
in Derivative Markets, Economic Quarterly, Federal Reserve Bank of Richmond, 81/4,1995.