In 1995, financial markets were shaken by the news that Barings Bank had lost over $1 billion because of unauthorized derivatives trading. This loss resulted in the bankruptcy of Barings, and it was purchased for 1 British pound by ING. This loss helped call into question the fragility of international markets and the destructive potential of derivatives. 

The 233-year old Barings was one of the oldest and most respected banks in Britain, and for most of its life had stuck strictly to banking. Barings, with about 4,000 employees and $10 billion in assets in 1994, managed about $46 billion for a variety of individual and corporate clients, including the Queen of England. As the financial world became more complex, however, and clients required securities trading capabilities, Barings opened a securities trading arm in 1984. This securities business was quite different from the traditional banking business and the business cultures of the two parts of the bank differed significantly. While products of the British establishment staffed the investment banking arm, known as Barings Brothers, many of the traders came from a working class background. To a large extent, the old-style bankers who dominated Barings' senior management looked down their noses at the traders. However, the trading arm managed to make some fairly strong profits and was thus left relatively alone until 1992 when falling stock prices in Tokyo pushed the normally profitable Barings Securities into a $20 million loss. A London-imposed restructuring of Barings in Asia led to a series of management changes and personnel turnover in Asia, which, in turn, left Barings trading expertise in Asiaquite thin by late 1994. 

Baring employees later commented that as a result of these management changes, it was difficult to know who was in change of what and where from month to month. The team that had been built up in the Asian securities operations was scattered and the pool of derivatives-based knowledge in the area virtually disappeared. 

Nick Leeson, the son of a North Londonworking class family, was a successful arbitrage trader in Singapore, and had devised a trading strategy that had made Barings a nice stream of profits. By September 1994, Leeson was viewed as the senior trader for Barings in Singapore, even though he was only 27 years old. His major job at Barings was to arbitrage Nikkei index futures contracts that were traded on both the Singapore and Osakaexchanges. Such arbitrage involves buying futures contracts on one market and selling them on another. Profits are made by exploiting small price differentials for the same contract between the two exchanges. Since the margins are small the volumes traded by arbitragers tend to be very large. However, this strategy is associated with very little risk. 

It was at this point that Leeson departed from his low-risk arbitrage strategy and began to speculate on the volatility of the Nikkei 255 Stock Index. Leeson's motives for speculation are not entirely clear, although maximizing the size of his bonus was certainly a factor. His strategy involved simultaneously writing uncovered put and call options on Nikkei 255 futures. Known as a straddle strategy, this procedure will make money for the option writer provided the market stays within a relatively narrow trading range. The strategy required Barings to sell the Nikkei 255 index when it crossed 19,500 and to buy it when it fell below 18,500. This strategy made Barings money as long as the Nikkei stayed within this relatively narrow range. Once the Nikkei went outside this range, Barings started to lose large amounts of money, about $70 million for every 1 percent move above or below these limits. The loss was exacerbated by the aggressive use of leverage by Leeson (he was writing options from a margin account.) 

At first, the strategy seemed to be working. Traders at other banks reckon that Leeson may have earned as much as $150 million for Barings from this strategy by the end of 1994. However, the strategy started to fall apart when the Kobeearthquake struck January 17, 1995. In response to the economic devastation caused by the earthquake, the Nikkei started to plunge. Worried that the market would fall well below 18,500, Leeson seemed to have entered the market and purchased Nikkei futures on a huge scale in an attempt to push the market up above 18,500. This is not an easy thing to do; the Tokyo stock market is the second biggest in the world. 

Leeson's position deteriorated even further on January 23 when the Tokyo Stock market plunged 1,000 points to under 17,800. An increasingly desperate Nick Leeson responded to the crisis by drawing on a margin account to continue purchasing Nikkei futures in what was to prove to be a futile attempt to prop up the Nikkei index. By late February 1995, Barings had accumulated index positions that effectively amounted to a $7 billion long bet on the Tokyo Stock market. At the height of Leeson's trades, Barings accounted for about half of the open positions in Nikkei 255 futures contracts. 

Such financial excess did not go unnoticed either by other traders in Singapore or by executives at Barings Bank in London. However, Barings executives and other traders were all under the impression that Leeson was acting on behalf of a major client, perhaps a big hedge fund. No one could conceive that the positions belonged to Barings. As for the cash required to purchase Nikkei futures, apparently much of this came from an account for a fictitious client that Leeson had set up as early as 1992. Into this account went some of Barings' own cash along with all the proceeds of Leeson's option sales and some fictitious profits from falsified arbitrage deals. He then used this fictitious account to pay margin calls on his growing futures position. When the account was exhausted, Leeson turned to Barings in London, telling them he was executing trades on behalf of a major client who would settle up in a few days. Barings proved only too willing to send more money to its star trader in Singapore. 

Bolstered by the arrival of additional funds from London, Leeson kept up the charade until February 23 when the cash flowing out to cover margin payments exceeded Barings' preset limits. With the Nikkei continuing to decline, Leeson apparently realized he could no longer carry on with the game. He hurriedly faxed al letter to Barings in Londontendering his resignation, adding that he was sorry for the trouble he had caused, and along with his wife boarded a plane out of Singapore. The next day, shocked Barings' executives informed the Bank of England they were technically bankrupt. 

Over the weekend of February 25 and 26, the stunned management of Barings tried to arrange for a bailout by the Bank of England. The bank tried; over the two-day period several investment banks were summoned to the Bank of England's offices to discuss the possibility of raising enough private money to recapitalize Barings before the Tokyomarket reopened Monday morning. However, the attempt failed because of the size of Barings' position in Japanese derivatives contracts, many of them still open and so liable to incur still bigger losses. No bank was willing to take on these contracts without a large fee or a guarantee from the Bank of England that it would cover these losses. The Bank of England was not prepared to put the money of British taxpayers at risk. On March 3, the Dutch financial group ING stepped in and offered to purchase Barings for one pound sterling in exchange for taking on all Barings' liabilities. In the following weeks ING moved quickly to replace virtually all of Barings' top management and to start to tighten control within the group. When the losses from Leeson's unsuccessful strategy and failed cover-up were tallied, he had blown through $1.33 billion of Barings capital.

 

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The collapse of Barings Bank indeed exposed several fundamental flaws in the global financial system ... View the full answer