In one late February weekend, Barings PLC went from a midsize investment bank with a top-drawer reputation to a pitiful, bankrupt heap. The Bank of England says it will be early autumn before it knows why, but enough is known to begin drawing important lessons now.
It's apparent that futures trader Nicholas Leeson managed to elude six layers of regulation. No one at Barings, its auditor Coopers & Lybrand, the Bank of England, the London securities regulator, the Singapore authorities, or the two exchanges had a complete picture of what Leeson was up to. He was, in theory, doing straightforward hedging by taking advantage of tiny price differences between Nikkei futures contracts traded in Osaka and Singapore. By going long in one city and short in the other, he ran what traders call a "no-brainer" hedging operation. But by using deceptive techniques, he hid the fact that he began speculating, not hedging, by holding long positions on both exchanges. Leeson also doubled his bets by selling options.
So what can be learned?
-- Never assume anything. One of the biggest mistakes was the assumption by Barings' management that it had plenty of time to carry out an auditor's August, 1994, recommendation to tighten controls in Singapore. Leeson reported to a Tokyo office on customer trades and to a London office on proprietary trades. Only on paper did he report to the head of Barings' Singapore office.
-- Recognize the dangers of mega-bonuses. Tongues wagged in London when Internationale Nederlanden Groep, the Netherlands bank that bought Barings, revealed that it would pay Barings' staff bonuses of $160 million, a sum equal to the investment house' 1993 pretax profit. Leeson was part of this culture.
-- Limit proprietary trading. From June to December, 1994, Barings' Singapore futures-trading unit brought in a $30 million profit, equal to 20% of the group's 1993 profit. It meant that proprietary trading, not traditional investment banking, was fueling most of the group's growth. By limiting proprietary trading, institutions can reduce their reliance on individual traders and smooth out the volatility of profits and losses.
-- Follow the money. Barings' managers loaned the Singapore office more than the bank's entire capital base of $900 million to make margin calls in January and February. And the Barings board consented when the Tokyo office put together a consortium of Japanese banks to finance futures trading. Such calls on the bank's capital should have sent up warning flares.
-- Regulate across borders. If nothing else comes of the Barings disaster, the world's regulators should act quickly to devise common rules for the regulation of securities trading. And they should begin setting up a system for cross-border sharing of information.
Oversight is never easy, but the Barings case demonstrates that there are usually plenty of signs of trouble, if one is willing to look for them. That's a lesson the Bank of England should act on.