Barings Bank Collapse, Essay Example

1. What was Nick Leeson’s strategy to earn trading profits on derivatives?

Hired to garner modest profit from low risk arbitrage opportunities between derivatives contracts, Leeson bankrupted Barings Bank by his unauthorized derivatives speculation in futures on Nikkei 225 stock index and Japanese government bonds. Leeson tried to exploit price differences in the price of Nikkei 225 contracts between the Osaka and Singapore market; meaning, he tried to gamble on fluctuations between two share markets.

Instead of trying to capitalize on small price differences between the futures contracts and hedging his positions, Leeson took massive speculative positions on the future direction of the Japanese markets, and financed margin requirements by selling options, while borrowing heavily from Barings.

2. What went wrong that caused his strategy to fail?

A number of factors combined to cause Leeson’s strategy to fail. First, his financial gambling was emotion-driven, reckless, and dishonest, rather than calculated trading, using derivatives for hedging and controlling risk. Relatedly, Leeson had ferociously bad luck, and the Kobe earthquake conspired with his emotional risk-taking to send his trading positions into the ground. In response to the falling market and his staggering losses, Leeson attempted to recoup the money lost by making increasingly risky trades, only serving to make his account plummet further still.

Another reason for Leeson’s strategy failure was the enormous position he had accumulated – with half the open interest in the Nikkei future and 85% of the open interest in the JGB future. This likely caused the market to trade against him.

3. Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed?

While a legitimate account (99002) was already in existence, Leeson established a bogus error account (88888) because it enabled him to hide his losses, as he posted profits in other trading accounts, to continue his sly trading and cover his losses. Relying on his intimate knowledge of the computer system, Leeson excluded error account 88888 from market activity reports to make sure that his furtive actions would not be transparent.

4. Why did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading?

Barings and its auditors did not discover that the error account was used by Leeson for unauthorized trading for a few different reasons. For one, Leeson fabricated false profits, misleading Barings’ head office management.

Second, the Barings’ computer system was incapable of properly monitoring the bank’s global trading activities. What is more, the Baring computer system was not sync-ed; specifically, in the Tokyo office, debts run up on one computer were not reflected on the other, and because Leeson had long-standing familiarity with the computer system, he was easily able to conceal the error account.

Another reason Barings and its auditors did not discover the error account was because Leeson was performing two jobs: acting as Chief Trader and also responsible for accounting and settlement activities, facilitating his risky trading and concealing his exorbitant losses, without managerial over-sight. Leeson had been afforded entirely too much leeway in his transactions.

5. Why was Barings Bank willing to transfer large sums of cash to Barings Futures Singapore?

Ostensibly, Leeson was Barings’ star trader and maintained his reputation manipulating the books, and was rewarded handily with bonuses from senior management. Given this stellar reputation, he was able to convince senior management to transfer large sums of cash to Barings Futures Singapore. Leeson explained that since the profits from individual arbitrage transactions are modest, trading volumes need to be large. And since SIMEX and OSE exchanges both required separate margins, he needed large amounts of money to deposit.

Further, Leeson explained that SIMEX demanded advance margin calls due to the volatility in the trading prices of the contracts, and he needed Barings to finance these requirements. Surely Barings’ confidence in Leeson enabled him to convince them to make large cash transfers.

6. Why did the attempt by the Bank of England to organize a bailout for Barings fail?

The attempt by the Bank of England to organize a bailout failed because of the size of Barings’ positions in Japanese derivatives contracts, many of which were still open and likely to incur bigger losses still. There was no bank willing to cover these contracts without a guarantee from the Bank of England that it could cover these liabilities.