The Collapse of Barings Bank Due to Nick Leeson’s Activities

In February 1995, the world witnessed the collapse of the bank that was providing finance to the likes of Napoleonic Wars, Louisiana Purchase and the Erie Canal. This one of the prominent cases in the history of banking was single handled done by one name by the name of Nick Lesson. In 1762, the  Barring bank was founded and was one of the oldest banks with respect to merchant accounting and was also the personal bank of then Queen Elizabeth. It was a pioneer in the banking industry that faced the major downfall because of the activities of a single man, in the Singapore branch of the bank. Nick Leeson was employed by the bank to profit from low-risk arbitrage opportunities between various derivatives contracts (Hunt & Heinrich, 1996). Due to his unauthorised speculation and lack of care, Nick did a major upheaval when he left a loss of total dollar 1.4 billion in the balance sheet of the banking company that resulted because of his trading activities and led to the downfall of the 233-year-old bank.  Nick lesson was a talented man and was promoted to the post of general manager in the banking company, on the basis of his talent and knowledge. His traders and he were authorised to perform the following activities that mainly were- Carrying out of the transaction of future and options order for the clients within the Barings organisation and also arbitration of the price differences that existed on the stock exchange while trading in options and futures.  There were various factors that led to the losses that resulted from widespread gambling done by the most trusted employee of the company through a secret trading account that incurred losses just from the beginning. He was responsible because he took his decisions based on his emotions and not on the basis if the calculated risks, that the company faced. After the fall down of the Barings, there was widespread upheaval in the world regarding the use of derivatives and trading in the same  (Rawnsley, 1996). People started to avoid them and stop taking risks, fearing to meet the same fate.

 2) The main protagonist in the entire story of his downfall was the use of the future contract. If we go by the standard definition, a future contract is a legally binding contract between two parties to buy or sell any securities at a determined price that is fixed today, at a future date. That implies that the buying and selling will take place at a future date but the price for the same will be determined today. The main reason why the companies sue these future contracts is to offset the overall risk involved in buying or selling the commodities at a future date because there is widespread speculation in the prices of the contract. And hedging is done to kerb the same and manages the overall risk exposure (Abdel-Khalik, 2013). They are designed in such a way that it will help the management to forgo some of the risk involved with the same. There is a wide-scale speculation involved in buying and selling of futures. The speculators mostly buy and sell these future contracts to take advantage of the overall movement of the prices on the stock exchange. This movement of stock also helps in providing the much-needed liquidity in the market.  The underlying price of the physical material forms the basis from which the future contracts derive their prices. For example, the cost of the silver future contract is based on the cost of the silver.  If we see from the perspective of risk management, if there is a fall in the prices of the silver falls in the physical market, the underlying prices of the future contract of silver will increase. Same goes if the price of the silver in the physical market rises, the overall prices of the underlying silver contract of future will fall. This is the basis of the risk management exposure in case of securities in the market (Reviews, 2016). The two prices that are the one prevailing in the physical market and the one associated with the future contracts will offset each other with one rising and the other falling. And thus that will help in reducing the price uncertainty in the market with respect to these stocks. There is an enormous market to manage the overall risk involved with the wide variety of future exchanges present in the market that will help in the management of the future contracts. There are various other means by which one can hedge the overall risk involved in the case of future contracts.

The Use of Future Contracts for Risk Management and Hedging

3) a)The basic rule that is required to be followed in buying and selling of contracts by establishing a hedging strategy is to carry out the transaction in the future market at present that will correspond with the what the person intends to do in the future date in the physical market (Scharfman, 2014). If a borrower is thinking of raising funds by selling off paper then it will sell the future contract today so that it will be able to cover up the interest risk disclosure when the same arises at the actual date.  The hedgers will close the transaction by buying the identical future contract when it will issue the paper. If in any case, an investor is planning to buy certain stock when it will be having surplus funds. but there is a concern over the increase in the prices of the stock in the meantime, in that situation, it will be beneficial to buy the future contract today.

1. b) The procedure involved in buying a future contract goes hereunder-

Brokers are mostly involved in buying and selling these future contracts and the person who wants to deal with the same will place an order to the broker.

Transaction in future contracts is mostly done by open objection on the exchange floor or on the electronic trading platform of the exchange (Vohra & Bagri, 2003). Most of the exchanges now use the electronic platform and match the prospective buyer and the seller on the basis of their demand.

The clearing house guarantees the transaction through payment of margin calls and novation, which is a process of replacing one party with another party. The entire price of future contracts is not sold, but only the margin calls on the basis of the same is deposited with the clearing houses.

The margin prices will be enough to cover the overall unfavourable movements in prices. It is essential for the clearing house to shut out the issue (Waring & Glendon, 1998). The clearing houses will mark the contract day to day basis.  Margin calls may be required to be paid by the broker and class may be made to the brokers to clear the dues as and when needed. They may be needed to pay extra over the initial deposit, if in any case the contract price has stimulated against the client and is causing loss to the broker.

1. c) In case of long position in case of a future contract, That in cases the prices of the contract falls, the broker will be exposed to margin calls and losses, he speculates that the prices will rise hence he gives long on the stock, that is he buys the stock (Ranganatham, 2011). I case of short position in the future contract the overall prices if rises, the broker will be exposed to margin class and losses, because he speculated that the price will fall, hence he enters into a contract to sell the future contracts.
2. d) The procedures for closing out these positions prior to delivery IS-

• By taking an opposite contrast the vast majority of open futures positions are closed out by the client
• There will be the occurrence of a long position if the underlying asset has been brought forward, that is, a buy futures contract. A party to a long position will close-out that open position by selling an additional futures contract with the similar product and date of expiry.
• A short position will arise when the underlying asset has been sold forward. The short position can be closed out by going long a futures contract with similar commodity and ending date.

The Procedure Involved in Buying a Future Contract

4) The barring management was hugely responsible for the overall downfall of the banking company. It was responsible for the downfall because it didn’t do its work properly, there was various loophole in its management (McRae, 1996). First and foremost, there was no proper segregation of duties. Management is responsible for assignment of duties and it fault o do so in the proper manner, it may lead to a lot of problem. Just in the case of Leeson, who was responsible for both the front office and the back office management? Nick was permitted to manage the work of both the front office and the back office. The internal auditor made recommendations to change such duties, but none of it was ever implemented by the management. The internal auditor report was presented before all the top management people. And thus there were aware of what was going on in the company. Yet till February 1995. No steps were taken by then management to implement all the recommendations that were made by these people. Most of the problem aroused because the management allowed Lesson to carry on with his unauthorised trading during the financial period.  As for Singapore itself, it was stated that the director of Barring Future Singapore, Simon Jones and didn’t take significant steps to reflect the changes that were recommended by the auditor and allowed all the fraudulent activities in the company (Gapper, 2011). Even though proper suggestion were made by the auditor, the management went ahead with dilution of the duties of Nick Lesson, who had the authority in signing cheques, making decisions, taking decisions and also managing accounts. The management placed too much resilience on the activities of Nick Lesson that ultimately led to its fall. There were no proper internal checks of his secret accounts and also no proper scrutiny of the transactions in which he entered, hence we can say that management was in responsible in more than many ways for the downfall of the company.

a) Risk management is concerned with identification, assortment and dilution of risk in any organisation and taking steps to reduce the same. The main goals of any organisation are to make sure that uncertainty is not affecting the company in any way. If there are chances of any kind of risk the management should take steps to reduce the same. Risk management will help the management in that process of elimination of risk from its prime activities (Walker, 2013).  There can be a risk because of many factors in any company, from the financial markets, threats from the failures of projects, legal liabilities, the risk of credit failures, natural disasters and other various accumulate often exposes an organisation to a risk. Thus the organisation needs to take steps so that the overall risk reduction takes place and uncertainty is reduced to the minimum level. It is important that the management helps in development of various strategies that will help in overall reduction of the level of risk. Though risk management is important and a fruitful method, however sometimes they are not as useful as they should have been. Hence it is widely criticised because it is not able to provide the required levels of result in any management (Moosa, 2007).  In ideal risk management strategy risks are prioritised on the amount of losses that can occur because of the same, and on the basis of that steps are taken to reduce the same.  The practice of overall risk assessment may be difficult because some of the risk might be hidden which the management might not be able to discover , in that case some losses cannot be avoided.

The Importance of Proper Management and Segregation of Duties in Preventing Financial Disasters

b)In any organisation the main responsibility of the management and identification of risk is with the management of the organisation, The board of directors are given the responsibility of formulation of risk and its agent, They are given the job of ascertaining specific risk averse are in the organisation  and discover the risk that can hamper the growth of the organisation and then take steps to solve them on the basis of strategies that they can develop by taking help of experts in the matter. In cases where it is not possible to discover the risk without proper scrutiny, they should appoint people like the auditors to audit their system and discover the risk unmake recommendations on how they can bring in changes in the same (Blacker & McConnell, 2015). They are responsible to not only form the policies but to see that the policies are properly implemented in the organisation and also check the results from the same. All the steps that the management take must be for the betterment of the organisation. They are the flag bearers of the company and should take reasonable steps in this regard, to bring out the requisite changes that will eventually help in making.

1. a) It is important that  requisite changes be brought by the company to identify the risk involved. If the management of the barring company had taken reasonable steps to decipher the level of risk involved and how they can reduce the same, the downfall of the company would not have occurred ever (Ferrell & Ferrell, 2009). It was important that when the auditors recommended changes in certain functions to reduce the risk, the management should have done the same. If Nick was not given that unadulterated power to rule the company and do whatever he wants, the downfall would not have ever occurred. So it was important on part of the management to take important steps in this regard so that overall risk may be reduced to very low levels.
2. b) A capital is very important part of any organisation. It provides the basis for the functioning of any organisation and provides a cushion to help it to recover from unexpected losses and various other adversities. it is important that the foreign investors hold enough amount of capital that will help the recovery from unexpected shock if there is any decrease in the value of their assets (Hirsh, 2010).

 c). In addition, the FDIC, which guarantee deposits, is anxious that enough capital is held so that their funds are protected, because they are responsible for paying insured depositors in case there is any failure on their part.

The First Pillar Deals With Maintenance Of Regulatory Capital Calculated For Three Major Components Of Risk That a Bank Faces: Credit Risk, Operational Risk, and market risk (Dahlen & van der Elst, 2010). Other risks are not considered material at this stage of recording.There are three ways in which the credit component can be calculated that are the standardised approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for “Internal Rating-Based Approach”.For the calculation of the operational risk also there are three methods mainly– basic indicator approach or BIA, standardised approach or STA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). VaR (value at risk) method is used in case of calculation of market risk. In the banking industry, the minimum capital requirement has been developed specifically for each bank based on their own demands and needs.

The second pillar provides better tools to the investors than the first pillar, It also provides a framework for dealing with the various types of risk that any organisation faces.It also helps in managing the risk management system of the banks (Meyendorff & Thakor, 2002). The outcome of the Internal Capital Adequacy Assessment Process (ICAAP) is that is the result of Pillar II of Basel II accords. This pillar aims to add to the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will let the market participant’s measure the capital adequacy of an organisation. The overall disclosures are to done twice a year in this respect.

d)Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (101, 2016). It was set up in 2004, to provide standardisation norms to the banking community for effective management of their risk and also provide them guard against the various kind of risk that might be involved.

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