The Crisis at Barings: Barings Ignored Early Warnings, Evidence Shows

This article was prepared by staff reporters Marcus Brauchli in Singapore, And Nicholas Bray and Michael Sesit in London 6 March 1995 The Asian Wall Street Journal (Copyright (c) 1995, Dow Jones & Company, Inc.)

Who knew what, and when did they know it?

It may take a long while before authorities can definitively explain Barings PLC's collapse under more than $1 billion in losses from futures and options trading. But, after the blame initially was put on 28-year-old derivatives trader Nicholas W. Leeson in Singapore, investigators are hinting at something more troubling: While Mr. Leeson took bigger risks than anyone imagined he would, Barings's executives may have known more than enough to prevent the financial debacle.

The way investigators now see it, the collapse of Barings wasn't the work of one man, but of an institution. "The group took a position and it took a loss," says Michael Lim of Price Waterhouse & Co., the accountants now administering Barings's Singapore operation that led to the venerable merchant bank's downfall. And losing so much money in a bad bet, as Mr. Leeson's futures-trading colleagues in Singapore are wont to say, may be tragic but isn't necessarily a crime.

"Nick was a hero for a long time," says Michael Hadley, a floor trader in Singapore. If he failed, Mr. Hadley says, it was because he "was given so many responsibilities; he watched the warehouse, the cash register, the whole thing."

What is emerging -- from documents and from interviews with current and former Barings executives -- is a fatally flawed organization: one that ignored at least several warning signs, going back not just weeks and months but years; one that so wanted to ensure the stream of profits from Singapore and the boost to bonuses that it was reluctant to impose tight controls; one that had a deeply split staff whose divisiveness ultimately may have contributed to its downfall. The very executives who "discovered" the huge bad trades on Mr. Leeson's books, in fact, ignored the many warning signals. "I would have thought it hard to believe that this will not go right to the top," comments the chief executive of a leading British company. Adds a former Barings executive, "The bank was devoured by the monster that they helped to create."

That doesn't mean Mr. Leeson is off the hook for the alleged forgery to hide possibly unauthorized trades, or for breach-of-trust charges that Singapore's government may bring against him. But his bosses likely will face tough questions, too. Already, one senior Barings executive -- James Bax, head of the group's non- Japan Asia business -- has had his passport seized by Singapore police, according to local newspapers. Authorities say they would like to talk to other senior Barings officials in London, though they didn't say who, and Britain's Serious Fraud Office is making inquiries.

Indeed, in their first public comments on Barings's collapse, Singaporean investigators and auditors on Saturday produced startling evidence of at least tacit management awareness of what Mr. Leeson was doing.

The evidence was a previously undisclosed Feb. 8 meeting at which Barings's treasurer and Asian finance director insisted that they not only knew the scale of the firm's exposure to the futures markets, but also promised regulators at the Singapore International Monetary Exchange, or Simex, that they could support it. At the time, Barings was sitting on staggering $20 billion in Japanese government bond and yen-denominated interest-rate futures, and $7 billion in futures based on the Tokyo Stock Exchange's Nikkei Stock Average.

When the Barings officials, responding to correspondence from Simex, met with Simex officials, they "assured (us) that Barings group was aware of its financial commitment . . . and additional credit would be arranged," says K. Shanmugan, a Simex lawyer. That remarkable Feb. 8 meeting with Barings Treasurer Anthony Hawes and Regional Finance Director Simon Dominic Jones, Mr. Shanmugan says, "indicates" that Barings's headquarters in London was aware of Mr. Leeson's trading activities.

Critics of Barings senior management contend that the Barings officials should have been alerted by the mounting margin sums needed to fund Mr. Leeson's snowballing futures and options trading activities. At a press conference in Singapore on Saturday, executives from accountants Price Waterhouse & Co., the court-appointed managers of Barings Futures, Singapore Pte., said that in January and February, Barings had transferred S$1.3 billion (US$897.2 million) to the futures subsidiary. The Price Waterhouse officials couldn't say how much of that had been paid to Simex for margin requirements. But early last week, the Singapore government said that in February, Barings paid S$128 million for margin calls.

Still, senior Barings executives in London contend that they were told by Mr. Leeson's superiors that although large, the trader's positions were effectively hedged by offsetting positions on the Osaka Securities Exchange.

In January, according to people familiar with Barings's management committee, two skeptical senior managers questioned Mr. Leeson's huge bets at a committee meeting. They were reassured, the people say, that Mr. Leeson's superiors knew what he was doing.

For their part, senior Barings executives contend they were hoodwinked by Mr. Leeson. While conceding that management and risk controls in Singapore should have been a lot tighter, they say they only later realized that they didn't really know what the firm's trading positions were because they weren't being told the truth.

No one disputes that Barings executives knew that Mr. Leeson's trading on the Simex began to balloon after the Jan. 16 Kobe earthquake. But senior Barings executives in London, who didn't want to be named, insist that they thought that Mr. Leeson hedged his bets, seeking profits by arbitraging the Nikkei Stock Average of major companies that trade on the Tokyo Stock Exchange. The matched, offsetting trades he was supposed to be making -- to exploit price differences in nearly identical contracts that trade on the Simex and the Osaka Securities Exchange -- shouldn't entail much risk.

But what Barings executives didn't realize, they claim, was that Mr. Leeson apparently hadn't matched all of his trades or was hiding other positions that put the firm at significant risk. At no time, other Barings insiders insist, had Mr. Leeson been given any mandate to take open speculative positions on behalf of Barings.

So, this explanation goes, when Messrs. Hawes and Jones met with Simex officials in early February to justify the firm's increased trading activities, they "felt the funding lines were against legitimate positions. The problem was that what Hawes thought didn't exist," says one Barings senior official. "Leeson had been hiding long positions."

Nonetheless, the executive doesn't believe that Mr. Leeson's activities went totally undetected. He contends that some people in the firm's Singapore back office had to suspect what was going on. "We certainly had concerns that we were having to put controls in place when the positions jumped up at the end of January," says a Barings executive. On either Jan. 25 or Jan. 26, "Leeson was told not to increase the size of his arbitrage position and to cut it where possible."

Barings's explanations are undercut, in part, by the fact that there were internal warnings about potential problems in Singapore. V.K. Rajah, a Price Waterhouse lawyer, on Saturday produced a letter written three years ago in which Mr. Bax, cautioned his colleagues in London against allowing Mr. Leeson to develop the futures operations in Singapore single-handedly, when the firm's own capital might be at risk.

"My concern is that once again, we are in danger of setting up a structure which will subsequently prove disastrous and with which we will succeed in losing either a lot of money or client goodwill or probably both," Mr. Bax wrote on March 25, 1992, to the head of Barings's equities department in London, Andrew Fraser. "In my view, it is critical that we should keep clear reporting lines, and if this office is involved in Simex at all, then Nick (Leeson) should report to" the head of the Singapore office's operations department, not London's derivatives department.

The revelation of the letter followed the disclosure last Thursday by The Wall Street Journal, later confirmed by London's Financial Times, that an internal audit last summer again warned that controls over Barings's Singapore office were lax. The report recommended that Mr. Leeson no longer be in charge of trading and settlement -- in effect, monitoring himself.

But changes weren't implemented, in part because of concerns about losing Mr. Leeson. "Without him," last summer's internal audit report noted, Barings's Singapore operation "would lack a trader with the right combination of experience of trading sizable lots, a detailed appreciation of the trading strategies, familiarity with local traders' limits and practices, and contacts among traders and officials."

The judgment of Barings's executives may have been clouded by Mr. Leeson's success, however. The small subsidiary Mr. Leeson managed -- Baring Futures Singapore Pte. Ltd. -- made $30 million in the first seven months of last year, according to the internal report. That compares with its profit of $1.6 million in 1992, the year Mr. Leeson arrived. Actual profits last year may have been even heftier, but booked to Barings's subsidiaries in London, Hong Kong and Tokyo.

Barings traditionally has paid out approximately 50% of its gross earnings as bonuses to its employees, and the 1994 bonus pot is estimated to have been around £100 million ($161 million). A number of directors would have got bonuses in the £1 million region, while Baring insiders say Mr. Leeson was in line for a bonus of several hundred thousand pounds -- approximately double what he had received the previous year. So highly regarded was Mr. Leeson that in January, he flew to New York to join Ron Baker, head of Barings's derivatives, and other Barings officials. Mr. Leeson was to become a member of an 18-member management committee for the global derivatives group.

The seeds of Barings's downfall, some believe, may have been sowed years ago. Like many people who had worked on the stockbroking side of the Barings group, Mr. Bax was worried three years ago that his franchise was being undermined by a rival team of managers at Baring Brothers & Co., the merchant banking side of the company.

At the time, it was. Baring Securities Ltd., the stockbroking side, was headed by Christopher Heath, a charismatic figure who had come to Barings in the early 1980s when it bought a brokerage he worked for. Mr. Heath soared on the crest of Japan's great financial boom of the late 1980s, riding an enormous wave of cheap capital to pre-eminence among foreign stockbrokers and the title one year of "Britain's most highly salaried man."

As the Nikkei average rose steadily higher until the end of 1989, Mr. Heath steered Barings into a lucrative new area: futures and options. Barings was among the top firms trading Japanese warrants -- a breed of option that allows its owner to buy stock for a set price before a certain date.

That era came crashing to a halt in 1990. A succession of interest-rate increases pierced the Tokyo bubble, share prices plunged, and Barings felt the pinch. It had been expanding its stockbroking operations into new markets in Europe and Latin America. With costs rising and cash flow from Japan shriveling, the securities firm lost money in 1992. At the time, friends of Mr. Heath say, he wanted to get fresh capital from outside, to support the kind of trading that -- ironically -- ultimately toppled the firm.

By selling a stake to a cash-rich investor, Mr. Heath hoped to steer Barings into so- called proprietary trading, in which a firm invests its own money instead of simply buying and selling investments for a fee on behalf of clients. "Where Christopher really fell out was when he wanted an outside partner," says a former Barings executive. "That's when they pounced."

Under Peter Norris, a Baring Brothers director who is now the company's chief executive, the group's management committee was restructured in October 1992. Baring Brothers alumni were put into positions where they could oversee the securities operations, which had been divided into four broad geographic areas -- and derivatives. In March 1993, Mr. Heath quit. Another Asian hand, Andrew Fraser, took over, but several of Mr. Heath's key loyalists -- many of whom were expert in Japanese futures and derivatives -- also departed.

Mr. Baker, an Australian, had been hired in early 1992 from Bankers Trust and given the task of building up a global fixed-income derivatives operation for Baring Brothers, based in London but with outposts in New York and Barings's Asian offices. Over the following 18 months, the derivatives-trading operation grew to around 150 people. With a view to imposing commercial discipline, he fixed strict trading limits for most of his traders, something that was never done, it turns out, for Mr. Leeson.

Tall and bearded, the Pavarotti-look alike Mr. Baker was something of a misfit, initially, in the staid banking halls of Barings. When he began importing other trader types like him into the bank, some longer-established colleagues were somewhat discomfited. Others, by contrast, welcomed what they perceived as "a breath of fresh air." From having been a traditional, somewhat hidebound English merchant bank, they saw Barings taking a track that brought power and riches to other institutions.

Whereas, traditionally, Barings had eschewed such risky activities as proprietary trading -- taking bets on markets using the bank's own money -- Mr. Baker began to do just that, albeit in a limited way, in some fixed-income markets. His aim was to establish Barings as a player in markets where it hitherto hadn't played any role at all, with a view to attracting clients.

About the time of these changes, Nick Leeson was setting up the settlements systems for Baring Futures in Singapore. He had been sent to the island republic in 1992, and he was apparently told he would report to the derivatives team in London. With support from his bosses in London, Mr. Leeson flourished in Singapore. He got a fifth-story, balconied $3,000-a-month apartment, with a swimming pool, not far from Orchard Road, the city's glitzy shopping boulevard. He worked at Barings' trading desk on the chaotic 11,000-square-foot trading floor of Simex, and kept a small Union Jack flag. He was often seen by friends in the business district, wearing his distinctive yellow-and-blue-striped Barings trading jacket. At night, he and his wife, Lisa, frequented Singapore's bars.

Mr. Leeson also grew rapidly in his job, adding sales and trading to his job as a settlements executive. Near the end of 1992, he went out one night to the Hard Rock Cafe with some futures brokers who had come to Singapore from New York. Though everyone was drinking and the music was loud, two other people who were there say Mr. Leeson spent much of the evening trying to win business for Barings. According to one Barings insider, Mr. Leeson eventually won the reputation of someone capable of "making the Simex market (for the Nikkei futures contract) move."

When Mr. Baker inherited Mr. Leeson's Nikkei-average arbitrage operation in 1994, however, people familiar with his operation say, he had no intention of embarking on proprietary trading in that area. Instead, with support from Mr. Norris, he instructed Mr. Leeson to continue building up what seemed to be a profitable arbitrage business.

Under the structure that was in place, Mr. Leeson was dealing mainly with other Barings offices, in London, Tokyo and Hong Kong, and reporting to the derivatives team London. Indeed, Singapore investigators this week said the local futures operation had only four clients -- the three Barings offices and Banque Nationale de Paris in Tokyo, a big futures player.

That meant that every virtually every trade Mr. Leeson did passed through the books of another Barings affiliate, though seldom through the Singapore office. For Mr. Leeson's positions to have gone unnoticed by others in Barings's derivatives operations, present and former Barings officials say, is near-impossible. The controls were almost standardized: In December 1992, the company's then- management committee decided to conduct regular reviews of all open positions in the Hong Kong futures market.

Since Mr. Leeson's clients were mainly other Barings arms, the group management in London should have been able to pick up on discrepancies among accounts. Barings in London received daily profit-and-loss accounts from every group. Included in those accounts were so-called error accounts, into which securities traders are supposed to put investments the company ends up holding for some reason. Every entry is supposed to be explained.

Some at Barings have accused Mr. Leeson of using his error accounts -- one bearing the number 88888 -- to stash away trades that he didn't want his superiors to know about. At the end of last year, according to the Financial Times, that account was so full of money-losing investments that it had an undisclosed loss of £50 million. But executives who have seen such accounts say they are almost always included in daily summaries. In what is perhaps a sign of the rifts within Barings, one former Barings official suggests that maybe the 88888 account was used to keep certain information away from Barings' Singapore office. This former Barings employee believes that Baring Futures ran two separate computer printouts each day, to disguise its true activities from some people within Barings group.

Still, in order for Mr. Leeson to keep those futures positions, he would have had to come up with additional margin money -- and that would have had to pass through Barings accounts. The flow of margin money is the sign investigators point to when they suggest that Barings managers in London knew what Mr. Leeson was doing. Often when the company has to come up with fresh margin money, it has to go to a bank. At least 15 Japanese banks had lent a total of 67.7 billion yen ($715 million) to Barings, much of it to cover margin calls on Japanese stock-index futures and options. Bankers in Singapore say they were told any loans were meant to cover increases in margin on securities that were hedged in other markets. Proof of such hedging usually came from Barings' head office in London.

How much support Nick Leeson felt he was getting from his bosses isn't known yet. But last week, before Mr. Leeson and his wife abruptly left Singapore on Thursday, his wife arranged to have a moving company give them an estimate on the cost of shipping their household belongings back to England.

According to Diane Massimiani, the moving agent, Mrs. Leeson said the couple planned to move to Kent. On Friday, after media around the world were reporting that the Leesons had fled, a friend of Mrs. Leeson called to say the couple had gone on holiday for the weekend, would be back on Tuesday and wanted all their belongings packed and shipped to England on Wednesday.

Dow Jones & Company, Inc.