Corporate Governance Failures - Barings Bank - Case Study Example

Corporate Governance xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Instructor xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Introduction Corporate governance forms an integral part of an organization. Rules, codes, norms and regulations of corporate governance are vital devices that are geared towards successful market economies. Corporate governance can be defined as a set of mechanisms that are used by organization that have been organized into a limited liability corporation and are properly directed and controlled. Corporate managers are held accountable for the performance and conduct of their corporations through corporate governance. According to Aguilera and Cuervo-Cazurra (2004), use of corporate governance has tremendously increased in the recent years after the realization that it plays major part in economies more so in capital markets. In other words, corporate governance is the way in which financiers of corporate organizations ensure returns from their investments. In addition, owners of the company (capital suppliers), can make critical decisions concerning the company based on corporate governance of managers. Mechanisms of corporate governance can either be market-based or institutional (Dine 2000). Monks and Minow (201)1 posits that European Union and its member states have adapted this concept following increased global competition, privatization of government enterprises, advanced technology and increasing mergers and acquisitions of European corporations. The purpose of this paper is to critically evaluate the concept of corporate governance making special reference to the case of Barings Bank. It worth noting that corporate governance is a sensitive issue that should be handled with care in an organization. The report will examine the corporate history and corporate governance development of Barings bank. It will further discuss the major corporate governance failures that caused the downfall of the company. The report further looks at some of the lessons that other companies could learn from Barings and finally provides recommendations for good corporate governance. Company history and corporate governance development at Barings Barings Bank is the oldest merchant bank in London. It was founded in 1762 by Sir francis Baring as one of his companies under the name ‘John and Francis Company’. Later on in 1806, Francis son, Alexander Baring joined the company as one of its directors and it was renamed to Barings Brother & Co. since 1806, the bank has participated in major activities such as s funding of the Louisiana Purchase and the Napoleon’s war (Brown 2005). In 1890, the company suffered significant loss in investments and ultimately bankruptcy during the Argentinean revolution. However, the firm was not hard hit since it had been bailed out to other London Banks such as Bank of England. After this incident, the company forcefully engaged in traditional merchant banking and in rejuvenating its corporate finance image and in strong management investments. In actual fact, it served one of the most powerful clients in the land during the time, The Royal Family (Colley 2003). In 1984, the company acquired Henderson Crosthwaite, a small stock broking company that had branches in London, Tokyo and Hong Kong. Baring Brothers and company later on established the Baring Security Limited (BSL) that was separately managed but still within the group of companies. Denis and McConnell (2001), state that corporate finance within Barings began towards the end of the nineteenth century when operations for domestic companies commenced. During this time, the world wars caused the government to bar foreign investors from undertaking operation in the country. Business within the British boundaries therefore became paramount. Corporate finance took centre stage and it was aimed at funding institutions and management. The bank was divided into three principle divisions. The Asia market seemed to be picking very well earning the company significant input and for this reason the board decided to incorporate Baring Futures in Singapore that was immediately granted membership by the Singapore International Monetary Exchange Ltd (SIMEX). In 1992, Barings board of directors decided to send Nick Leeson to the Singapore subsidiary since as the general manager since he was quite good in the financial fraternity. The mission of the company was to bit all its competitors and become the best in Singapore. Leeson traded on behalf of the company in London, Singapore and Japan and was assigned six main financial futures (Porta et al 2000). Around 1993, the arbitrage business in Barings Far Eastern branches was beginning to bear much fruits. At this point, Leeson took advantage of the situations by buying contracts at a cheaper price and selling them out at higher price thus benefiting from the small differences. He was able to keep his affairs concealed since he was in charge of both office functions and trading. Besides this, the senior manager of the bank came from a merchant background and had little knowledge concerning trading. Profits from the Asian subsidiaries were tremendously increasing which blindfolded the board to think that Leeson’s performance was incredibly unmatched. Leeson’s unauthorized activities were unraveled in 1995 during the earthquake which saw it suffer huge losses. In less than a year, the company had lost all its money and gone bankrupt. In February 27, Nikkel 225 dropped by 5% when international markets were re-opened. At the same time London Stock Exchange Index (FTSE 100) lost about 12.4 in the international market rating. The market damages however were not as critical as per the expectations. This small difference resulted from the fact that Baring was still a young player in the international banking as compared to other huge Swiss and American banking. Barings’ capital resources in assets amounted to £ 5.9 billion and liquidated capital of £ 354 million was quite small unlike other international banks that operated billions such as Barclays. The bank was purchased by the Dutch Bank ING at a sum of £ 1 (Edwards 2004). Reasons of the collapse of Barings Bank There was lack of internal balances and checks. Though the internal audit had suggested segregation of duties in the bank, power concentration still remained in the hands of Leeson. He did not delegate the most of the sensitive work to the employee who were in charge of the bank’s finance. Poor understanding of the business If the bank top management and auditors had proper understanding of the trade business, they could have realized that it was very impossible for Nick to make profit s that he reported without calling for undue risks. They could have also questioned the source of the money. Of concern is the fact that arbitrage is a low risk and results to low profit business. Therefore, the large profits could have raised an alarm instead of praise. In addition, given the fact that arbitrage is meant to be cash-rich or cash-neutral; more alarms should basically go off because Barings bank did wire millions of money to Singapore. Supervision of employees Leeson is said to have no trading license as he was arriving in Singapore. Indeed, to add fuel to the situation is the fact that he little was known of his activities and no also the fact that no individual had directed responsible of checking his trading strategies. The plan that he was strategizing and carrying out could have been understood and reactions could have been seen from the top management (Prentice 2002). Reporting line The fraud committed by Leeson may have been as a result of confusion in the reporting line. One of the reporting lines was for London for trading in proprietor and the other for Tokyo that was meant to trade on behalf of the customers. Problems and Consequences The Barings and Swiss bank faced problems that are related to failures in corporate governance. Of important to note is that these problems are not only face by the two banks, but are common in the corporate bank world (Sinclairet al 2003). The problems are as a result of poor management, poor supervision and regulations, poor corporate governance and poor liability and assets management. One of the problems faced by the banks due to its activities in Singapore is the capability to fund the required cash for those positions that saw the bank plunge under (Lemke 2002). Management of liquidity risks have it that the management must have adequate strategic plans to meet and fund unforeseen liquidity requirements. This led to the Barings Bank to incur losses that rose during the settling of the above transactions (Ledgerwood &Idol 2000). Capital shortage was another problem that was face by both banks. During its collapse, it had capital of nearly $600 million. This is was as a result of poor internal control and poor corporate governance in Barings Bank. This affected the lending rate and running of other financial institutions. This was also felt by the shareholders and the exchange market. The bank lacked the cash payment to the exchanges. Another problem evident is the huge liabilities that totaled up to $1.4 billion which was definitely more than reserves and entire capital of the British institutions (BIS 2002). The London Stock Exchange Index did also loss 12, 4 points the same month that the bank was declared bankrupt. However, it is important to note that this small slope was caused by the fact that Baring was a much tiny player in the world banking system as compared to Swiss and American banks (Hughes & MacDonald 2002). One of the consequences of the collapse of Barings Bank is the selling of insurance policy that covered banks for rouge trader risk. This was done by an insurance company in London that provided cover for a loss in trading which could be as a result of concealment by a trader or may be as a result of records that were false. This cover was up to $ 300m extended to various commitments that included permitted limits, trading that involved unauthorized instruments and unapproved counterparties. For the banks to qualify for this cover they had to have the necessary internal control in the right place (Shibut & Curry 2000). Lesson Learned from Corporate Governance failures within Barings Bank It is quite evidence that the collapse of Barings Bank brought up two official inquires where several important lessons were learnt. These lesson where learnt from various revelations about the courses of the problems and events especially those that revolved around corporate governance. Coming up with comprehensive lesson learned as well as building up of recommendation in relation to these lessons is very essential in ensuring that substantial understanding of what exactly took places and where such occurrences can be secured in future. According to CBCnews (2011), the Barings incident provides a clear insight on the importance of an effective risk management normally posed by operations within banks. Evidently, either the baring management disregarded or did not understand the concept created in the allocation of resources proportionately with risk largely posed by the various business activities carried out within banks (CBCnews 2011). Zaheer (2002) maintains that, there are two key principal lessons that are largely drawn from the following factors in relation to corporate governance failures in Baring Banks in relation to the recent UBS situations. These factors are; Regulators either within or outside organizations must not at any given time permit excessive growth in markets that are unfamiliar or even permit methods of settlement so as to be out of control There is need for financial institutions to realize the importance of internal controls (Zaheer 2002). It is quite evident that although Nick Leeson dual role was constantly noted, regulator most particularly Bank of England were largely concern with various capital margin issues. Tschoegl (2002) maintains that, from reports submitted in relation to the collapse of Barings Bank, it is quite evident that managers were mainly concern with the creation of a financially consolidated structure for the designed group whereby independent consolidation largely caused considerable difficulties for the said regulators. Lesson learned from this is that if there is a sufficiently strong linkage between an institution that is authorized and one of its subsidiaries, a bank can at any time permit the subsidiary is treated as a division within the institution which in turn can be included in that particular institution unconsolidated prudential returns usually filed with the bank (Tschoegl 2002). Further, it is notable that the emphasis on the need for internal control is the central lesson learnt from corporate governance failures within Barings Bank. According to Tschoegl (1995), this emphasis on this lesson largely needs financial institutions to monitor their internal systems of control as opposed to collecting objective factors which was widely overlooked by Barings bank such as capital adequacy (Lyons1998). Evidently, no collection of designated objective financial information can ensure there is effective control of a parent by a certain subsidiary exists. Further, this data cannot iron out the hostility that may exist between the individual who caused failure of the system especially in the reporting and controlling the Baring Bank group (Kaplan and Strömberg 2003). Although most manager would deny that the collection of data which largely plays a part in indicating to institution such as Barings Banks what is the acceptable and definable capital ratio that normally speeds up such designed indicators can largely be undermined. According to Kaplan and Strömberg (2003), undermining largely focus where adequate internal control lacks as it was experienced in Barings Bank. The final lesson learnt was in relation to having a clear understanding of the business. Ammer and Brunner (1997) maintain that, through a clear understanding of Barings Bank would not have enabled Leeson to make huge profits without thinking of undue risk. This would have resulted to other individuals questioning where all that money from profits was coming from. Evidently, understanding of the bank operation would have inspired alarm based on Leeson profits as opposed to praise. Given that arbitrage should either be cash-rich or cash-neutral, additional alarms should largely have gone off as the bank wired huge amount of money to Singapore (Ammer and Brunner 1997). Recommendations It is very important that recommendations in regard to the corporate governance failures within Baring Bank in relation to the recent UBS situations. These recommendations are helpful in ensuring that these failures are not repeated by any other financial institutions (Kaplan and Strömberg 2003). It is very important for organizations to largely segregate duties. Segregation of duties is important since it ensure that integrity and accuracy of information is maintained. Lack of proper segregation of duties is known to amplify risks. It is therefore important for organization to segregate duties in relation to job description of each particular individual. According to Hogan (1997), there is need to ensure that organization engage in the development of internal control and risks management. It is further important that organizational systems respect the time used in testing fundamental necessity so as to come up with an effective internal control as well as a risk management. Failure by organization to do so may result to heighten risks for irregularities (Hogan 1997). After successful implementing an internal control system, it is important to develop a mechanism that will assists in assessing and monitoring of the control system effectiveness (Ammer and Brunner 1997). It is important for organizations to set up the right tones right from the top management to junior employees. This indicates that senior managers and board members need to encourage a culture of responsible risk taking as well as culture of compliance. These two policies should widely be communicated to employees so as to ensure that an environment of accountability and integrity is created (Ammer and Brunner 1997). Ammer and Brunner (1997) maintain that, creating effective risk management architecture is very crucial. It is important that organization understand that risk management practice and structure can rapidly transform market risk exposures into definable significant economic losses of a company therefore there is need to develop an effective risk management structure and practice (Latham 1998). Conclusion The problem, reasons and lesson learn from this discussion in relation to corporate governance failures within Barings Banks in relation to recent UBS situation need to be understood by organization to avoid the repeat of the outlines failures. Within financial institutions or banks, it is important that all major risk in any undertaken business activity be identified and widely asses in a more consistent and proactive manner. Had Baring Bank senior management implemented the recommendation issued in this discussion, the bank would have been in a better situation in dealing with the recent UBS situation. It is important to properly embed an organizational culture since organizational culture is known to largely influence how business is carried out and also as a way of ensuring that an organization is able to enjoy a long term viability of a given entity. References Aguilera, R. and Cuervo-Cazurra, A. 2004. Code of good governance worldwide: What is the tigger?. Organization studies, volume 25, number 3, p. 415-443. Ammer, J and Brunner, A. 1997. Are banks market timers or market makers? Explaining foreign exchange trading profits”, Journal of International Financial Markets, Institutions & Money 7:43-60. BIS, 2002. ‘Supervisory Guidance on Dealing with Weak Banks’ Basel committee paper no 88, March Brown, D. 2005. Making sense out of the collapse of Baring Bank. Human relations, volume 58, Issue12, p. 1579-1604. CBCnews. 2011. UBS case latest failure of risk management. Retrieved on 18th January 2012 from http://www.cbc.ca/fp/story/2011/09/16/5411355.html Colley, J. 2003. Corporate governance. New York: McGrawhill Education. Denis, K. and McConnell, J. 2001. "International Corporate Governance". Purdue CIBER Working Papers. Paper 17. http://docs.lib.purdue.edu/ciberwp/17. Dine, J. 2000. The governance of corporate groups. Cambridge: Cambridge university press. Edwards, H. 2004. Barings-A case study in risk management and internal controls. The risk and regulatory forum. Hogan, W. 1997. Corporate Governance: Lessons from Barings”. ABACUS 33 (1):26-48. Hughes, J, MacDonald, S, 2002, International Banking, New York: Prentice Hall. Kaplan, S. and Strömberg, P. 2003, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts”, Review of Economic Studies 70 (2):281-315. Koford, K. and A. Tschoegl. 1999. Problems of Bank Lending in Bulgaria: Information Asymmetry and Institutional Learning”, MOCT-MOST: Economic Policy in Transitional Economies 9 (2):123-152. Latham, M. 1998. Corporate Monitoring: New Shareholder Power Tool”, Financial Analysts Journal 54 (5):9-15. Ledgerwood, G, Idol, B, 2000. Environment Ethics and the Corporation, Houndsmills: Macmillan Lemke, T, 2002. Allfirst cites Trading Fraud; Says Fired employee Lost $ 750 Million in Past Year. The Washington Times, 7. Lyons, R.1998. Profits to Position Control: A week of FX Dealing”, Journal of International Money and Finance 17 (1):97-115. Monks, R. and Minow, N. 2011. Corporate governance. Chichester: Wiley. Porta, R., Lopez-de_Silanes, F. and Shleifer, A. 2000. Investors protection and corporate governance. Journal of financial economics, volume 58, issues 1-2, p. 3-27. Prentice, R, 2002. Whither Securities Regulation? Some Behavioral Observations regarding Proposals for Its Future. Duke Law Journal, 51(5), Shibut, l, Curry, T, 2000. ‘Cost of the S&L Crisis’, FDIC Banking Review Sinclair, P, Reidhill, J, Hoggarth, G. 2003. ‘Resolution of Banking Crises; A Review’, Financial Stability Review. Tschoegl, A.1995. Comment”, in Corporate Decision Making in Canada, Daniels, R.J.; Morck, R. (eds.) Calgary: Univ. of Calgary. Tschoegl, A.2002.FDI and Internationalization: Evidence from US Subsidiaries of Foreign Banks”, Journal of International Business Studies 33 (4): 805-815. Zaheer, S.2002. „Acceptable Risk: A Study of Global Currency Trading Rooms in the US and Japan”, in Zenios, S.; Harker, P. (eds.), The Performance of Financial Institutions, Cambridge: Cambridge University, Ch. 15:462-495. Read More