Rogue Trading within Bank Industry about Nick Leeson - Research Paper Example

?Rogue Trading within Bank Industry about:(Nick Leeson) Contents Contents 2 Introduction 3 1.Aims and Objectives 3 2.Review of Literature 4 2 The Mechanism and Impact of Rogue Trading 4 3.The Case of Nick Leeson and Collapse of Barings Bank 5 4.Major Causes and Implications of Barings Bank Collapse 7 5.Initiatives by Regulating Authority against Rogue Trading 8 6.Research Methodology 10 7.Findings 10 8.Conclusion 11 9.Recommendations 11 Bibliography 12 1. Introduction Corporate scandals can be of different types and in any kind of corporate scandals generally top executive managements are involved due to personal gains and other biasness. Corporate scandal may include the offences like frauds, insider trading, manipulation of financial statement for misguiding stakeholders, excessive compensation to top executives etc. Among these rogue trading is also a kind of corporate scandal and hurt shareholders’ and investors’ interests (Tulder and Zwart, 2006, p.174-175). After the bankruptcy of Barings bank in 1995, the rogue trading has become a major issue for the entire corporate world and for the capital market efficiency. Since 1995 till date, there have been nearly eight to nine instances of big losses due to the rogue trading, and among this rogue trading in banking industry has been the most frequent one. The collapse of Barings Bank of UK in 1995 was due to Nick Leeson, who took an arbitrage position in Nikkei 225 future contracts and lost $1.4 billion whereas the bank’s capital was only around $600 million. This paper will present the case of Nick Leeson as to how he brought down one of UK’s oldest banks and the inefficient role played by regulators. 1.1. Aims and Objectives In order to conduct a focused research through discussion and analysis, a set of objectives have been determined considering area of this research topic. To discuss the bankruptcy of Barings Bank as a result of rogue trading by its employee Nick Leeson. To analyze the causes and implications of rogue trading in the light of Barings bank. To offers a set of plausible recommendations against rogue trading. The above stated objectives will be met by presenting relevant analysis of authenticated literatures, journals and previous related research papers. 2. Review of Literature 2.1 The Mechanism and Impact of Rogue Trading Corporate scandals can be of different types and in any kind of corporate scandals generally top executive managements are involved due to personal gains and other biasness. Corporate scandal may include the offences like frauds, insider trading, manipulation of financial statement for misguiding stakeholders, excessive compensation to top executives etc. Among these rogue trading is also a kind of corporate scandal which hurts investors’ interests (Tulder and Zwart, 2006, p.174-175). Generally, those traders who are authorized by corporate bodies as an employee indulge in such activities. The rogue trader acts as an independent trader in high risk environment. To make huge profits, such traders invest in risky financial instruments like derivatives. Here the potential of losing money is also high. Ethically responsible firms never allow such risky investments considering shareholders’ interest and business sustainability. Since the rogue trading case of Nick Leeson in 1995, there have been several instances of unethical and unauthorized trading that caused billions of losses to shareholders. The persons found to be engaged in rouge trading are charged with severe offences and have to face legal consequences (Butler, 2009, p.201). The rogue traders have taken the investments activities to the level of gambling where along with huge returns, risks are also too high. In most cases rogue traders keep doubling their bets in order to recover the previous losses without considering future consequences. The tricks doubling up the bets are quite common for them for camouflaging the previous losses with higher level of risk as by averaging down, they try to reduce the volatility. In a simpler term, when a rogue trader losses a bet, he or she try to recovering it in the second bet by doubling the amount of bet, and this process keeps going until the trader recovers all previous losses within one bet or the entire capacity of investments exhausts. However, the strategies for averaging down the previous losses are not illegal in investment activities. These strategies also help in reducing the volatility but for the limited period of time. This strategy requires intensive and complex mathematical calculation which often leads to confused investors (Rensselaer Polytechnic Institute, 2009, p.3). Financial services sectors are very crucial for any economy and hence, the regulatory authorities strive to maintain financial stability. The amount of losses due to rogue trading are huge usually in billions. When a corporate loses such significant amount, it may face bankruptcy. Trading activities are prominent in the financial institutions like banking sectors and the managements use the idle money that are invested or deposited by clients to generate revenue from investment activities. Therefore, when firms lose that money suddenly due to rogue trading, investors are hurt badly. Moreover, many prospective clients lose their faith in that particular organisation causing drastic business losses for long term. The negative impacts of rouge trading and other scams are not limited within the firm or a region of an economy but it affects the global business (British Retail Consortium, 2004, p.148). 3. The Case of Nick Leeson and Collapse of Barings Bank Barings bank, which was also known as Queen’s Bank as it was used by Queen Elizabeth II, was founded in 1762 by Sir Francis Baring and his brother and was considered the strongest bank in British history. Nick Leeson who was a working-class graduate joined Barings bank in 1989 and soon became an admired trader. He was sent to trade on SIMEX (Singapore International Monetary Exchange) from Barings’ Singapore office in 1992 where he made profits equivalent to 10% of the bank’s total profit in that year and was granted a huge bonus (BBC News, 1999). The bank’s senior officials trusted him a lot. He had the authority and responsibility to record the whole day’s trading activities in the back office. This work was supposed to be done by a different person. This meant that he could hide any losses he would have made. Till 1994, his profits had dwindled and he was desperate to make up for the piling losses. At the end of 1994, he took a long position in Nikkei 225 on Osaka Stock Exchange. Barings London assumed Nick Leeson would have taken corresponding short position of same notional value on SIMEX. One Osaka contract’s notional value was twice that of one SIMEX contract’s notional value, which meant that he had to take twice as large as short position for the long position. This, unfortunately, he did not do and instead took long position on SIMEX as well. He hid this position in an error account number 88888. In the beginning of 1995, an earthquake in Kobe, Japan led to the fall of Nikkei 225 which according to Nick was a temporary fall and he didn’t square off his position. The index dropped further accumulating Nick’s losses to $7 billion and he received a margin call for which Barings London had to deposit $835 million which was more than the bank’s capital. This finally made the Barings bankrupt and its shareholders lost $1 billion. Later the bank was bought by ABN Amro for ?1. Barings was imprisoned for 6.5 years in Singapore and by 2002, the creditors of the collapsed bank were still fighting lawsuit against Bank of England for its negligence as a regulator. The employees of Barings who failed to control the situation were either sacked or resigned. Nick Leeson was released in 1999 and wrote a book about his misadventure titled ‘Rogue Trader’ (Benhamou, 2011). 4. Major Causes and Implications of Barings Bank Collapse Corporate frauds may appear a doing of one person but its culpability is not limited the person himself but the management of the firm as well. The organizational culture of the Barings bank contributed to some extent to its failure. Before the collapse of Barings, the audit report notified that there is a concentration of powers in the bank with Nick Leeson doing both the activities-trading and settlement. Generally financial institutions delegate such operations to different departments to avoid fraud and insider trading. Moreover bank did not even closely supervise the activities of Leeson. The bank did not adequately investigate the request for transfer of large cash from the Asian exchanges. The board of directors of a company are entrusted with the responsibility of sound management and operations of the firm. The board of a bank has the responsibility to look into the risk management reports issued by senior risk managers and lookout for any unusual trading activities. In case of Barings bank, the senior management never bothered to enquire about the high percentage of profits (around 20%) generated by the branch’s arbitrage trading department. Mostly the rogue trading is a result of actions taken to cover up initial losses. Grange (2000) gave the reasons, that most of the trading losses incur as a result the following factors: trading with restricted or unapproved counter-party, trading in unapproved instruments, breach of authority, insufficient disclosure to investors, breach of investment guidelines given by the bank’s risk management team, management’s failure as supervisor, excessive borrowing, inadequate internal controls, model failure causing valuation and pricing risk and lack of suitability (Grange, 2000, p.330-338). According to the Bank of England, Barings’ senior officials did not have the understanding of the risks represented by the derivative instruments which Leeson traded. Leeson engaged in options strategies which he was not authorised to engage in, which in turn created the unlimited downside risk for the bank under certain market conditions. Unlike a stock investment where the loss is limited to one’s capital invested, some derivatives trading strategies involve much greater risks depending on the leverage of the instrument, trading structure, and market performance. Sometimes the risk is bound by the historical statistical relationships, if broken by unusual events, can amount to huge losses. In case of Leeson, the earthquake in Kobe did the same thing (Gerstein, 2007). 5. Initiatives by Regulating Authority against Rogue Trading The ill effects of rogue trading is not limited to any particular country but across the world. The biggest loss due to rogue trading amounted to nearly €4.9 billion, and behind this massive rogue trading, the Jerome Kerviel, a trader from the one of the giant French bank, Societe Generale was found responsible for this (The New York Times, 2008). Some other such case and their loss amount due to rogue trading are given below. Allied Irish Bank; loss-?697 million Daiwa Bank; loss- $1.1 billion National Australia Bank; loss-AU$360 million Groupe Caisse d'Epargne; loss-€751 million (Wearden, 2008; Thomson Reuters, 2011) Hence the regulatory bodies across the world have taken many steps in order to limit the rogue trading. The regulatory body of United Kingdom, Financial Service Authority have filed many cases against the persons who are suspected to be involved in any unauthorized trading. Financial Services Authority is also investigating on the institutions which are indirectly involved in rogue trading by not preventing the unauthorised and improper trade. It also imposes huge penalties on the organisations whose employees are found to be involved in rogue trading like in 2009 Financial services Authority found some of the employees of Swiss bank of London to be involved in improper trading and find the bank with 8 million pounds (Enrich, Bryan low and Munoz, 2011). In Australia there is an act called Fair Trading Act 1999 (Vic) which empowers the state to deal with the rogue trading activities. This act is aimed at ensuring fair trade practices as rogue trading is an improper method of trading therefore this act is also applicable to deal with the rogue trades. As per this act if any person is found to be involved in improper trading activities then that person would be penalised with financial penalties and can be made to compensate the damage suffered by the investors because of the improper trading (Consumer Affairs Victoria, 2006, p.13). In order to prohibit and identify the persons involved in rogue trading the consumer protection commission has also proposed to take a coordinated action with the European Union countries against the persons practicing improper and unauthorised trading practices by forming a regulation Authorities if national enforcement will work together (Europa, 2003, p.1). Apart from the mentioned steps taken by the different regulatory bodies many other steps have also been taken by different other regulatory bodies and government to ensure consumer protection from different improper trade practices. In UK the government has proposed to form a Trading Standard Policy Board who will scan the trading practices in the country and will identify the possible threats which may arise due to improper trading practices. Apart from this the financial markets will be monitored by the Competition and Market Authority who will be responsible to tackle the problems of structural problems (Department of Business Innovation and Skills, 2011, p.11). The Basel II guidelines issued by the Basel Committeefor banking supervision have led to significant improvements in the banks’ capital adequacy ratios and risk management because Basel II is based on three pillars – Minimum Capital Requirement. Supervisory Review Process Market Discipline (BIS, 2006, p.6). It is difficult to stop rogue trading as this type of trading though improper but attract a lot of profits like any other high risk bearing instrument and as the rogue traders are authorised employees of the organisation therefore it becomes difficult to identify and limit their activities. But the Basel committee guidelines have made sure that banks have adequate capital and are involved in voluntary supervisory review process so as to avoid Barings’ like collapse. 6. Research Methodology The validity of research depends on the proper selection of research methods. The research methodology should be determined as per the aims and objectives of the research. This research paper aims to analyze the rogue trading case of Nick Leeson and the other factors that caused the bankruptcy of Barings bank. This is a literature based research project and only secondary data has been gathered from various books, journals and websites. The journals and websites were most helpful in conducting the research for Nick Leeson and Barings bank. 7. Findings In the present paper, the bankruptcy of Barings Bank at the hands of Nick Leeson is analyzed using the news articles and relevant websites and found that the bank’s collapse cannot be attributed to a single person but a mix of operational weaknesses, lack of supervision by senior executives and regulators, and low levels of knowledge of the complex derivative instruments led to bankruptcy. Furthermore implications of such rogue trading incidents are also discussed and found to have affected the stakeholders’ confidence in the banking operations and internal risk management. 8. Conclusion Rogue trading at Barings’ involved high risk investment strategies which many times earned a high amount of profits but like any other high risk strategy this type of trading also exposed Leeson to high risk of incurring losses. The informality of Barings’ management approach and internal control systems led to its collapse which could have been avoided had the management of the bank paid more attention to the risk management than the profits they were getting out of such strategies. Similar reasons have been with other rogue trading cases. The efforts of the regulatory bodies and Basel regulations along with the recent financial crisis have made financial institutions and investors more cautious about trading in derivatives. 9. Recommendations In the above sections the incident of rogue trading by Nick Leeson and subsequent collapse of Barings bank has been discussed. Many companies, stakeholders, investors and the financial markets in general have suffered huge losses due to rogue trading. The regulatory bodies and the governments have initiated many actions to prohibit this type of improper trading. The regulatory bodies of different countries should take strict actions like increasing the punishment of the perpetrators in view of Nick Leeson’s short term sentence considering the level of crime. Moreover, banking industry should be regulated strictly allowing limited exposure to risky derivatives trading. This is due to the fact that even after twelve years of the bankruptcy of Barings bank, the banking industry did not learn to be cautious and the proof of this is the collapse of American bank Bear Stearns in 2007 and Lehman Brothers in 2008, where both were involved in heavy trading of leveraged derivatives strategies (Mason, 2009, p.5). Bibliography BBC News. (1999). How Leeson broke the bank. [Online]. Available at: http://news.bbc.co.uk/2/hi/business/375259.stm. [Accessed on November 01, 2011]. Benhamou, E. (2011). Barings Bank (Risk Management Disaster). [Pdf]. Available at: http://www.ericbenhamou.net/documents/Encyclo/Barings%20bank.pdf. [Accessed on November 01, 2011]. 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