How Individual Firms Can Prevent A Leeson Incident From Happening To Them - Research Paper Example

?Introduction Rogue traders are traders who make un ized transactions. In the pantheon of rogue traders, perhaps none is more famous then Nick Leeson, who single-handedly brought down the esteemed Barings Bank (Hawkes & Wearden, 2011). Leeson was brought into Barings Bank with a dearth of qualifications, but apparently a good deal of charm, for he was well-liked by the Barings’ management. This proved to be the esteemed bank’s undoing, for, because it liked Leeson so much, put Leeson in charge of both the trading end and the settlement end, which was a catastrophic decision, considering that the settlement end’s job is to check the trading end. Leeson’s double role enabled him to cover up losses and hide them from Barings’ management. Then, like a desperate gambler at the roulette table, Leeson tried to make up his losses with ever-riskier trades, until finally the bottom fell out and Barings was bankrupt because of his actions. The aim of this paper is to examine in more detail why the Leeson affair occurred. Another aim is ascertain the best way that firms can prevent another catastrophe like the Leeson affair from happening, by examining specific, concrete steps that firms may take to prevent such a thing from occurring to them. Lastly, this paper aims to examine how the United Kingdom changed its laws in response to the scandal, by examining the new regulations that have come about to address the Leeson affair. The objective of this paper is to advise firms about how to prevent a Leeson catastrophe from happening to them by showing exactly why the Leeson affair occurred, and the steps that may be taken to remedy it. By this research, firms may be able to take the steps necessary to prevent this from happening to them, and this is the objective of this project. Literature Review The collapse of Baring Bank was primarily due to one rogue trader, named Nick Leeson, who was making fraudulent transactions (Brown, 2005, p. 1591). Leeson occupied a great deal of power in Barings Limited, as he was both the Chief Trader and Head of Settlements, which means that he could make any trades he wanted without any oversight – the fox was in charge of the chicken coop, so to speak. What this essentially meant was that Leeson was able to cover up losses and report them as gains, because, as Head of Settlements, which was in charge of reporting trading losses and errors, he was able to be dishonest in this way (Simkins & Ramirez, 2008, p. 575). This was brought to the attention of the auditors, which stated that this set-up provided great risk, but Barings did nothing to rectify it. In the end, it was this lack of governance that proved to be the undoing of the firm, as Leeson single-handedly brought the bank down (Drennan, 2004, p. 261). The Cause of the Leeson Affair The Leeson affair was caused by a number of different factors. First, according to Hoch & Kunreuther (2001), bad decisions played a large part in fomenting the conditions under which the scandal occurred. One of the bad decisions was on the part of the managers, who looked the other way regarding Leeson because their emotions got in the way. The managers liked Leeson, as he initially was successful in trading, and the emotion of greed got in the way of closely scrutinizing him. Moreover, Leeson had very little experience in trading, and he had some personal bad debt that was not disclosed in his application for a trading license. All of these should have been red flags, however, they were overlooked by the individuals in the hiring process and by the managers who could have prevented Leeson’s reckless trading, simply because Leeson was liked (Hoch & Kunreuther, 2001, p. 6) Hoch & Kunreuther (2001) also state that there were other reasons why there were so many bad decisions that were made in the Leeson case. One of these is that the company relied too much on intuition. Another is that they were in too much of a rush – they felt that they must capitalize on the Far East market as quickly as possible, without implementing the appropriate controls. The managers were also too trusting, as they did not suspect deception from Leeson, therefore they did not look for evidence that Leeson was deceiving them. The fact that Leeson worked both in settlement at the Jakarta branch and worked as a floor manager for Barings at the Singapore International Money Exchange (SIMEX) was another problem, as the trader is supposed to make money, while the settlement person is supposed to catch trader’s mistakes. Since Leeson was both the trader and the settlement person, he was able to make mistakes and hide them. The fact that Barings did not avail themselves of technological advances which would helped them in the area of risk management is another factor, as is the lack of regulation by the UK government (Hoch & Kunreuther, 2001, pp. 6-7). Giddens (1999) adds to this analysis. He states that the Leeson affair occurred because Leeson was working with a complex system that he did not fully understand, due to the ever-changing nature of our global economy. Leeson was, essentially, like an astronaut, according to Giddens, in that he was working outside the realm of bankers and financial experts, and was doing so without a lifeline. The other possibility entertained by Giddens is that the Leeson scandal was caused by the fact that Barings Bank at the time was controlled by upper-crust managers who did not truly understand the dynamics of the changing global market (Giddens, 1999, p. 2). In other words, neither Leeson nor the managers at Barings truly appreciated the fact that global markets constantly change, nor did they understand the implications of this. Hollnagel et al. (2006) is in accord with this analysis, stating that he management of Barings did not understand the securities business and derivative trading, thus were not able to properly manage Leeson’s behaviour. This lack of understanding led to a lack of management strategy and controls, and it led them to approve excessive margin calls, and also to fail separate sales and reconciliation, as well to fail to request critical data (Hollnagel et al. 2006). How Individual Firms Can Prevent A Leeson Incident From Happening To Them Holton (1996) has identified ways that firms can prevent a scandal such as the Leeson scandal from happening to them. One of the ways a firm can do this is to assess its culture, and make sure that its culture is not conducive to allowing such scandals to occur. The culture of an organization has an impact on how well risk-management systems work, and it impacts individual decision-making as well. For instance, a potential whistle-blower may keep his or her mouth shut if the culture of the organization is such that he or she would risk losing his or her job for blowing the whistle; a manager may decide not to address employee fraud for fear of alienating colleagues (Holton, 1996, p. 4). Therefore, the overall culture of the organization must be geared towards making sure that people who address risks are not alienated or fired. Greener (2006) sees the organizational culture of Barings as one of the major reasons for the Leeson debacle. This was because Leeson did his dealings in the presence of people who looked the other way for one reason or another. Perhaps it was because of the fear of losing their jobs, or the fear of not getting bonuses. Sometimes it was an issue of loyalty. Other times it was an issue of Leeson essentially bribing the young females who worked for him, and these women also covered up Leeson’s deeds because of the patriarchal culture of Singapore. Whatever the motivation, Leeson’s deeds went unnoticed and unpunished because of the culture in which he worked (Greener, 2006, p. 430). Holton (1996) also offers specific ways that organizations can change their cultures to manage risk taking better. One is making individuals make decisions, as opposed to groups. The reason for this is simple – a group might make riskier decisions because no one person is accountable. An individual, however, will have his or her reputation on the line, so will be less likely to make foolish risks. Furthermore, individuals must be encouraged to question procedures, and must be willing to admit when they do not know the answer to something (Holton, 1996, pp. 4-5). Another important step, according to Holton (1996) is the risk analysis step. This is where a firm takes stock of the amount of risk that they are taking, and they look at this prospectively, as opposed to respectively. They can use such statistical analysis of risk measurement as the value at risk measure for market risk, and the expected exposure or maximum exposure measure for measuring the risk caused by credit exposure. The value at risk measure tells the firm how much risk they are taking at the present time, taking into account market volatility, thus capturing hedging and diversification efforts; credit exposure risk assessments work much the same (Holton, 1996, p. 11). Jorion (2002) states that value at risk measures are valuable, as they are able to assess the effects of leverage, diversification and the probabilities of adverse price movement in a single dollar amount (Jorion, 2002, p. 911). Sundstrom & Hollnagel (2004) have specifically identified ways that Barings could have prevented the Leeson affair from occurring. One of the ways that they could have prevented it was to properly define their systems goals, which means that the firm should have defined the level of risk that it was willing to take. They also should have defined the variables that would have taken the level of risk from healthy to unhealthy, and monitored these variables. In particular, the variables related to operational risk – people, processes and systems – should have been defined and monitored (Sundstrom & Hollnagel, 2004). The UK Government’s Response to the Scandal After the scandal with the Barings Bank, the U.K. implemented different oversight regulations. One of the changes was a reworking of the regulatory framework (Fearnley & Beattie, 2004, p. 118). Lax auditing procedures was one of the major causes of the Barings debacle, so, in response to this, UK set up the Coordinating Group on Auditing and Accounting Issues (CGAA). The CGAA’s focus is on financial reporting, auditing, corporate governance, as well as the structure of auditing and accounting oversight. Auditor independence was another facet of the CGAA, which means that the auditor must not have a conflict of interest in the firms with which they deal (Fearnley& Beattie, 2004, p. 127). A lack of oversight by the Board of Directors was another reason for the Barings scandal, so the UK changed the functions of the Board of Directors and made legislation to hold the Boards more accountable (Gillespie & Zweig, 2010, p. 4; Roles and Responsibilities of Directors and Boards). Board oversight of firm activities is a crucial part of the oversight process. However, according to Gillespie & Zweig, Boards often are lax with their oversight and negligent because they are beholden to the CEO who hired them, and they are reluctant to make bold moves or give bold advice for fear of running afoul of the CEO (Gillespie & Zweig, 2010, p. 5). Because of this problem, the UK set up principles which oversee Board of Directors through regulations. The UK Corporate Governance Code is the regulatory framework for the Boards of Directors, and the major principle is that, in a nutshell, the Boards must take their jobs seriously. Furthermore, the Chairman of the Board must be a different person from the CEO. Boards must also make sure that the people on the Boards have different skills, experience and knowledge, so that the Boards are diverse and balanced in this regard. There are other changes as well, including the requirement for re-election of Board members. Boards must also make their procedures transparent to the public and shareholders, with whom they must now keep a dialogue. Included in this transparency is the requirement that Board issue an annual report that details how the performance evaluation of the Board was conducted, and how the Board conducted their responsibility in the preparation of annual reports and accounts. Risk management is another area that has been affected by the new rules, in that Boards must now maintain sound risk management (UK Corporate Governance Code). These are just some of the principles that have been established to make the boards accountable to their shareholders, and force them to take their positions seriously, as opposed to being the happy gladhanders with no responsibility that they used to be. Methodology The research method that was used was secondary data. Secondary data is, in a nutshell, data that has been collected by others. It can be in the form of government and regulatory reports, company reports, published academic research, and internal documents produced by organizations, just to name a few. (Harris, 2001). It can be distinguished from primary data, in that primary data would be data that I, as the researcher, would collect myself. The advantages of using secondary data is that it is readily available, and generally has a low cost. (Hopperth, 2005). Conversely, collecting primary data is often prohibitively expensive. (Brown & Semradek, 1992). Primary data can take years to compile; secondary data, a matter of months. (Hopperth, 2005). Also, there is the issue of sample size – secondary research is often compiled by a government agency, with well-documented collection procedures and well-maintained data files. The information that is compiled is often comprehensive – everything from information on births, deaths, employment, income, etc. to specialized information, such as information about participant's attitudes, beliefs, and related family issues. (Hopperth, 2005). Findings Perhaps the major flaw that Barings committed was putting Leeson in charge of the trading and the settlement, despite the warnings from risk management that this kind of set-up was a disaster in the making. Therefore, the simplest thing that a firm can do is to make sure that one person does not have this kind of power, for it gives that person incentive to hide losses, which is exactly what happened in the Leeson affair. Beyond this, Barings also was at fault because the managers did not really understand the complexity of what they were dealing with, in that they did not understand the dynamics of the ever-changing global market. Again, this seems to be a rather self-evident problem with a self-evident solution – make sure that managers are hired who are experts in the global market and understand the dynamics and nuances, and then something like the Leeson affair will be prevented. Firms also need to make sure that their corporate governance procedures are put into place and followed, and that the culture is conducive to an atmosphere where individuals in the firm can look out for a rogue trader and report him as soon as possible. Better procedures involving the assessment and monitoring of risk are also paramount. Leeson certainly was not alone in playing financial roulette, as the current recession, which was caused by Wall Street playing risky games that lost, can attest. However, with the proper procedures, oversight and governance, future scandals can be alleviated if not prevented. Conclusion Firms must use better risk management to ensure that they do not fall victim to a Nick Leeson. They also must make sure that an individual does not have the power that Leeson had. 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