Corporate Governance

Barings Bank
Failure of Internal Controls
Case Analysis

GROUP 8
 ABHISHEK CHAINANI (1914015)
 DIPTA GHOSH (1914024)
 NEELABH MAYAND (1914044)
 VISHAKHA PANT (1914056)
 JANUPRIYA SUNDARARAJU (1914068)
History of Barings Bank

Baring bank was founded in 1762 by Francis Baring. The 233-year-old bank was a United
Kingdom institution with worldwide reach. The bank was involved in many major events
such as Purchase of Louisiana state by the US from France in 1803 and the liquidation of US
assets during World War II in 1940 by the British Govt. Baring Futures (Singapore) (BFS)
was incorporated in Singapore on 17 September 1986. Baring bank, once also known as
‘Queen’s Bank’, collapsed in 1995 after suffering huge losses, resulting from fraudulent
investments conducted by its employee Nick Leeson. Dutch bank ING acquired Barings
Bank.

Nicholas William "Nick" Leeson and his growth in Barings Bank

 1989 – Nick joins Barings bank in the settlement department after a brief stint in Morgan
Stanley.

 1990 – Nick was sent to Barings securities, Jakarta Indonesia Office to sort out settlement
issues.

 1991 – Nick returns to London. As Nick was able to solve the complex settlement issues
in Jakarta, Barings London management started regarding Nick as settlement expert in
Futures and options.

 1992 – Nick applied for SFA license to trade securities. Nick lied in the application. SFA
denied the license because of an outstanding judgment against him.

 1992 – Nick was moved to Singapore as Head of the SIMEX trading operations. Nick
was in charge of both the ‘front office’ and ‘back office’ for Barings Singapore
Operations.

 1992 – Nick was granted a SIMEX trading License.

Error Account 88888

 Error Account 88888 was created to write off trivial errors but the practice later shifted to
Error Account 99905 and Error Account 88888 remained dormant.
 1st fraudulent use of Error Account 88888 was done on 17th July 1992 to hide an amount
of £20,000 in order to protect a subordinate.
 After Nick got his SIMEX trading license, he started trading on his behalf and cover up
these activities using the 88888 account.
 James Bax, Regional Manager of Baring South Asia, expressed the conflict of interest
situation. James views were neglected.
 Since Nick was able to hide his losses in Error account 88888 and project only profits, he
became a star in the organization.
 Nick exploited the fact that top management in London was only focused on how to
maximize their year-end bonuses.
 Fund demand from Baring Futures (Singapore) kept on escalating.
 In 1995, Nick resorts to forgery to hide £ 50m. In mere half, an hour discussion Managing
committee rules in favor of nick and describe the matter “operational error”.
 The Kobe Earthquake deepened Nick Leeson’s losses.
 When the 88888 Account was discovered, Barings could be facing net losses of at least £
200m and total losses amounted to £ 830m

Question 1 –
Who could be held responsible for the failure to detect the problems
(including fraud) in the Bearings Bank? Give your reasons /illustrate.
Nick Leeson
Nick Lesson can be most closely linked to the collapse of Barring Bank as he used the gaps in
procedures and systems to hide his losses.

1. He used the error account 88888 to hide his trade losses. Initially, he did not want the
Barring in London to know about his mistakes as it could have damaged his reputation. By
the end of 1992, he put over 30 errors in 8888 account. In 1992, Lesson was granted a
SIMEX trading license. Since he was in charge of both front and back office, he found it
easy to trade on his behalf and use the error account to cover the losses.
2. He did not follow his supervisor- Simon Jones’ order of informing the losses to his bosses
in London. Instead, he used the error account to mask his losses so that his reputation could
not get jeopardized.
3. He traded both on his behalf as well as his client although he was allowed to trade only on
his client’s behalf. During the first half of 1993, his losses due to fraudulent measures
climbed and they reached to 6M pounds. He practiced selling straddles which combine a
 put (buy) option with a call (sell) option at an identical strike price. The downside of this
strategy was that if the market moved significantly from the strike price, it would have led
to huge losses. Also, Lesson did not hedge his losses which increased the overall risk.
4. Lesson used to hide his deception by exploiting differences among his seniors in London.
His disguise made him successful in demanding a large amount of cash to cover his margin
calls. The cumulative funding in Dec 1994 reached more than twice the reporting capital
of Barring Group.
5. He used the forged documents to disguise his deception. For instance, in Jan 1995 he
claimed that an amount of 50 M pounds was outstanding because Over the counter trade
had been incorrectly booked. He arranged the transfer of the same amount from Citibank
and then canceled the amount. However, he used the statement to show that the amount
was received by Barrings Singapore.

Barring Management
1. Nick was allowed to work at both at front and back office. This was in a conflict of interest
as he was now a trader as well as responsible for the accounting of those trades in the back
office. Due to this conflict of interest, he was successful in using error account to hide his
losses. He was successful in trading on behalf of himself as well as of his client.
2. There was no direct oversight on Nick’s books and he even set up a dummy account to hide
his losses. There was not much supervisory control over his activities. There was also not
much heed paid to the advice of the regional manager of South Asia who warned about the
implication of not having clear reporting lines and conflict of interest. There was a matrix-
based reporting system within the Barings Group, which had Leeson reporting through
different management lines. This resulted in no one having the ultimate responsibility for
monitoring Nick’s activities.
3. Profits posted by Nick instilled confidence in management and they did not ask him any
questions. The management did not want to annoy Lesson which would have led him to
leave their firm by joining another.
4. Bonus and Profits were Priority – The management was not wary of demand for huge
funding request which amounted to more than twice the capital of the group. Both the head
of derivation trading and head of equity derivative trading were concerned about profit and
loss account and their bonuses. They ignored the warning signals which could have been
detected from huge amounts of funding requests by Nick to cover his margin calls.
 Auditors
Proper Accounting Procedures could have revealed his doctored information and hidden
losses. The information showed that his tradings were legitimate and hedged which was
not so. He also used forged documents which could have been caught if internal controls
and audit would have been strong. It was the auditor’s duties to detect the wrongdoings by
Nick.

SIMEX
SIMEX gave a trading license to Nick in spite of his past fraudulent records. These were
the reasons due to which he did not get the licence to trade by SFA. SIMEX should have
checked the court judgments outstanding against him in a similar manner SFA did when
they rejected Nick’s application.

Question 2 –
Identify the elements of the COSO framework that were inadequately
covered.

I. Control Environment

1. Integrity and Ethical Values: No proper stress on Integrity and Ethical Values
- No negative impact on Nick Leeson even though he has lied in his SFA Application
- Management attitude towards violation of Ethical Values is not serious.

2. Board of Directors or Audit Committee: Ineffective Audit Committee

- Leeson Superiors were reluctant to question the Star Trader because of overwhelming
Profits from Singapore Operations.
- No control or limits on funding requirements raised by Barings Financial Services
Singapore Operations.
- Internal Audit Committee described the Over the Counter-Trade details based on the
forged documents as Operational Error.

3. Organizational Structure: Reporting relationship/Organization Structure is not effective

 - Lack of Separation of responsibility between Front and Back Office for Nick Leeson.
He was able to Conduct Unauthorized trading and park it under the infamous 88888
secret account
- The advice of James Pax, Regional Manager of Barings South Asia about clear roles
demarcation was not given importance.

4. Human Resource Policies and Practices: No Proper Human Resources policies and
Practices
- No negative impact on Nick Leeson even though he has lied in his SFA Application

II. Risk Assessment

1. Entity-Wide Objectives: No Clear Entity-Wide Objectives on Risk Assessment.

- Conflict of Interest among Top Management. Everyone was interested only in their
bonuses.
- Ron Baker, head of derivatives trading and Mary Walz, Head of equity derivatives
trading were focussed on Profit and Loss Account, hence their bonuses.
- Tony Hawes, Treasurer and Tony F & O Settlement Clerk concerns regarding
increased requirements from Singapore operations were ignored
- Barings Bank staff ignored the warning signal of high capital demands and risky bets
by Leeson in capital market

2. Risks: No Proper Risk Assessment process in place at Barings bank

- Even Barings Bank neglected the market sentiments:
- Huge Trading volumes generated by Barings created doubts about Barings’ financial
position in the market.
- -The Bank for International and Ex-Head of Barings Securities of Hong Kong raised
concerns about Barings bank or a client of Barings bank going bankrupt
- No control or limits on funding requirements raised by Barings Financial Services
Singapore Operations.
 3. Managing Change
- No mechanisms to anticipate, identify and react to routine events or activities that
affect the achievement of an entity or activity-level objectives

III. Control Activities:

No Control Activities in place at Barings bank:

- Nick Leeson was able to Conduct Unauthorized trading and park it under the
infamous 88888 secret account.
- Complete Over the Trade Counter (worth 50 million Euros) documents were forged
by Nick Leeson and Management committee called it as an Operational Error.
- No control or limits on funding requirements raised by Barings Financial Services
Singapore Operations.

IV. Information and Communication

- No Effective ways with which employees’ duties and control responsibilities are
communicated and there was no proper channel established for Communication. There
was no Timely and appropriate follow-up action by management resulting from
communications received from customers, vendors, regulators or other external
parties.

V. Monitoring
- As per the case reading there is no communications from external Parties
corroborated with internally generated information. Employees were not asked
periodically to state whether they understand and comply with the entity’s code of
conduct and regularly perform critical control activities.

Summary:
- In Sum, there were several failings associated with internal control and risk
management within the operations of Barings. It is visible that the internal control
mechanism as mentioned by the COSO Framework was completely ignored by the
Barings Bank executives and employees.
Question 3 –
Identify the 6 sources of risk in a trading operation and suggest suitable
control mechanism for the same.
1) Trading and settlement were performed by the same person
Trading is the front office job while the settlement is a back-office job. These two
jobs should be performed by two different sets of people.

Solution – The access to trading and settlement should be segregated. This is a clear
segregation of duties issue. The company should create a risk matrix where two job
functions with conflicting duties should raise an alert to senior management.
The company should also create monitoring controls where such risks are captured,
and alerts are sent to risk controllers for mitigation.

2) No upper limit on the trading

No upper limit on trading was set by Barings Bank on traders, hence Leeson was able
to ask for more money whenever he wished.

Solution - The company should come up with a mechanism to enforce an upper limit
on the money that can be used by an individual trader for daily trading activities.
A release strategy should be created where the request for money over the acceptable
limit should go through the chain of approvals depending on the amount requested.
For example – an individual trader can utilize the maximum amount of 10000$. If the
trader needs an additional amount of 2000$, the approval should go for manager
approval. If more than 5000$ is needed that 2-level approval should be mandatory. A
requested amount of 100000$ should need approval for CFO.

3) Error account 88888 deactivations was not done

The London Office of Barings Bank decided that all the errors should be recorded in
the error account 99905, and no further transactions to be done in the error account
88888.

Solution - Account which lay dormant should be deactivated as soon as they are of no
use. This deactivation request should be raised by the concerned manager.
 There can be instances where manager forgets to raise such request to deactivate an
unused account, hence a procedure to review and monitor such accounts should be in
place. If some inconsistency is found, reconciliation of such account should be done.

4) Regional manager’s memo was ignored

A memo regarding conflict of interest sent by Regional Manager James Bax to MD of
Barings Securities in London was ignored to maintain the high profit that Leeson was
bringing.

Solution – There should be a mechanism to review the Memos and reports sent by
management and to track the action taken on each memo. The accountability to each
report/memo should be assigned and periodic assessment of such memo should be
performed.

5) Barings Bank staff ignored the warning signal of high capital demands and risky bets
by Leeson in capital market
Solution-The internal control should have stipulated a corrective course of action
once the key indicators of risk management such as “total amount requested”, “total
exposure to market” were breached. From the case, it is visible that such warning
signs were ignored and there was no procedure to escalate such instances. The staff
was either ill-equipped to handle such a situation or were purposefully keeping the
whole situation under the carpet.

6) Leeson’s application to SFA was rejected on grounds of judgment outstanding against

him. This information was not made available to the company, even though Leeson
answered negatively to the question. This shows unethical behavior was not punished.
The company went to the extent of sending Leeson to Singapore.

Solution-Internal control should be strengthened to make sure any negative report

towards an employee is made available to higher management so that the company
can make a decision based on past behavior.
We can also comment on the culture of Barings Bank that the profitability was given
more importance and integrity/ethical behavior took a backseat.
Questions 4 –
Suggest some good governance practices that should have been in
place.
1) Segregation of Duties b/w Front Office and Back Office: Involving two or more
people in a trade significantly reduces the risk of fraud. A trade initiated by one
person shoud be settled and recorded by someone else to avoid any confict of interest.
In case of Barrings bank, Leeson was responsible for trading as well as recording
those trades in the Singapore office. No action was taken even after this conflict of
interest was pointed out by James bax
2) Effective Internal Control Systems:
a. Barrings Bank should have had an effective audit committee comprising
external board members responsible for reviewing internal control
mechanisms
b. The external auditor should be held accountable for not being able to identify
the indiscrepencies. Leeds and Kellog couldn’t identity the fraudulent papers
submitted by Leeson.

3) Effective HR Practices: There should be strict disciplinary action against the

employees not abiding the law. At Barrings Bank, Leeson could get away with lying
in his trading licence application. No action was taken against him. He was
transferred to Singapore when we couldn’t get his licence in the UK.
4) Effective Risk Management System

a. Automated system to identify dormant accounts: A critical component in

Leeson’s fraud was the dormant account no. 88888. Initially set up with the
purpose of recoding error trades, this account was never closed. A system to
identify and close such accounts could have prevented this fraud.

b. Strict limits on trading volume: Approvals for cash for trading should be given
after taking risk into account. Rules can’t vary from trader to trader. In case a
trader needs additional cash, it should be provided only after a number of
rounds of approval from the risk management team.