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Q.1. Explain your overall understanding about the poor control procedure discussed in the case?

Answer: From this case I have understood the following things about the control procedures: (i) Funding risk and less disclosure Barings Securities faces these funding problems: Leesons unauthorized position. No difference between variation margin needed to cover proprietary and customer trades of Leeson No use of the Standard Portfolio Analysis of Risk (SPAN) margining programme to calculate margins Remittance of fund to Leeson by London without any query. No justification was sought about the astounding size of Leesons demand. Poor book-keeping and sloppy treasury management in Barings Futures [BFS] No reconciliation of funds remitted to Singapore to both proprietary in-house and individual client positions

Figure 1:Top-up Funding from BSGT to BSL and Margin Balances from BFS from 1 January 1995. The graph shows that from 1 January to 24 February 1995, the proportion of genuine client moneys which were transferred to BFS fell as a proportion of the total funding Indeed on 21 February 1995, BSGT had to advance all the client margins of some US$440 million. On 24 February, only US$50 million of the US$540 million sent to Singapore to cover client

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positions had been recovered from individual clients (i.e. the difference between the solid and broken lines). Barings control did not reconcile the top-up payments to individual client balances - if it did it would have discovered that it was sending out far too much money just to cover the margin calls of clients. So, to run a company smoothly, there should have assigned duties and responsibilities; Standard method of Risk analysis; accountability of the employees; sound book keeping and treasury management; proper reconciliation of funds etc. (ii) Excessive Credit Risk Every company should have to minimize credit risk efficiently. Barings faced the following credit risk exposures: No query about by the Credit Risk department about Barings lending over US$500 million to its clients to trade on SIMEX, and collecting only 10% in return. No limit per client or on the total 'top-up' funds was set No credit approval process for client margin. Recording advances on the balance sheet without considering the aspects of top-up balance So, Barings should set up a sound and effective credit risk department having sufficient manpower as well as amenities. Client margin should be undergone with credit approval process. (iii) Market Risk Minimization of market risk depends on the proper utilization of market risk repots, independent units performance for checking accuracy and right input. Barings faced the following market risk exposures: No independent unit for checking the accuracy of Leesons reports Market risk reports generated by Barings' risk management unit and passed on to ALCO were inaccurate Garbage in Garbage out problem. (iv) No Credit Limits

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Even a high risky firm has a certain credit limit because of the high credit risk. Barings had no credit limits on Leesons margin call. So, following things happened: No impose on any gross position limits on Leeson's proprietary trading activities Wrong forecast about market risk attached to arbitrage trades Basis and settlement risk Liquidity and funding risk So, Company should have set a credit limit. Besides this, forecasting about market risk should be realistic and attainable. There should have a comsideration about how to minimize basis and settlement risk. (v) Lack of Supervision In a matrix management system, supervision is a crucial thing. A performing board is as like as the blood of a sound body. But, Barings lacked this quality mostly. Some examples are given below: supervisors identified. Operational error No guideline about who reports to whom in Barings Leeson's reporting lines for product profitability were not clear cut and defined Cavalier attitude Barings had towards supervising Leeson A break of SIMEX rule 822 by financing the margin requirements of Account 88888 A margin difference of US$342 million in Account 88888 No further investigation about the customer who faced credit risk in margin requirement A due of US$83 million from Spear, Leeds & Kellogg was not No exercise of supervision on Leesons activities by a lot of

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Leesons engagement in unauthorized activity by trading Over The Counter (OTC) option.

So, a company should have a performing and efficient supervisory board to achieve the long term goal and keep away from being technically insolvent and banmkrupt.

Q.2. Explain what you have understood from the incident of Lessons breaking of Barings? Answer: Leeson engaged in unauthorised activities almost as soon as he started trading in Singapore in 1992. He took proprietary positions on SIMEX on both futures and options contracts. (His mandate from London allowed him to take positions only if they were part of 'switching' and to execute client orders. He was never allowed to sell options.) Leeson lost money from his unauthorised trades almost from day one. Yet he was perceived in London as the wonder boy and turbo-arbitrageur who single-handedly contributed to half of Barings Singapore's 1993 profits and half of the entire firm's 1994 profits. This situation is clear in Table-1. Period 1 Jan 1993 to 31 Dec 1993 1 Jan 1994 to 31 Dec 1994 1 Jan 1995 to 31 Dec 1995 Reported (million) +GBP 8.83 +GBP 28.529 +GBP 18.567 Actual (million) -GBP 21 -GBP 185 -GBP 619 Cumulative actual (million) -GBP 23 -GBP 208 -GBP 827

Table-1: Facts versus Fantasy: Profitability of Leeson's Trading Activities. Leeson entered into a significant volume of cross transactions between account '88888' and account '92000' (Barings Securities Japan - Nikkei and JGB Arbitrage), account '98007' (Barings London - JGB Arbitrage) and account '98008' (Barings London - Euroyen Arbitrage). Thus while the cross trades on the Exchange appeared on the face of it to be genuine and within the rules of the Exchange, the books and records of BFS, maintained in the Contac system, a settlement system used extensively by SIMEX members, reflected pairs of transactions adding up to the same number of lots at prices bearing no relation to those executed on the floor. Alternatively, Leeson would enter into cross trades of smaller size than the above but when these were entered

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into the Contac system he would arrange for the price to be amended, again enabling profit to be credited to the 'switching' account and losses to be charged to account '88888'. Barings collapsed because it could not meet the enormous trading obligations, which Leeson established in the name of the bank. When it went into receivership on February 27, 1995, Barings, via Leeson, had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and Euroyen contracts. Leeson also sold 70, 892 Nikkei put and call options with a nominal value of $6.68 billion. The nominal size of these positions is magnificent; their enormity is all the more astounding when compared with the banks reported capital of about $615 million. This situation is illustrated in Table-2.

Transaction time

Reported

Actual

Futures
Long Nikkei 225 JGB Euroyen 30112 $2809 million 15940 $8980 million 601 $26.5 million $7000 19650 350 short

Options
$3580 million in calls Nikkei 225 Nil $3100 million in puts

Table -2: Leesons unreported positions This point is key to understanding Leeson's actions because prior to the Kobe earthquake, his unauthorised book, i.e. account '88888&' showed a flat position in Nikkei 225 futures. Yet on Friday 20 January, three days after the earthquake, Leeson bought 10,814 March 1995 contracts. No one is sure whether he bought these contracts because he thought the market had over-reacted to the Kobe shock or because he wanted to shore up the Nikkei to protect the long position which

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arose from the option straddles. (Leeson did not hedge his option positions prior to the earthquake and his Nikkei 225 futures purchases after the quake cannot be construed as part of a belated hedging programme since he should have been selling rather than buying.) Date Value per SIMEX JPY millions 20 January 23 January 23 January 25 January 26 January Total Table-3: Leesons manipulation of books The large falls in Japanese equities, post-earthquake, also made the market more volatile. This did not help Leeson's short option position either - a seller of options wants volatility to decline so that the value of the options decreases. With volatility on the rise, Leeson's short options would have shown losses even if the Tokyo stock market had not plunged. The bottom line of all these cross-trades was that Barings was counterparty to many of its own trades. Leeson bought from one hand and sold to the other, and in so doing did not lay off any of the firm's market risk. Barings was thus not arbitraging between SIMEX and the Japanese exchanges but taking open (and very substantial) positions, which were buried in account '88888'. It was the profit and loss statement of this account which correctly represented the revenue earned (or not earned) by Leeson. Details of this account were never transmitted to the treasury or risk control offices in London, an omission which ultimately had catastrophic consequences for Barings shareholders and bondholders. From the breaking of Barings we can say that a firms employees duties and responsibilities should be defined and a proper monitoring process should be in action to check whether they comply with the trading rules and procedures. Clear knowledge about derivatives market is also a must thing. 66173 26715 (71970) 91528 148193 Value per CONTACT JPY millions 66413 28223 (73332) 92020 149560 Profit/(Loss) to '92000' JPY millions 240 1508 (1362) 492 1367 2245

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Q.3. If you were a financial manager what can you do to maximize the wealth using the knowledge you have derived from the case? Answer: A financial manager has the responsibility to run a company both effectively and efficiently. Because, here the cost is too much. Once, you have failed to cope up the recent scenarios as well as challenges, you are supposed not to cope up with the market anymore because of the huge competition. So, a financial manager should strive for maximizing shareholders wealth as high as it is realistic and attainable. To do this a financial manager has to do the following tenets efficiently: (a) Defined and clear cut company organogram (b) Segregation of front office and back office (c) A performing and efficient board (d) Suffcient capital Adequacy (e) Effective control and montoring procedures (f) Clear knowledge about the business etc. These points are illustrated below: (a) Defined and clear cut company organogram An organogram tells the basic structure of a company having who reports to whom, assigned duties and responsibilities, contingency plans etc. A clear cut organogram is necessary to: Have a clear and defined reporting line Clear duties and responsibilities Have unity of control and direction Have a decentralization effect Have less transaction cost and less hassles Reduce HRD costs Avoid any misunderstandings among the employees etc (b) Segregation of front office and back office

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The back-office records, confirms and settles trades transacted by the front office, reconciles them with details sent by the bank's counterparties and assesses the accuracy of prices used for its internal valuations. It also accepts/releases securities and payments for trades. Some back offices also provide the regulatory reports and management accounting. In a nutshell, the back office provides the necessary checks to prevent unauthorised trading and minimise the potential for fraud and embezzlement. Since Leeson was in charge of the back office, he had the final say on payments, ingoing and outgoing confirmations and contracts, reconciliation statements, accounting entries and position reports. He was perfectly placed to relay false information back to London. So, a segregation of front office and back office is necessary to: Avoid fraudulent acts by employees Reduce transaction cost minimize settlement and basis risk ensure accountability among the employees etc. (c) A performing and efficient board A non performing board can cripple the normal functioning of a company and may hamper the development process. The crux of the Barings' collapse lay in senior management's lackadaisical attitude to its derivative operations in Singapore. Every major report on managing derivative risks has stressed the need for senior management to understand the risks of the business; to help articulate the firm's risk appetite and draft strategies and control procedures needed to achieve these objectives. So, a performing and efficient board is necessary to: run the normal functioning of the company smoothly and efficiently. Set up the both short term and long term attainable but challenging goals Avoid any errors related to transactions

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minimize transaction and HRD cost avoid technical insolvency and bankruptcy etc (d) Sufficient capital adequacy Cash is said to be the life saving blood of the company. So, a company should have sufficient cash balance as well as sound capital requirement. In the case of Barings, it was hemorrhaging cash and still London took no steps to investigate Singapore's requests for funds - partly because senior management assumed that a proportion of these funds represented advances to clients. It was funding risk that seriously wounded Barings but the terminal shot came from the discovery that the enormous positions were unhedged. So, capital adequacy is necessary to: meet up the both short term and long term obligations increase the solvency and liquidity position increase the companys cash reserve have the most flexible and comfortable capital structure etc.

(e) Effective control and monitoring procedures Whether the company is on the track or not depends on controlling and monitoring procedures. So, it should be handled efficiently. In the case of Barings, this process is very rare to define. It is necessary to: minimize funding risk present timely and full disclosures minimize credit risk and market risk set up credit limits Supervise the functionings of the company efficiently etc.

(f) Clear knowledge about the business etc.

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Finally, the company employees as well as board of directors should have the proper knowledge about the business they are trading. They should have a clear idea about the business risk and financial risk also. In case of Barings, very few top officers and managers had clear and deep knowledge about derivatives market and its trading. So, clear knowledge about the business is necessary to: Set up the mission, vision, objectives of the company Know about the business risk, financial risk and other risks Defend any uncomfortable scenario etc.

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