Classic Financial Scandals:Corruption, Discovery, Black Wednesday

<< The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions

RECAP:FINANCIAL INSTITUTIONS, CENTRAL BANK, >>

Management of Financial Institutions - MGT 604

Lecture # 44

Classic Financial Scandals

"Bankers who hire money hungry geniuses should not always express surprise and

amazement when some of them turn around with brilliant, creative, and illegal means

of making money." "The quotation is from a speech by the financial thriller writer on the

Psychology of Risk, Speculation and Fraud, at a conference on EMU in Amsterdam.

Barings Bank collapsed when one of the Singapore based employees of London's Barings

Bank, Nick Leeson, lost £827 million (US$1.4 billion) - primarily on futures contract

speculation. Leeson's actions led the oldest merchant bank to default on its debts. The bank's

collapse is considered a pivotal turning point in the history of banking and has become a

textbook example of accounting fraud.

Internal auditing

The way that Barings Bank's activities in Singapore were organized between 1992 and 1995

enabled Leeson to operate effectively without supervision from Barings Bank's head office

in London. Leeson acted both as head of settlement operations (charged with ensuring

accurate accounting) and as floor manager for Barings' trading on Singapore International

Monetary Exchange (SIMEX). Normally the positions would have been held by two

employees. This concentration of functions placed Leeson in the position of reporting to an

office inside the bank which he himself held. Several observers, including Leeson, placed

much of the blame on the bank's own deficient internal auditing and risk management

practices.

Corruption

Because of the absence of oversight, Leeson was able to make seemingly small gambles in

the futures market at Barings Futures Singapores (BFS) and cover for his shortfalls by

reporting losses as gains to Barings in London. Specifically, Leeson altered the branch's

error account, subsequently known by its account number 88888 as the "five-eights

account," to prevent the London office from receiving the standard daily reports on trading,

price, and status. Leeson claims the losses started when one of his colleagues bought

contracts when she should have sold them. By December 1994 Leeson had cost Barings

£200 million but he reported to British tax authorities a £102 million profit. If the company

had uncovered his true financial dealings then, collapse might have been avoided as Barings

had capital of £350 million

Kobe earthquake

Using the hidden "five-eight account," Leeson began to aggressively trade in futures and

options on SIMEX. His decisions routinely lost substantial sums, but he used money

entrusted to the bank by subsidiaries for use in their own accounts. He falsified trading

records in the bank's computer systems, and used money intended for margin payments on

other trading. Barings Bank management in London at first congratulated and rewarded

Leeson for what seemed to be his outstanding trading profits. However, his luck ran out

when the Kobe earthquake sent the Asian financial markets into a tailspin. Leeson bet on a

rapid recovery by the Nikkei Stock Average which failed to materialize.

Discovery

Appointed administrators began managing the finances of Barings Group and its

subsidiaries on 26 February 1995. On 26 February, the Board of Banking Supervision

launched an investigation led by Britain's Chancellor of the Exchequer. The Chancellor

released his report on 18 July. By 27 February, Leeson had cost the bank £827 million. The

collapse itself cost the bank another £100 million.

163

Management of Financial Institutions - MGT 604

Barings Bank auditors finally discovered the fraud, around the same time that Chairman

Peter Barings received a confession note from Leeson, but it was too late. Leeson's activities

had generated losses totaling £827 million (US$1.4 billion), twice the bank's available

trading capital. The Bank of England attempted a weekend bailout but it was unsuccessful.

Barings was declared insolvent 26 February 1995. The collapse was dramatic and

employees around the world were denied their bonuses

Aftermath

ING, a Dutch bank, purchased Barings Bank for the nominal sum of £1 and assumed all of

Barings liabilities. Barings Bank therefore no longer has a separate corporate existence,

although the Barings name still lived on as Baring Asset Management. BAM was split and

sold by ING to Mass Mutual and Northern Trust in March 2005. Nick Leeson fled

Singapore but was arrested in Germany and extradited back to Singapore, where he was

convicted of fraud and imprisoned for six years. Upon release, he wrote an autobiography,

Rogue Trader, covering the events leading up to the collapse. A film maker later dramatized

the book in the film Rogue Trader.

Black Wednesday

In British politics and economics, Black Wednesday refers to 16 September 1992 when the

Conservative government was forced to withdraw the Pound from the European Exchange

Rate Mechanism (ERM) due to pressure by currency speculators--most notably George

Soros who made over US$1 billion from this speculation. In 1997 the UK Treasury

estimated the cost of Black Wednesday at £3.4 billion.

The trading losses in August and September were estimated at £800m, but the main loss to

taxpayers arose because the devaluation could have made them a profit. The papers show

that if the government had maintained $24bn foreign currency reserves and the pound had

fallen by the same amount, the UK would have made a £2.4bn profit on sterling's

devaluation (Financial Times 10 February 2005). The papers also show that the Treasury

spent £27bn of reserves in propping up the pound; the Treasury calculates the ultimate loss

was only £3.4bn.

The currency speculators' attack

The fundamental sterling problem in September 1992 was that the dollar was rapidly

depreciating against the deutschmark. Tied as it was to the ERM, the pound was hence

appreciating to unsustainable levels against the US currency. With a large proportion of

British exports priced in dollars, a pound/dollar correction was well overdue. ERM

membership was preventing this from happening. In anticipation of the inevitable dam-

bursting, speculators hastened the process by borrowing pounds (and also lire) and selling

them for DM, in the expectation of being able to repay the loan in devalued currency and to

pocket the difference.

On September 16 the British government announced a rise in the base interest rate from an

already high 10% to 12% in order to tempt speculators to buy pounds. Despite this and a

promise later the same day to raise base rates again to 15%, dealers kept selling pounds,

convinced that the government would not stick with its promise. By 19:00 that evening,

Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would

remain at the new level of 12%.

EU economists' analysis of this event concluded that stable exchange rates are the result, not

the cause, of a common approach to economic management, resulting in the Stability and

Growth Pact that underpins ERM II and subsequently the Euro single currency.

164

Management of Financial Institutions - MGT 604

Treasury bond Scandal

"Saloman Brothers"

Salomon Brothers was a Wall Street investment bank. Founded in 1910, it remained a

partnership until the early 1980s, when it was acquired by the commodity trading firm then

known as Phibro Corporation. This proved a "wag the dog" type merger as the parent

company became first Phibro-Salomon and then Salomon Inc. and the commodity

operations were sold. Eventually Salomon was acquired by Travelers Group (now

Citigroup) in 1998.

It eventually became the largest issuer and trader of bonds in the United States, its PR man

defining a liquid bond as any bond traded by Salomon Brothers.

During its time of greatest prominence in the 1980s, Salomon became noted for its

innovation in the bond market, creating the first mortgage-backed security. Later, it moved

away from traditional investment banking (helping companies raise funds in the capital

market and negotiating mergers and acquisitions) to almost exclusively proprietary trading

(the buying and selling of stocks, bonds, options, etc. for the profit of the company).

Salomon had an expertise in fixed income trading, betting large amounts of money on

certain swings in the bond market on a daily basis. The top bond traders called themselves

"Big Swinging Dicks", and were the inspiration for the books The Bonfire of the Vanities

and Liar's Poker.

During this period however the performance of the firm was not to the satisfaction of its

upper management. The amount of money being made relative to the amount being invested

in all the markets Salomon was in was small, and the company's traders were paid in a

flawed way which was disconnected from their true profitability (fully accounting for both

the amount of money they used and the risk they took). There were debates as to which

direction the firm should head in, whether it should prune down its activities to focus on

certain areas. For example, the commercial paper business (providing short term day to day

financing for large companies), was apparently unprofitable, although some in the firm

argued that it was a good activity because it kept the company in constant contact with other

businesses' key financial personnel. It was decided that the firm should try to imitate Drexel

Burnham Lambert, using its Investment Bankers and its own money to urge companies to

restructure or engage in leveraged buyouts which would result in financing business for

Salomon Brothers. The first moves in this direction were for the firm to compete on the

leveraged buyout of RJR Nabisco, followed by the leveraged buyout of Revco stores (which

ended in failure).

165

Table of Contents: