Enterprise Risk Management Lessons Learned Review
This will be a “Lessons Learned” Review. You will perform and prepare a Lessons Learned Review of a major Corporate Scandal due to breakdown or lapse in Risk Management, providing a review of the breakdown in Risk Management: the cause, impact/consequences, actions taken, and most importantly lesson learned to prevent future occurrences.:
- Description of the Risk Management breakdown – what happened/chronology?
- What caused the Risk Management breakdown (e.g., control deficiencies, lack of oversight, poor management/supervision, etc.)? Be specific.
- Who(m) was to blame?
- What was the impact/consequences of the breakdown (e.g., financial loss, reputation, regulatory penalties/sanctions)
- Could the breakdown been prevented or minimized?
- What actions/remediations (e.g., Company, Government, Public) were taken after the event occurred?
- What are the “applicable” Lessons Learned? – this is based on your opinions/reflections of the case tying into the respective Lessons Learned.
The Baring’s Collapse – Lessons Learned Review
Background: Description of Risk Management Breakdown
The Barings Group started a subsidiary in Singapore in order to increase its reach and expand its business horizons. The Singapore subsidiary was known as Barings Futures Singapore (BFS). The Barings Futures Singapore was headed by Nick Leeson. The role of Nick Leeson was to participate in active trading in the country as part of an arbitrage between the Osaka and Singaporean futures exchanges. The operations authorized by the company to be carried out by Nick Leeson were considered low-risk, and thus did not put the company at any uncomfortable position. However, Leeson engaged in unauthorized dealings that involved position taking in Japanese Government Bond and Nikkei futures on Osaka futures exchanges and SIMEX.
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Nick Leeson also exposed the company’s capital to potential unlimited loss by writing exchange-traded alternatives against Nikkei trading indices on the same exchanges that involved Osaka futures and Japanese Government Bond (JGB). Leeson had a structured system that involved taking or buying long positions in Nikkei futures, taking a short volatility position in Nikkei, and taking short positions in Japanese Government Bond futures. As such, Leeson needed Nikkei prices to increase, JGB to decline, and Nikkei’s volatility to remain significantly low. However, Nikkei prices fell sharply and JGB underwent significant losses based on significant reduction in interest rates. By the end of February of 1995, most of the unauthorized investments made by Leeson had experienced significant losses, which subsequently affected the parent company, Barings Group.
Causes of the Risk Management Breakdown
The risk management breakdown at Barings Group was a result of failures at many levels. Firstly, the bank did not have a distinction between the back offices and the front offices within the Barings Futures Singapore (BFS). This made it possible for Leeson to serve at both offices, and thus had control of both ends of the trading operations. This enabled him to conduct fraudulent operations that were not in the interest of the company. He was able to significantly manipulate transactions and hide the losses made by creating secret accounts which helped to conceal the operations from the parent company. Secondly, there was an ambiguous monitoring system that allowed Leeson to find loopholes for exploitation. The company had a matrix-based reporting channel that made it impossible for the right kind of oversight to be exercised on all managers. As such, it was impossible to notice Leeson’s unauthorized actions on time.
Thirdly, the company did not raise any doubts on the high returns that Leeson registered from the operations they assigned him to carry out. Although it was clear to the company that most of the revenues registered by the company came from Leeson’s operations, the company did not question the possibility of his arbitrage operations not being the only source of such amounts of profits. As such, it is clear that the company neglected its oversight role completely. Fourthly, the company did not effect the audit resolutions recommended by an internal audit review carried out in 1994. The internal audit revealed to the company that BFS had a questionable risk management controls and structure which were not sufficient to guarantee a positive future for the company. Finally, Barings Group did not have any limits that its subsidiaries could adhere to. This opened the space for misuse by such managers as Nick Leeson. Although all these factors facilitated the unauthorized actions carried out by Leeson, it is apparent that the collapse of the bank can be squarely blamed on Nick Leeson.
When Leeson discovered that Barings Group was on the verge of a crisis, he decided to run away from the company. He left a note behind with the message “I am Sorry”. His first destination was Maylasia, followed by Thailand, and then to Germany. He was arrested in the airport in Germany and flown to Singapore. He was charged with fraud and sentenced to close to seven years in jail. On the part of the bank, Barings Group was rendered insolvent after it was discovered that it had lost about $1.4 billion through Leeson’s dealings. This necessitated the selling of the bank for a paltry $1. This represented an unprecedented fall from grace for a bank that had existed for 223 years.
Barings Group could have prevented its collapse by having a robust oversight over its various subsidiaries. The oversight structures adopted by the company were too irregular, which created many opportunities for inefficiency and misuse. For example, Nick Leeson did not have any direct oversight that monitored his various actions in Singapore. The company should have also put in place structures that would help in breaking down revenues that came in from its numerous subsidiaries (Betz, 2018). This would have enabled it to notice irregularities in the revenues reported by Leeson from the Singapore subsidiary. Finally, putting limits on the amounts that each unit operated on would have limited the amounts of money that Leeson put in unauthorized operations. This approach would have acted as damage control and prevent the company from losing the large amounts it did as a result of Leeson’s fraudulent investments.
The collapse of Barings led to many sweeping changes being made in the banking industry in order to prevent future recurrence of such events. The board of the Bank of England recommended that a review of the number of people and skills needed in a bank to provide essential services such as on-site visits and advice on derivatives (Tham, 2020. The collapse of the bank also led to an increase in liaisons between many financial operators and regulatory bodies. Many banks also resolved to have frequent meetings with the board of the Bank of England for discussion of their banks’ internal audits for proper assessments and recommendations.
The case shows that arbitrage should be carried out in the atmosphere of transparency because it carries significant risks. As it involves simultaneous buying and selling of stocks or bonds with the intention of making profits based on price variations, caution should be taken when using it as a business model. The case also illustrates that a huge sum of money should not be invested in such kind of trade because it can lead to significant losses when the market system suddenly collapses. The case also has many lessons for financial institutions in terms of adopting sound structures and exercising robust auditing systems. The accountability channels employed by the bank were not good enough to prevent against fraudulent activities by rogue managers. This created the space exploited by Leeson in carrying out unauthorized activities. Finally, financial institutions should seek to act upon the recommendations provided in their internal audits as soon as possible.