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FAILURE : Barings’ Failure: A Case of ‘Upstairs, Downstairs’

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<i> John Micklethwait is the business editor of the Economist</i>

It was rather as if, right before the release of “The Lion King,” a rogue illustrator had added an unprintable large appendage to the film’s leonine star. The next day, mothers and children across America were outraged and a $30-billion class-action suit was launched against Disney--enough to wipe out its capital. Hollywood’s studio heads met to see if anybody would take over the firm, but nobody wanted to write a blank check for the litigants. By Monday morning, Disney was in Chapter 11, the illustrator was last heard of in Acapulco--and most of Los Angeles didn’t know whether to laugh or cry. Everything--Uncle Walt, Michael D. Eisner, the studio lot in Burbank, those irritating lines in Anaheim--all finito . In a single weekend.

The house of Baring, which collapsed so spectacularly last weekend after 233 years of banking in the City of London, was not as rich as Disney, but it was considerably older and, dare one say it, classier. This is not mere British snobbery. In the rough-tough world of international finance, Baring Brothers & Co. seemed to stand for older values. It had a reputation for looking after its employees well. Indeed, the eponymous family, which still controlled the bank, was famous for paying its staff better than its own members.

Given its age and influence, there were relatively few skeletons in Barings’ closet. True, a professor of Politically Correct Finance might have noticed that the number of Old Etonians in the bank was out of all proportion to the private school’s place in Britain. However, even Barings’ toffs tended to be of the understated, efficient sort. There was notably less aristocratic dead wood at Barings than in other British upper-class vessels.

This assurance came from longevity. Back in 1820, when the bank was a mere 58 years old, it was described by a Frenchman as “Europe’s sixth great power.” Over the centuries, the Baring family has managed to pick up five different peerages--something English families had hitherto only managed to do by beating up foreigners or sleeping with royalty. The only blot on the bank’s copy book was in 1890, when Barings almost went bust after losing millions in dud Argentine loans--and had to be bailed out by the Bank of England.

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From a modern viewpoint, Barings seemed to be doing all the right things. Rather than trying to be all things to all people, it was a classic case of a company “sticking to its knitting”--picking out niches where it could make money and trusting its people to get on with it. Quietly, it became perhaps the world’s leading merchant bank in emerging markets. It built up a presence in places like South America and Asia long before it was fashionable; similarly, it showed no sign of wanting to desert them after the recent falls in emerging stock markets. This long-term view was linked to its managers’ sense of security. With most of its shares owned by a charitable institution, Barings was safe from takeover.

It was not, however, safe from Nicholas W. Leeson. If Tom Wolfe had been born British (and thus even more obsessed about class than he already is), he would have written “Bonfire of the Vanities” about Nick Leeson rather than Sherman McCoy. Leeson grew up in a council house in Watford (a sort of soggier version of Pomona). Ambitious, quick-witted but not particularly clever (he failed his maths exam), it was only a matter of time before Leeson found his way to a dealing-room floor.

It is easy to caricature a City of London bank as a sort of “Upstairs, Downstairs” arrangement--with the chinless corporate financiers gliding around the Old-Mastered corporate dining rooms, while the Cockney barrow boys lark around the subterranean dealing rooms. Like most generalizations, it is factually inaccurate (there are plenty of public schoolboys hiding behind the tabloids in the dealing rooms; and many--perhaps most--of the svelte pin-striped creatures in the dining rooms came from modest backgrounds) but spiritually correct. Everyone upstairs tries to give the impression they have just had tea with the queen; everybody downstairs fancies himself (there aren’t many “herselves”) as bit of “a wide boy.”

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Leeson, who was wide indeed, did well in the city and was sent to Singapore. He does not seem to have made much effort to get on with the locals--there was an incident where he got into trouble for “mooning” in a bar. He played for a local soccer team, where he bragged not only that he could have been a professional soccer player but also that he was the highest-paid derivatives trader in Asia. The second boast, unlike the first, may well have been true.

Officially, Leeson was an arbitrageur specializing in Japanese derivatives. How did somebody who wasn’t particularly good at sums end up in something so complicated? Derivatives are financial products like options and futures that are, in effect, bets on which way an index, a share, a currency or a commodity is going. If the underlying index moves a little, a derivative will move a lot--hence their use as a “hedging” device for people with positions in the underlying markets. A lot depends on whether the derivatives trader is making a bet--in which case, all he can lose is his stake--or accepting it--where, if the bet is not laid off, he stands to lose much more.

Derivatives are priced according to complicated mathematical formulas that only computers or rocket scientists can work out. But, like every other type of financial instrument, their prices fluctuate with market sentiment, which is driven by people like Leeson. Leeson’s official task was to look for minute price differences between the two exchanges where Japanese futures were traded--Osaka and Singapore. But he was also allowed to take a punt on the markets. Barings felt safe, partly because of his experience and partly because he was dealing on exchanges: If Leeson ran into trouble, the exchanges would make margin calls.

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Rather than betting that the Nikkei index would go up or down, Leeson bet it would essentially stay still by constructing what is known as a straddle. As long as the Nikkei stayed in a certain range--18,500-19,500--Leeson was safe. Indeed, it seems he made a fortune (perhaps as much as $150 million) until the Kobe earthquake on Jan. 17. The market plunged and Leeson tried to drive it up again with increasing desperation.

By Wednesday, Feb. 22, when Barings got its first inkling of what was going on, Leeson had disappeared, having completed trades worth a whopping $27 billion. By the weekend, the bank’s losses were around $1 billion and rising. Despite attempts by the Bank of England, no buyer was prepared to take on such an unlimited liability.

Peter Baring, the bank’s chairman, claims his bank was brought down by fraud. Leeson seems to have set up a string of fake accounts. However, Barings has only itself to blame. Inexplicably, it allowed Leeson--whose wife temporarily worked in settlements as well--to settle his own deals. It also failed to notice the oodles of cash being sucked into Singapore for margin calls.

More facts will probably come out now that Leeson, disguised in a baseball hat and glasses but traveling under the imaginative name of “Leeson,” was arrested at the Frankfurt airport. Nonetheless, Barings’ failure arguably has as much to do with class in post-Thatcherite Britain as futures contracts on the Nikkei. Barings “upstairs” managers tended to regard their traders as a profitable sideshow--but not really what their bank was all about. A decentralized management structure suited not only the bank’s traders but probably also its managers, who can hardly have looked forward to squinting at derivative position reports over the weekend.

The result? The Baring family handed control of their bank to somebody they would not have invited to dinner. Interestingly, the class divide even extended to coverage of the event. Serious “upstairs” newspapers fell over themselves to write about Barings’ internal controls. The tabloids, proclaiming “What a little banker,” set off in pursuit of Leeson. Tabloid reporters may even have invented the rumor that Leeson had fled to the Thai island of Phuket--partly because the name was a headline-writer’s dream and partly because they wanted to go there themselves.

This whole tale has a relative lack of victims. The Baring family had taken enough money out of the bank. In fact, there can scarcely be a better argument for the often despised aristocratic habit of salting away all the improper money you have made from “trade” in land and castles. Most of the bank’s 4,000 employees will find jobs elsewhere. Barings investment management business alone may be worth $500 million. More sadly, the Baring foundation, a charitable trust that owned most of the shares, will probably shut down.

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At first sight, the cult of the canny British amateur has also taken a knock. It turns out all those owly-eyed regulators who clog up Wall Street do have a raison d’etre after all. However, the fact that the City of London could lose one of its foremost names relatively painlessly is also a sign of its strength: The city is now bigger than just Britain. The Bank of England was probably right not to pour taxpayers’ money into propping up Barings when it would have meant signing a blank check no private institution would have countenanced.

The saddest casualty from the Barings affair could be a decision to close down Leeson’s playground--the derivatives market. At first sight, this seems a strange thing to say. From a global regulator’s viewpoint, that Barings, one of the wisest old birds in the financial skies, could be brought down by these speculative new instruments is a far more worrying affair than, say, Orange County--which was run by civil servants. Surely, many are already asking, it is time for governments to clamp down on this hocus-pocus--perhaps even ban it.

That almost certainly would be the worst possible thing governments could do. First, banning derivatives will not work anywhere that has banks and computers. Though some regulatory tinkering is needed--such as more global cooperation and stricter monitoring of banks’ internal controls--the best way to limit derivatives risk is for banks to do it themselves. Already, post Barings, every bank in the world is reviewing its controls. Besides, underneath all the new-fangled technology, the real failures at Barings appear to be human ones even older than the bank: greed, laziness and mutual incomprehension.*

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