Management of Financial Institutions

Classic Financial Scandals:Corruption, Discovery, Black Wednesday

<< The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
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
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.
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.
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
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.
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).
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday