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A Lesson on Greed: The Reasons Behind the Collapse of Barings Bank and What You Can Learn From It
How many times can you play the market before your debt becomes insurmountable? How could one person possibly manage to bankrupt a large multi-national corporation? The answer lies in internal controls. Nick Leeson's fraudulent activities could only go by undetected because of Barings Bank's weak internal controls, specifically the lack of supervision, the inadequate segregation of duties and blatant disregard for ethics by senior management. Driven by greed, executives of Barings Bank increased the pressure on Leeson to deliver results. He responded in kind by doing everything he could to hide losses and show profit. As the vicious cycle gain momentum and the errors remain unaddressed, the collapse of Barings Bank was unavoidable.
A strong control environment sets the tone of an organization. It reflects the company’s integrity and values and influences the behaviors and attitudes of its employees. If the “tone at the top” appears to disregard ethical behavior, then the employees will use management’s example as a rationalization for fraud. A strong control environment provides the discipline and structure necessary for smooth business operations. Thus, it is the foundation on which all other components of internal control are built upon.
The general environment at Barings Bank is profit-focused, especially in the short-term. Management is more concerned with meeting the bottom line than complying with the code of conduct. Thus, management would allow their key employees (like Leeson), who generate profit for the company, remain free and unchecked. For example, when Leeson was arrested for his unethical behavior at the bar, management did not focus on his actions, instead, they worked to get him out of jail as quickly as possible. Immediately following the incident, they did not reprimand or punish him for his actions. This creates an unbalanced distribution of power and makes it clear that Leeson is being treated differently.
Secondly, the company’s performance and incentive programs are highly demoralizing. For example, Leeson was woken up in the middle of the night by Ron Baker, the head of Barings Financial Products Group located in London, with orders to generate two million pounds by next month in order to secure their bonuses. Not only was the timing of the call unreasonable, the proposition is simply unrealistic. Leeson has no choice but to manipulate transactions and hide losses to meet the demand. Yet, even when management was informed about the excessively high margin payments, they did not approach Leeson to question his trading methods. In fact, Ron Baker dismissed Brenda Granger’s concerns as negligible because Leeson was making the bank money. From his viewpoint, it did not matter to him how Leeson gained his profits, just so long as he did.
Finally, senior management tends to take extreme actions in regard to employee error/noncompliance. For example, when Leeson’s assistant sold twenty contracts instead of buying them, Simon Jones’s decision was to terminate her immediately. Jones did not consider the reason behind her mistake nor did he see the need to investigate and adjust controls that allowed for it to happen. Such an action shows that management does not care about their non-key employees. It conveys a direct message that unless you bring in profit, the company will not tolerate mistakes. However, if you do bring in profit, no matter what you do, the company will let it slide.
Risk assessment is vital in any business. It helps identify and analyze risks in terms of likelihood and occurrence, allowing the company to install proper controls. However, Barings Bank often overlook risk assessment in favor for profit. For example, when senior management decided to merge the Hong Kong and Tokyo markets together to replicate Leeson’s “success” in Singapore, they completely disregarded the business risks associated with the new venture. Similarly, the company also did not discuss and consider control issues associated with expanding business lines abroad. Management’s only consideration for their decision was profit. Thus, when it was revealed that Leeson’s strategy was arbitrage, the company conducted a meeting with all key employees to push insider trading as their new form of business. The adoption of information arbitrage greatly increases all aspects of business risk – especially in an emerging market like SIMEX.
Lack of risk assessment could also be seen when the board of executives met in London to discuss the amount of money being invested in the Singapore division. No one questioned Leeson; no one asked him why he needed the money or what it was used for. In fact, even after realizing that Singapore had funding restriction laws, they continued to send funds so long as Leeson requested for it simply because Leeson was making money. Even when the company began to question how Leeson was able to generate so much profit and sent Ash Lewis, the auditor, to check his documentation as part of government regulation, the board called her off the job since Barings was facing some difficulties with their securities. She was then subsequently replaced with two less experienced auditors who did not know what to look for indicating an inadequate training program for staff employees.
In simple terms, control activities are the policies and procedures that an organization develops to protect the assets of the firm. Yet, Barings Bank did not find internal controls to be a vital component of their business. Not only was there no training provided for the employees to understand the controls in place there are no evaluations being done on the control systems to check for quality and improvement. Executives and upper management at Barings Bank did not visit the Singapore division to check on progress and evaluate operations.
The most basic and essential internal control that was violated by Barings Bank is the segregation of duties. Leeson was promoted to be the general manager of the trading floor in Singapore. Yet, he was also the one responsible for settlement. That is, Leeson can make the trading transaction then recorded it himself. One of the main aspects of segregation of duties separates the function of generating revenue and documentation of revenue. Having proper segregation would allow a check on the process and reduce the opportunity for fraud.
Another lack in control activities is the absence of authorization. For example, when Beau Marchais asked Leeson to buy 4,000 contracts, even though the market average was lower, Leeson did not need to obtain any type of authorization prior to the purchase. After the purchase, no one from the company needed to review the transaction to ensure that it aligned with company objectives. In another instance, Leeson was able to freely create a new subaccount and transfer large amounts of money between the subaccount and other customer accounts. To prevent this, the internal controls IT program should require supervisors to co-sign large transactions and transfers. They should also implement trading limits/quotas so if someone wanted to do a large volume of trades, they would require supervisor authorization.
5Information and Communication
Information and communication includes the methods management uses to record, process and exchange information within the firm. It allows employees to gain a full understanding of their roles and responsibilities in particular to internal controls. Barings Bank fails in delivering information to and from its employees and senior management. In particular, board members and senior executives do not receive internal and external accounting information in a timely basis, if at all. When Leeson was told there was no money left in the 88888 subaccount to make margin payment to the clients (at that point, there was 10 million in losses), upper management at Barings Bank were completely unaware and thus agreed to send more financing to Leeson. Similarly, audit reports were not distributed to the right people in a timely manner. When Leeson was being audited by Mui Mui, he was the one that forged the documentation that justified the 7.78 million SIMEX receivable.
Personnel at Barings Bank did not understand their roles in the control system nor do they understand the accountability for their actions. For example, when Leeson’s boss, Simon Jones, received a letter from SIMEX regarding the suspicious activities in subaccount 88888, he took no action to follow up on it. Instead, he passed on the duty to Leeson and presented him with the letter after asking him to present a report regarding the account. In doing so, Leeson could take the chance to cover up his tracks. Similarly, Leeson’s assistant, Risselle Sng, continued to dump losses in the 88888 subaccount at request and never once questioned what she was doing and why.
While there is a lack of competent and knowledgeable personnel, the lack of information/resources provided to them aggravates the issue. For example, Brenda Granger was responsible for transferring funds to Leeson to meet SIMEX margin payments. When she noticed the funds being transferred were unusually high and requested to meet with Leeson to look over his paperwork, the board did not mandate Leeson to show up and as a result, the concern were discarded.
Most importantly, the accounting system at Barings Bank do not properly identify, assemble, analyze, classify, record and report the organization’s transactions in accordance to GAAP. The most obvious example would be the 88888 subaccount where Leeson dumps all of his losses. Similarly, he also used the 88888 subaccount to “transfer” the needed amount to match accounts receivables despite there not being any funds in the account to do so.
Monitoring allows management to assess the quality of internal control performance over time. It can indicate flaws in the system and help facilitate change. Therefore, without monitoring, all implemented internal controls can be considered useless.
A key component of monitoring is the relationship between management and the internal audit function. The internal audit group at Barings Bank did not have any support from management. For example, when Lewis was assigned to the audit of the Singapore operation, she was almost immediately called off the job to assist with securities. This action shows a lack of respect for the audit. Her replacements were almost a second-thought and they did not possess the level of expertise to catch any fraud in Leeson’s operations. Likewise, when Granger brought up concerns with margin payments, management merely brushed her off.
All of the problems associated with internal controls at Barings Bank could be ameliorated if management paid more attention and monitored their employees. For example, if Jones (or someone in a similar position) reviewed the different positions with the corresponding journal entries and documentation, it would be difficult for Leeson to commit fraud by forging signatures and confirmations.
From the analysis of Barings Bank’s internal controls above, it is clear that it was these violations that caused the large multi-national corporation to collapse. Greed for profit had blindsided the executives and management of Barings Bank to ignore the importance of strong controls (creating opportunities for fraud) and increased the pressure on key employees like Leeson to perform. This pressure coupled with an observed lack of ethical behavior and disregard for anything but results from the organization created the rationalization necessary for fraud to occur. If management had paid more attention to the tone of the organization and enforced the controls set in place, Barings Bank would not have been bankrupted by one person.