Merchant bank vanishes into a loophole

Issue 

By Eva Cheng

The creative accounting of a 28-year-old whiz-kid in faraway Singapore blew open a US$1 billion hole into which the British merchant bank Barings fell, never to emerge. Observers fear that other financial "time bombs" are still ticking.

Or, to change the metaphor, Nick Leeson was not necessarily the one rotten apple in the banking barrel. There may be worms not in one apple, but in the whole basketful.

Merchant banks (called investment banks in the USA) deal primarily in big-ticket transactions. Those with less than a couple of million dollars to spare wouldn't even qualify to be on their client list.

The truth may never be ascertained, but initial evidence suggests that Leeson created a chain of fictitious accounts to get around Barings' internal surveillance. This enabled him to build up a huge position, as well as to siphon off gains when prices moved in his favour.

Leeson gambled on futures on the Nikkei-225 index, which measures the price movement of Japan's 225 biggest listed companies. He bet that the index would rise. When Japanese stock prices tumbled following the earthquake in Kobe, Leeson and Barings were in big trouble. He apparently tried to recover the loss by taking on even bigger positions, only to get deeper in the mud.

Futures, together with products like forwards, swaps and options, are financial products which together are called derivatives. Derivatives are financial obligations packaged up as tradeable commodities. Through such vehicles, literally trillions of dollars are at stake every year.

Futures are obligations to buy or sell an asset at a specified price on a specific date (any time from 90 days to a few years in the future). A player "longs" in anticipation of the price of the asset rising, and "shorts" if expecting it to fall.

By way of a margin system, a participant has to make a down payment of only a fraction of the worth of the contract in order to be in the game. This is called "leveraged" play; it opens one to a windfall or a downfall depending on how the price moves.

This explains why the Bank of England, the British regulatory watchdog, refused to bail out Barings despite the risk of rocking the system by letting it go under. It just does not know how deep the hole is. No-one does. It can be as deep as the Nikkei index can fall, multiplied by the extent of leverage.

Governments and regulatory bodies are now discussing whether it is possible to prevent future repeats of the Barings fiasco. The answer is that it's very unlikely.

When it comes to fraud, especially by top management, the world's regulatory watchdogs are still looking for a way to prevent it.

To ban derivatives is out of the question. Like bonds and stocks, derivatives are created for purposes found indispensable by modern capitalism.

Bonds are debt instruments which enable borrowers to pay a fixed rate and lenders (bond holders) to get a fixed rate income. The yield is usually modest relative to stocks, but the principal investment is secure unless the borrower goes bankrupt.

Stocks are another story. Each stock represents ownership of a tiny fraction of a company, whether listed on the stock exchange or not. The yield can be much higher than that of bonds, but the principal investment can be wiped out by business failures.

Neither bonds nor stocks are designed for speculation, but they become a means of speculation, particularly when capital is short of profitable productive investments.

Derivatives are designed primarily as tools for risk management. Futures, for example, are a way to neutralise one's exposure to the fluctuating value of a product or currency. An Australian wool exporter who is to be paid in Japanese yen a few months down the track can sustain major losses if the yen falls in the meantime. The risks can be contained by a currency future to exchange yen for Australian dollars at a specified rate at a specified date.

Swaps enable one to exchange obligations on, say, currencies or interest rates. A floating rate obligation can be traded for a fixed rate one, and one currency for another one.

The risks of futures and swaps are hard to gauge because the value of the underlying asset is shaped by complex factors. Leveraging makes things worse.

It is hard to imagine doing without derivatives. Ask an exporter or importer, for example, how they are going to manage their interest rate or currency exposure in the absence of derivatives. It would introduce enormous chaos to business.

Out in the market, meanwhile, those with sizeable spare cash have long stopped hoarding their money primarily with banks, preferring stocks, currencies, futures and property, to name a few. Similarly, sizeable borrowers more and more go directly to the capital market to raise funds instead of taking out a more expensive bank loan. To remain part of the action, banks have to expand into the new financial supermarkets.

While banks still maintain a residual role in traditional money transactions, most of the big-ticket actions go directly to the markets. Some markets provide a bit of room for small players, but the main actions are between the institutional players with deep pockets.

These big players are not happy that loopholes have enabled a bit player like Nick Leeson to beat the system. But they haven't yet found a way to plug the holes.

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