Historical Background and Inherent Risk Analysis

Historical Background and Inherent Risk Analysis

The history of Baring traces back to 1762. Once remarked as one of the six great powers in Europe, it was the oldest merchant bank in the United Kingdom at the time of its collapse (Robert 2002). Initially its main business was financing foreign trade. After the deregulation of financial market in 1986, Barings expanded aggressively into derivative trading and recruited some extreme risk takers. Aiming at being the pioneer in speculative derivative trading, The Bank appointed Nick Leeson who seemed to understand financial market as the Chief trader in Barings Futures Singapore (BFS).

During the first stage of audit risk assessment, the auditor should obtain understanding of the BFS's business strategy to determine the corresponding risks. The main inherent risk including the following:

Nature of the entity’s business There were two core trading strategies employed by BFS. Baring's management called the first one 'switching'. It related to buying and selling Nikkei 225 futures contracts simultaneously in Singapore International Monetary Exchange (SIMEX) and Osaka Stock Exchange (OSE). BFS also constructed ‘baskets’ that contained weighted stocks composing the Nikkei Index futures, and arbitraged against Nikkei Index Futures itself. The profit came from the prices discrepancy. Although this is theoretically risk-free, BFS may not be able to match the number of contracts at the point of time. Another trading strategy was 'straddle'. It involves selling both put and call options of a standardized quantity of Nikkei 225 Index at same exercising price and same expire date, and then offset the loss from being excised against by premium collected. This kind of straddle will 'generally produce positive earnings (limited by premiums) when markets are stable but can result in unlimited losses if markets are volatile'(Barings Bank and Nick Leeson u.d p. 2). What’s worse, the volume Leeson had BFS exposed was large, which leads to high risk of insolvency if the market moves against his business decisions. The fluctuations of exchange rate and financial market are also part of the risk. The extreme case was the Kobe earthquake that caused significant systematic fall in prices.

Management experience and knowledge The speculative trading of derivatives largely depends on trader's experiences, analysis and judgement of market movement. Nick Leeson was a 25 years old young trader dedicated responsibilities that are not commensurate with his experience and management skills. In addition, the Barings management teams both in Singapore and London lack the knowledge of derivative trading, which leads to ineffective supervision. As a consequence, Leeson practically dominated the company's operating and financing decisions, and controlled the accounting system.

Integrity