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A reflection on the Leeson incident

by Simon Longstaff

The collapse of Britain's oldest merchant bank, Barings, should hold a number of lessons for directors and other officers responsible for a company's operations.

Most important is the need to realise that no amount of external or internal regulation and surveillance is going to prevent determined people from going off the rails. Instead, directors should realise that they can expect comfort after having made real and sensible efforts to ensure that management addresses issues to do with the culture of the organisation they control.

The investigation ordered by Britain's Chancellor of the Exchequer, Kenneth Clark, is bound to concentrate on issues to do with internal control and compliance mechanisms. If this is all that it does, then a golden opportunity to address issues to do with the management of derivative-related risks will have been squandered. This is because the seeds of the destruction of Barings lie in the micro-culture of the dealing room.

The crisis precipitated in Baring's Singapore dealing room could just as easily have been the basis for a spectacular triumph. As is so often the case, censure has followed failure. The actual behaviour of the dealer is condemned because he bet the wrong way and then compounded his error by chasing losses. Had his judgement (or luck) been a little better, then he might now be enjoying the fruits of an enhanced reputation and a healthy bonus. It may appear a little cynical, however one must wonder whether Nick Leeson's superiors would have castigated him for the same deals if they had led to windfall profits.

Perhaps they would have been concerned. After all, it seems that Leeson disregarded instructions relating to the running of his book. His task was, essentially, to buy securities futures on the Japanese exchanges and then sell them, in short order, to buyers on the Singapore exchange. His profits were to be generated through the price differential - the classic role of the arbitrager. At its best, the work of arbitragers can improve the efficiency of markets. We have now seen the results of work done at its worst.

Why did it happen? It seems to me that events such as these are a direct product of the environment in which derivatives are traded. For the most part, traders operate as relatively isolated individuals whose remuneration is specifically linked to performance. That is, there is a direct nexus between profit and the size of the year's bonus. For my part, I have not yet come across a remuneration policy that gives a hoot about the way in which the profits are generated. Hence the apparent indifference that some banks show, when considering the interests of clients. Consciences are salved by the notion that clients entering the over-the-counter trade should have known better. Relationships between “counter-parties” are disdained.

At the same time, a climate of radical individualism in a highly competitive market breeds a culture in which errors are disguised in the hope that a sudden reversal in fortune will save the day. In these circumstances, traders are loathe to admit a mistake and, in some cases, will commit the cardinal error of chasing losses. What needs to be understood is that this can happen even when the motive of greed is absent. The atmosphere of most dealing rooms is saturated with testosterone. Aggressive behaviour and a need to hide any weakness dominate the psychology of the players.

Then there is the problem of the speculative bent of the market. Derivatives were originally synthesised as a tool of risk management. The idea of 'hedging' goes back to the old agricultural practice of building hedges to keep in the good and exclude the bad. Yet, the market has made a virtue of speculation (which is the euphemism used to describe what others freely admit to be gambling). A gambler is often blind to the consequences of each action. The temptation is to raise the stakes and wager an even higher stake. As has been seen in this case, there are clear winners and losers. What is more, the winners have no mercy. They press home their advantage to the last.

So what might be done about this? The first thing to note is that derivatives are neither inherently good nor bad. Used as a risk management tool they are innocuous. It all depends on the attitudes of the people who make the trades. Secondly, those who caution against over-regulation are right to point out that formal rules only have a limited effect. As one person wryly observed, “Hang a few peasants and it only makes the others smarter”.

Given this, we need to be cautious about adopting a response that is based on a technical ‘quick fix’. That is, it would be a foolish (and very brave) board that though that it could satisfactorily address the risks by the sole measure of bolstering the internal systems of surveillance and control. To be sure, such measures are needed and play an important role. However, there are inherent limitations in their efficacy.

Rather, there is a need to consider a radical re-appraisal of the way in which treasury operations are conceived and executed.

For example, the board might need to assure itself that profit expectations are realistic and not likely to add pressures of a kind likely to stimulate 'rogue' behaviour.

Secondly, remuneration policies may need to be reviewed so that a trader is rewarded not just for results but also on the basis of how the results were achieved.

Thirdly, there should be some consideration of the utility of introducing some form of inter-personal accountability - perhaps through the development of 'dealer teams", perhaps by fostering a wider sense of obligation to the company and its diverse stakeholders.

Fourthly, the company needs to define (and explain) the nature of its strategic position in the market-place. For example, those operating at the leading edge, in product design and delivery, may need to think through the extent to which their clients will look for and rely on a reputation for trustworthiness. Learning to trust is a shared practice that is best developed at home.

Finally, and most importantly, there is a need to address questions about the fundamental values of an organisation. What does the organisation value in practice, as opposed to what it says it values?

This is the hardest prescription to accept, because it involves a decision to open something of a 'Pandora's Box' from which all manner of expectations and disappointments might be liberated. Not least, a focus on values may raise fundamental questions about using principles of laissez-faire as a model for parts of the company's operations.

A reliance on external and internal regulation will not be enough. Directors have to bite the bullet and ensure that management see issues to do with ethics as being of fundamental importance. The impression is sometimes given that a concern about the values of a company is an ‘optional extra’, that it involves facing uncomfortable truths better left unexplored, that there are more important matters relating to the bottom line.

Tell that to Barings' customers, employees, shareholders and directors! Directors, in particular, ignore this latest lesson at their peril.

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