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Barings - the need for ethical culture

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 will, by itself, prevent determined people from going off the rails.

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.

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. Indeed it is rare to find a remuneration policy that specifically takes account of the manner in which profits are generated.

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, dominates the psychology of the players.

There is also the issue 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 even higher. As has been seen in this case, there are clear winners and losers. What is more, the winners display no mercy.

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 (and potentially useful). 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 thought that it could satisfactorily address the risks of unethical behaviour by the sole measure of bolstering the internal systems of surveillance and control. Such measures are needed and play an important role. However, there are inherent limitations in their efficacy.

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

For example, a responsible board will need to assure itself that profit expectations are realistic and not of an order likely to stimulate 'rogue' behaviour.

Secondly, remuneration policies may need to be reviewed so that a trader is rewarded - not only for the quantum of results, but according to the means employed in attaining the result.

Thirdly, there may be a need to introduce 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, need to think through the extent to which their clients will look for and rely on a reputation for trustworthiness. If trust is considered important, then it will need to be built across all relationships - even with supposedly sophisticated counter-parties.

Finally, and most importantly, there is a need to address questions about the fundamental values of an organisation. What does the organisation say it values? And what does it value in practice? The need to look seriously at the values of the organisation may be the hardest thing to accept.

Taken seriously, it involves a decision to open something of a 'Pandora's Box' from which all manner of unsettling expectations and disappointments might escape. Yet, I believe that there is no alternative for those who are serious about compliance.

A reliance on external and internal regulation will not be enough. Directors have to bite the bullet and ensure that management recognises the importance of developing an ethical culture. Some people act as if a concern about the values of a company is an ‘optional extra’, as if it involves facing uncomfortable truths better left unexplored, as if there are more important matters relating to the bottom line. Tell that to Baring's customers, employees, shareholders and directors!

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