The breaking of the bank at Bishopsgate

If it had been a movie, no one would have believed it. Hamish McRae outlines the triple failure that led to one of the greatest banking collapses in modern times The Bank of England could have taken on Barings' liabilities, but it reckoned that the syste

The very idea that the actions of one 28-year-old in Singapore should bring down an august merchant bank, let alone threaten the stability of the world's financial system, is so inherently improbable that were it presented as a film script it would be regarded in the same light as Jurassic Park - great entertainment, but mercifully impossible in the real world.

Yet it has happened. That it could have happened is a morality tale for our times. It is a tale of three parts: the way in which individuals work nowadays in the world of finance; the way the international financial markets work; and the way the various regulatory bodies which oversee these markets carry out their task.

Part one concerns Nick Leeson, the employee in the Barings Singapore office who has subsequently disappeared and is being blamed for the losses. Until we hear his own version of what has happened, there will be a puzzle: why did he not stop? People in London who know him say he is a very competent dealer, not prone to acting in an irrational way and well aware both of the risks of trading in financial markets and of the rules that all banks impose on their dealing staff.

What is known is that last year he took on a series of contracts that bet on the Japanese stock market rising in the first weeks of this year. If the Nikkei-Dow index had indeed risen, these contracts would have been profitable. Instead, the market fell, partly in reaction to the Kobe earthquake, partly because the Japanese government seems to have suspended its support for the stock market.

You might think it odd for a British bank to be making bets on the movement of Japanese share prices, but Barings has a lot of experience of investment in East Asia, and merchant banks expect to make part of their profits by following their investment judgement. The scale of the Barings position at the turn of the year was apparently quite modest, sufficiently modest that even if the market fell the losses would be annoying but acceptable.

What ought at this stage to have happened is that Nick Leeson would recognise that the strategy had failed and close the contracts, taking the loss. Instead, it appears that he did the opposite, taking out new and larger contracts in an attempt to make good the earlier losses. The further that share prices declined, the larger the new positions; the further the market fell, the greater the bets and the greater the losses. Between the beginning of the year and last Thursday, when the scale of the losses was first revealed to senior management at Barings, the Nikkei-Dow had fallen by about 10 per cent.

There are plenty of precedents for this sort of behaviour. The late Robert Maxwell speculated disastrously on the financial markets in the last months of his life, hoping to win back some of the losses he had made on his other investments. But precisely because doubling up to cover losses is such a common gambler's instinct, all banks not only impose dealing limits on individuals, but have complex computerised reporting systems so that, in theory, they know the scale of the risks they are running at any moment in any market in the world. For some reason yet to be explained - maybe collusion between the dealer and settlement staff - these controls did not work.

All people make mistakes. All organisations have to have systems to pick up these mistakes, ideally before they do too much damage. In many walks of life - such as medicine or air traffic control - human failure can result in catastrophic loss of life. In the financial markets at least, it is only money which is lost. But the scale of the losses, here and in other recent financial crashes around the world, is such that everyone involved in the financial services industry must ask themselves how it might better order its affairs.

For if this is a tale of human failure, it is also a tale of industrial failure. On most measures, financial services is the largest industry in the world. As business has become more international, exporting more and importing more, companies have sought to insulate themselves as far as they can from the swings of the foreign exchanges or from changes in the trend of interest rates. The financial services industry has created a series of products, contracts that companies can buy, to try to offset these swings.

These products (see panel, right), go under the generic name of derivatives and can become immensely complex. Not surprisingly, there have been calls for more regulation of the products and the markets on which they are traded. Even central bankers find them too complicated to trust. The general public, for its part, can be forgiven for supposing that much of the trade on these specialist financial markets is little better than gambling - because that is precisely what it is.

People can understand that a bank is doing something useful if it is raising money for industry. It is harder to see the value if it is taking a punt on Japanese share prices. Yet if the commercial companies are to carry on protecting themselves against, for example, rises in interest rates, someone else has to take the gamble. The financial services industry takes this risk.

The trouble in this instance is that the industry failed to control its own gamble. It failed to remember the most basic rule of investment: stock markets can go down as well as up.

Part three of the tale concerns the regulators. In 1890, the Bank of England rescued Barings, a rescue that became an important landmark on the path towards central banks taking greater responsibility for the security of the financial system. In 1995, it didn't, thereby signalling that there were clear limits to the risks that it was prepared to incur on behalf of taxpayers in supporting financial institutions. The change in strategy reflects a decline in the relative importance of Barings itself. It was top of the world league of merchant banks in 1890; now it is merely top of the UK second division.

But an equally important reason for the change is a rethinking of the role of regulators: to what extent is it the duty of the taxpayer to bail out these rich (and pretty arrogant) financial institutions when they make a mess of things?

This is not just a British issue. At the weekend, the US Congress finally and reluctantly approved the administration's plans to provide financial support for Mexico. What, one might ask, is the US taxpayer doing paying for Mexican financial mismanagement? In the event, it was judged that collapse in Mexico would have a serious impact on US banks, so it was better to shore the place up. But is it the duty of British taxpayers to help shore up share prices in Tokyo? If the US support for Mexico suggests that support for bailing out continues, the refusal by the Bank to take on this commitment seems to suggest a new and more robust approach. The test of this approach will be whether the collapse of Barings damages the British banking system as a whole. The Bank could have taken on Barings' liabilities itself, for the numbers are not enormous in public finance terms. But it reckoned that the system was tough enough to take the crash.

As taxpayers, we should be relieved. In many ways it is much more healthy to allow companies that make fools of themselves in the financial markets to pay the full price of their stupidity. Just as a century ago the first Barings crisis marked a shift of responsibility from financiers to the authorities, so the second Barings crisis should mark the start of a return to self-reliance on the part of the supposedly clever people who run the world's financial institutions.

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