No Excuses: Managing Operational Risk

Headlines about high-profile white-collar criminals sometimes mask underlying weakness in business controls and risk management. This book excerpt looks behind the curtain.

Surviving a Series of Unfortunate Events

As we left the twentieth century and welcomed the beginning of the twenty-first, the world economy appeared to be in greater shape than ever before. Things were probably going well for you, too.You had an enjoyable job, working for a first-rate company. Every day you looked forward to your commute. On any given morning, you would make your way downstairs to your front door to be the first to take the morning's newspaper. Opening the paper, you would read the headlines. Let's take a look at the following news headlines and consider how much you or your company's board members would like to see headlines like these about the first-rate company for which you worked:

  • Exxon Takes a Spill in Alaska

    Newsday April 2, 1989
  • Heads Roll at Showa Shell

    The Independent—London February 26, 1993
  • Kidder Scandal Rocks Wall Street

    The Plain Dealer April 19, 1994
  • NASDAQ: An Embarrassment of Embarrassments

    BusinessWeek November 7, 1994
  • A Big Bank Goes Belly Up

    Los Angeles Times February 28,1995
  • How Many Other Barings Are There?

    Wall Street Journal February 28, 1995
  • Boss Resigns as More Daiwa Losses Emerge

    South China Morning Post October 10, 1995
  • Enron Falls—With a Whimper

    Miami Herald January 16, 2002
  • Andersen, Enron Get Federal Review

    Washington Post January 26, 2002
  • Allied Irish Plunges after Suspected Fraud

    Reuters News February 2, 2002
  • MCI Expected to Pay Massive Fine in SEC Deal

    Wall Street Journal May 19, 2003
  • Citigroup Private Banks Kicked Out of Japan

    New York Times September 20, 2004
  • Prudential to Pay Restitution and Fines of $ 600 Million

    Deseret Morning News August 29, 2006

Note that these headlines not only point to the financial impact on companies, but also have consequences beyond their earnings—from the personal to the greater community. Many people, especially those never involved in any wrongdoing, have been hurt and even ruined. Aside from resulting in headline news and adversely affecting a variety of industries and thousands of people, these obviously independent and unfortunate events have something else in common. Let us examine one of the more famous cases to help us better understand this unique commonality.

Crime of the Century

On February 26, 1995, Barings Bank, the oldest bank in Great Britain, was unable to meet its funding requirements and was declared bankrupt. Barings was founded in 1762, helped finance the Napoleonic Wars, the Louisiana Purchase, and the Erie Canal, and 233 years later, on March 3, 1995, the Dutch Bank, ING, bought it for a total of £1.00. How did something like this happen? Virtually all of the stories about this subject blame one man: Nick Leeson. These stories, often told and retold, are virtually the same.

Nick Leeson grew up in a suburb of London, England, and fi rst worked for Morgan Stanley. He later joined Barings and was asked to fix an operations issue in their Indonesia office, which he successfully accomplished within a year. As a result of this, he was moved to the Barings office in Singapore, and then by 1993 was promoted to general manager of that office, giving him authority over both the traders and the operations, or back office, personnel. He then passed an exam that allowed him to trade on the Singapore Mercantile Exchange (SIMEX) and then acted in the capacity of a trader, in addition to managing other traders and back-office personnel.

Leeson was an unlucky, or perhaps a poor, trader and began to mount major losses. He was able to hide these losses in an error account and show profits in his trading accounts. Being the head of both the front and back offices, he was the senior person to review both the trading and error accounts and decide what to report to Barings management at headquarters. Once Barings's senior management realized what had happened, the bank's losses had accumulated to $1.4 billion, and Barings was not able to meet its cash obligations to SIMEX, resulting in bankruptcy. Meanwhile, Leeson had fled the country and then was found and arrested in Frankfurt, Germany, on March 3, 1995, the same day ING purchased Barings for £1.00 (or $1.60 at that time).

Leeson was convicted of fraud and sentenced to six and a half years in a Singaporean prison. During this same time, statements like the following were made in many articles and magazine articles:

  • "One man single-handedly bankrupted the bank that financed the Napoleonic Wars..."
  • "The failure was caused by the actions of a single trader..."
  • "The activities of Nick Leeson led to the downfall of Barings"
  • "Leeson, acting as a rogue trader, accumulated over a billion in losses..."

Even Leeson himself admitted his guilt, and while in prison he wrote a book on the subject, entitled Rogue Trader: How I Brought Down Barings Bank and Shook the Financial World. That book was then made into a movie, called Rogue Trader, starring Ewan McGregor as Nick Leeson. And finally, TIME magazine includes the collapse of Barings among the top 25 crimes of the twentieth century! [[1]]

[Editor's note: Also see How to Stop Fraud on CSOonline.com]

Yet these stories and newspapers and magazines got it wrong.Yes, Leeson had engaged in unauthorized trading for over two years and exposed the capital of Barings Bank to almost unlimited potential loss. Yes, he committed fraud and needed to be punished for that crime. And yes, he took full responsibility for his actions, pleaded guilty, and spent time in jail. However, the collapse of Barings Bank cannot be placed squarely 100% on him. This was not a crime of just one person.

Another View of the Barings Collapse

While the vast majority blamed Nick Leeson as the "lone gunman" that killed Barings, a few dissenters emerged with a different, if not more enlightened, view. One such view, surprisingly, came from England's Board of Banking Supervision.The Board operated under England's 1987 Banking Act and then was subsumed within the Financial Services Authority (FSA) in 1998 (under the 1998 Bank of England Act). Immediately after the Barings collapse, the Board of Banking Supervision was requested by the Chancellor of the Exchequer to conduct an "Inquiry into the Circumstances of the Collapse of Barings" and issued its report on July 18, 1995. [[2]] This report paints a different picture of Barings Bank and its senior management. Rather than showing Barings management as a victim of a clever criminal of the century, the Board of Banking Supervision laid the responsibility for the collapse of Barings on the company's Board of Directors and management.

Beyond what the Board of Banking Supervision concluded, reviewing the facts would lead someone who understands risk management and control to conclude that Barings management allowed themselves to become bankrupt. How could this happen? Management of any thriving company would typically want their company to stay healthy and afloat. Barings management did not purposefully drive their company to bankruptcy, nor did they attempt to design a structure that would endanger company profits.This was a case of management inattentiveness and indifference, the results of which were the same as if management purposefully drove their company to ruin. What did management do or not do? Investigations found several things, including the following:

  • Allowing a lack of segregation between front-office and back office operations
  • No senior management involvement
  • Lack of supervision
  • Poor control procedures

Barings management allowed the lack of segregation between front- and back-office operations, a clear violation of a basic control in every business, especially banking. When Leeson was made general manager, Barings management allowed him to trade while simultaneously supervising back-office personnel—the same personnel who were supposed to independently review and process the trades executed by Leeson. What an absurdity—to be the manager of those who are supposed to independently review your work!

Even Barings's internal audit department became involved, as they should in every corporation as a normal course of business. In 1994, James Baker, the internal auditor assigned to review Leeson's operations, noted the lack of segregation of duties (by having the same manager supervise both front- and back -office operations) and recommended in his report that the "back office should be reorganized so that the General Manager is no longer directly responsible for the back office."[[3]] Leeson agreed to this recommendation in writing and then proceeded to ignore it. No one followed up to ensure that the promised action actually took place. This is just one of many examples where senior management did not bother to involve themselves in a significant operation.

On paper, Leeson had several supervisors. In reality, he had none, mostly because no one felt fully responsible for his actions. In fact, when Leeson first began his Singapore business at Barings in 1992, James Bax, the head of Barings Securities in Singapore, complained to senior management in London that Leeson's unclear reporting lines would create a "danger of setting up a structure which will subsequently prove disastrous." [[4]] This warning was ignored and Leeson was able to march ahead without suitable supervision or direction, without proper checks and balances. Anyone could easily go astray if even some minimal type of feedback is not provided.

Finally, what control procedures did Barings have in place? At some point in 1993, Barings reportedly tried creating a risk committee to review trading positions. That effort dissipated soon thereafter.Then, in April 1994, Barings management read the news of Wall Street trader Joseph Jett of Kidder Peabody, who created false profits of $350 million, resulting in major losses for that company. In response, and like many other financial services firms, Barings management began to review its controls in an attempt to prevent a similar incident at their bank. Even though control inadequacies were found, no changes were made.This is not surprising.A company that was willing to have a trader in a satellite location unsupervised with management oversight for both front- and back-office operations would not only be lacking in control procedures, but also unwilling to make the painful, yet important, changes necessary to ensure a return to some control over its risk.

Therefore, the eventual collapse of Barings Bank, whether brought into the open by the antics of Nick Leeson or by some other person, was due to the lack of controls at Barings Bank. Moreover, the collapse of Barings was due to the bank's lack of operational risk management.

A Story Closer to Home

The Barings story is truly fantastic and one that hopefully would not be repeated at another company, if its lessons were truly and fully learned. In fact, these are life lessons that need to be applied to all parts of business. Consider the following fictional account that could be happening at your company. Granted, this is a small event, and purposefully so. Such things may happen often and you are not aware of it. Perhaps what is happening at your company is not exactly like this incident, but something close....

Ken Clarkson has been very happy in his three years at Unicon Inc. He moved from operations to sales just a few weeks ago and believes that he is moving up in the company.

"Here you go, Ken." Alicia, the sales department's administrative manager handed him a familiar white envelope. "Your first official paycheck in sales."

He laughed as he took the envelope from her. While it was his first time being paid in his new department, it was the same process throughout Unicon.The envelope did not contain a check, but instead a statement of his earnings for the past two weeks, noting gross earnings, deductions for federal and state taxes, insurance and 401(k) benefits, and finally net earnings. Being a progressive company, Unicon places all of its employees on electronic direct deposit, thereby preventing losses and mistakes with printed paychecks.

"Oh, look at this," said Alicia. "You have a second one." She handed Ken a second envelope."Must be some hours left over from your previous department. Or maybe it's just your lucky day!" She laughed and walked over to another worker.

Ken knew that he was appropriately paid just two weeks earlier, so the second envelope could not be for any hours left over. He opened the first one—everything was what he expected: correct salary, correct deductions, and the correct net amount deposited into the correct bank account. He opened the second—same salary, deductions, and net amount also directly deposited into his bank account.

What should he do?

"Keep it," volunteered a coworker. "It's their problem."

"No," said a second coworker, "they are bound to catch it sometime and then you'll be in trouble."

"You won't be in any trouble," answered the first worker. "They made the mistake, and you thought one check was for your time in your previous department."

This is not a lesson in morals. People act according to their beliefs. In real life, Ken presented the two statements to the company's payroll department, where he was told "Thank you. We would never have caught this if you did not show us."

You say: This does not happen in my company.

Think again.

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