NEWS ANALYSIS: Barings Seen as Case of Systems Failing to Keep Pace

U.S. financial institutions can learn important lessons in the importance of trading risk management from the failure of Barings PLC, according to industry observers.

John Boyd, president of Columbus, Ohio-based Transformation Management Inc., a firm specializing in management consulting and strategic planning, said the collapse of the 233-year-old British firm appears to be the direct result of a lack of controls over traders and management's fear of dealing with losses.

"It is a very big error to allow the person who is conducting the trades to report his actions to management, but an even bigger mistake for management to avoid warnings," he said.

"It appears that management looked at the paper losses and were afraid to recognize the losses because of the unfavorable impact on the institution."

In a traditional banking environment, risk management in the trading area is handled by physically separating the record of purchase or commitment to purchase a security from the process of entering the item into the books. This separation gives trading overseers what they term "dual control."

However, as trading technology grows more sophisticated, it becomes more difficult to monitor the operations by traditional means. Enter the need for advanced risk-management systems.

"It seems that Barings had elevated its ability to conduct trades electronically, but it did not keep pace with risk-assessment technology or the ability to keep track of what was happening," Mr. Boyd said.

"Traders know where their positions are, but management does not have the ability to distill the data or understand what is going on."

David Berry, director of research at Keefe, Bruyette & Woods, echoed Mr. Boyd's concerns, adding that strict oversight rules can be as important in risk management as the technology employed.

"In any environment, two eyes are always better than one, no matter what you are looking at," he said.

"There has been a lot of looking into trading and derivatives, and there are a lot of models to look at. Sometimes (the instruments are) hard to understand, but it is very easy to understand who reports to whom and on what level decisions are made."

Mr. Berry said he believed that the management structure at Barings was unclear, and that the offices through which the trades that brought the investment bank down were not subject to much outside scrutiny.

U.S. banks tend to have more trading controls than Barings, Mr. Berry said, but he noted that there was still a lesson to be learned from the bank's troubles.

"In any large bank in New York, there is an understanding that when it comes to trading you are dealing with dynamite, and that the operation needs to be treated as such," Mr. Berry said. "There are traders, the back office, auditors, and management checking on the operation at all times.

"At Barings, it looks as though this structure was not in place."

U.S. financial institutions typically use risk-management systems that employ a number of checks and balances, trading limits, and audit functions to limit the effect a lone trader can have on an entire operation.

William Spinard, managing director of Furash & Co. in Washington, said most U.S. firms did not let traders settle the trades as Baring's rogue trader Nicholas Leeson did in Singapore.

"Having the checks and balances in place ... insures that the risk that the trader is taking is the risk that is defined by senior management and the board," he said.

"Without the checks and balances in place, there is no meaningful measurement to risk exposure and no meaningful measurement that the bank is getting adequately compensated for the risk that it is incurring."

Though many institutions have effective mechanisms in place, experts emphasized the need to frequently audit risk-management procedures to ensure they are doing their intended job.

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