Modern Banking
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because it was offering higher interest rates. Western Isles Council lost up to £24 million when the bank was closed, which it had to borrow from the Scottish Office (to be repaid over 30 years) to finance the provision of local council services. In different parts of the world (BCCI had offices in 73 countries), such as Pakistan and Hong Kong, where the bank was not closed immediately, there were runs on BCCI branches. Many depositors lost all their savings.
During the Florida criminal case, it was revealed that top BCCI managers knew about and approved of the money laundering. Therefore, BCCI management failed the ‘‘fit and proper’’ test. The Bank of England did not suspend management, even though it had the discretionary power so to do. The Florida drug case prompted the establishment of a College of Regulators because of concern about BCCI. The original group consisted of regulators from the UK, Switzerland, Spain and Luxembourg. Hong Kong, the Cayman Islands, France and the United Arab Emirates joined later. However, it was largely ineffective. In July 1989 Manhattan District Attorney staff attended an international conference on money laundering, held in Cambridge, UK. They discovered BCCI had an international reputation for capital flight, tax fraud and money laundering. Assuming the Bank of England also knew about it, there is the question of why BCCI was not closed earlier. Furthermore, it is alleged the Bank of England and Price Waterhouse failed to cooperate with the US authorities. For example, investigators from the New York District Attorney’s office claim they were refused access to BCCI London documents in July 1989. Also, the Manhattan District Attorney and the Federal Reserve were unsuccessful when they tried to get a copy of the Price Waterhouse special audit report. In the autumn of 1990, the Federal Reserve demanded a copy of the audit.
Price Waterhouse (PW) had been BCCI’s sole auditor since 1988, and submitted 10 reports to the Bank of England. Two Price Waterhouse reports were published in April and October 1990, indicating large-scale fraud. The Price Waterhouse evidence to the British House of Commons (February 1992) confirmed that as early as April 1990, they had been informed by the Bank of England at BCCI, ‘‘certain transactions have either been false or deceitful’’. In October 1990, PW reported fictitious loans and deposits to the Bank of England. By December, the auditors told the Bank the main shareholders in Abu Dhabi were aware of the fraud. The Bank of England admits that it received its first indication of fraud in January 1991, but it did not activate section 41 of the Banking Act until March. The section 41 investigation carried out by Price Waterhouse confirmed large-scale fraud, but it was a further four months before BCCI was closed.
Two people appeared in a UK court, charged with conspiring to mislead BCCI’s auditors. Mohammed Abdul Baqi, a former managing director of a London based trading group, was convicted in April 1994 and given a custodial sentence. In 1997, Abbas Gokal was found guilty on two counts of conspiracy – one to defraud, the other to account falsely, which involved the secret removal of £750 million from the bank. He was fined £2.9 million and sentenced to 14 years in prison. In the USA, two Washington ‘‘super lawyers’’, Clark Clifford and Robert Altman, were accused of concealing BCCI’s ownership of Bankshares, fraud, conspiracy and accepting $40 million in bribes, but the charges were dropped against Clifford in early 1993, and Altman was acquitted in 1994. In Abu Dhabi, 14 ex-BCCI
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faith – ‘‘knowingly and recklessly’’ failing to supervise the bank properly, thereby subjecting customers to unreasonable amounts of risk. Failure to forecast an imminent collapse is not enough. The case is expected to last for up to two years.
7.3.8. UK Small Bank Failures and Liquidity Problems, 1991–9333
This episode is reported here because it began before the failure of BCCI but appears to have been exacerbated by it. It shows how regulators can contain the problem if it is largely one of liquidity. The Bank of England opted to keep the liquidity difficulties of up to 40 small34 banks a secret until after the crisis had passed. The banks faced problems on both sides of the balance sheet. The British economy enjoyed a boom until 1988, then recession: commercial property prices fell 27% between 1989 and 1993; residential by 14%. Many of these small banks specialised in property lending. Recession reduced the quality of their assets and the value of collateral, which was largely in property. These banks also depended on wholesale funding. At the end of 1990, US, Japanese and other foreign banks began to reduce their sterling deposits because of increased concerns about the UK’s unexpectedly prolonged recession. By the end of 1992, they had fallen over sevenfold. The Bank of England closely monitored 40 small banks very closely from mid-1991. Many were told either to reduce their assets and/or increase their liquidity. There were virtually no systemic effects after three small banks failed in early 1991.
The collapse of BCCI and the losses incurred by the Western Isles Council exacerbated the problem, as local authorities shifted their funds into the bigger banks, which they considered to be too big to be allowed to fail. In 1991, the Bank of England supplied liquidity in the form of loans to a few small banks, and had to provision for it – provisions peaked at £115 million in 1993. The Bank decided to take action because it believed contagion was the main culprit, which could spread to larger banks if not kept in check. Not all banks survived. Auditors of the National Mortgage Bank could not sign it off as healthy because of concerns about its illiquidity. The Bank of England purchased it for £1 in 1994, and it was sold in 2000. In total, 25 small banks failed in the first half of the 1990s, but there was no contagion or systemic crisis, no doubt due to the willingness of the Bank to support the small banks that were illiquid but solvent.
7.3.9. The Secondary Banking Crisis, 1973
The events of the early 1990s share some features with the UK’s secondary banking crisis. In the early 1970s, several small banks were rescued by the Bank of England. A number of so-called ‘‘secondary’’ banks were established in the UK in the 1960s. Unlike the mainstream banks, which relied on relatively cheap, stable retail deposits, most of the funding for the new banks came from the growing wholesale money markets, which they
33This account is from Hoggarth and Soussa (2001) and Logan (2000).
34According to Logan (2000), there were 116 authorised small banks and 92 of them had a full data set. Their average size, by assets, was £166.4 million, compared to a mean of £11.8 billion for the UK’s major banking group. Within the small bank group, the smallest had assets of £1 million; the largest stood at £3.2 billion.
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used to fund long-term loans, mainly to property and construction companies. A tightening of monetary and fiscal policy in 1973, together with the first OPEC oil price hike, caused interest rates to increase and declines in property prices and the stock market. The balance sheets of the secondary banks suddenly began to look quite weak, especially because much of the collateral backing their loans was stocks or equity. Some suffered from a withdrawal of deposits. The Bank of England organised a lifeboat rescue: 26 secondary banks were given £1.3 billion in loans, 90% of which came from the major UK clearing banks. The Bank of England was able to persuade shareholders and creditors not to take action that would cause a failure. Some of the insolvent banks were either taken over by other banks or the Bank of England itself. At the time there was no deposit insurance, but depositors (not shareholders) were protected. The lessons from the crisis were reflected in the UK’s first major piece of banking legislation, passed in 1979 (see Chapter 5), which included a deposit insurance scheme and tighter restrictions on bank licensing.35
7.3.10. Barings
‘‘The recovery in profitability has been amazing following the reorganization, leaving Barings to conclude that it was not actually terribly difficult to make money in the securities markets.’’
(A 1993 remark attributed to the Chairman of Barings plc, speaking to Mr Brian Quinn, Director of the Bank of England at the time)
‘‘People at the London end of Barings were all so know-all that nobody dared ask a stupid question in case they looked silly in front of everyone else.’’ (Nick Leeson, Rogue Trader, 1996)
On Sunday, 26 February 1995, the oldest merchant bank in the UK, Barings (founded in 1762) ceased trading and was put into administration.36 It owed over £800 million on financial derivatives contracts, but had a capital base of just £540 million. On Friday, 24 February, Barings’ senior management became aware of large losses in its Singapore office and requested support from the Bank of England. Auditors’ reports came in suggesting Barings was highly likely to be insolvent, raising the question of whether contagion effects arising from the bank’s failure were serious enough to warrant the central bank’s intervention. It was decided the risk of contagion was small because Barings was a small merchant bank; the exposures were largely bilateral (see below), and it was due to fraud.
The next question to be addressed was whether other banks, concerned about the reputation of other merchant banks or the City of London as a financial centre, might be willing to purchase Barings. The decision whether to provide support had to be taken by Sunday evening London time before the Japanese markets opened because insolvent firms are not allowed to trade. So the Bank of England spent the last weekend of February 1995
35This account is taken largely from Davis (1992), but see also the Bank of England (1978) and Reid (1982).
36Under the 1986 Insolvency Act, a firm can be put into administration, and an administrator appointed to try and prevent a failing business from being liquidated, and to keep it operating as a going concern. Administration automatically freezes the enforcement of creditors’ rights. By contrast, the receiver’s duty is to protect the interests of the creditors.
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trying to put together a lifeboat rescue package involving other banks, but it conceded defeat late on Sunday night. The Bank could not persuade a bank or banks (both domestic and foreign) to close futures contracts entered by a trader, Mr Nick Leeson, in Barings’ Singapore offices. A syndicate of commercial and investment banks was ready to recapitalise Barings (at an estimated cost of £700 million), but none would accept a fixed fee in exchange for closing these trading positions. The Bank of England announced it was ready to provide liquidity to the markets if necessary, but refused to use public funds to bail out Barings. As it turned out, global market disruptions were minimal, demonstrating the point that the insolvency of a small merchant bank, however famous, was unlikely to provoke systemic collapse.
The Chancellor of the Exchequer, Mr Kenneth Clarke, announced that the Barings collapse would be investigated by the Bank of England’s Board of Banking Supervision, but ruled out a public or independent inquiry. This Board was chaired by the Governor of the Bank of England and consisted of six outside members, in addition to Bank of England representatives. In March 1995 the Bank’s governor, Mr (later Sir Edward) George revealed that six external members had been asked to make an independent assessment of the Bank of England’s supervision of Barings. The Board of Banking Supervision’s Report (‘‘The Report’’) was made public on 18 July 1995.
Before its collapse, Barings was well known in the City of London for mergers and acquisitions and its strength in emerging markets. Roughly half of the bank’s employees were based outside the UK – a third in Asia. The broking and market making arm of the bank, Barings Securities, was a leading equity broker in Asia and Latin America. The fund management operation had a reputation for its expertise in Eastern Europe. Just as exposure in Latin America had led to near ruin in 1890, so exposure in the Far East was the cause of Barings’ downfall in 1995.
On 6 March 1995, Internationale Nederlanden Group (ING Bank), a Dutch bancassurance concern, purchased Barings’ banking, securities and asset management businesses for one pound sterling. Bancassurance is the combination of banking and insurance in one group. ING had been formed as a result of the merger, in 1991, of Nationale Nederlanden (the largest Dutch insurer) with the Netherlands’ third largest Dutch bank, NMB Postbank, known for its lending to small and medium-sized Dutch companies. Bank branches sell insurance and the group was able to offer new financing schemes to corporations by pooling the short and long-term funds from, respectively, the banking and insurance arms of the company. ING took responsibility for Barings’ existing liabilities (estimated at £860 million), but any future liabilities will be borne by Barings plc, the holding company, which ING did not buy.
ING was inexperienced in third party fund management, corporate finance and brokerage, and there were high expectations that Barings’ expertise in this area would prove beneficial.37 Just under 5 years later (November 2000), ING announced that its US operation (2000 employees) of ING Barings was to be sold or wound down, while the London office would be integrated into the wholesale operations of ING. At the time of the announcement Barings’
37 To encourage staff to stay on in the aftermath of Leeson, the chairman of ING announced that all senior executives of Barings would be kept on until the publication of the Bank of England report. Staff bonuses of close to £100 million were paid, though senior employees directly involved in the losses were excluded and executive directors of Barings waived them.
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limiting it to a single exposure of no more than £100 million. Yet in the first two months of 1995, Barings transferred a total of £569 million to Barings Futures, Singapore. The losses accumulated in Mr Leeson’s account amounted to £384 million. Barings did not report the exposure to the Bank of England. However, the Bank of England should have been able to detect the substantial increase in credit exposure through the monthly liquidity report, supplied by a bank’s treasury to supervisors. Though some other banks, including the BIS, noted Barings’ increased borrowings on the money market by the end of January 1995, the Bank of England apparently did not. Mr Chris Thomson, the supervisor for merchant banks, resigned from the Bank of England in the week before the Report was published. He had agreed to allow Barings to exceed exposure limits on the Osaka Securities Exchange. This informal concession was granted without any consultation with more senior Bank of England officials. Once discovered, the Bank of England took over a year before it rescinded this concession, in January 1995.
One gets a sense of dej´a` vu when reading the Report’s criticism of Barings’ external auditors, Coopers and Lybrand. Coopers and Lybrand London was criticised for failing to conduct sufficiently comprehensive tests that would have detected the large funding requests from Singapore, which were inconsistent with the claim that Leeson’s profits were coming from arbitrage. Coopers and Lybrand Singapore had audited Barings Futures Singapore in 1994, and had been satisfied that proper internal controls were in place. Coopers London responded that it did find and report a £50 million discrepancy – the documentation for a £50 million receivable was insufficient. The firm also argued it cannot be criticised, because Barings collapsed before it had conducted its 1994 audit. But the Board of Banking Supervision has called for improved communication between internal and external auditors, and regulators – recall that similar conclusions were reached after the JMB and BCCI investigations. As was discussed in Chapter 5, the duties of auditors have been considerably enhanced under the FSA.
Mr Leeson fled to Germany (en route to London) after the losses came to light. He was arrested by the German authorities after Singapore filed an extradition request. In late November 1995, Mr Leeson gave up his fight against extradition, was later convicted of fraud, and sentenced to 6.5 years in a Singapore prison before being released in July 1999.
BCCI’s administrators (KPMG) sued Coopers and Lybrand – both the London and Singapore offices were named in the law suit. They settled out of court soon after the trial began in 2001, for a sum of £65 million. In addition, an accounting watchdog (the Joint Disciplinary Scheme) fined Coopers and Lybrand for its role in the downfall of Barings. In April 2002, C&L appealed to a tribunal and lost, though the size of the fine imposed was reduced to £250 000. Of the complaints against two audit partners, one was dismissed but the other was upheld, though the size of the fine was reduced to £25 000 from £65 000. In June 2003, a High Court judge ruled that Deloitte and Touche (Singapore) was not liable for the £850 million in trading losses but was negligent in its audit work at Barings Future Singapore in 1992 and 1993. The fine of £1.5 million was well below the £130 million demanded by KPMG.
Since the Barings fiasco, there have been a number of other rogue trader incidents.
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7.3.11. Daiwa Bank
In September 1995, a senior bond trader, Mr Toshihide Iguchi, lost just over $1.1 billion, over a 10-year period, while working for the New York branch of Daiwa Bank. He covered up the trading losses through the sale of securities stolen from customer accounts, which were replaced by forged securities. The losses remained undetected until Mr Iguchi confessed to Daiwa in July. Japan’s Ministry of Finance had given the New York branch a clean bill of health in 1994. The branch had also been subject to joint regulatory scrutiny by the Federal Reserve Bank of New York and state banking authorities since 1991. The auditors in Japan (part of Ernst and Young International) did not conduct a separate audit of the New York branch, so failed to spot any problems. While the parent bank had sufficient capital to absorb the loss, American regulators were furious with Daiwa for a number of reasons.
žIguchi had worked in the back office for many years before becoming a trader in 1983. However, he did not give up his back office duties. Regulators criticised Daiwa in 1993, and Daiwa had agreed to reorganise the bank to ensure separation of back and front offices. Traders would no longer report to Iguchi, as Head of Securities Custody. However, the bank failed to act on its promise, and Iguchi remained in this post from 1977 to 1995. Iguchi was effectively auditing his own accounts, giving him the opportunity to hide the losses.
žDaiwa used its hidden reserves to purchase and replace the securities that Iguchi had sold off.
žDaiwa management failed to report the losses for two months even though an official at Japan’s Ministry of Finance had been informed of the problem in early August.
The bank faced several criminal charges but in a plea bargain, was fined $344 million. More serious, in November of 1995, Daiwa was ordered to cease US operations within 90 days. Sumitomo Bank purchased most of its US assets (worth $3.3 billion), and Daiwa sold its 15 US offices. In December 1996, Iguchi was given a four-year prison sentence and fined $2.6 million. In September 2000, eleven current and former Daiwa board members were ordered (by a Tokyo judge) to pay Daiwa $775 million in damages. The judgement was subsequently appealed.
7.3.12. Sumitomo Corporation
In June 1996, the UK Securities and Investment Board revealed that for over a decade, one of Sumitomo’s copper traders, Yasuo Hamanaka, hid losses of $1.8 billion, which eventually rose to $2.6 billion. Problems began in 1985 when Saburo Shimizu, Hamanaka’s boss, began forward trading on the London Metal Exchange forward market for copper. The trades were an unauthorised attempt to recover earlier losses on physical trades of copper. But the losses mounted to $60 million, at which point Mr Shimizu resigned. Hamanaka continued the trades, in an effort to recoup the losses. It is estimated he conducted up to $20 billion in unauthorised trades. Tried in Tokyo in 1997, Hamanaka pleaded guilty to charges of fraud and forgery.