bad ethical decisions

7/29/2019 Bad Ethical Decisions

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WHY DO GOOD MANAGERS MAKE

BAD ETHICAL DECISION?

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What is Ethics?

Simply stated, ethics refers to standards of behavior that tell us how human beings ought

to act in the many situations.

The behavior that includes respecting human dignity and vulnerable people and keeping

them in mind when making decision in

It is helpful to identify what ethics is NOT

Ethics is not the same as feelings

Ethics is not religion

Ethics is not following the law

Ethics is not following culturally accepted norms.

Ethics is not science

Why Identifying Ethical Standards is Hard?

There are two fundamental problems

On what do we base our ethical standards?

How do those standards get applied to specific situations we face?

A Framework for Ethical Decision Making

Recognize an Ethical Issue

Get the Facts

Evaluate Alternative Actions From Various Ethical Perspectives

Utilitarian Approach: The ethical action is the one that will produce the greatest

balance of benefits over harms.

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Rights Approach: The ethical action is the one that most dutifully respects the

rights of all affected.

Common Good Approach: The ethical action is the one that contributes most to

the achievement of a quality common life together.

Fairness or Justice Approach: The ethical action is the one that treats people

equally, or if unequally, that treats people proportionately and fairly.

Virtue Approach: The ethical action is the one that embodies the habits and values

of humans at their best.

Make a Decision and Test It

Act, Then Reflect on the Decision Later

Ethics Principal

Honesty Dont mislead or deceive others. Integrity Do what is right.

Trustworthiness Supply correct information, and correct information that is not

factual.

Loyalty to facility Avoid conflicts of interest and dont disclose confidential

information.

Fairness Treat individuals equally; always appreciate diversity.

Concern and respect Be considerate of those affected by decision-making.

Commitment to excellence Always do the best you can do.

Leadership Lead by example.

Reputation and morale Work to enhance the facilitys reputation and to improve

the morale of employees.

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FOUR COMMONLY HELD RATIONALIZATIONS THAT

LEAD TO UNETHICAL DECISIONS

The first rationalization is :

A belief that the activity is within reasonable ethical and legal limitsthat is, that it

is not really illegal or immoral

The idea that an action is not really wrong is an old issue. How far is too far? Exactly

where is the line between smart and too smart? Between sharp and shady? Between profit

maximization and illegal conduct? These are some complex issues that a manager has todeal with.

Put enough people in an ambiguous, ill-defined situation and some will conclude that

whatever hasnt been labeled specifically wrong must be OKespecially if they are

rewarded for certain acts.

Top executives seldom ask their subordinates to do things that both of them know are

against the law or imprudent. But company leaders sometimes leave things unsaid or give

the impression that there are things they dont want to know about. In other words, they

can seem, whether deliberately or otherwise, to be distancing themselves from their

subordinates tactical decisions in order to keep their own hands clean if things go awry.

Often they lure ambitious lower level managers by implying that rich rewards await those

who can produce certain resultsand that the methods for achieving them will not be

examined too closely.

How can managers avoid crossing a line that is seldom precise? Unfortunately, most know

that they have overstepped it only when they have gone too far. They have no reliable

guidelines about what will be overlooked or tolerated or what will be condemned. When

managers must operate in murky borderlands, their most reliable guideline is an old

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principle: when in doubt, dont

A belief that the activity is in the individuals or the corporations best interests

that the individual would somehow be expected to undertake the activity.

Turning to the second reason why people take risks that get their companies into trouble,

believing

that unethical conduct is in a persons or corporations best interests nearly always

results from a parochial view of what those interests are.

Ambitious managers look for ways to attract favorable attention, something to distinguish

them from other people. So they try to outperform their peers. Some may see that it is not

difficult to look remark ably good in the short run by avoiding things that pay off only in

the long run. For example, you can skimp on maintenance or training or customer service,

and you can get away with itfor a while. The sad truth is that many managers have been

promoted on the basis of great results obtained in just those ways, leaving unfortunate

successors to inherit the inevitable whirlwind.

Companies cannot afford to be hoodwinked in this way. They must look closely at how

results are obtained.

A belief that the activity is safe because it will never be found out or publicized;

the classic crime-and-punishment issue of discovery.

The third reason why a risk is taken is belief that one can probably get away with it, is

often the most difficult to deal with because its often true. A great deal of the unethical

behavior often escapes detection.

We know that conscience does not deter everyone. The most effective deterrent for such

wrongdoings is not to increase the severity of the punishment for those who are caught

but to increase the probability of being caught in the first place. Simply increasing the

frequency of audits and spot checks is a deterrent especially when combined with three

other simple techniques: scheduling audits irregularly, making atleast half of them

unannounced and setting up some checkups soon after others.

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A trespass detected should not be dealt with discreetly. Managers should announce the

misconduct and how the individuals involved were punished. Since the main deterrent to

illegal or unethical behavior is the perceived probability of detection, managers should

make an example of people who are detected.

A belief that because the activity helps the company the company will condone it

and even protect the person who engages in it.

Top management has a responsibility to exert a moral force within the company. Senior

executives

are responsible for drawing the line between loyalty to the company and action against

the laws and values of the society in which the company must operate. Executives have a

right to expect loyalty from employees against competitors and detractors, but not loyalty

against the law, or against common morality, or against society itself. Managers must

warn employees that a disservice to customers, and especially to innocent bystanders,

cannot be a service to the company. Finally, and most important of all, managers must

stress that excuses of company loyalty will not be accepted for acts that place its good

name in trouble.

These are some justifications that managers give for making unethical decisions. A good

way to deal with these is to ensure that there are strong controls and a well defined code o

ethics in place in the organization.

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MENTAL GYMNASTICS BEHIND UNETHICAL BEHAVIOR

Decision making can often result in managerial missteps, even those decisions thatinvolve ethical considerations.

Most significantly, various cognitive processes that leaders often unwittingly employ andwhich may be called mental gymnastics or mind games may serve to support andsustain unethical behavior.

Mind Game #1: Quickly Simplify - Satisficing

When we are confronted with a complicated problem, most of us react by reducing theproblem to understandable terms. We simplify. We tend to make quick decisions basedon understandable and readily available elements related to the decision.

We search for a solution that is both satisfactory and sufficient.

Unfortunately, this process, called satisficing, can lead to solutions that are less thanoptimal or even ethically deficient.

Satisficing leads the managerial leader to alternatives that tend to be easy to formulate,familiar, and close to the status quo.

Ways to guard against oversimplifying and reaching less than optimal solutions to

ethical challenges

Discuss the situation with other trusted colleagues. Ask them to challenge your decision.The resulting dialogue can improve the quality of your ethical decision making.

Before settling on a solution, ask yourself the following questions:

How would I describe the problem if I were on the opposite side of the fence? Whom could my decision or action harm? Could I disclose without reservation my decision or action to my boss, our CEO, theBoard of Directors, my family, or society as a whole?

Mind Game #2: The Need to be Liked

Most people want to be liked. However, when this desire to be liked overpowers businessobjectivity, ethical lapses can occur. Because they want to be liked, they may have adifficult time saying, No.

Such an overriding desire to be liked can ultimately adversely affect the ethics of peoplein an organization and thus can decrease the firms bottom line.

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One way is to solve this problem is to distance yourself from subordinates (e.g., reduceunnecessary socializing)

Another successful approach would be to respond warmly and assertively towardemployees while still going forward with appropriate but possibly less popular decisions.

Mind Game #3: Dilute and Disguise

In trying to strike a diplomatic chord, leaders can disguise the offensiveness of unethicalacts by using euphemisms or softened characterizations. Words or phrases such ashelped him make a career choice are used to describe firing someone, or inappropriateallocation of resources is used to describe what everyone knows is stealing.

Regardless of whether people want to be seen as kinder and gentler, or just politically

correct, this process merely helps wrongdoers and those associated with them to getaway with unethical behavior. Such softened characterizations serve to dilute anddisguise unethical behavior.

The antidote is for leaders to talk straight and to avoid euphemistic labeling orrecharacterizing unethical behavior.

Mind Game #4: Making Positive

The mental gymnastic of comparing ones own unethical behavior to more negativebehavior committed by others serves only to avoid self degradation.

For example, the salesperson who occasionally cheats when reporting his expenses maysay to himself, I do this only a few times a year, while Hardikdoes it all the time.Unethical behavior appears more ethical by comparing it to worse behavior.

To avoid this mind game, ask three questions about the comparison:

Am I comparing apples to oranges?

How self-serving is this comparison?

What would three objective observers say about me and my objectivity regardingthis comparison?

Relativity does not excuse ethical lapses.

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CONSEQUENCES OF UNETHICAL DECISIONS

"When a business makes an unethical decision, they are taking a risk that they wont get

caught for a short term gain. If you think about it in these terms then obviously mostpeople would want to make an investment. However, if you decide to take the risk thenyou should be aware that you are taking a risk at three different levels.

"The first level of risk is personalPeople are always observing other peoplesbehavior. If you act unethically in one situation then people will assume you might actthat way in others. Consequently, people may begin to distrust you and/or your judgment,even under unrelated circumstances. For instance, if a coworker hears you convincinglylie to a customer then your coworker might think, Wow, he or she is really good at lying.I wonder if I would be able to tell I was being lied to or not. From that moment on,mistrust begins to build.

"The second level of risk is to your company. People learn by example. If topmanagement is doing things that are unethical then people might get the message that it isokay for them to do the same. For instance, if the company just cheated another companyout of $50,000, then my stealing $50 in office supplies doesnt seem so bad.

"Finally, being unethical also places your industry at risk. For instance, taketelemarketers. I will absolutely not give out my credit card information, even to charities.Now, not all telemarketers are unethical. But, the ones that are have so badly damagedtheir reputation that the whole industry is tainted."

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A FRAMEWORK FOR THINKING ETHICALLY

This document is designed as an introduction to thinking ethically. We all have an image

of our better selves-of how we are when we act ethically or are "at our best." Weprobably also have an image of what an ethical community, an ethical business, an ethicalgovernment, or an ethical society should be. Ethics really has to do with all these levels-acting ethically as individuals, creating ethical organizations and governments, andmaking our society as a whole ethical in the way it treats everyone.

What is Ethics?

Simply stated, ethics refers to standards of behavior that tell us how human beings oughtto act in the many situations in which they find themselves-as friends, parents, children,citizens, businesspeople, teachers, professionals, and so on.

It is helpful to identify what ethics is NOT:

Ethics is not the same as feelings. Feelings provide important information for ourethical choices. Some people have highly developed habits that make them feelbad when they do something wrong, but many people feel good even though theyare doing something wrong. And often our feelings will tell us it is uncomfortableto do the right thing if it is hard.

Ethics is not religion. Many people are not religious, but ethics applies toeveryone. Most religions do advocate high ethical standards but sometimes do notaddress all the types of problems we face.

Ethics is not following the law. A good system of law does incorporate manyethical standards, but law can deviate from what is ethical. Law can becomeethically corrupt, as some totalitarian regimes have made it. Law can be afunction of power alone and designed to serve the interests of narrow groups. Lawmay have a difficult time designing or enforcing standards in some importantareas, and may be slow to address new problems.

Ethics is not following culturally accepted norms. Some cultures are quite ethical,but others become corrupt -or blind to certain ethical concerns (as the UnitedStates was to slavery before the Civil War). "When in Rome, do as the Romansdo" is not a satisfactory ethical standard.

Ethics is not science. Social and natural science can provide important data to

help us make better ethical choices. But science alone does not tell us what weought to do. Science may provide an explanation for what humans are like. Butethics provides reasons for how humans ought to act. And just because somethingis scientifically or technologically possible, it may not be ethical to do it.

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Why Identifying Ethical Standards is Hard

There are two fundamental problems in identifying the ethical standards we are to follow:

1. On what do we base our ethical standards?2. How do those standards get applied to specific situations we face?

If our ethics are not based on feelings, religion, law, accepted social practice, or science,what are they based on? Many philosophers and ethicists have helped us answer thiscritical question. They have suggested at least five different sources of ethical standardswe should use.

Five Sources of Ethical Standards

The Utilitarian Approach

Some ethicists emphasize that the ethical action is the one that provides the most good ordoes the least harm, or, to put it another way, produces the greatest balance of good overharm. The ethical corporate action, then, is the one that produces the greatest good anddoes the least harm for all who are affected-customers, employees, shareholders, thecommunity, and the environment. Ethical warfare balances the good achieved in endingterrorism with the harm done to all parties through death, injuries, and destruction. Theutilitarian approach deals with consequences; it tries both to increase the good done and

to reduce the harm done.

The Rights Approach

Other philosophers and ethicists suggest that the ethical action is the one that bestprotects and respects the moral rights of those affected. This approach starts from thebelief that humans have a dignity based on their human nature per se or on their ability tochoose freely what they do with their lives. On the basis of such dignity, they have a rightto be treated as ends and not merely as means to other ends. The list of moral rights-including the rights to make one's own choices about what kind of life to lead, to be told

the truth, not to be injured, to a degree of privacy, and so on-is widely debated; some nowargue that non-humans have rights, too. Also, it is often said that rights imply duties-inparticular, the duty to respect others' rights.

The Fairness or Justice Approach

Aristotle and other Greek philosophers have contributed the idea that all equals should be

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treated equally. Today we use this idea to say that ethical actions treat all human beingsequally-or if unequally, then fairly based on some standard that is defensible. We pay

people more based on their harder work or the greater amount that they contribute to anorganization, and say that is fair. But there is a debate over CEO salaries that arehundreds of times larger than the pay of others; many ask whether the huge disparity isbased on a defensible standard or whether it is the result of an imbalance of power andhence is unfair.

The Common Good Approach

The Greek philosophers have also contributed the notion that life in community is a goodin itself and our actions should contribute to that life. This approach suggests that the

interlocking relationships of society are the basis of ethical reasoning and that respect andcompassion for all others-especially the vulnerable-are requirements of such reasoning.This approach also calls attention to the common conditions that are important to thewelfare of everyone. This may be a system of laws, effective police and fire departments,health care, a public educational system, or even public recreational areas.

The Virtue Approach

A very ancient approach to ethics is that ethical actions ought to be consistent withcertain ideal virtues that provide for the full development of our humanity. These virtues

are dispositions and habits that enable us to act according to the highest potential of ourcharacter and on behalf of values like truth and beauty. Honesty, courage, compassion,generosity, tolerance, love, fidelity, integrity, fairness, self-control, and prudence are allexamples of virtues. Virtue ethics asks of any action, "What kind of person will I becomeif I do this?" or "Is this action consistent with my acting at my best?"

Putting the Approaches Together

Each of the approaches helps us determine what standards of behavior can be consideredethical. There are still problems to be solved, however.

The first problem is that we may not agree on the content of some of these specificapproaches. We may not all agree to the same set of human and civil rights.

We may not agree on what constitutes the common good. We may not even agree onwhat is a good and what is a harm.

The second problem is that the different approaches may not all answer the question"What is ethical?" in the same way. Nonetheless, each approach gives us important

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information with which to determine what is ethical in a particular circumstance. Andmuch more often than not, the different approaches do lead to similar answers.

Making Decisions

Making good ethical decisions requires a trained sensitivity to ethical issues and apracticed method for exploring the ethical aspects of a decision and weighing theconsiderations that should impact our choice of a course of action. Having a method forethical decision making is absolutely essential. When practiced regularly, the methodbecomes so familiar that we work through it automatically without consulting the specificsteps.

The more novel and difficult the ethical choice we face, the more we need to rely on

discussion and dialogue with others about the dilemma. Only by careful exploration ofthe problem, aided by the insights and different perspectives of others, can we make goodethical choices in such situations.

We have found the following framework for ethical decision making a useful method forexploring ethical dilemmas and identifying ethical courses of action.

A Framework for Ethical Decision Making

Recognize an Ethical Issue

1. Is there something wrong personally, interpersonally, or socially? Could the conflict,the situation, or the decision be damaging to people or to the community?

2. Does the issue go beyond legal or institutionalconcerns? What does it do to people, who have dignity, rights, and hopes for a better lifetogether?

Get the Facts

3. What are the relevant facts of the case? What facts are unknown?

4. What individuals and groups have an important stake in the outcome? Do some have agreater stake because they have a special need or because we have special obligations tothem?

5. What are the options for acting? Have all the relevant persons and groups beenconsulted? If you showed your list of options to someone you respect, what would thatperson say?

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Evaluate Alternative Actions From Various Ethical Perspectives

6. Which option will produce the most good and do the least harm?

Utilitarian Approach: The ethical action is the one that will produce the greatest

balance of benefits over harms.

7. Even if not everyone gets all they want, will everyone's rights and dignity still berespected?

Rights Approach: The ethical action is the one that most dutifully respects the rights

of all affected.

8. Which option is fair to all stakeholders?

Fairness or Justice Approach: The ethical action is the one that treats people

equally, or if unequally, that treats people proportionately and fairly.

9. Which option would help all participate more fully in the life we share as a family,community, society?

Common Good Approach: The ethical action is the one that contributes most to the

achievement of a quality common life together.

10. Would you want to become the sort of person who acts this way (e.g., a person ofcourage or compassion)?

Virtue Approach: The ethical action is the one that embodies the habits and values

of humans at their best.

Make a Decision and Test It

11. Considering all these perspectives, which of the options is the right or best thing to

do?

12. If you told someone you respect why you chose this option, what would that personsay? If you had to explain your decision on television, would you be comfortable doingso?

Act, Then Reflect on the Decision Later

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13. Implement your decision. How did it turn out for all concerned? If you had it to doover again, what would you do differently?

So why really do good managers make bad ethical decisions?

First we need to define what we mean by a good manager. According to the AgencyTheory, which defines the Principle-Agent relationship, a manager is the agent ofshareholders and his objective should be to maximize the wealth of shareholders.So if we speak in a broader context, a good manager has to take decisions which are infavor of all its stakeholders. Stakeholders can be shareholders, suppliers, customers,employees, creditors, society and public at large.

But as we know that sometimes it is simply not possible to satisfy all the stakeholderssimultaneously. For example, a chemical factory whose drainage pollutes the river or seawater due to its effluents cannot stop is operations because it is answerable to itsshareholders.

Hence, if a manager wants to takes good decision he might be forced to make bad ethicalchoices. This can be avoided if a manager thinks about stakeholders and not onlyshareholders.

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CASE STUDY: BARINGS BANK & NICK LEESON The Rogue Trader

A Brief history of Barings Bank

Barings Bank(1762 to 1995) was the oldest merchant bank in London until its collapse

in 1995 after one of the bank's employees, Nick Leeson, lost 827 million ($1.4 billion)

speculatingprimarily on futures contracts. It was founded in 1762 as the 'John and

Francis Baring Company' by Sir Francis Baring, the son of John Baring, originally from

Bremen, Germany.

The collapse of Britain's Barings Bank in February 1995 is perhaps the quintessential

tale of financial risk management gone wrong. The failure was completely unexpected.

Over a course of days, the bank went from apparent strength to bankruptcy. Barings was

Britain's oldest merchant bank. It had financed the Napoleonic wars, the Louisiana

purchase, and the Erie Canal. Barings was the Queen's bank. What really grabbed the

world's attention was the fact that the failure was caused by the actions of a single trader

based at a small office in Singapore.

The trader was Nick Leeson. He had grown up in the Watford suburb of London. After

attending university, he worked briefly for Morgan Stanley before joining Barings.

Leeson first started working for the UK firm, Barings Securities Ltd (BSL), in 1989 and

in early 1992 he applied for registration as a dealer with the Securities and Futures

Authority (SFA) in England. However, the SFA discovered that Leeson had made a false

statement on his application form, about unsatisfied judgement debts against him. The

SFA queried BSL on this matter and BSL subsequently withdrew the application.

In April of that same year, Leeson was posted to Singapore and was involved in trading

at BFS, as its floor manager at SIMEX (the Singapore International Monetary Exchange).

Leesons previous history was never communicated to SIMEX and in his application to

SIMEX, Leeson made a similar false statement that no judgement in civil proceedings

had ever been entered against him. While Leesons trading role at BFS was intended to

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be limited, it gradually changed over time and, by the end of 1994, Leeson was

considered to be one of the major contributors to the profits of the Baring Group. Leeson

stood to personally gain out from this success. In 1993, his bonus was 115,000. In 1994,

it was expected to reach 450,000

At both firms, he worked in operations, but shortly after joining Barings, he applied for

and received a transfer to the Far East. His first task when he arrived was working

through a back-office mess in Jakarta. The bank was sitting on GBP 100MM in stock

certificates and bearer bonds that were not in deliverable form. Many of the stocks had

been purchased on behalf of clients. Because the stock market had subsequently declined,

the clients trying to avoid taking deliverythey complained that certificates were in the

wrong denomination, not properly document or in physically unacceptable condition.

Over a period of 10 months, Leeson worked his way through the certificates, addressing

the problems and making delivery.

King Midas of the SIMEX

Because he had become a successful specialist in the management of derivatives, he wasone of the people Barings took on in their subsidiary, Barings Futures Singapore (BFS),

in Singapore when it opened in 1992. His brief was to employ a group of traders working

on the floor of the Singapore International Monetary Exchange (SIMEX), and to operate

channels of communication between this team and traders operating in Japan, in order to

take advantage of price fluctuations between these two places.

He proved to be very efficient and became general manager of this subsidiary in January

1993. He was voted Best Trader of 1994 by the SIMEX, and was not only heralded as a

star in Singapore, but also in Barings. In 1994, he single-handedly made estimated

earnings of 30 million out of a total of 50 million generated by his department. On

February 24th 1995, he was promised a bonus of 450,000, in other words, nine times his

salary and four times his bonus in the year before ! His superiors liked him because

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financially they also profited from his results. During this period, when Barings was not

doing very well, he seemed to be a safe bet for the company

Barings had maintained an office in Singapore since 1987. Called Baring Securities

(Singapore) Limited (BSS), it had originally focused on equities, but its volume of

futures trading on the SIMEX (today's Singapore Exchange) was growing. Without a seat

on the exchange, BSS was having to pay commissions for all its transactions. The next

step was to purchase a seat and hire traders.

Leeson's accomplishments in Jakarta attracted the attention of Barings management.

When he applied for a position within BSS, they not only accepted him, but they made

him general manager with authority to hire traders and back office staff.

Leeson arrived at BSS in 1992 and started hiring local staff. As general manager,

Leeson's job was not trading, but he soon took the necessary exam so that he could trade

on SIMEX along with his small team of traders. He was now general manager, head

trader and, due to his experience in operations, de facto head of the back office. Such an

arrangement should have rung alarm bells, but no one within Barings' senior managementseemed to notice the blatant conflicts of interest.

Leeson took unauthorized speculative positions primarily in futures linked to the Nikkei

225 and Japanese government bonds (JGB) as well as options on the Nikkei. He hid his

trading in an unused BSS error account, number 88888. Exactly why Leeson was

speculating is unclear. He claims that he originally used the 88888 account to hide some

embarrassing losses resulting from mistakes made by his traders. However, Leeson

started actively trading in the 88888 account almost as soon as he arrived in Singapore.

The sheer volume of his trading suggests a simple desire to speculate. He lost money

from the beginning. Increasing his bets only made him lose more money. By the end of

1992, the 88888 account was under water by about GBP 2MM. A year later, this had

mushroomed to GBP 23MM. By the end of 1994, Leeson's 88888 account had lost a total

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of GBP 208MM. Barings management remained blithely unaware. On February 23,

1995, Nick Leeson hopped on a plane to Kuala Lumpur leaving behind a GBP 827MM

hole in the Barings balance sheet.

As a trader, Leeson had extremely bad luck. By mid February 1995, he had accumulated

an enormous positionhalf the open interest in the Nikkei future and 85% of the open

interest in the JGB future. The market was aware of this and probably traded against him.

Prior to 1995, however, he just made consistently bad bets. The fact that he was so

unlucky shouldn't be too much of a surprise. If he hadn't been so misfortunate, we

probably wouldn't have ever heard of him.

1995 collapse

At the time of the massive trading loss, Leeson was supposed to be arbitraging, seeking

to profit from differences in the prices of Nikkei 225 futures contracts listed on the Osaka

Securities Exchange in Japan and the Singapore International Monetary Exchange. Such

arbitrage involves buying futures contracts on one market and simultaneously selling

them on another at higher price. Since everyone tries to take advantage of a price

difference on a publicly traded futures contract, the margins on arbitrage trading are small

or even wafer thin. Consequently, the volumes traded by arbitrageurs must be very large

to gain any meaningful profit. However, in arbitrage, one is buying something at one

market while selling the same good at another market at the same time. Consequently,

almost all risks are hedged and the strategy is not very risky. Certainly it would not have

bankrupted the bank. For example, one could buy a futures contract on Nikkei worth

$100 million on one day but at the same time sell the same product in Singapore for say$100,001,000. Though a person would have bought and sold nearly 200 million, their

profit is only $1,000, that is 1,000 dollars for a 100 million dollar investment. However,

instead of hedging his positions, Leeson gambled on the future direction of the Japanese

markets. If one uses the above example, one could buy $100 million worth of Nikkei

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futures contracts then hope that the contract price goes up in future. In this instance, even

a percentage change of the price would create 1 million dollar worth of profit or loss.

According to Eddie George, the Governor of the Bank of England, Mr Leeson began

doing this at the end of January 1995. Due to a series of internal and external events, his

unhedged losses escalated rapidly.

Internal auditing

Under Barings Futures Singapore's management structure through 1995, Leeson doubled

as both the floor manager for Barings' trading on the Singapore International Monetary

Exchange and head of settlement operations. In the latter role, he was charged with

ensuring accurate accounting for the unit. The positions would normally have been held

by two different employees. As trading floor manager, Leeson reported to the head of

settlement operations, an office inside Barings Bank which he himself held, which short-

circuited normal accounting and internal control/audit safeguards. In effect, Leeson was

able to operate with no supervision from London. After the collapse, several observers,

including Leeson himself, placed much of the blame on the bank's own deficient internal

auditing and risk management practices.

Corruption

Because of the absence of oversight, Leeson was able to make seemingly small gambles

in the futures arbitrage market at Barings Futures Singapore and cover for his shortfalls

by reporting losses as gains to Barings in London. Specifically, Leeson altered the

branch's error account, subsequently known by its account number 88888 as the "five-

eights account", to prevent the London office from receiving the standard daily reports on

trading, price, and status. Leeson claims the losses started when one of his colleagues

bought contracts when she should have sold them, costing Barings 20,000.

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By December 1994, Leeson had cost Barings 200 million. He reported to British Tax

Authorities a 102 million profit. If the company had uncovered his true financial

dealings then, collapse might have been avoided as Barings had still had 350 million of

capital.

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Kobe earthquake

Using the hidden five-eights account, Leeson began to aggressively trade in futures and

options on the Singapore International Monetary Exchange. His decisions routinely

resulted in losses of substantial sums, but he used money entrusted to the bank by

subsidiaries for use in their own accounts. He falsified trading records in the bank's

computer systems, and used money intended for margin payments on other trading. As a

result, he appeared to be making substantial profits. However, his luck ran out when the

Kobe earthquake sent the Asian financial markets into a tailspin. Leeson bet on a rapid

recovery by the Nikkei, which failed to materialize.

Discovery

On 23 February 1995, Leeson left Singapore to fly to Kuala Lumpur. Barings Bank

auditors finally discovered the fraud around the same time that Barings' chairman, Peter

Baring, received a confession note from Leeson, but it was too late this time. Leeson's

activities had generated losses totalling 827 million (US$1.4 billion), twice the bank's

available trading capital. The collapse cost another 100 million. The Bank of England

attempted a weekend bailout, but it was unsuccessful. Employees around the world did

not receive their bonuses. Barings was declared insolvent on 26 February 1995 and

appointed administrators began managing the finances of Barings Group and its

subsidiaries.

What is amazing about Leeson's activities is the fact that he was able to accumulate such

staggering losses without Barings' management noticing. As Leeson lost money, he had

to pay those losses to SIMEX in the form of margin. Leeson needed cash. By falsifying

accounts and making various misrepresentations, he was able to secure funding from

various companies within the Barings organization and from client accounts. His

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misrepresentations were flimsy at best. For example, he claimed that he needed funds to

make margin payments on behalf of BSS clients, and he gave a technical argument

related to how the SIMEX collected margin as justification. This claim was false. It was

actually against SIMEX rules for a broker to post its own money as margin for a client.

Even if the claim were true, the funds would have been needed only temporarilyuntil

the client could make payment. Instead, Leeson continued to ask for ever more funding.

Another issue was that Leeson was an accomplished liar. He falsified records, fabricated

letters and made up elaborate stories to deflect questions from management, auditors and

even representatives of SIMEX. Leeson actively played on people's insecurities.

Such concerns went largely unheeded. Leeson was somewhat of a celebrity within

Barings. While he was secretly accumulating losses in account 88888, he was publicly

recording profits in three arbitrage trading accounts, numbers 92000, 98007 and 98008.

This was accomplished through cross-trades with account 88888. By performing futures

transactions at off-market prices, Leeson was able to achieve profits in the arbitrage

accounts while placing offsetting losses in the 88888 account. During 1994, Leeson

booked GBP 28.5MM in false profits. This was a staggering profit to earn from futures

arbitrage, but it ensured that Barings employees earned bonuses that year. Needless to

say, there was little incentive for employees to question the unusually high arbitrage

profits. If anything, Leeson was viewed as a star trader who was not to be interfered with.

Why Did it Happen?

Industry analysts felt that the fall of Barings served as a classic example of poor risk

management practices. The bank had completely failed to institute a proper managerial,financial and operational control system.

Due to the lack of effective control and supervision, Leeson got an opportunity to

conduct his unauthorized trading activities and was able to reduce the likelihood of their

detection.

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The management systems required Leeson to report to both his local managers in

Singapore, and his product managers in London, but this did not work in practice. Leeson

transacted his fraudulent activities through a special account that Barings said was

unauthorised and that they had no knowledge of, but the inspectors investigating the

collapse took the view that they either knew, or should have known, about it and of the

losses incurred through the transactions on that account.

In the third quarter of 1994, BFS was internally audited. The auditors were concerned at

the powerful position that Leeson was occupying. As both Chief Trader and Head of

Settlements, he was in a position to record the trades he had made, in any way he wanted.

An internal audit report specifically highlighted this point, stating that it created a

significant risk, as internal controls could be over-ridden. But the Baring Group already

knew this, and nothing was done to remedy the situation. It was probable that, until

February 1995, Barings could have averted financial collapse, by taking timely action to

prevent it. Instead, matters were allowed to get worse.

After the Baring Groups failure, senior management of the company continued to denyknowledge of Leesons activities

This analysis raises the question as to why Barings, an old established firm of merchant

bankers with links to the aristocracy of England, would behave in such a manner. An

analysis by prominent researchers suggests that what Barings did was to respond to the

massive changes that were taking place as a result of the Big Bang - the de-regulation of

the UK financial services market - by creating as a saviour, a shadow to themselves,

in the form of the highly risky Baring Securities operation. The firm then chose a

number of extreme risk takers, including Leeson, to run this operation. Leeson was

introduced to the chief executive of Baring Securities, as the red-hot trader from

Singapore, second to none.

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As the evidence of Leesons misdeeds built up, Barings senior management either would

not, or could not, believe it. They continued to support him till the bitter end. The scale of

corporate misjudgement was staggering and the resulting collapse of the firm was

spectacular. Barings directors failed to assess the risks of the strategies that they were

employing and, further, failed to understand the responsibility they bore for the events

that unfolded. It is events such as these that have focused increasing attention on

corporate governance, as a means of ensuring that the Board operate effectively,

responsibly and in the best interests of its shareholders and other stakeholders.

bad ethical decisions

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