Sample Internal Financial Control System: The Case of Barings Bank
Category : Internal Financial Control System, Singapore Topics
Internal Control: The Case of Barings Bank
1. Barings Bank Internal Control Environment
Internal control environment in the case of Barings Bank is at its barest minimum, particularly in the case of Barings Future in Singapore. Apart from being set at the most fundamental controls that only allowed the bank to persist without any suspicions from its internal and external auditors and top managers for several years. The lack of a strong internal control also explains why management learned of the financial anomalies only during the time it has reached the status of being bankrupt.
2. Internal Control Principle Violations
Risk assessment particularly the activities to control the risk of human error as well as industry regulation and statutory provisions was violated in the case of Barings Bank because the manager of the Barings Future in Singapore was allowed to trade in options as well as maintain un-hedged positions despite the lack of authority to engage in these activities. Nick Leeson’s job description only covers the realization of arbitrage profits by recognizing and taking advantage of changing price differences in similar contracts in the Osaka and Singapore stock exchanges. Had there been sufficient control activities such as the managed segregation of tasks and accounting of the flow of financial resources in and out of accounts, bank management could have detected the anomalies in financial accounting and the overreaching of Leeson’s scope of work.
3. Other Internal Control Weaknesses
Internal monitoring was weak because Nick Leeson was given free reign over the Barings Future in Singapore. There was no close supervision by the main office over Leeson’s task performance in Singapore or thorough auditing. This is supported by the fact that the bank was caught off-guard when it’s learned the extent of its losses.
4. Reward Structure or Reward and Risk Taking
Derivatives trading offer great rewards, particularly for highly networked and experienced people in stocks which overshadows the possible risks that the trader may incur in case of miscalculations or inaccurate information in decision-making. In the case of the derivatives investment of Nick in 1993, even with small amounts he was able to gain more than £10 million amounting to almost 10 percent of the total profit of Barings for the entire year (British Broadcasting Corporation 2006).
5. Attitude of Top Management
Barings Chief Executives took a complacent attitude towards Leeson because of his financial performance. Barings also had the belief that the bank was not exposed to any immediate risk of loss because they believed Leeson’s claim that his engagement in derivatives trading was in compliance with the purchase orders of clients.
6. Human Resource Management
Nick was treated differently because he was extended with complacency by the bank’s chief executives due to his financial contribution to the company despite his unilateral extension of his task towards derivatives trading.
What were some of the red flags that management ignored? Why did they ignore them?
Several warning signs were existent during the time prior to the eventual bankruptcy of Barings Bank. First is the extension of the scope of work of Lesson when part of internal control is the segregation of tasks in order to prevent human-based anomalies. Second is the eventual excessive trading done by Leeson which obviously multiplied the risks faced by the bank. Barings Bank ignored these signs because of the impending returns expected from the activities of their operations in Singapore especially after Leeson has proven that with his skills and experience he can rake in at least 10 percent of the aggregate annual earnings of the company. This is caused by their lack of information about the affairs in Singapore due to minimal supervision giving Leeson unfettered power.
6. Controls to Prevent Fraudulent Activities
Nick covered his mounting losses by opening an error account 88888. The error account started out as a means of covering up the mistake committed by an inexperienced member of Leeson’s team causing the bank £20,000 worth of loss. However, after trading heavily in derivatives the Nikkei index plunged by 7 percent in just one week. Despite this Leeson made the bet that the Nikkei index would stabilise at 19,000 but when the 1995 earthquake hit Kobe the losses were too enormous to hide. (British Broadcasting Corporation 2006) Had there been a sufficient internal supervision so that thorough investigation of what Leeson claimed as an error account was made, it would have been determined that this was not a feasible explanation. Also, there should have been strict segregation of tasks but the bank allowed Leeson to remain as chief trade while he is also responsible for settling his trade portfolio.
7. Other Factors Causing Bankruptcy
Overall, Barings Bank suffered from gross mismanagement of its internal affairs. It provided unsupervised power to Leeson and also failed to closely monitor the activities of Barings Future in Singapore despite the excessive derivatives trading and the growing risks for the bank. Although derivatives investment is a high risk activity with huge potential for windfall profit, the bank never cared to put up hedges such as bets the other- way-around as protection to the bank. Thus, internal control is imperative to protect banks and its clients.