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The Bank of England

Supervision by the Bank

13.56 As noted in Section 1 of this report, the conclusions expressed here are those of the independent members of the Board. The ex-officio members have not participated in this part of the report.

13.57 The Bank was at all relevant times the consolidated supervisor of the Barings Group, and lead regulator of BB&CO. The supervision was primarily carried out by its Supervision and Surveillance Division (S&S). The only relevant supervision for the purposes of this report was that of S&S. From April 1991 the senior manager in that division with responsibility for UK merchant banks (including Barings) was Thompson. Until March 1993 he reported to the Head of Banking Supervision, Barnes; from that date he reported to the Head of Major UK Banks Supervision Division, Sergeant, who in turn reported to the Deputy Director in charge of S&S, Foot (from September 1993). Thompson had a number of different individual analysts assisting him over a period of time in supervising Barings.
13.58 The Bank was told of the intention of Barings' management to apply BB&Co's standards of control to BSL. The Bank regarded the controls in Barings as informal but effective. It had confidence in Barings' senior management, many of whom were longstanding Barings' employees. Accordingly, it placed greater reliance on statements made to it by management than it would have done had this degree of confidence not existed. With regard to Barings' overseas subsidiaries the Bank undertook no reviews. In that respect, it placed reliance on what it was told by Barings and its auditors and reporting accountants (C&L); on the existence of a 'connected lending' limit on BB&Co's (or the solo consolidated group's) exposure to the overseas securities subsidiaries of 25% of unconsolidated (or solo consolidate capital base; and (in accordance with recognised supervisory practice) on the supervision performed by the relevant overseas regulators.

13.59 While the Bank's supervision was primarily focused on BB&CO, as the authorised institution, the Bank's supervisory responsibilities extended, and were understood by the Bank to extend, to the activities of other parts of the Group insofar as such activities were capable of affecting the financial soundness and reputation of BB & Co.
13.60 In the event, Barings in London received false information from its subsidiary, BFS and Barings in London itself failed to distinguish adequately between its house and client trading. In consequence, it was not aware that it was not complying with the connected lending limit and not providing the Bank with accurate information. It is true that the Bank knew that the Far Eastern operations of Barings were reporting very significant profits; it knew that there were issues relating to large exposure and that large and increasing funding was required for these operations; and it would have appreciated that there could be reputational risks to BB&CO arising from any significant default in these operations. However, we consider that the Bank reasonably placed reliance on local regulators of the overseas operations; and it was also entitled to place reliance on the explanations given by management a profitability of these operations and on the other information provided by Barings to the Bank.
13.61 Had the Bank had a greater understanding of Barings' Far Eastern operations and a greater awareness of the degree of control of these operations as exercised by Barings in London it would have been better placed to supervise the consolidated group. There does not appear to have been any guideline or system in place within the Bank for determining whether the situation with regard to a member of a banking group for which the Bank was responsible for consolidated supervision was material such that it could affect the well-being of the bank. Although consolidated supervision requires an evaluation of risks presented to a bank by the activities of other members of the same group that evaluation is left to the unaided discretion of individual managers. We consider that there should be guidelines to assist this process. From this a wider lesson can be identified and it is one which we address in Section 14 of this report.

Large exposures

13.62 One key aspect of the Bank's supervision for the purposes of monitoring credit risk was the large exposures rules which it imposed, or which were imposed by the Act, on banks. These included a requirement that (to the extent that the Bank had a discretion to allow exposures to exceed 25% of capital base) BB&CO should first notify the Bank of any proposed exposures that would exceed 25% of its or its Group's capital base; and from 1 January 1994 a requirement (under the EU Large Exposure Directive) that, subject to certain specific exceptions and transitional arrangements, consolidated large exposures should not exceed 25% of consolidated capital base.

13.63 In 1993 Thompson permitted Barings, by what he described as an 'informal concession', to exceed the 25 % limit with regard to the Group's exposure to OSE. This concession, not surprisingly, was taken by Barings also to apply to its exposure to SIMEX. Further, Barings apparently took the concession to release it from the obligation to pre-notify those exposures. The concession was granted without any apparent reference to more senior management at the Bank, which was a breach of the relevant internal Bank guideline. Moreover, no limit was at any time imposed on the concession. In consequence, Barings in London was prepared to allow exposures to the exchanges often to exceed 25 % and latterly (by February 1995) to reach 73 % on OSE and 40% on SIMEX. We consider that this informal concession, permitting Barings to exceed the 25% limit and without imposing any limit on the concession, was an error of judgement. Although we do not suggest that the Bank could, on the information then known to it, have appreciated that this concession involved any material risk to Barings, the unfortunate consequence of this concession, which continued over a lengthy period, was to facilitate the 'increasing transactions being undertaken by BFS.
13.64 The informal concession was granted pending a review within the Bank as to whether Barings could be exempted from the 25% limit in respect of its exposures to overseas exchanges. Barings referred this matter to the Bank in January 1993. It was recognised that it involved a policy issue but nothing was done by the Bank to progress it until May 1994. Even the coming into effect of the EU Large Exposure Directive on 1 January 1994 did not cause the Bank to consider whether it should continue the concession, which had been granted pending resolution of the issues regarding the correct treatment of the exchange exposures. Barings prompted the Bank, by their letter of 29 April 1994, for a response. While the Bank's S&S Policy Group was then consulted, it was only asked the narrow question whether exposures could be reported net of segregated clients' funds. The point was then discussed by Thompson at a meeting with senior management of Barings on 18 May 1994. The result of this meeting was that the Bank, through Thompson, indicated that it would write to Barings setting out its understanding of the position. Again, nothing was done until eventually (in January 1995) the question as to whether there could be an exemption from the 25% limit in respect of exposures to exchanges was raised with the Bank's S&S Policy Group, who confirmed that no such exemption was possible. This view was then passed on to Barings by Thompson by letter dated 1 February 1995.

13.65 We have considered whether, but for this delay, the unauthorised trading activities within BFS might have been curtailed or uncovered earlier. If the Group's exposure to OSE had been kept within the 25% limit throughout the period from 1 January 1994 (the date on which the EU Large Exposure Directive took effect), the authorised 'switching' activity between OSE and SIMEX would have had to be reduced in the absence of third party guarantees of the exchange exposures. The maintenance of smaller positions, however, would not necessarily have caused a curtailment in Leeson's unauthorised activities until around the end of January 1995. Until that time the concealment of the unauthorised activities booked in account '88888' was unrelated to the authorised 'switching' business; and therefore, because all trades in account '88888' were through SIMEX, they would not have been affected by any reduction of exposure to OSE. However, from the end of January 1995 the funding ostensibly obtained for authorised 'switching' activity was used in part to finance the unauthorised activities. From that time, therefore, had the 25% limit been strictly enforced and complied with and in the absence of third party guarantees of the exchange exposures, Leeson would have had either to curtail significantly the positions on account '88888'; or to call for significantly increased funding from London by way of 'top up'; or to seek some other unauthorised means of funding the positions. If the second course had been adopted it might have caused senior management at Barings to investigate the positions and thereby uncover account '88888'.

13.66 We are therefore unable to determine whether or not the delay on the part of the Bank in imposing the 25 % limit with regard to Barings' exposure to OSE was a contributory factor in Barings' collapse. Nevertheless, we consider that the delay was unacceptable; the Bank was not entitled to assume that the delay would be inconsequential.

Solo consolidation

13.67 A lack of rigour was also displayed by the Bank in the context of the solo consolidation of BSL with BB&CO towards which Barings had been moving from 1992. This was a very significant step - since it would result in BSL (a substantial securities operation) being included in the unconsolidated returns submitted by BB&CO to the Bank and in BSL being, in effect, treated as one with BB&CO for capital adequacy and large exposures purposes. It was also novel, being the first solo consolidation of such a kind which the Bank had experienced. Yet the Bank failed properly to address all the issues regarding the solo consolidation of BSL with BB&CO or to finalise conclusions on points which had been raised.
13.68 Carol Sergeant, in handwritten notes to Thompson dated 20 October 1993, made a number of relevant comments as to whether solo consolidation was appropriate. There is no record of all the issues raised by her being properly answered. By the letter from Thompson to Barings of 4 November 1993 a number of proposals were put forward with the Bank indicating that it was prepared to treat BSL as solo consolidated with BB&CO on a provisional basis, pending further review by the Bank. But there was no follow up to this letter; nor (although the letter indicated that the Bank was giving consideration to whether solo consolidation was appropriate) does there appear to have been any further review (save with regard to capital adequacy measurements) undertaken by the Bank. Given the novelty of solo consolidating a substantial securities company with a bank, and the questions already raised, we believe that the matter should not have been left on this provisional basis with no further consideration of all the outstanding issues being undertaken after 1993. Indeed, the whole issue of the solo consolidation of BSL with BB&CO was of sufficient importance to warrant its being referred up to the highest level within the Bank. We would have expected that the matter, because of its novelty and importance, would then have been referred to BoBS itself.
13.69 In consequence of the informality with which solo consolidation was permitted, important points - including the need to give a direction under Section 38(3) of the Act - were not addressed. As a result the criminal sanctions potentially available under Section 38 in respect of failures to make reports of large exposures as required by that section were not extended to cover transactions of BSL; although we accept that BB&CO would probably have established that no offence had been committed because it did not know the facts requiring it to make the reports.

13.70 We consider that the Bank did not fully assess the impact of BSL being solo consolidated with BB&CO. A consequence of solo consolidation was that no limit was imposed on the amount that could be advanced by BB&CO to BSL; as a result, owing to the inadequate controls within BIB the remittance of large advances from BB&CO via BSL to BFS, ostensibly to finance client trading but in fact (as it has transpired) substantially to finance the concealed trading, was in practice facilitated. We accept that it could not have been appreciated by the Bank at the time that such trading on the part of BFS would be so facilitated, and we also accept that solo consolidation was not of itself the cause of the collapse. Nevertheless we consider that, because of its importance, the Bank should not have permitted solo consolidation of BSL with BB&CO to continue on a provisional basis for so long without a proper analysis of the issues that arose.

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