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Lessons Arising from the Collapse of Barings


14.1 Barings' collapse was due to the unauthorised and ultimately catastrophic activities of, it appears, one individual (Leeson) that went undetected as a consequence of a failure of management and other internal controls of the most basic kind. Management failed at various levels and in a variety of ways, described in the earlier sections of this to institute a proper system of internal controls, to enforce accountability for all risks and operations, and adequately to follow up on a number of warning over a prolonged period. Neither the external auditors nor the regulators red Leeson's unauthorised activities.
14.2 Management and directors of all financial institutions will draw lessons for themselves. However, we would emphasise the following five significant lessons of the Barings case, which we discuss later in this section, to which particular attention needs to be paid:

(a) Management teams have a duty to understand fully the businesses they manage;

(b) Responsibility for each business activity has to be clearly established and communicated;

(c) Clear segregation of duties is fundamental to any effective control system;

(d) Relevant internal controls, including independent risk management, have to be established for all business activities,-

(e) Top management and the Audit Comni-ittee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly;

14.3 The failings at Barings were not a consequence of the complexity of the business, but were primarily a failure on the part of a number of individuals to do their jobs properly. Both before and since the collapse of Barings much has been written about the derivatives markets. While the use of futures and options contracts did enable Leeson to take much greater levels of risk (through their leverage) than n-dght have been the case in some other markets, it was his ability to act without authority and without detection that brought Barings down.

14.4 The standards and practices required of external auditors in the UK are found in auditing guidelines issued by the Auditing Practices Board. These include specific guidance for the auditors of banks which are presently being revised. We do not think that it is for us to anticipate these revised guidelines. We would emphasise the importance of a close working relationship between internal and external auditors, both in the UK and in respect of overseas subsidiaries, including exchanging significant information such as that contained in internal audit reports and management letters. We do not think it necessary or appropriate for us to refer further to lessons for external auditors.
14.5 The events leading up to the collapse of Barings do not, in our view, of themselves point to the need for any fundamental change to the framework of regulation in the UK. There is, however, a need for improvements in the existing arrangements. Mindful of our terms of reference we concentrate our conunents on regulation to the UK system of regulation and, in view of our experience, the majority of the lessons we draw relate to the Bank.
14.6 We believe that some of our comments on the Bank may also be relevant to the SFA: understanding the business and associated risks; liaising with internal auditors, external auditors and, for larger institutions, the Audit Comn-dttee; and haising with other regulators. We set out in paragraph 14.63 a particular reconunendation concerning the extent to which the SFA should have regard to companies related to a member firm. We also set out in Appendix XV a number of other matters for consideration by the SFA.
14.7 While it is outside our terms of reference to conunent on broader issues facing the derivatives markets, we do note and welcome the initiatives which have been taken by the SIB and the Commodity Futures Trading Conu-nission (through the Windsor Declaration and their conurdtment to further studies), the Futures Industry Association (in its recent report on financial integrity reconunendations for futures and options markets and market participants), and by other regulatory bodies and trade associations. These initiatives have addressed international cooperation and information sharing as part of their remit, and have also considered some of the internal control implications of the collapse of Barings. We would also note that all of the positions on the Far Eastern exchanges in which Barings executed derivatives trades, were either liquidated (proprietary positions) or transferred to other clearing members (client positions) at, we understand, no loss to the exchanges, members of the exchanges or their clients, following the collapse of Barings.

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