The primary objective of derivative activity is to hedge current or anticipated risks relating to operations and financial position; or take speculative positions to benefit from anticipated market movements. However, in the last two decades, many financial institutions suffered significant losses because of the inappropriately use of derivatives. The main reasons for these financial losses are largely related to the ineffective of the internal controls and supervision. Each of these scandals significantly reduced the companies' value as well as impacted the investors' confidence. The financial derivatives are very uncertain based on its nature, complex transactions, market risks, objectives etc. The Barings Bank Collapse (losses $1.4 billion) in 1995 and the world largest derivatives trading fraud $7.2 billion losses of Societe Generale in 2008 are two famous scandals of derivatives trading, which has given the warning to both financial and non-financial institutions and the lessons of how important role of internal controls play on the derivatives trading. The financial derivatives are neutral, the key is how the trader utilizes and management takes control of it. This paper is to research the important internal controls in derivatives, by combining and comparing the Barings Bank Collapse and Societe Generale Loss in order to identify similarities and differences, point out the unregulations of the trading behaviour, and try to provide the reference and caution to other institutions undertaken in derivatives trading.
Accounting Standards for Derivatives
John C. Hull has defined a derivative as a financial instrument whose value depends on the value of other, more basic, underlying variables. More specifically, International Accounting Standards IAS 39 (Financial Instruments: Recognition and Measurement) defines a derivative as a financial instrument or other contract with all three of the following characteristics (page 1942):
its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract;
it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
it is settled at a future date.
International Financial Reporting Standard IFRS 7 (Financial Instruments: Disclosures) requires disclosure of (page 751): the significance of financial instruments for an entity's financial position and performance; qualitative and quantitative information about exposure to risks arising from financial instruments, including specified minimum disclosures about credit risk, liquidity risk, market risk and management's objectives, policies and processes for managing those risks.
The derivatives have the characteristics of risk transferrable, contractual, leveraged and innovative. Based on these characteristics, derivatives can either hedge risks out to the external party or speculate risks into the firm. The frequently derivatives' innovation makes the existing regulations not quickly respond to the changes of derivatives. Therefore, many companies suffer huge losses on the derivatives trading due to the lack of internal controls.
The Framework of Internal Control in Derivatives
Internal control is the key to securing the assets of a company. It play an important role in limiting the risk of fraud or asset misappropriation. COSO (Committee of Sponsoring Organizations) and ISA 315 (International Standards on Auditing) defines internal control as having five components which can utilize in derivative management:
Control Environment: The board should review management's planned decisions regarding the appropriateness and effectiveness of derivative strategies and positions. Employees involved in derivative activities should possess the necessary skills and experience.
Risk Assessment: Risk analysis processes for derivative activities should include identifying risk, estimating its significance, and assessing the likelihood of its occurrence.
Information and Communication: Directors and senior management should obtain sufficient and timely information to monitor achievement of objectives and strategies for using derivative instruments.
Control Activities: Aspects of the risk management policy for derivatives should include controls relating to managerial oversight and responsibilities; the nature and extent of derivative activities, including limitations on their use; and reporting processes and operational controls.
Monitoring: Control systems relating to derivative activities should be monitored to ensure the integrity of system-generated reports.
Applying the COSO Framework can help firm to ensure that the use of derivatives is carefully integrated into the overall organizational control system and that unforeseen and undesirable outcomes are minimized. However, the Barings Bank Collapse and Societe Generale Loss imply the limitations of internal control, which some factors are outside the scope of internal control, such as competition, innovation, or speculation. Therefore, an effective internal control can only manage risk rather than eliminate it.
A Comparative Case Study
The derivative trading is a complex and uncertain activity. The cases of Barings Bank and Societe Generale show how risky the business is. The chain of events which led to Britain's oldest merchant bank Barings collapse and the largest fraud in world financial history via derivatives trading by Societe Generale, is a demonstration of how important of internal control and risk management are, and lessons to be learnt from these two events make people deepen thinking what steps taken to prevent recurrences
Barings Bank Collapse
Founded in 1762, Barings Bank was the oldest merchant bank in England. This 233-year-old British bank was collapsed on February 26, 1995 as the result of the activities of one of its traders, Nick Leeson, in Singapore. The trader's mandate was to arbitrage between Nikkei 225 futures quotes in Singapore and Osaka. Instead, he made big bets on the future direction of the Nikkei 225 using futures and options. The total loss was $1.4 billion. Following the collapse, Barings was purchased by the Dutch bank/insurance company ING for the nominal sum of £1 along with assumption of all of Barings liabilities. Barings Bank therefore no longer has a separate corporate existence, although the Barings name still lived on as Baring Asset Management. BAM was split and sold by ING to MassMutual and Northern Trust in March 2005.
Internal Controls at Barings Bank
The collapse of Baring bank confirmed that the lack of internal control and supervision were clearly not sufficient to detect Lesson's unauthorized trading activities, he had an opportunitiy to hide his losses and was able to reduce the likelihood of being discovered.
Barings Bank made a crucial mistake in its failure to segregate of duties. Lesson was responsible both trading activities and account settlements, which he had cheque signing authority, authority to sign off on trading and prepare bank reconciliations. The fundamental rule of separating the front office from the back office was violated in the Barings Bank resulted in Lesson was able to participate in an extremely high risk transactions and hide his losses by manipulating records in an error account '88888'. On the other hand, Lesson's trading activities were unauthorised and no individual was directly responsible for monitoring his work.
The Managements did not really understand the business of derivatives, because the arbitrage, a relative low risk of derivative strategy, involves locking in a riskless profit by simultaneously entering into transactions in two markets, hence relative low profit. If managements understood the arbitrage strategy, they might have questioned where the fabricated large profit was coming from. At the same time, managements ignored their own internal auditors' comments, the internal auditors had identified the dual role of Leeson as unsatisfactory, and the internal audit report did make specific recommendations as to the separation of roles. These recommendations were never implemented.
Barings had a very poor internal control system. No system of controls for detecting fraudulent activity or dealing Limits. There is lack of reporting system to identify risks and exposures. For example, Barings bank had no department to monitor the market risk, no daily reports generated by traders; no department questioned to Leeson why he requested huge amount money every day for his trading activities; and the accounting department didn't assess the liquidity risk of the company.
Barings Bank had a lack of human resource function. For example, unstructured reward and performance system which massive bonus payments given to traders (e.g. Leeson's salary was reportedly only £50,000 but his anticipated annual bonus for 1994 was £450,000 - nine time his salary); Unstrucrured selection, training and promotion system which Leeson had never held a trading license and less experience in front office, he is not quite qualified trader because he created a top straddle strategy by selling a call and a put with same exercise price and expiration date, in this case the Nikkei 225 Index. The following graph shows this option strategy is extremely high risk, because the loss arising from a large market move is unlimited.
Societe Generale Loss
Founded in 1864, Societe Generale is second largest bank in France and also one of the largest financial services groups in the world. On January 24, 2008, Societe Generale announced huge loss of $7.2 billion, the largest derivative trading loss in the world financial history, by the activities of a junior futures trader Jerome Kerviel, who was speculating on the futures direction in equity indices. Partly due to the loss, that same day credit rating agency Moody's reduced the bank's long term debt ratings from Aa1/B to Aa2/B-. The trader was assigned to arbitrage discrepancies between equity derivatives and cash equity prices. Instead, he placed directional bet on European Stock Index using futures resulted in an irreparable loss of $7.2 billion.
Internal Controls at Societe Generale
After a rogue trader Leeson who destroyed the Barings Bank, the Societe Generale's huge financial loss made people thinking why such a thing would happen again. In the case of Societe Generale just like Barings Bank, the failure of system of internal controls and inadequate supervision was the main reason for the Societe Generale's loss.
Internal Control at Societe Generale is significantly deficient. In the front office, Kerviel's derivative trading was not well supervised, the unauthorized trading lasted over 2 years, and the internal control systems didn't recognize his trading exceeding the limits. In the middle office, the place of controlling the operations, no one discovered Kerviel's trading activities. In the back office, the fictitious transactions were not monitored and reconciliations were not carried out. There was significantly lack of internal communications between these departments. Kerviel worked alone and was able to hide fictitious transactions by his middle-office experience and excellent computer skills; his behaviours proved that there were deficiencies in the internal controls system in Societe Generale.
On the other hand, the risk taking culture in Societe Generale that encouraged such fraud. The approximately 0.5% bonus was based on the trader's performance, which was called "fair pay" in French investment banks.
Comparative Analysis
Both Barings Bank and Societe Generale had gaps in the internal control systems, which had not been discovered. This was the crucial factor that Baring Bank was destroyed and Societe Generale was fraudulently lost. The banks were only preoccupied with earning profits, not with protecting the risks they faced, the financial derivatives meet the investment banks needs for interests. Massive bonus payments given to the traders which encouraged them taking high risks, thus increased the business and financial risk of the company.
Both Leeson and Kerviel had remarkable performance on their previous trading activities which enabled them to act freely without supervisory. They both attempted to hide information on their behaviour, Leeson manuplicated the accounts and Kerviel changed the internal records by his computer skills. They ignored the rules and regulations, unauthorized transactions resulted in Barings collapse and Societe Generale massive loss.
Despite both cases have many commons, but they are some different in the internal control weaknesses. Barings Bank's internal incentive mechanism was the largely reason for its collapse, the traders' bonus payments were directly linked to the profits earned even if the company had a flat profit over the year. The internal control systems of Societe Generale existed in name only regards to Kerviel, when he made $1.5 billion profits and reported only $600 million, no one checked and balanced his trading accounts, no one found out the large differences between the actual profit he made and reported.
Lessons to be learned for Irish Banks
Barings Bank and Societe Generale are not the only two financial institutions effected by ineffective internal controls. For example, Allied Irish Bank (AIB) lost about $750 million from speculative activities of one of its foreign exchange traders, John Rusnak, which lasted a number of years. Rusnak covered up his loss by manipulating bank records and documents and reported false profits. The events of Baring Bank, Societe Generale, AIB illustrated the dangers of derivatives and the important of internal controls. These events have a very important warning significance to the Irish Banks.
Irish Banks should monitor derivatives' traders carefully. It is important to daily review of trades by a registered and qualified supervisor, who immediately reports unusually large transations. Company should set up strictly trading limits. It is also important to check the computer systems and pricing models are correct and are not being mainpulated.
Irish Banks should strictly separate the front, middle, and back office. Irish Banks should also enhance internally mutual cooperation and communication in order to find out risky activities in time. It is important to make sure separate duties to be in place in order to prevent from unauthorized trades. In the case of Barings Bank, Leeson controlled both front and back office in Singapore branch resulted in he was able to hide the information; in the case of Societe Generale, despite the front, middle and back office are separated, but these departments are lack of communication resulted in Kerviel was able to modify his trading records.
The senior managements should understand the business of derivatives and its nature of risk. It is important for the Irish Banks to know the high returns by derivatives trading are being made by taking unreasonable high risk. The profits are important to all business, but this is not a reason to ignor the risks.
The internal control systems are crucial to the Irish Banks, but senior management should not excessively rely on the computer systems. The banks should daily review its computer systems to make sure its working properly and no one manipulates the systems. In the case of Societe Generale, the management trusted the internal control systems too much resulted in Kerviel had an chance to enter into internal system and created fictitious trades.
Irish Banks should establish strictly rules and regualtions in relation to the derivatives trading. It is important to establish standarded human resource functions in relation to seletion and training. The only qualified and properly trained employee is able to become an derivatives' trader. In the case of Barings and Societe Generale, both Leeson and Kerviel were woring in middle or back office, they all had less experience in trading prior to taking up a position in front office.
Recommendations on Internal Controls of Derivatives Trading
The Baring Bank collapse and Societe Generale $7.2 billion huge loss illustrated that the deficiencies of internal controls on derivatives could destroy the whole organization or significantly reduced company's value. Based on these two cases, to establish an effective internal control on derivatives, the following recommendations should be carefully considered.
The financial institutions should conscientiously implement COSO internal control framework in derivatives and COSO enterprise risk management. The internal auditors committee must be established and their reports must be carefully considered and implemented. International Standards on Auditing IAS 240 (page 271) states that those charged with governance of an entity are responsible for the design and implementation of a system of internal control to monitor risk and financial control; provide reasonable assurance that the entity's use of derivatives is within its risk management policies. The top managements must understand the nature business of derivatives in order to reduce inherent risk. Meanwhile, the accounting department must properly disclose the detail of derivatives in the financial statements according to ISA 39 and IFRS 7.
The managements must clearly understand the important of risk management on derivatives. The credit risk control, market/price risk control, liquidity risk control, and operating risk control etc must be established and properly monitored.
Management should establish clear rules and regulations in relation to derivative activities, especially on the limits for maximum tradings a day and policies for purchase and sale of derivatives.
The management must establish the separation of duty policy in relation to derivatives trading. The trading, confirmation, settlement and valuation must be performed by different person in order to prevent unauthorized trading. The trader's activities must be supervised; the derivatives trading should be daily reviewed. Meanwhile, the traders must be properly trained and experienced.
Conclusion
Financial derivatives can be either good or bad, which depends on the objectives for the use of derivatives. For the purpose of hedging, derivatives can be used to reduce risks that company exposed. For the purpose of speculating, derivatives can be used to bet on future movements in asset's price or market's direction; company are taking high risk to make a high potential profits, however, the losses sometimes are unlimited. The cases of Barings Bank and Societe Generale have showed the huge losses experienced from the use of derivatives, the derivatives trading is extremely high risk business if inappropriately used. Thus, the financial institutions must establish effective internal control systems in order to monitor the implicit risks of derivatives trading. It is a disaster for the company to give individuals trading authority without a closed monitor the risks being taken. The Baring Bank collapse and the Societe Generale's $7.2 billion loss should give a warning to the companies which face the same challenges of internal control in derivatives.
