Silicon Flat Irons June 5, 2009 Kimberly D. Krawiec

 The risk of loss from inadequate or failed internal processes, people, and systems or from external events  Historically, a residual risk category  i.e. not market or credit = operational  New focus & importance, thanks to Basel II and market changes

 Bad – maybe worst of all alternatives  Require capital cushion, but use internal models  Limited effectiveness  Banks w/ highest op risk levels are least likely to credibly assess

 High costs: Definition, modeling, and data problems  Enforcement likely to be lacking  Room for interest groups –lawyers, accountants, risk management experts – to capture definition and management  Incentive to “manage the model,” rather than op risk

 Status quo  Plausible deniability re: other limits  Do it better  Future:  incentivize market-based solutions (e.g. insurance)  Non-financial metrics  Other proposals – compensation revisions

 Authorized to engage in client sales and arbitrage  Not authorized to take directional positions  Fraud = series of unauthorized directional positions in equities and equity futures  Concealed by a series of fictitious transactions  Note that subsequent investigation turned up numerous violations

 Entry then cancellation of fictitious trades  947 transactions  “matched” trades – i.e. purchase/sale of equal quantities at different “off market” prices, thus generating gain or loss as needed  115 transactions  Intra-monthly provisions  9 transactions

 28-year-old trader who never graduated from college  Barings Bank desk at the Singapore International Monetary Exchange  In charge of both trading and settlement

 Accused of losing $1.3 billion  Charged with forgery and trading violations on December 1, 1995  Sentenced to six and a half years

 Short Straddles:  Profitable (Premium) if Nikkei traded within or near strikes between 18,500 – 20,000

 4Q January 1995  Nikkei in a range of 19,000 – 19,500  Recall that Leeson’s goal = 18,500-20,000 Nikkei 225 日経平均株価

 January 17, 1995  Kobe Earthquake  Nikkei dropped sharply  Leeson goes long

 January 20 – February, 1995  Leeson launched aggressive buying program: 55,206 March contracts and 5,650 June contracts

 Barings collapsed – could not meet huge trading obligations  Outstanding futures positions of $27 billion (Barings’ capital was $615 million)

ST17 10 largest net Nikkei 225 futures positions ST.xls*Osaka Sec Ex?Chart 2

 Improbable profits  Esp. in light of experience level and authorized trading strategy  Unusual trades (real and/or fictitious) in terms of type and/or volume  Back office issues  Bully back office, evasive answers  Ignored inquiries from regulators, exchanges, competitors, other employees