Why giant institutions like Bear Sterns go bust

• Delegation is not abdication or relegation of responsibility. Similarly, empowerment doesn't mean it is boundary less - Madhavan T Gopalachary • It is always easier to stay out of trouble than to get out of trouble - Anonymous • If anything can go wrong, it will go wrong - Ade's Law Preamble:

The financial institution of Bear Sterns went bust recently and the takeover attempt by J P Morgan is undergoing a tussle. The shareholders are up in arms over the price offered and J P Morgan had agreed to revise the price. While it will take some time for the dust and matter to settle, it may appear very strange to many as to how giant organizations like Bear Sterns can collapse overnight without a warning. It will also appear very strange as to why the government or FRB should bail out such institutions with the tax payer’s money. Perhaps they know best as to why it collapsed and why it needs a bailout. We do not know the exact reasons for Bear Sterns collapse, but experience shows that giant institutions go bust primarily because of poor management controls and practices over a fairly long period. There are some people in such institutions who are given wide latitude and powers that are often misused and leading to eventual collapse. We all know as to why Enron, WorldCom, Adelphia, ImClone, Paramalat and many others went bust not very long ago.



The collapse of Barings merchant bank in 1995

Barings was a much respected and revered British merchant bank and in existence for more than 200 years. All merchant banks invest and trade in stocks, currencies, derivatives like futures & options, CPs etc., Barings was no exception. In 1994, twenty eight year old Nicholas 'Nick' Leeson was the bank's general manager based in Singapore and in charge of its 'Futures' operations. Trading in financial institutions and merchant banks is normally handled by very young, highly qualified, skilled, talented and brilliant people. It is a very high pressure job. They are heavily paid but their job carries very high risks. Decisions have to be taken in a matter of seconds and the 'burnout rate is very high in this profession. Such young professionals have very lavish and fancy lifestyles and treated like stars and celebrities by their employers as long as they bring home the bacon. Their salaries, bonuses and stock options runs into millions of dollars. While the gains of such companies can be very high, the losses can be disastrous. It is a typical case of high stakes and desperate men.

Trading in index 'futures' is like gambling because there are too many imponderables and even the best brains may not be able to decipher them. Among the various available stock market instruments, futures of indexes are the most difficult to predict. The element of luck has the largest role to play in it. The 'futures' traders lose or gain in millions in a matter of few seconds. The merchant banks know that and normally keep an upper limit beyond which they do not allot more funds to the trader, fire the trader in extreme cases and absorb the losses into cost of operations. Nick Leeson invested very heavily in the Japanese Futures market, betting that the NIKKEI index would rise. The index kept falling. But he kept on investing further in the concerned index in the hope that it would eventually rise and that he would recover the losses. It was a typical gambler's desperate ploy and he threw caution to the winds, maybe out of fear of discovery or failure and hoping against hope. His superiors did not know the extent of the investments in the futures because he had set up dummy accounts to cover his tracks. In a case of misplaced empowerment, he was in control of both front and back office functions in Singapore office. His superiors based in England did not suspect anything was amiss. It was also a case of misplaced trust. They kept the funds rolling in for Leeson to invest and where he wanted to with no questions asked.

Unfortunately, something happened which nobody could have predicted, except perhaps the seismologists. Leeson had also run out of his luck and his day of reckoning had come. On January 17, 1995, a violent earthquake shattered the Japanese cities of Kobe and Osaka and the NIKKEI index went down under, breaking zero degree latitude. The next morning Bearings management in England woke up to learn that they had lost USD 1.3 billion, which was more than double the 600 million cash reserve they had then. They went bust after a month. Leeson went to jail after a global manhunt by the British Police and an Interpol red alert after he went missing, which was right out of fiction and about 4000 people lost their jobs. The remnants of Barings were eventually taken over by the Dutch banking giant ING.

Delegation and Empowerment of people are very good concepts but the case of Barings collapse will reveal how these good concepts were misused and/or mishandled. Delegation is not abdication or relegation of responsibility. Similarly, empowerment doesn't mean it is boundary less. Too much of control will result in employees not taking initiative, interest and involvement in the work. Too little will mean that there is always a danger of something seriously going wrong. If anything can go wrong, it will go wrong. It may sound very negative but it is true. It is always easier to stay out of trouble than to get out of trouble. Most organizational collapses are due to inadequate control systems, misplaced trust & judgment and lastly poor management practices, ignoring safety. It does not mean that risks should not be taken. All risks must be well calculated and limits fixed so as to know when to exit without further losses. Everything in life is time bound. If Leeson had the chance to wait for some more time, his gamble would have paid off. But time and tide wait for no man.

All people in an organization, whether the CEO or the Security Guard at the entrance must follow the required procedures so as to ensure safety of the organization is maintained. Safety is inviolable. There can be no compromise on this aspect.



© Copyright, Written on April 11, 2008. Without prejudice. All rights reserved

To learn more about this author, visit Madhavan T Gopalachary's Website.

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