A Review of 5 Main Causes of Barings Crisis

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Exceptionally professional in international investment and trade, Barings Bank management was attracted to invest in the booming Southern American economies with a target of Argentina. Serving as the led investment to Argentine government, Barings bank was able to channel approximately £140 million worth investment in Argentina for the period ranging between 1885 and 1890. The immediate effects of such huge inflow of investment resulted into widespread and chronic inflation that eroded the value of the economy at that time adversely.

Despite the fact that by this time Barings was not highly leveraged, a failure in the daily operations emerged as the bank could not meet and cover its current needs. Specifically, Barings had a market capitalization of £4 million with all assets totaling £20 million. However, compared with the liabilities that the bank had, different scholars and analysts who have examined the collapse of the bank in 1890 have exposed that the Barings bank had accumulated at least £8.3 million worth “toxic” of Argentine securities in the balance sheet that could not be recovered due to the weakening of the exchange rate in the trading of government bonds and securities. The specific causes of the Barings crisis are discussed below.

Poor portfolio management and the Barings Crisis

The Portfolio or reserve level maintained by any banking institutions is key to the performance of the entity. For instance, there are Bank of England requirements which ought to be observed in regard to liquidity maintenance by different players in the financial sector. Maximum portfolio management is a key driver to the success of the company. However, when evaluated against the Baring crisis, studies and insights investigating the demise have expressed a strong discontent in in regard to how portfolio was managed at the institutions.

While investing in Argentine securities and other ventures, Barings bank worked closely with Banco de la Provincia de Buenos Aires as the main bank of operations in Argentina. High rate of investment reduced the amount of current assets to meet the current liabilities by the two banks. Barings and its partner bank Banco de la Provincia de Buenos Aires maintained a very low cash ratio in their portfolios that was considered to be below the requirements set. this was the preansmbel settings for Barings crisis.

For instance, Banco de la Provincia de Buenos Aires was reported to have 5.8% cash deposit ratio that was much below the required 34% for all private banks. As a result, the struggle to meet short-term liabilities resulted in pressure both in England and Argentina where eventually the situation could not be maintained as Barings had no cash to meet its current obligation both in Argentina and in England compared to available assets whose value had deteriorated further due to panic in the economy.

Investigation insights connote the bank engaged in massive lending to the government in exchange for short-term treasury bills and other bonds. Surprisingly, the short term and medium term treasury bills offered in exchange were not traded in the stock markets and thus proving their inability of being highly liquid to offset any change in the economic demands.  It is this imbalance in the issuance of the Treasury bills, both short and medium that led to the outflow of cash that was not hedged against with investment in the stock markets that later lead to low portfolio size and therefore triggering the Barings crisis.

Speculative trading and the Barings crisis

A classic situation that was purely speculative in nature and which caused the largest outflow of money from the institution was the investments made by the founder of the bank, Leeson, which was unauthorized in nature and resulted in huge investment that caused him earn the trust of the many people both within and outside.

The use of speculative investment especially in the Argentine,  the prevailing  economic conditions caused an upsurge in the profits by at least 10%. For instance, Lesson at the point of collapse traded more than 40, 000 options and other contracts on Nikkei. For the strategy to work, Leeson needed Nikkei to pay at least 18,500 options and 19,500 futures as the profitable trading margin range.

Nevertheless, this could not be realized owing to the immediate wobble in interest and exchange rates that happened at Nikkei stock exchange. Shorter than it was expected, the short-term investment became a nightmare and caused the bank to lose a lot of money.

Systemic risks and the use of derivatives to trade and the Barings crisis

Systemic risks are associated with derivative trading due to its relation with economic conditions. Derivatives are financial products that are traded in the financial market who value is derived from the value of the underlying asset.

Despite the fact that financial derivatives or illiquid assets can have higher returns, it is worth to note that, just like Barings, the parties engaged can be at risk of losing all the investment used and thus suffer from systematic risks.

Essentially, Barings management used to buy contracts on margin on behalf of Barings and was led by Lesson. The use of derivatives to speculate on huge returns was short lived as the markets were responding to the current information.  The reverse happened, in this case, SIMEX and the Osaka Exchange demanded a different margin. As a result, it gave Barings a low switching cost and in return causing a big loss to the invested funds. The top management failed to investigate the biggest misuse of derivatives to fraud the company.

Information asymmetry and the Barings crisis

Essentially, during the period, the information in the market was not a true reflection of the actual figures and facts on the ground in Argentina. The investors could not collect the needed information to predict the profitability and status of Argentina bonds to develop a mechanism that could be used to mitigate future uncertainties. As a result, it was difficult for investors to advise the company management about the potential default that was to come from the fact that Argentina was at risk of defaulting their debt.

Information failure in the market relating to different projects that the bank had shown interests in, the pursuance of investment opportunities which were less based on the actual market information led to impulsive investment in the Argentine economy. This resulted in the mismatch  between the available information in the and the ambitious plans that the bank had which later resulted in a huge deviance in information asymmetries that caused the Barings crisis.

Underwriting of the loans and the Barings crisis

One of the factors that has been thought to have triggered the Barings crisis was the underwriting of the loan extended to the Argentine government. Nonetheless, the problem did not solemnly arise from the mere underwriting of the Argentine state loan, but the fact that a considerable amount of money was spent in underwriting one of the largest and historic loan that was extended to the government of Argentina.  The motive was to attract and win trust to manage the water supply and sewage and maintenance in the city of the Buenos Aires.

The specifics of the matter remained that the bank engage in the fragile business of promoting private entities that later took over the management of Buenos Aires sewage and water management which failed. It became difficult to recoup the investment and meet the galloping investment deficit that was made in the project with the hope of increasing company profits. The cash required by Barings to support the water system in Argentina approximated to be about £7.5 million British.

 

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