Institutional investors on both sides of the Atlantic will demand stronger controls to prevent further financial disasters like the Baring PLC collapse.
Baring's demise was the latest in a string of debacles in just one year that nearly wiped out Kidder, Peabody & Co. and devastated Orange County, Calif. These showed how vulnerable financial institutions could be to missteps by one person, especially when derivatives are involved, experts said.
While U.S. pension funds escaped largely unscathed, British pension funds were more exposed. While it now appears prospective buyer ING Group, Amsterdam, will make good any losses, some (pounds) 600 million in pension assets held as cash by Baring Brothers & Co., the firm's bank, were at risk. Another (pounds) 1.4 billion in other client assets also were deposited with the bank.
Among the steps being considered to insulate pension funds from similar disasters are:
In Britain, the crisis might accelerate a move toward hiring independent custodians.
At minimum, U.K. pension officials will examine investment of cash more closely.
The National Association of Pension Funds will use the Barings issue in trying to persuade the British government to include an independent custody requirement in the pending pensions bill. Baring was both manager and custodian for many U.K. pension funds.
Pension executives will further tighten controls on use of derivatives by their fund managers. Some might bar use of some derivatives until they are fully understood by pension trustees, noted Carol Proffer, managing director of William M. Mercer Asset Planning, Dallas.
The financial soundness of money managers and their parents may become more important. "There's likely to be a flight to quality," said Craig Ueland, director of international operations for Frank Russell International, London.
Stronger due diligence of managers with their own brokerage arms will be demanded.
Baring, a blue-chip British merchant bank, was brought down by a $1 billion mistake by its 28-year old head futures trader in Singapore, Nick Leeson.
Last week, the ING Group was close to wrapping up a deal to acquire the assets and liabilities of the Barings Group. ING is in exclusive negotiations to acquire Barings' corporate finance, securities and asset management arms reportedly for 91, while assuming all of their debts.
An ING spokesman, however, said Friday the company had not yet made a bid on Baring, and that its representatives were still examining the books. It may take up to a week for ING to make a bid, he said.
Late Friday it was reported that other financial institutions - most notably a consortium including Smith Barney - were preparing bids in case ING withdraws.
While ING has a major presence in managing smaller Dutch pension funds and running mutual funds, it barely registers among pension funds outside Holland.
At the end of 1993, the bank and insurance firm managed some 37 billion guilders ($19.1 billion) in assets worldwide, nearly three-fifths of which were for pension funds. It ran another 92 billion guilders ($47.4 billion) in group insurance assets. ING's 1994 annual report said it planned to build up its institutional money management business and it would seek to expand beyond Holland.
Also, ING's emerging-market debt capability is viewed as a good fit for Baring Securities' strength in emerging markets stocks.
Baring Asset Management, Barings' investment management arm, runs some (pounds) 28 billion ($44.4 billion). As of June 30, Baring managed $23 billion in pension fund separate accounts. Of the pension assets, 53% was managed on behalf of U.K. funds, 42% for U.S. institutions and 5% from elsewhere, according to William M. Mercer International, London.
All calls to Baring in the United Kingdom were referred to Ernst & Young, the administrator for Barings once it collapsed. Representatives there could not provide further details about the asset management business.
The problem for ING will be to retain Baring's best investment bankers and investment management professionals and their clients, and to rebuild morale and confidence in both.
"It's pretty early to have an opinion about ING," said Susan Schueren, senior portfolio manager Florida State Board of Administration, Tallahassee, for which Baring managed just more than $90 million.
"We have to learn a lot more before we can get comfortable with the sorts of things that are key to our making an assessment (of ING as manager). Issues will involve the continuity of the asset management team and continuity of its investment strategy, the quality of its resources, etc."
But Donald Schaefer, communications director of the $14.4 billion Colorado Public Employees' Retirement Association, said: "We have heard good things about ING Bank, and we are quite favorably impressed with them - especially their interest in resolving (the Baring matter) quickly. There is no reason not to (conduct) operations with them" as Baring's replacement.
None of the U.S. pension fund clients contacted by Pensions & Investments had plans to drop Baring, although officials noted they were watching the situation closely.
Consultants were encouraged by ING's lack of a major institutional asset management operation, and felt ING might provide a good fit for Baring. Said one consultant: "A hands-off owner, a benevolent parent, would be the best possible thing."
Tighter controls needed
Pension executives, money managers and others are planning to batten down the hatches against other future financial disasters.
Sponsors will demand more due diligence on the existing controls over trading, said Robert F. Hill, investment officer for the $16.5 billion Virginia Retirement System, Richmond. "I think that would be a logical thing for the sponsors to do. I think first of all the oversight has to come from the firms themselves. These guys have to regulate themselves to impress on us and convey confidence in the industry," he said.
He also expects more oversight over asset management firms connected with brokerages. The Virginia fund has $60 million under management with Baring; that has not been affected, thanks to the fund's custody arrangements.
Jim Douglas, state treasurer of Vermont, which has $56 million in international equities with Baring Asset Management, agreed sponsors will demand additional oversight in the wake of Baring's collapse.
The situation could lead to calls for more government control and oversight, which Mr. Douglas said would not be a good thing. Greater due diligence is warranted instead, he said.
Already, both U.K. and European parliamentary committees are planning hearings to review institutional use of derivatives.
Sponsors also will want to clarify their relationships with money managers that are part of companies with brokerage subsidiaries, said Mr. Douglas.
"We'll make sure that we understand our relationship with a firm like that," he said.
Ash Williams Jr. executive director of the $40 billion Florida State Board of Administration, said: "I think the message here is the same message that has been brought out with every other derivatives-based situation; one has to have clear controls and very effective guidelines" on using derivatives.
But institutional investors do not have much confidence that tighter controls, though necessary, will be 100% effective in preventing another such financial crisis.
"The knee-jerk reaction would be to put on more controls and stand (looking) over people's shoulders," said Reza Vishkai, director international research at RogersCasey, Darien, Conn. "That might not resolve anything. You will always have the bad apple there that can find a way to go around the system."
Even if the strategy was executed in good faith, institutions are very vulnerable to highly leveraged speculative strategies.
"I think there will more financial shocks like this because you've gone through rapid short-term cycles of market changes," said Michael Beasley, managing director of Strategic Investment Solutions, San Francisco.
John Scotford, country treasurer for the (pounds) 1 billion Hampshire County Council Superannuation Fund, Winchester, England, said: "I have to believe it could happen again. I didn't think it could have happened the first time."
Lack of controls slammed
Many experts were appalled by the lack of management controls in place over Baring's Singapore operation.
In particular, many experts said that having Mr. Leeson serve as both chief trader and in charge of settlements violated basic rules. If Mr. Leeson were clearing his own trades, "that's a recipe for disaster," said Heinz Binggeli, managing director for derivatives consultant Emcor, Irvington, N.Y.
Early finger-pointing was targeted at both Baring and the Singapore International Monetary Exchange for failing to catch the huge exposure building up.
But Richard Hu, Singapore's minister of finance, last week deflected charges of SIMEX's failure of oversight, saying Baring had met margin calls from the end of January. He said margin deposits were more than sufficient to offset Baring's unrealized losses from its SIMEX positions and that most of the firm's open positions have been unwound.
Still, the Singapore government last week proposed tougher oversight requirements on parents of member firms and proposed barring chief traders from heading settlement areas.
More blame is starting to pile on Baring's London operation, which advanced huge sums of cash to support Mr. Leeson's derivatives play. Mr. Leeson created a $7 billion exposure to the Japanese stock market through purchase of Nikkei stock index futures contracts. He also had a $20 billion short position in Japanese government bonds and Euroyen contracts.
Baring senior officials apparently had thought Mr. Leeson was engaging in arbitrage between the Osaka and Singapore futures markets, and that the position had been hedged.
One London banking source questioned how the bank could have advanced half of its (pounds) 541 million in capital to its Singapore unit without warning flags being raised.
What's more, a loan of that scale must have required governmental permission, he said. The Bank of England should have known about the loans and sought to impose controls. "I think supervision at the Bank of England must have been asleep at the stick," he added.
Other reports say an internal report from last summer warned of inadequate controls in the Singapore unit, but turf battles between Baring's banking and securities arms prevented its recommendations from being implemented.
Pension fund implications
U.S. pension funds have escaped the crisis relatively unscathed, although there might be some losses on investments in Baring managed pools whose uninvested cash was managed by Baring Brothers & Co.
Baring's U.S. affiliate never went into administration, the U.K.'s equivalent of reorganizing under bankruptcy laws. It continued trading throughout the week.
Money managers who had unsettled trades outstanding with Baring Securities were able to smooth things out. Paul Guidone, managing director and chief investment officer of HSBC Asset Management Ltd., London, said $15 million in unsettled trades had been reduced to $5 million within two days.
British pension funds, which typically lodge custody functions with their fund managers, face the potential for greater losses than their U.S. counterparts, which are required by law to use independent custodians.
Where Baring doubles as custodian, the manager hands cash to the Baring bank for investment. Those pension clients then became creditors of the bank for those assets. (All securities investments, however, were protected.)
Efforts to get potential buyers to make good any potential losses became a sticking point in negotiations, because the total exposure was unknown, sources said. The unit's market value was estimated at (pounds) 600 million at current values.
Pension consultants also warned Ernst & Young that a buyer would have to pick up any losses or else face wrath from clients. If clients walked, the value of the franchise would diminish substantially.
The problems with the cash deposits will lead some U.K. funds to reconsider hiring independent custodians. Colin Cross, principal technical assistant for the (pounds) 1 billion Essex County Council Superannuation Fund, Chelmsford, said trustees at the fund will "actively revisit" the issue.
Similarly, Hampshire's Mr. Scotford said fund officials will review their policy, although he, among others, questioned whether anyone would have thought Baring was unsafe prior to last week.
Morfydd Evans, a partner at Bacon & Woodrow, London, said U.K. pension clients would examine more closely whether securities are properly safeguarded and how cash is managed within the portfolio.
Cash management has been regarded as low risk, but it has proven not to be so in Baring's and other cases. Some consultants discussed imposing limits on the amount of cash that could be invested with any one institution.
The cash problem has given fresh ammunition to the NAPF's efforts to get an independent custody requirement included within the pensions bill now before the House of Lords.
Pension officials would then be required to perform due diligence on the custody function, explained Geoff Lindey, chairman of the NAPF's investment committee. Trustees still might have picked Baring, but requiring them to examine the issues will enable them "to control their own destiny," he said.
This story was written by Joel Chernoff, with reports from Paul G. Barr, Mercedes M. Cardona and Margaret Price.
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