ISSUE 11 FEBRUARY 2010

Researcher:

Let’s focus our discussion by talking about the 1995 collapse of a family business, Barings Bank. I’d like to ask where they went wrong in their risk management and how do you avoid similar issues in your own businesses?

Just to summarize the Barings story: the bank was formed in 1762 by Sir Francis Baring and by the 1990s it had become the oldest merchant bank in London. If anyone knew about managing risk and long-term survival, it should have been Barings.

Then in 1995 a rogue trader, Nick Leeson, admitted to losing $1.3 billion in trading derivatives. Peter Baring, the chair of the Barings Group, had no warning or prior knowledge of the losses. Family ownership came to a sudden end as Barings went bankrupt.

So where did they go wrong?

Family Business Leader:

The absolute starting point is to have a full and real understanding of risk. Of course, this isn’t easy to get because you can’t always predict what will go wrong - there are ‘unknown unknowns’.

Barings might have noticed that some other companies had got caught by derivatives. Metallgesellschaft lost $1.4 billion on oil derivatives in 1993. If Barings had seen this and acted on the warning, they would still have had enough capital to survive Nick Leeson’s activities.

The way we try to build our understanding of risk is to watch our competitors very carefully and see what trips them up. We’re more likely to pick up on risks if we’re watching 100 companies than if we’re just looking inwards at our own company.

Without question, the worst failures in my own business came when we forgot to look outwards. It takes a wide knowledge of yourself, your competitors, industry, economy and history to gain a good understanding of risk.

Researcher:

Should all the blame be put on the top management at Barings?

Family Business Leader:

In my experience top management can get an issue right in theory, but then they delegate out of sight and it goes wrong in practice. In the Barings case, top management agreed that Nick Leeson could trade in derivatives - but to exploit small differences in price between similar derivatives in different markets. The problem was that Nick Leeson went far beyond this and actually made short-term unhedged bets on which way the market would go.

Researcher:

Didn’t anyone spot that Nick Leeson was doing more than he was supposed to?

Family Business Leader:

Nick Leeson, as a trading floor manager, was supposed to be supervised by the Head of Settlement Operations. But the Head of Settlement Operations was none other than...Nick Leeson. So he was supervising himself. No one else was involved.

The lesson here is to have a good process and make sure it’s followed. If you get the process wrong, the risk soars.

Researcher:

What should a good process include?

Family Business Leader:

Good process should include clear responsibility for each business activity, clear segregation of duties between different people, and internal controls that identify and prevent unacceptable actions.

In our family business, which has a turnover of well over $1 billion, part of our process is to involve a full-time Risk Manager. His only role is to independently assess risk. Our Risk Managers are seconded into the position and we change them every three years to keep a fresh pair of eyes. The Risk Manager is backed up by a team of three assistants and they play a key part in our process.

In addition, it’s important to have an independent Board that has broad experience of what works and what doesn’t work. Our Board includes someone with accounting skills who understands financial risk; also a CEO of another company who understands operational risk. Other Board members have skills and experience that helps them understand further types of risk.

Watch competitors very closely to see what trips them up.

Researcher:

It’s clear that Barings failed to have the right processes and internal controls. But do you think there was also something about the culture that drove excessive risk taking?

Family Business Leader:

I’m sure that was the case. Problems come when people’s only values are how much money they can make. Thanks in part to Nick Leeson, the bank’s bonus pool in 1994 was nearly two hundred million dollars. Top managers were very pleased with Nick Leeson and wanted him to keep doing what he was doing. It was too good to be true - but there was no incentive for people to ask how one trader could possibly make so much money so consistently.

In contrast, like many family businesses, we try very hard to align our reward structure with our values. So we don’t offer bonuses for people who deliver short term increases in profit. Instead we reward people who build the business for sustainable longer term improvements.

Researcher:

What was the final piece of risk-taking that destroyed Barings as a family business?

Family Business Leader:

Disaster came when Nick Leeson was using so much leverage that he had committed Barings for an amount far in excess of the firm’s assets. Leeson’s losses were twice the bank’s available trading capital. There was no way back and Barings collapsed.

This shows another very important lesson. Never bet the company farm on a single project. No matter how sure you are, it’s sensible to keep a level of diversification.

Researcher:

Do you think that family businesses are better at managing risk, in general?

Family Business Leader:

Family businesses may have an advantage if they have a tradition of prudence and a framework of accountability. But don’t forget that Barings Bank was a family business. It’s an uncomfortable reality that no business model is risk-free. It’s something that we need to watch all the time and with all our effort.

In this issue

Onvest Oy and Maarit Toivanen-Koivisto
Onvest Oy is a leading family business in Finland.

Marrying into the business What is it like for people to marry into a family business?

How to build trust during difficult times
Trust is a special form of business capital.

Never waste a good crisis (Part I)
Family leaders came together for a unique "ideas café" at the FBN's 2009 International Summit.