University of Zurich              Institute for Empirical Research in Economics                            The UBS Crisis ...
Disclaimer: This is an English translation of the German original. The English version is for convenience purposes only. I...
Contents1. Introduction                                        32. UBS and the Subprime Crisis                         53....
1. IntroductionThere is no doubt: Through the shortcomings in the conduct of its investment bankingand cross-border wealth...
consciousness; it lacked healthy mistrust, independent judgement and strength ofleadership.     Thus it happened that alth...
leadership was aware of what was at stake, but was not in a position to implement of thenew US regulations in a timely and...
management. The impression was created that the bank’s leadership had ignored allconcerns expressed by its risk divisions ...
created hitherto unimaginable business opportunities, but also fundamentally altered therules of the economy and of bankin...
The experience of the 1930s led government authorities to subject the bankingindustry to stringent regulation. The Second ...
structural reforms, technological innovation, and good policy.”4 It was in this vein thatUS Federal Reserve Bank Chairman ...
would have received a warning signal as early as March 2007. As it was, however, thefact that first-class paper had not re...
However, some claimed that UBS had already restructured its low-quality subprimeinvestments (BBB–) in such a way as to pos...
write-downs of 4 billion Swiss francs due to the US mortgage crisis. At a single stroke, itwas now clear to all that UBS h...
the fixed-income business. It is noteworthy that, also in the cases of two US investmentbanks that incurred significantly ...
1934; the Basler Handelsbank and the Eidgenössische Bank were taken over in 1945 bythe Swiss Bank Corporation and the Unio...
strategy more and more towards growth in volume and earnings. For this reason too littleattention was paid, particularly i...
held the status of a Qualified Intermediary (QI), was governed by the terms of a QIAgreement.     There were two concrete ...
business divisions. According to the SFBC/FINMA, repeated signals were sent from thetop management that incomplete executi...
had remained neutral throughout the war, were politically stable, and had well developedfinancial industries. As early as ...
providing that account information could not be divulged without a court order.Luxemburg, one of the founding members of t...
strictly with the terms of the QI agreement while, at the same time, their superiorsexpected them to rapidly acquire new c...
4. Conclusion and PerspectivesThe present report is deemed to examine the question of how to assess the mistakescommitted ...
however, that none of the mistakes committed by UBS were unusual. Whenever financialbubbles rise, a large number of market...
unrealistic to expect that a gradual optimization of all available instruments will be ableto prevent all future losses, o...
les dessous d’un scandale: comment l’empire aux trois clés a perdu son pari, Lausanne 2008; Lukas Hässig,Der UBS-Crash: Wi...
22     On the origins of banking secrecy in Switzerland, see Robert Vogler, Das Schweizer Bankgeheimnis:Entstehung, Bedeut...
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The Ubs Crisis In Historical Perspective

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A September 2010 investigation into the 50 Billion dollar debacle at the world\'s largest private bank. Repeated risk-control warnings were ignored throughout the company, its culture and reputation for prudence corroded by short-term riches,speculation and lucrative sub prime derivatives business during the good times before the 2008 crash.

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Transcript of "The Ubs Crisis In Historical Perspective"

  1. 1. University of Zurich Institute for Empirical Research in Economics The UBS Crisis in Historical Perspective Expert Opinion prepared for delivery to UBS AG 28 September 2010Dr. Tobias Straumann, Lecturer, University of ZurichAddress:Institute for Empirical Research in EconomicsChair of Economic HistoryZürichbergstrasse 14CH–8032 Zurichstraumann@iew.uzh.chAll opinions expressed in this study are the author’s own and do not reflectthe views of the Institute for Empirical Research in Economics, of theUniversity of Zurich, or of UBS AG.© 2010 PD Dr. Tobias Straumann, University of Zurich
  2. 2. Disclaimer: This is an English translation of the German original. The English version is for convenience purposes only. In caseof discrepancies, the German version shall prevail.
  3. 3. Contents1. Introduction 32. UBS and the Subprime Crisis 53. UBS and the Cross-border Business with US Clients 154. Conclusion and Perspectives 21 2
  4. 4. 1. IntroductionThere is no doubt: Through the shortcomings in the conduct of its investment bankingand cross-border wealth management business, UBS inflicted great damage toSwitzerland’s financial industry as well as the country as a whole. Admittedly, theregulatory authorities also made mistakes, as the reports by the Financial MarketSupervisory Authority and by the Control Committees of the Federal Assembly haveshown. Nevertheless, without the huge write-downs in the subprime market and theviolations of US law in the cross-border business, the train that ultimately led to acontroversial use of public funds and to a substantial weakening of the Swiss bankcustomer secrecy would never have left the station. For this reason, it is of greatimportance that the causes behind the misconduct of UBS be thoroughly investigated. Why was UBS affected so much by the subprime crisis? What caused the cross-border wealth management business with US clients to develop so adversely? In seekinga response to these questions, the UBS Board of Directors requested me to analyze theBank’s conduct from a historical perspective. To this end, I had access to all relevantreports by UBS, its external advisers and the regulatory authorities. In addition, I wasalso assured by the Board of Directors that there would be no attempt to influence thecontent of my inquiry. Ever since the size of the Bank’s losses – going into the billions – and the nature ofits legal violations have become known, the public has queried the true causes of the UBScrisis. This has given rise to a wide range of explanations. There is one, however, thatstands out: the theory that sees top management at UBS as having behaved like gamblersat a casino, constantly taking greater risks as their profits and their bonuses increased,until they finally lost everything and almost landed in prison. Having read the internaland external reports, I reach an entirely different conclusion. The problem at UBS wasnot that the Bank’s leadership simply ran rampant without any restraint. In fact, thecontrary was the case: top management was too complacent, wrongly believing thateverything was under control, given that the numerous risk reports, internal audits andexternal reviews almost always ended in a positive conclusion. The bank did not lack risk 3
  5. 5. consciousness; it lacked healthy mistrust, independent judgement and strength ofleadership. Thus it happened that although problems in the subprime market had been identifiedearly on, the Group Executive Board and the Board of Directors did nothing, because theinternal calculations and assurances coming from lower levels in the organizationconstantly confirmed that the UBS Investment Bank was sufficiently well-protected todeal with a downturn. For too long, management remained blinded by the high creditratings assigned to its proprietary positions, even as other banks started to recognize thatsuch ratings were deceptive. The same thing occurred in the wealth managementbusiness. The Bank’s leadership was aware of the importance of resolutely enforcing thenew US regulations. Instead of making sure that the requirements were properly satisfied,however, they relied on the positive conclusions of the audits and remained in thebackground until it was too late. Above all, leadership failed to make clear from theoutset that it was prepared to accept significant reductions in business volume in order toensure correct implementation of the new regulations. Viewed from an historical perspective, all of these leadership flaws are virtually ahallmark of large banks. With regard to investment banking, UBS was neither the sole,nor the first bank to believe that it was possible to achieve exceptional balance sheetgrowth without having to accept massive increases in risk exposure. Citigroup wascompelled to undertake write-downs in even greater amounts. In the 1930s, four ofSwitzerland’s major banks had become insolvent because they failed to recognize thehigh risks attaching to their investments. Barely ten years ago, Credit Suisse also incurredsizable losses, having underestimated the likelihood of a strong correction in the marketfor technology shares. The mistakes committed by UBS in the wealth management business were alsoanything but unusual. Deliberate indiscretions have revealed that in a fair number ofSwitzerland’s banks, up until very recently, not all of the client assets under managementwere tax compliant in the home jurisdiction of the account holder. The entire industry hadunderestimated the speed with which foreign authorities had intensified their efforts tocombat tax evasion. UBS differed from its competitors only in the particularly inflexiblemanner of reacting to the change in circumstances in the United States. The Bank’s 4
  6. 6. leadership was aware of what was at stake, but was not in a position to implement of thenew US regulations in a timely and resolute manner. If this analysis is correct, the UBS crisis is more than just an accident involving asingle large bank. It shows that, in international banking, management failures, even ifcommon, are capable of having unusually damaging effects. In light of this turn ofevents, a fundamental discussion over the future direction of Switzerland’s financeindustry cannot be avoided. In view of the UBS crisis, only two possible scenarios appearfeasible: either Switzerland is to remain a large and international center of finance,accepting in exchange the possibility that every so often there may be violent upheavals;or preference is given to stability, through domestication of the financial industry bymeans of strict regulatory measures, the price for this being a contraction in the size ofthe banking sector in Switzerland. The damage caused by UBS cannot be undone. In contrast with Iceland, however,where the banking crisis led to the financial ruin of the entire country, Switzerland stillhas sufficient room to maneuver. At least in this respect, the UBS crisis has had a positiveeffect. It has compelled the public to debate openly and honestly the role of the bankingsector.2. UBS and the Subprime CrisisUntil the outbreak of the financial crisis in 2007, UBS was reputed to be a particularlyconservative and solid international bank. Its risk management was even considered asexemplary by the supervisory authorities.1 Within the company, no less than 3000persons were employed in risk assessment. The Chief Risk Officer was a member in fullstanding of the Group Executive Board and head of the Risk Committee, of which notonly the responsible managers, but also the Group CEO and a vice-president of the Boardof Directors were members. Internal and external audits were conducted on a regularbasis. Following the announcement of the write-downs in October 2007, UBS’s reputationchanged overnight. It was now claimed that the bank had no solid footing at all and hadbeen run like a hedge fund. Heavy criticism was also directed at its conduct of risk 5
  7. 7. management. The impression was created that the bank’s leadership had ignored allconcerns expressed by its risk divisions and had acted with deliberate negligence. Thepersons in charge of UBS, who had once been considered prudent bankers, were nowseen as compulsive gamblers, only having in mind their own bonuses. That the general public sees things in this way is entirely comprehensible. It issimply inconceivable that a large international bank with a reputation for itsconservativeness, would suddenly incur such huge losses. If one compares the UBSsubprime losses with other cases in history, however, there is less reason to beastonished. In retrospect, it may be observed that the UBS case fits perfectly into apattern that has repeated itself again and again in the past. In reality, the biggest losers ina financial crisis usually are not those who have exposed themselves to major risks withtheir eyes wide open, but rather the ones who believed having their affairs well undercontrol. UBS was convinced that it had predominantly first-class subprime positions onits books, and had a very strong sense of security. Its image as a conservative bank wasnot made up to deceive the public, but corresponded fully with the picture the bank hadof itself. It was only with the outbreak of the financial crisis that UBS realized that thehigh ratings that had been given to subprime paper were misleading, whereas otherbanks, which had long since divested themselves of such positions, were able to limittheir losses. The most recent financial crisis is thus nothing but a new version of an old story,and the UBS case is in no way unique. The events always unwind in the samechronological order, as Charles Kindleberger has lucidly set forth in his book, “Manias,Panics, and Crashes.”2 At the beginning of a boom there is usually some kind ofinnovation, be it industrial or financial, which opens up new business opportunities andattracts investors with risk appetite. The second phase is marked by an increasing senseof euphoria, so that a self-reinforcing process is set into motion. The prospect of higherprofits attracts more and more investors, which, in turn, leads to a further expansion ofthe market and to an acceleration of the rise in profits. Carried along by this wave ofgeneral euphoria, many investors and bankers, along with market analysts, journalists,economists and regulators, are increasingly prepared to throw time-honored principlesright out the window. They come to believe that the latest innovations have not only 6
  8. 8. created hitherto unimaginable business opportunities, but also fundamentally altered therules of the economy and of banking. The third phase is one of unbridled enthusiasm,which Kindleberger has characterized as manic. Now, second-tier investors or companiessuch as pension funds and regional banks, who had stayed away from the market untilthis point, also begin to invest in it. In the fourth phase, isolated players begin to pull out,having noticed in time that the market has passed its peak. In the most recent crisis, thissmall group included banks such as Goldman Sachs or the hedge fund manager JohnPaulson, who began to bet on a decline in securities prices. The fifth and final phase ismarked by the collapse of the markets, whereby the overwhelming majority of investorsincur large losses. This group included UBS, together with Citigroup, Bear Stearns,Lehman Brothers, Merrill Lynch, Germany’s regional banks, countless investment fundsand small investors. The nature of the innovations that induce the type of investor euphoria that leads tothe abandonment of time-honored rules changes again and again over time. In the 19thcentury, investors let themselves be seduced repeatedly by the prospect of making profitson American railroad companies, which led to large fluctuations in the stock markets.The potential for profits on commodities from the countries of Latin America regularlyattracted large amounts of capital as well. In the 1920s, there was virtually unboundedenthusiasm for the new durable consumer goods such as automobiles, radios andtelephones. Retailers also invented new modalities for installment payments, based on theprinciple “buy now, pay later,” as a means of increasing sales. This, of course, led to asubstantial rise in the level of private debt.3 An investment bubble also developed inEurope in the 1920s. Here the optimism of market participants had its origin in the beliefthat Germany would soon regain the economic strength it had enjoyed prior to the FirstWorld War. There was a conviction that the stabilization of the Reichsmark in 1924 andthe reduction of international tensions under Foreign Minister Gustav Stresemann hadcreated the conditions for a sustainable economic revival. At the end of the 1920s, thisconfidence in the future proved to be a grand illusion. On both sides of the Atlantic theeconomy fell into a deep depression, which has remained unforgotten until this day forthe catastrophic political consequences that ensued. 7
  9. 9. The experience of the 1930s led government authorities to subject the bankingindustry to stringent regulation. The Second World War then led to a collapse in the freeinternational movement of capital. As a result, during an extended period of time, therewere no more major international financial crises. As the cross-border flow of capitalgradually resumed and was liberalized, however, instability grew as well. In the 1970s,the granting of loans to developing countries in Latin America and Eastern Europe led toan exaggerated sense of euphoria. In the 1990s, there was unbounded enthusiasm for thecountries of Asia. There was talk of an Asian miracle and a Confucian growth model thatwas considered immune to crisis for the foreseeable future. During that same period, abubble developed in the US stock market, which spilled over into the Europeanexchanges. Groundbreaking innovations in communications technology allowed investorimaginations to run wild beyond all measure. The belief that the old rules were no longerapplicable to the here and now proved to be, in all of these cases, a costly mistake injudgment. Banks and investors were compelled to absorb high losses, or to go intobankruptcy. In the developing countries, the real economies entered a period of deepcrisis. A financial bubble is, of course, not solely the result of collective enthusiasm for anew innovation. Crises are almost always also preceded by a lengthy period of lowinterest rates. False incentives created by government regulations may often also play adecisive role. In the most recent crisis, internationally agreed capital requirements (BaselII) had a calamitous effect, since they allowed the banks to fully exploit the leeway thatthe standards left them. However, the UBS losses can only be understood by taking quiteseriously the generalized belief that all was now different than in the past – and notsimply dismissing it as a cheap excuse. Carmen Reinhart and Kenneth Rogoff, authors ofa groundbreaking book on the history of financial crises, offer a succinct description ofthe phenomenon: “The essence of the this-time-is-different syndrome is simple. It isrooted in the firmly held belief that financial crises are things that happen to other peoplein other countries at other times; crises do not happen to us, here and now. We are doingthings better, we are smarter, we have learned from past mistakes. The old rules ofvaluation no longer apply. The current boom, unlike the many booms that precededcatastrophic collapses in the past (even in our country), is built on sound fundamentals, 8
  10. 10. structural reforms, technological innovation, and good policy.”4 It was in this vein thatUS Federal Reserve Bank Chairman Alan Greenspan declared, in October 2005, thatincreasingly complex financial instruments had “contributed to the development of a farmore flexible, efficient, and hence resilient financial system than the one that existed justa quarter-century ago.”5 Belief in the superiority of the new financial instruments was fueled by thecircumstance that many of the members of the executive boards and boards of directorsof the large financial groups had not the slightest notion as to what it was precisely thattheir risk divisions calculated. Rather than adopting an attitude of healthy skepticism,however, they allowed themselves to be overly impressed by their economists,mathematicians and physicists. They, too, were now convinced that inferior mortgageloans could merit the highest of rankings by the rating agencies if only they wereproperly bundled. With the advantage of hindsight, it is almost impossible to imagine, butit is nevertheless true: the majority of investors actually believed that subprime securitieswith a AAA rating were just as secure as US treasury paper. It is not only these general observations, however, that suggest that UBS was unableto separate the wheat from the chaff. Internal UBS documents, the UBS ShareholderReport and the SFBC/FINMA reports demonstrate quite clearly that the Board ofDirectors and Group Executive Board were convinced, up until the end of July 2007, thattheir investments in the subprime market were secure. All risk reports, as well as theinternal and external audits had arrived at the conclusion that UBS would be able to dealwith declining real estate prices without any difficulty. It was this immense confidence inthe well-oiled and universally praised risk control system that led to the high level oflosses. What the UBS leadership lacked in the decisive phase was independence ofjudgment.6 This analysis is supported by the fact that by far the greatest part of the UBS losseswas incurred on paper that had been given the highest rating (AAA).7 It paid little interestand remained unscathed in the initial waves of the subprime crisis. Not until July 2007did prices on this type of paper begin to fall, which quickly dried up the market for it.Until that time, even paper with the second-highest rating (AA) had remained stable (seefigure 1). Had UBS assumed the full risk and gambled on low-rated paper (BBB–), it 9
  11. 11. would have received a warning signal as early as March 2007. As it was, however, thefact that first-class paper had not reacted in the earlier collapse only strengthened UBS inthe belief that it had its risks, for the most part, under control. By contrast, the in-househedge fund Dillon Read Capital Management (DRCM), which was operated as anindependent division within the Group, was heavily invested in low quality paper. As aresult, it began showing a loss as early as the first quarter of 2007. In response, theBank’s management then decided to fully integrate DRCM into UBS, as of May 2007.Figure 1: ABX Index of Subprime Paper 2007 (Source: Markit) Specifically, the minutes of the Risk Committee show that the unqualified trust thatwas placed in the official ratings and the Bank’s own calculations was crucial. Wheneverthe question was raised as to whether the deterioration that had been observed would leadto major losses at UBS, the immediate response was always that internal calculationsgave no indication of serious problems. Everything was under control. Discussions of thiskind first began to take place in the third quarter of 2006, as housing prices in the USAbegan to decline. Risk managers provided detailed analyses showing that even in theevent of a negative scenario, UBS would have to cope only with minor losses. In the first quarter of 2007, new calculations confirmed that UBS was on the rightpath. It was clear that the subprime market was headed for further deterioration. 10
  12. 12. However, some claimed that UBS had already restructured its low-quality subprimeinvestments (BBB–) in such a way as to possibly even be in a position to profit from thedeterioration of the market.8 Attention was expressly drawn to the fact that UBS heldmainly AAA rated paper on its books. Because of this optimistic outlook, the GroupExecutive Board decided to continue its policy of not placing any limits on balance sheetgrowth.9 There was a conviction that the strategy that had been followed up until thenwas the right one. Moreover, Ernst & Young had given UBS high marks for its RiskReporting.10 It was at this same period that the SFBC and the Chief Risk Officer of the UBSInvestment Bank met in London, on 9 March 2007. The Swiss supervisory authoritywanted to know what state UBS was in with regard to the marked deterioration of thesubprime market. The Chief Risk Officer responded “that the Investment Bank wasprofiting from the deterioration of that market, notably due to its having accumulatedlarge short positions.” The so-called super senior CDO positions, that is, paper of thehighest quality, had not even been taken into account in the risk calculations, since theywere considered to be absolutely secure. The SFBC noted that, “From this point on thebank’s management placed its trust in the supposed short positions and shifted itsattention to other, seemingly bigger risks.”11 The SFBC/FINMA later noted self-critically, that it had acted far too credulously. The UBS crisis shined a merciless light onthe weaknesses in supervision. In the second quarter of 2007 the general assessment of the situation remainedlargely unchanged. The UBS leadership continued to be optimistic and the InvestmentBank went on purchasing highly rated subprime paper while other banks were quicklyunloading their positions, regardless of whether or not they had been rated AAA. Bydoing so, UBS had missed its last chance to act in time to prevent major losses. Not untilthe end of July, as prices for AAA paper clearly retreated and trading came to a standstill,did UBS realize that it had relied for too long on the valuations of the rating agencies. On14 August it announced record earnings for the second quarter of 2007, but, at the sametime, issued a warning in anticipation of the difficult market conditions to be reckonedwith in the coming months. In October 2007, UBS reported that it was compelled to take 11
  13. 13. write-downs of 4 billion Swiss francs due to the US mortgage crisis. At a single stroke, itwas now clear to all that UBS had been caught up in the maelstrom of the financial crisis. How did it happen that UBS took such an exceptionally long time to discover thatthere were two different types of AAA ratings – one for truly safe securities, such asthree-month US treasury bills, and another for supposedly safe structured products? Ifone compares the situation with that of Credit Suisse (CS), which had divested itself of itsrisky positions at an early date, everything depended on the judgment of a few individualmembers of the Bank leadership. CS was also compelled to accept write-downs in recordamounts, but it was able to cope without government assistance. What was the reason forthis marked difference between Switzerland’s two large international banks? Withoutaccess to minutes of meetings held at CS, it is difficult to say with certainty. Thefollowing four factors may, however, have played a decisive role: 1. Credit Suisse was possibly more cautious because it had been among the biggestlosers in the preceding financial crisis, when the Internet bubble burst. The sense ofhaving suffered a major rout was still so fresh in their minds that the bank’s managementwas more attentive to signs of a new bubble. Conversely, UBS had survived thepreceding financial crisis without serious wounds. This had largely been a function of itshaving incurred major losses only a few years earlier with the collapse of the hedge fundLTCM, which had been taken by the Bank as a signal to proceed more prudently in thefuture. While this caution had at first made UBS an object of reproach during the Internetboom, it was later a source of much praise once the bubble had burst. It had no trouble inwooing good teams away from other investment banks and was quickly able to improveits standing on Wall Street. Had it been weakened in the same way as CS in the precedingfinancial crisis, UBS would possibly have been more sensitive to the dangers of thefollowing boom. 2. Since the departure of John Costas, head of the Investment Bank from 2001 to2005, no executive from the fixed-income business had been included in top-levelmanagement. John Costas’ successor was Huw Jenkins, who had previouslydistinguished himself as the head of UBS’s equities division, but was barely acquaintedwith the business of securitized mortgage loans. At CS, by contrast, both CEO OswaldGrübel and the head of the Investment Bank, Brady Dougan, had made their careers in 12
  14. 14. the fixed-income business. It is noteworthy that, also in the cases of two US investmentbanks that incurred significantly smaller losses than UBS, the top post at each was heldby a man from the interest rate business: John Mack at Morgan Stanley and LloydBlankfein at Goldman Sachs. There is no 100 percent correlation, however. LehmanBrothers’ head Richard Fuld had also made his career in the fixed income business, butstill managed to run his bank into the ground. 3. The founding and subsequent reintegration of the in-house vehicle for alternativeinvestments, DRCM, had a disruptive influence on the organization. In the summer of2005, John Costas left his position as head of the UBS Investment Bank and moved to thenewly created DRCM, taking some 100 traders with him. He left behind an investmentbank that was obliged to build up its business in fixed-income investments from theground up, having lost good traders. In the time that followed, veritable rivalry developedbetween the new team at the Investment Bank and the highly paid employees at DRCM.The reintegration of DRCM following the losses incurred in the first quarter of 2007, asdescribed above, was extremely costly, not least because John Costas and his traders hadnegotiated high severance packages, and absorbed a great deal of senior management’stime and energy. During the decisive second quarter of 2007, the main preoccupation waswith DRCM reintegration issues, distracting attention away from concentration on areview of the Bank’s own risk exposure. 4. In historical retrospect, it is possible to observe that banks that try to burst theirway into the top ranks of the industry tend to suffer particularly large losses when afinancial crisis breaks out. In the period between the two World Wars, a number of largeSwiss banks fell victim simultaneously to their ambitious attempts to catch up inGermany. Their goal had been to narrow the gap between themselves and the two leadinginternational Swiss banks at the time, the Swiss Bank Corporation (SchweizerischerBankverein) and Crédit Suisse (Schweizerische Kreditanstalt), both of which hadsucceeded in establishing themselves in the international capital markets as early as theend of the 19th century. No fewer than four large Swiss banks ended up shipwrecked: theBanque d’Escompte Suisse of Geneva, the Basler Handelsbank (Commercial Bank ofBasle), the Eidgenössische Bank (Federal Bank) of Zurich, and the SchweizerischeVolksbank (People’s Bank of Switzerland) of Bern. The Geneva bank disappeared in 13
  15. 15. 1934; the Basler Handelsbank and the Eidgenössische Bank were taken over in 1945 bythe Swiss Bank Corporation and the Union Bank of Switzerland, respectively; and theVolksbank, a cooperative bank, survived only thanks to an injection of 100 million francsin equity capital from the Confederation, an amount representing roughly one fourth ofthe Federal budget at the time. In the official Message of the Federal Council regardingits financial contribution to the Volksbank, express mention was made of the bank’sfailure to properly plan its international expansion: “The cause of these losses lay first,without any doubt, in the severe generalized crisis that broke out unexpectedly towardsthe end of 1929 and in the currency collapse. However, the circumstance that neither theVolksbank’s cooperative form nor the organization and structure of its balance sheet weresuited for the undertaking of international business relationships, and that it disposedneither of the requisite international connections nor of officers qualified in this respect,certainly contributed substantially to exacerbate the failures that took place.”12 Switzerland’s recent economic history also furnishes numerous examples of failedstrategies for catching up with the competition. The Swiss Bank Corporation attempted inthe late 1980s to establish a foothold in the international lending business, but soonsuffered large losses and a damaged reputation, having not been sufficiently critical in theselection of its foreign clients. The Union Bank of Switzerland, in the 1990s launched aneffort to break into international investment banking, but was forced to undertake majorwrite-downs in the wake of the Asia crisis. The failed undertaking with the hedge fundLTCM, mentioned above, was also the Union Bank’s doing. The actual losses did notcome to light until later, however, after the merger with the Swiss Bank Corporation. Theheavy losses with which the CS Investment Bank’s business ultimately ended up at theend of the 1990s were also the result of an all too ambitions catch-up strategy. Within UBS, there was a widespread feeling that the interest rate business wasslipping away from them.13 In 2004, Marcel Ospel, the Chairman of the Board ofDirectors, announced in an interview that he was aiming for first place among Wall Streetinvestment banks.14 John Costas, still head of the UBS Investment Bank at the time, alsostated shortly thereafter that the goal for the coming years was to overtake the two frontrunners in the field, Goldman Sachs and Morgan Stanley.15 UBS presented itselfincreasingly, also internally, as a “growth company,” and oriented its compensation 14
  16. 16. strategy more and more towards growth in volume and earnings. For this reason too littleattention was paid, particularly in the Investment Bank, to the quality and sustainabilityof the business, as UBS later admitted.16 In this respect, UBS was similar to Citigroup,which suffered the highest losses of any of the US universal banks. There as well,instructions had come down from the very top to close the distance to leading investmentbanks Goldman Sachs and Morgan Stanley. Like UBS, Citigroup only realized in thethird quarter of 2007 that it would have to take write-downs amounting to billionsbecause of the collapse in the prices for AAA paper. According to “The New YorkTimes,” Citigroup had assured the supervisory authorities as late as June 2007 that it hadnot even subjected the AAA paper to a risk analysis, since the likelihood of losses onsuch paper was so low.17 In view of these circumstances, the case of UBS appears, in retrospect, to have beeninevitable. At the same time, however, it ought never to be forgotten that the losses wouldhave been much smaller if the Bank’s leadership had taken control and shifted course inMarch, 2007. If it had been understood that low-quality subprime paper, as it declined,would soon be dragging high-quality subprime paper down with it, it might have beenpossible to try unloading problematic positions in the second quarter of 2007, or at leastto freeze the business at the level at which it stood, rather than continuing to take on morepositions. It was an open situation, in which the judgment of a very few individualsdecided everything.3. UBS and the Cross-border Business with US ClientsAt first glance, the mistakes made by UBS in the cross-border wealth managementbusiness with US clients appear to have little to do with the losses in its investmentbanking division. While the massive write-downs on subprime paper had their roots inoverly optimistic market assessments, the legal difficulties were the result of insufficientcompliance with new US regulations. From 2001 onwards, UBS as a so-called “QualifiedIntermediary,” was obliged to assist in the collection and remittance of withholding taxeson US securities. The relationship between the US tax authorities and foreign banks that 15
  17. 17. held the status of a Qualified Intermediary (QI), was governed by the terms of a QIAgreement. There were two concrete grounds for the conflict between UBS and the USauthorities. First, the Bank offered services that made it possible for individual US clientsto set up intermediary companies that obscured their true tax status. All together, some300 clients fell into this category. Among them was Igor Olenicoff, whose UBS clientadvisor Bradley Birkenfeld turned over secret UBS documents to the US Department ofJustice in June, 2007. Olenicoff himself contributed to an escalation of the affair with hisown confession, in December, 2007. Second, UBS client advisors continued travelling tothe USA to serve clients who had not identified themselves to the US tax authorities, butnevertheless expected UBS to actively manage their assets for them in Switzerland. Thiscategory included several thousand US clients.18 On closer examination, however, a parallel may be seen between the subprimelosses and the shortcomings in the conduct of the US cross-border business. In bothcases, the Bank’s leadership remained too complacent and was thus too late inrecognizing the problem. In its investment banking activities, UBS top managementrelied for all too long on the assessments of its risk management and on the externalrating agencies. In spite of the awareness that housing prices were declining and thatsubprime debtors were having increasing difficulties in meeting payments, there was ahesitancy to question the positive results of the risk calculations and to assess thesituation independently. With regard to the wealth management business, the Bank’sleaders believed for all too long that implementation of the QI agreement required only agradual adaptation of existing business practices and failed to ensure, from the outset,that the new US regulations were actually respected in day-to-day operations. It was onlyin the second half of the year 2007, when it was already too late, that UBS topmanagement resolved to make a clean sweep of things. As in the case of the subprime losses, those who held the highest positions ofresponsibility cannot be accused of having unthinkingly ignored all warning signs. Oncontrary: the Bank’s leadership was aware from the beginning that the changes necessaryfor compliance with the QI Agreement required a major effort. In the first months of2000, the leadership created a large dedicated project designed to include all relevant 16
  18. 18. business divisions. According to the SFBC/FINMA, repeated signals were sent from thetop management that incomplete execution of the QI Agreement would not be tolerated:“non-compliance is not an option.” The Bank’s top executives were, moreover, fullycognizant of the fact that since the purchase of US wealth management companyPaineWebber, in 2000, UBS had a very strong interest making sure that it remained ingood standing with the US authorities.19 The real problem lay much more in the fact that UBS continued for far too longusing only standard procedures and refrained from taking unusual measures in the face ofunusual situations. In this case, that would have implied cutting off, without hesitation,all risky client relationships and sharply reduce the volume of the US cross-borderbusiness. Because the people at the highest level of responsibility failed to make thingsclear from the outset, implementation took several years and remained, to the end,incomplete. It was deemed sufficient to simply issue a clear order, without makingcertain that all of the troops were, in fact, marching in the right direction. In proportion tothe entire wealth management business, the division in question, North America, wassmall, both in terms of its staff and of its contribution to total earnings. This should not,however, be allowed to shroud the fact that the ultimate responsibility lay with theBank’s leadership. Those in charge were not sufficiently conscious of the need for acomprehensive change in the corporate culture, for which strict direction from above wasindispensible. From an historical point of view, the extent of the paradigmatic change necessitatedby the QI agreement cannot be stressed enough.20 Until that time, it should be recalled,Swiss Banks had not considered it their duty to ensure that foreign tax regulations wereobeyed. This was a result, among other things, of their frequent experience that foreignpolitical leaders, although eager to publicly denounce the ills of tax evasion, nevertheless,when push came to shove, always refrained from taking drastic measures against SwissBanks and were unable in concert to compel Switzerland to relent. This had already beenobserved in the 1920s, when the ascent of Swiss wealth management began. Politicalturmoil following the end of World War I, high inflation and the rise in sovereign debtled many German and French nationals to move large amounts of untaxed capital out ofthe country. The main countries to benefit were the Netherlands and Switzerland, which 17
  19. 19. had remained neutral throughout the war, were politically stable, and had well developedfinancial industries. As early as 1922, former warring countries Germany, France andItaly had made a joint attempt, within the framework of the League of Nations, toadvance international cooperation in the combating of tax evasion. These efforts soonproved ineffective, as not only Switzerland, but also the Netherlands and Great Britainhad expressed their opposition thereto. The Swiss envoy to The Hague wrote to ForeignMinister Motta, in 1924, that Holland would never tolerate the abrogation of bankingsecrecy. Such a thing, he claimed, was not compatible with the Dutch character.21 In the 1930s, German and French authorities intensified their efforts by sendingspies to Switzerland. In October 1932, moreover, employees of the Commercial Bank ofBasle were caught in the act in a Paris hotel, aiding French clients to evade taxes.Confiscation of the documents led to the discovery that some 2000 French clients hadbeen dodging their taxes – among them well-known personalities from the worlds ofbusiness, politics and the Church. Once again, the measures taken by the German andFrench authorities showed little effect. Unmoved by pressures from abroad, in 1934 theSwiss Federal Assembly passed the first Swiss Federal Banking Act, firmly anchoringtherein the principle of banking secrecy, violations of which were made punishable. Abank employee who disclosed client information was held criminally liable, and could besentenced either to prison or to a large monetary fine.22 In the immediate wake of World War II, there was a brief period during which Swisswealth management came under fire. However, with the Washington Agreement, signedby the Allies and Switzerland in 1946, a way was found to satisfy the claims of thevictorious countries to German assets deposited in Switzerland, including stolen gold thathad been acquired by the Swiss National Bank, without the need to divulge clientidentities. The Confederation paid 250 million francs and, in return, the United Statesunfroze Swiss assets. From that time, up until the 1990s, there were no further such concerted efforts onthe part of other countries. When Austria decided, in 1979, to impose, for the first time,comprehensive legal rules for a strict version of the principle of banking secrecy, nointernational protest was heard. Following the country’s entry into the EU, in 1995, onlythe provisions on the anonymity of savings accounts were repealed, but not the law 18
  20. 20. providing that account information could not be divulged without a court order.Luxemburg, one of the founding members of the European Coal and Steel Community,from which the EU was later to emerge, was also able to build up its wealth managementindustry in the 1970s, without any fear of sanctions. Even when the Grand Duchyintroduced, in 1981, a law anchoring the principle of strict banking secrecy, on the Swissmodel, no veto was cast by Brussels, Bonn, or Paris. Lichtenstein decided in 1992 toenter the European Economic Area (EEA) as it estimated the risk of negativeconsequences for its wealth management industry to be small.23 There has not thus far been a great deal of research into the question as to whyGermany, France, Italy or the United States tolerated the expansion of cross-borderwealth management for such a long time. Tax evasion was probably accepted, to a certainextent, because strong economic growth in the 1950s and 1960s generated sufficient taxrevenues. Perhaps the authorities were also aware that the construction of a welfare statewas possible only if large taxpayers were not subject to all too much harassment.Whatever the reason, wealth managers in Switzerland, in the European Principalities, andon the British Isles, had the definite impression that in spite of their professions poorpublic image, their business was not fundamentally in danger. One needed only consultthe list of clients for confirmation that tax evasion was an extremely common practiceeven in the very highest circles of the society. Given the tradition in which this business stood, it is not particularly surprising thatthe North America division of UBS Wealth Management would attempt to maintainlongstanding client relationships to the greatest possible extent. Older client advisors aresaid to have been particularly reluctant to comply with the new requirements instituted bythe QI Agreement. Conversely, it is astonishing that the UBS leadership requested “zerotolerance” with no deeds to follow their words. This can only be explained by theassumption that they either underestimated the implications of the change in corporateculture, or that they wished to delegate the responsibility. Symptomatic of the UBS leadership’s ignorance of the problem was theimplementation of a new system of incentives at UBS in 2004, as mentioned by theSFBC/FINMA. Bonuses were now contingent upon “New Net Money.” This created aconflict for many US client advisors. On the one hand, they were expected to comply 19
  21. 21. strictly with the terms of the QI agreement while, at the same time, their superiorsexpected them to rapidly acquire new client assets. Some client advisors concluded thatthe Bank’s management was not, in fact, serious about the literal application of the newUS regulations, and no longer had any hesitations in the conduct of illicit advisoryactivities.24 Was UBS the only Swiss bank that failed to implement the QI Agreement properly?At the present time, the question cannot be answered. There is, however, no doubt thatother Swiss banks have also experienced difficulties in adapting to the new circumstancespractices that had for decades been in regular use. According to the Suisse Romandebased broker Helvea, more than half of the European fortunes deposited in Swiss banksare undeclared. Moreover, UBS is by no means the only bank to have been targeted byforeign authorities in recent years. In 2002, an employee at LGT Treuhand AG, in Vaduz,pilfered a large amount of client information, which he later sold to Germany’s FederalIntelligence Service (Bundesnachrichtendienst; BND), among others. This led to a muchpublicized search at the home of the then Chairman of the Board of the Deutsche Post, inFebruary 2008. An employee with HSBC Private Bank (Suisse), in Geneva, copied clientdata onto a CD and offered it to French authorities in August 2009. Not many monthsago, German authorities also purchased stolen CDs containing confidential clientinformation. Having entered a period in which large countries treat tax evasion by their citizenswith less and less tolerance, cross-border wealth management by Swiss Banks hasgenerally become more vulnerable. It would thus be wrong to see the errors committedby UBS in its cross-border business with US clients as an isolated or unique case. It wascertainly more aggressive and less careful than others in the way it went about things. Inessence, however, it was all about a business practice that had a tradition established overdecades. 20
  22. 22. 4. Conclusion and PerspectivesThe present report is deemed to examine the question of how to assess the mistakescommitted by UBS in the US subprime market and in its cross-border business with USclients from an economic and historical point of view. Based on a study of internal UBSreports, EBK/FINMA reports and a range of books, newspaper articles and other sources,two findings strike me as particularly significant. 1. Among the members of the highest UBS corporate bodies, there was a lack ofleadership personalities with a sense for detecting hidden risks. As far as investmentbanking is concerned, for all too long a time, trust was placed in the notations given byrating agencies and in the Bank’s own risk models, rather than once actually reflecting onthe fundamental issue of whether bundled subprime paper really was as safe aninvestment as US government bonds. It was not until the prices for AAA subprime paperbegan to retreat that the mathematical models were seriously questioned by seniormanagement and an attempt was made to arrive at an assessment independently of themodels. With regard to the cross-border business with US clients, UBS directors andsenior officers underestimated the risks that arose in connection with adapting operationsto the new US regulations. Even if the persons in the highest positions of responsibilityhad no direct knowledge of systematic breaches of US law, it is incomprehensible thatthey did not take steps to ensure, from the outset, that such a conduct was simply notpossible. A business sector that had operated in scorn of foreign law over a period ofdecades could not be brought into full legal compliance by means of a few instructionsissued from above. Here again, a sense of judgment was lacking, which would have madeit possible to recognize the essential problems independently of legal opinions, internalaudits and business models. Overall, the top floor at UBS was characterized by atechnocratic management style, which in extraordinary circumstances proved not to beflexible enough. 2. The errors committed by UBS were, in part, avoidable, since they were caused bythe mistaken assessments of a few individual members of senior management. Otherbanks pulled out of the US subprime market in time and had their client advisors undercontrol, since the right decisions were made at the top. A historical comparison shows, 21
  23. 23. however, that none of the mistakes committed by UBS were unusual. Whenever financialbubbles rise, a large number of market participants allow themselves to be tempted intoignoring the time-honored rules of the banking business. In historical retrospect, theerrors in the cross-border business with US clients also seem to be less unusual than firstappeared. The fact that a Swiss bank would experience difficulties in adapting itstraditional wealth management activities to a dramatically tightened regulatoryenvironment was almost predictable, even if the damage that resulted thereof may nothave been. UBS acted only with particular carelessness, but not fundamentally differentlythan the other banks that had been conducting cross-border business with foreign clientsfor decades. If this appraisal is correct, then it is of little use to repeatedly target the individualsresponsible. Public opinion in Switzerland would be better advised to discuss thequestion of how the country’s two large international banks should position themselves inthe future. An honest assessment leaves only two alternatives: Either it is considereddesirable that Switzerland remain a financial center of international importance, also inthe future, in which case the two large banks will be permitted to further expand in thesectors of investment banking and cross-border wealth management. This also implies,however, that there must be acceptance of the fact that CS and UBS will continue to payhigh salaries and bonuses and run the risk of once again incurring large losses or cominginto conflict with foreign governments. In other words, it is an illusion to believe thatSwitzerland can continue to maintain its position as a center of international financewithout having to live with the attendant risks. The UBS crisis has clearly demonstratedthat errors in investment banking or in cross-border wealth management can causeenormous damage at any time. Any attempt to classify the UBS crisis as a regrettable butisolated incident necessarily underestimates the force of financial market dynamics andthe appetite of foreign tax authorities. Naturally, improvements in the regulation ofinvestment banking are possible and the standards applying to wealth management can beraised. An increase in capital ratios and a tightening of liquidity requirements, as widelyfavored by all sides, will certainly strengthen the ability of the large banks to resist intimes of crisis. Improvements in risk control methods, both at the large banks and by thesupervisory authorities, will presumably also have a positive effect. It is, however, 22
  24. 24. unrealistic to expect that a gradual optimization of all available instruments will be ableto prevent all future losses, once and for all. To the contrary, placing too much trust innew rules might only increase the probability of further severe financial crises. The second alternative places the entire weight on safety and imposes on thefinancial industry a regulatory regime that renders investment banking and cross-borderwealth management unattractive. In choosing this path, one must be prepared to accept asevere contraction in the Swiss financial industry and a loss in international prestige. Thisoption cannot provide full protection against bank crises, either. A domestic real estatecrisis, such as the one experienced by Switzerland in the 1990s, can also recur in thefuture. However, the danger that losses by a single bank could come to threaten theeconomy of the entire country would certainly be diminished.It goes without saying that this view of the situation, like all other assessments expressedin this report, is subject to debate.25 Economic history is anything but an exact science.Moreover, there still exist large research gaps that make it difficult, at this point in time,to provide a comprehensive description of the historical roots of the UBS crisis. Onething, however, may already be stated without contest: the mistakes committed by UBScannot be explained solely by the behavior of its management; the wider environmentmust also be taken into account. The present report has attempted to provide certainmarkers. The real work still lies ahead of us.1 FINMA, Financial market crisis and financial market supervision, Bern, 14 September 2009, p. 21.2 Charles Kindleberger, Manias, panics, and crashes: a history of financial crises, 3rd ed., New York 1996,p. 12-16. Kindleberger takes his cue from the observations of US economist Hyman Minsky. Also worthreading is John Kenneth Galbraith, A short history of financial euphoria, New York 1994.3 Martha Olney, Buy now, pay later: advertising, credit, and consumer durables in the 1920s, Chapel Hill1991.4 Carmen Reinhart und Kenneth Rogoff, This time Is different: eight centuries of financial folly, Princeton2009, p. 15.5 Remarks by Chairman Alan Greenspan: Economic flexibility, Before the National Italian AmericanFoundation, Washington, D.C., October 12, 2005.6 This is also the conclusion reached by the Swiss Federal Banking Commission, Subprime Crisis: SFBCInvestigation into the Causes of the Write-downs of UBS AG, Bern, 30 September 2008; Myret Zaki, UBS: 23
  25. 25. les dessous d’un scandale: comment l’empire aux trois clés a perdu son pari, Lausanne 2008; Lukas Hässig,Der UBS-Crash: Wie eine Grossbank Milliarden verspielte, Hamburg 2009.7 For an overview of the losses, see UBS, Shareholder Report on UBS’s Write-Downs, 18. April 2008,pp. 6-7.8 UBS, Shareholder Report on UBS’s Write-Downs, 18 April 2008, p. 37.9 UBS, Shareholder Report on UBS’s Write-Downs, 18 April 2008, p. 26.10 UBS, Shareholder Report on UBS’s Write-Downs, 18 April 2008, p. 24.11 FINMA, Financial market crisis and financial market supervision, Bern, 14 September 2009, p. 23-24.12 Botschaft des Bundesrates an die Bundesversammlung über die finanzielle Beteiligung des Bundes ander Reorganisation der Schweizerischen Volksbank, 29 November 1933, Federal Gazette, vol. II, Bern1933, p. 807. On the banking crisis in the 1930s, see, among others, Jan Baumann, Bundesinterventionen inder Bankenkrise 1931-1937: Eine vergleichende Studie am Beispiel der Schweizerischen Volksbank undder Schweizerischen Diskontbank, Zurich 1997; Willi Loepfe, Geschäfte in spannungsgeladener Zeit:Finanz- und Handelsbeziehungen zwischen der Schweiz und Deutschland 1923 bis 1946, Weinfelden 2006;Marc Perrenoud, Rodrigo López, Florian Adank, Jan Baumann, Alain Cortat, Suzanne Peters, La placefinancière et les banques suisses à l’époque du national-socialisme: Les relations des grandes banques aveclAllemagne (1931-1946), Zurich 2002.13 Peter Wuffli, “Ich habe nicht fahrlässig gehandelt,” Bilanz, 24 September 2010, p. 54.14 Dirk Schütz, “Unsere Investmentbank soll die Nummer Eins werden”: Der UBS-Präsident über denBundesrat, Rivalen und ehrgeizige Ziele, Cash, 23 December 2004, p. 25.15 Zoé Baches and Arno Schmocker, “Wir wollen unseren Marktanteil verdoppeln”: John Costas, CEO undChairman UBS Investment Bank, zur angestrebten Position der weltweiten Nummer eins, Finanz undWirtschaft, 8 January 2005, p. 18.16 UBS, Shareholder Report on UBS’s Write-Downs, 18 April 2008, pp. 41-42.17 Eric Dash and Julie Creswell, Citigroup Saw No Red Flags Even as It Mad Bolder Bets, New YorkTimes, 23 November 2008, p. A1.18 On the regulatory background and the violations of law committed by UBS, see FINMA, EBKinvestigation of the cross-border business of UBS AG with its private clients in the USA, Bern, 18February 2009; Lukas Hässig, Paradies perdu: Wie die Schweiz ihr Bankgeheimnis verlor, Hamburg 2010.19 FINMA, EBK investigation of the cross-border business of UBS AG with its private clients in the USA,Bern, 18 February 2009, p. 16.20 On the international structural changes, see Myret Zaki, Le secret bancaire est mort, vive l’évasionfiscale, Lausanne 2010.21 Christophe Farquet, Le secret bancaire en cause à la Société des Nations (1922-1925), Traverse:Zeitschrift für Geschichte – Revue d’histoire 1 (2009), p. 110. 24
  26. 26. 22 On the origins of banking secrecy in Switzerland, see Robert Vogler, Das Schweizer Bankgeheimnis:Entstehung, Bedeutung, Mythos, Zurich 2005. See also Sébastien Guex, The Origins of the Swiss BankingSecrecy Law and its Repercussions for Swiss Federal Policy, Harvard Business History Review 74 (2000),S. 237-266; Peter Hug, Steuerflucht und die Legende vom antinazistischen Ursprung desBankgeheimnisses: Funktion und Risiko der moralischen Überhöhung des Finanzplatzes Schweiz, in:Jakob Tanner/Sigrid Weigel (ed.), Gedächtnis, Geld und Gesetz: Vom Umgang mit der Vergangenheit desZweiten Weltkriegs, Zurich 2002, pp. 269-288.23 On the financial history of Europe after 1945, see Christoph Maria Merki (ed.), Europas Finanzzentren:Geschichte und Bedeutung im 20. Jahrhundert, Frankfurt a.M. 2005. On the financial history ofSwitzerland, see Claude Baumann und Werner E. Rutsch, Swiss Banking – wie weiter? Aufstieg undWandel der Schweizer Finanzbranche, Zurich 2008; Philipp Löpfe, Banken ohne Geheimnisse: Was vomSwiss Banking übrig bleibt, Zurich 2010; Peter Hablützel, Die Banken und ihre Schweiz: Perspektiveneiner Krise, Zurich 2010.24 FINMA, EBK investigation of the cross-border business of UBS AG with its private clients in the USA,Bern, 18 February 2009, p. 15.25 The literature on the regulatory issue has greatly expanded since the financial crisis. A good overview ispresented by Urs Birchler, Diana Festl-Pell, René Hegglin, Inke Nyborg, Faktische Staatsgarantie fürGrossbanken: Gutachten erstellt im Auftrag der SP Schweiz, Swiss Banking Institute, University of Zürich,8 Juli 2010; Boris Zürcher, Too Big To Fail und die Wiederherstellung der Marktordnung, Avenir Suisse,Discussion Paper, Zurich, March 2010. 25

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