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transcript
The UBS Crisis
in Historical Perspective
Expert Opinion
prepared for delivery to UBS AG
28 September 2010
Dr. Tobias Straumann, Lecturer, University of Zurich
Address:
Institute for Empirical Research in Economics
Chair of Economic History
Zürichbergstrasse 14
CH–8032 Zurich
straumann@iew.uzh.ch
All opinions expressed in this study are the author’s own and do not reflect
the views of the Institute for Empirical Research in Economics, of the
University of Zurich, or of UBS AG.
© 2010 PD Dr. Tobias Straumann, University of Zurich
University of ZurichInstitute for Empirical Research in Economics
Disclaimer: This is an English translation of the German original. The English version is for convenience purposes only. In case of discrepancies, the German version shall prevail.
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Contents
1. Introduction 3
2. UBS and the Subprime Crisis 5
3. UBS and the Cross-border Business with US Clients 15
4. Conclusion and Perspectives 21
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1. Introduction
There is no doubt: Through the shortcomings in the conduct of its investment banking
and cross-border wealth management business, UBS inflicted great damage to
Switzerland’s financial industry as well as the country as a whole. Admittedly, the
regulatory authorities also made mistakes, as the reports by the Financial Market
Supervisory Authority and by the Control Committees of the Federal Assembly have
shown. Nevertheless, without the huge write-downs in the subprime market and the
violations of US law in the cross-border business, the train that ultimately led to a
controversial use of public funds and to a substantial weakening of the Swiss bank
customer secrecy would never have left the station. For this reason, it is of great
importance 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 seeking
a response to these questions, the UBS Board of Directors requested me to analyze the
Bank’s conduct from a historical perspective. To this end, I had access to all relevant
reports by UBS, its external advisers and the regulatory authorities. In addition, I was
also assured by the Board of Directors that there would be no attempt to influence the
content of my inquiry.
Ever since the size of the Bank’s losses – going into the billions – and the nature of
its legal violations have become known, the public has queried the true causes of the UBS
crisis. This has given rise to a wide range of explanations. There is one, however, that
stands out: the theory that sees top management at UBS as having behaved like gamblers
at 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 internal
and external reports, I reach an entirely different conclusion. The problem at UBS was
not that the Bank’s leadership simply ran rampant without any restraint. In fact, the
contrary was the case: top management was too complacent, wrongly believing that
everything was under control, given that the numerous risk reports, internal audits and
external reviews almost always ended in a positive conclusion. The bank did not lack risk
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consciousness; it lacked healthy mistrust, independent judgement and strength of
leadership.
Thus it happened that although problems in the subprime market had been identified
early on, the Group Executive Board and the Board of Directors did nothing, because the
internal calculations and assurances coming from lower levels in the organization
constantly confirmed that the UBS Investment Bank was sufficiently well-protected to
deal with a downturn. For too long, management remained blinded by the high credit
ratings assigned to its proprietary positions, even as other banks started to recognize that
such ratings were deceptive. The same thing occurred in the wealth management
business. The Bank’s leadership was aware of the importance of resolutely enforcing the
new 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 the
background until it was too late. Above all, leadership failed to make clear from the
outset that it was prepared to accept significant reductions in business volume in order to
ensure correct implementation of the new regulations.
Viewed from an historical perspective, all of these leadership flaws are virtually a
hallmark 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 sheet
growth without having to accept massive increases in risk exposure. Citigroup was
compelled to undertake write-downs in even greater amounts. In the 1930s, four of
Switzerland’s major banks had become insolvent because they failed to recognize the
high risks attaching to their investments. Barely ten years ago, Credit Suisse also incurred
sizable losses, having underestimated the likelihood of a strong correction in the market
for technology shares.
The mistakes committed by UBS in the wealth management business were also
anything but unusual. Deliberate indiscretions have revealed that in a fair number of
Switzerland’s banks, up until very recently, not all of the client assets under management
were tax compliant in the home jurisdiction of the account holder. The entire industry had
underestimated the speed with which foreign authorities had intensified their efforts to
combat tax evasion. UBS differed from its competitors only in the particularly inflexible
manner of reacting to the change in circumstances in the United States. The Bank’s
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leadership was aware of what was at stake, but was not in a position to implement of the
new US regulations in a timely and resolute manner.
If this analysis is correct, the UBS crisis is more than just an accident involving a
single large bank. It shows that, in international banking, management failures, even if
common, are capable of having unusually damaging effects. In light of this turn of
events, a fundamental discussion over the future direction of Switzerland’s finance
industry cannot be avoided. In view of the UBS crisis, only two possible scenarios appear
feasible: 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 by
means of strict regulatory measures, the price for this being a contraction in the size of
the 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 still
has sufficient room to maneuver. At least in this respect, the UBS crisis has had a positive
effect. It has compelled the public to debate openly and honestly the role of the banking
sector.
2. UBS and the Subprime Crisis
Until the outbreak of the financial crisis in 2007, UBS was reputed to be a particularly
conservative and solid international bank. Its risk management was even considered as
exemplary by the supervisory authorities.1 Within the company, no less than 3000
persons were employed in risk assessment. The Chief Risk Officer was a member in full
standing of the Group Executive Board and head of the Risk Committee, of which not
only the responsible managers, but also the Group CEO and a vice-president of the Board
of Directors were members. Internal and external audits were conducted on a regular
basis.
Following the announcement of the write-downs in October 2007, UBS’s reputation
changed overnight. It was now claimed that the bank had no solid footing at all and had
been run like a hedge fund. Heavy criticism was also directed at its conduct of risk
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management. The impression was created that the bank’s leadership had ignored all
concerns expressed by its risk divisions and had acted with deliberate negligence. The
persons in charge of UBS, who had once been considered prudent bankers, were now
seen as compulsive gamblers, only having in mind their own bonuses.
That the general public sees things in this way is entirely comprehensible. It is
simply inconceivable that a large international bank with a reputation for its
conservativeness, would suddenly incur such huge losses. If one compares the UBS
subprime losses with other cases in history, however, there is less reason to be
astonished. In retrospect, it may be observed that the UBS case fits perfectly into a
pattern that has repeated itself again and again in the past. In reality, the biggest losers in
a financial crisis usually are not those who have exposed themselves to major risks with
their eyes wide open, but rather the ones who believed having their affairs well under
control. UBS was convinced that it had predominantly first-class subprime positions on
its books, and had a very strong sense of security. Its image as a conservative bank was
not made up to deceive the public, but corresponded fully with the picture the bank had
of itself. It was only with the outbreak of the financial crisis that UBS realized that the
high ratings that had been given to subprime paper were misleading, whereas other
banks, which had long since divested themselves of such positions, were able to limit
their 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 same
chronological 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 of
innovation, be it industrial or financial, which opens up new business opportunities and
attracts investors with risk appetite. The second phase is marked by an increasing sense
of euphoria, so that a self-reinforcing process is set into motion. The prospect of higher
profits attracts more and more investors, which, in turn, leads to a further expansion of
the market and to an acceleration of the rise in profits. Carried along by this wave of
general euphoria, many investors and bankers, along with market analysts, journalists,
economists and regulators, are increasingly prepared to throw time-honored principles
right out the window. They come to believe that the latest innovations have not only
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created hitherto unimaginable business opportunities, but also fundamentally altered the
rules 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 companies
such as pension funds and regional banks, who had stayed away from the market until
this 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, this
small group included banks such as Goldman Sachs or the hedge fund manager John
Paulson, who began to bet on a decline in securities prices. The fifth and final phase is
marked by the collapse of the markets, whereby the overwhelming majority of investors
incur large losses. This group included UBS, together with Citigroup, Bear Stearns,
Lehman Brothers, Merrill Lynch, Germany’s regional banks, countless investment funds
and small investors.
The nature of the innovations that induce the type of investor euphoria that leads to
the abandonment of time-honored rules changes again and again over time. In the 19th
century, investors let themselves be seduced repeatedly by the prospect of making profits
on American railroad companies, which led to large fluctuations in the stock markets.
The potential for profits on commodities from the countries of Latin America regularly
attracted large amounts of capital as well. In the 1920s, there was virtually unbounded
enthusiasm for the new durable consumer goods such as automobiles, radios and
telephones. Retailers also invented new modalities for installment payments, based on the
principle “buy now, pay later,” as a means of increasing sales. This, of course, led to a
substantial rise in the level of private debt.3 An investment bubble also developed in
Europe in the 1920s. Here the optimism of market participants had its origin in the belief
that Germany would soon regain the economic strength it had enjoyed prior to the First
World War. There was a conviction that the stabilization of the Reichsmark in 1924 and
the reduction of international tensions under Foreign Minister Gustav Stresemann had
created the conditions for a sustainable economic revival. At the end of the 1920s, this
confidence in the future proved to be a grand illusion. On both sides of the Atlantic the
economy fell into a deep depression, which has remained unforgotten until this day for
the catastrophic political consequences that ensued.
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The experience of the 1930s led government authorities to subject the banking
industry to stringent regulation. The Second World War then led to a collapse in the free
international movement of capital. As a result, during an extended period of time, there
were no more major international financial crises. As the cross-border flow of capital
gradually 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 to
an exaggerated sense of euphoria. In the 1990s, there was unbounded enthusiasm for the
countries of Asia. There was talk of an Asian miracle and a Confucian growth model that
was considered immune to crisis for the foreseeable future. During that same period, a
bubble developed in the US stock market, which spilled over into the European
exchanges. Groundbreaking innovations in communications technology allowed investor
imaginations to run wild beyond all measure. The belief that the old rules were no longer
applicable to the here and now proved to be, in all of these cases, a costly mistake in
judgment. Banks and investors were compelled to absorb high losses, or to go into
bankruptcy. In the developing countries, the real economies entered a period of deep
crisis.
A financial bubble is, of course, not solely the result of collective enthusiasm for a
new innovation. Crises are almost always also preceded by a lengthy period of low
interest rates. False incentives created by government regulations may often also play a
decisive role. In the most recent crisis, internationally agreed capital requirements (Basel
II) had a calamitous effect, since they allowed the banks to fully exploit the leeway that
the standards left them. However, the UBS losses can only be understood by taking quite
seriously the generalized belief that all was now different than in the past – and not
simply dismissing it as a cheap excuse. Carmen Reinhart and Kenneth Rogoff, authors of
a groundbreaking book on the history of financial crises, offer a succinct description of
the phenomenon: “The essence of the this-time-is-different syndrome is simple. It is
rooted in the firmly held belief that financial crises are things that happen to other people
in other countries at other times; crises do not happen to us, here and now. We are doing
things better, we are smarter, we have learned from past mistakes. The old rules of
valuation no longer apply. The current boom, unlike the many booms that preceded
catastrophic collapses in the past (even in our country), is built on sound fundamentals,
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structural reforms, technological innovation, and good policy.”4 It was in this vein that
US Federal Reserve Bank Chairman Alan Greenspan declared, in October 2005, that
increasingly complex financial instruments had “contributed to the development of a far
more flexible, efficient, and hence resilient financial system than the one that existed just
a quarter-century ago.”5
Belief in the superiority of the new financial instruments was fueled by the
circumstance that many of the members of the executive boards and boards of directors
of the large financial groups had not the slightest notion as to what it was precisely that
their 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 mortgage
loans could merit the highest of rankings by the rating agencies if only they were
properly bundled. With the advantage of hindsight, it is almost impossible to imagine, but
it is nevertheless true: the majority of investors actually believed that subprime securities
with a AAA rating were just as secure as US treasury paper.
It is not only these general observations, however, that suggest that UBS was unable
to separate the wheat from the chaff. Internal UBS documents, the UBS Shareholder
Report and the SFBC/FINMA reports demonstrate quite clearly that the Board of
Directors and Group Executive Board were convinced, up until the end of July 2007, that
their investments in the subprime market were secure. All risk reports, as well as the
internal and external audits had arrived at the conclusion that UBS would be able to deal
with declining real estate prices without any difficulty. It was this immense confidence in
the well-oiled and universally praised risk control system that led to the high level of
losses. What the UBS leadership lacked in the decisive phase was independence of
judgment.6
This analysis is supported by the fact that by far the greatest part of the UBS losses
was incurred on paper that had been given the highest rating (AAA).7 It paid little interest
and remained unscathed in the initial waves of the subprime crisis. Not until July 2007
did 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 (see
figure 1). Had UBS assumed the full risk and gambled on low-rated paper (BBB–), it
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would have received a warning signal as early as March 2007. As it was, however, the
fact that first-class paper had not reacted in the earlier collapse only strengthened UBS in
the belief that it had its risks, for the most part, under control. By contrast, the in-house
hedge fund Dillon Read Capital Management (DRCM), which was operated as an
independent division within the Group, was heavily invested in low quality paper. As a
result, it began showing a loss as early as the first quarter of 2007. In response, the
Bank’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 that
was placed in the official ratings and the Bank’s own calculations was crucial. Whenever
the question was raised as to whether the deterioration that had been observed would lead
to major losses at UBS, the immediate response was always that internal calculations
gave no indication of serious problems. Everything was under control. Discussions of this
kind first began to take place in the third quarter of 2006, as housing prices in the USA
began to decline. Risk managers provided detailed analyses showing that even in the
event 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 right
path. It was clear that the subprime market was headed for further deterioration.
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However, some claimed that UBS had already restructured its low-quality subprime
investments (BBB–) in such a way as to possibly even be in a position to profit from the
deterioration of the market.8 Attention was expressly drawn to the fact that UBS held
mainly AAA rated paper on its books. Because of this optimistic outlook, the Group
Executive Board decided to continue its policy of not placing any limits on balance sheet
growth.9 There was a conviction that the strategy that had been followed up until then
was the right one. Moreover, Ernst & Young had given UBS high marks for its Risk
Reporting.10
It was at this same period that the SFBC and the Chief Risk Officer of the UBS
Investment Bank met in London, on 9 March 2007. The Swiss supervisory authority
wanted to know what state UBS was in with regard to the marked deterioration of the
subprime market. The Chief Risk Officer responded “that the Investment Bank was
profiting from the deterioration of that market, notably due to its having accumulated
large short positions.” The so-called super senior CDO positions, that is, paper of the
highest quality, had not even been taken into account in the risk calculations, since they
were considered to be absolutely secure. The SFBC noted that, “From this point on the
bank’s management placed its trust in the supposed short positions and shifted its
attention 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 on
the weaknesses in supervision.
In the second quarter of 2007 the general assessment of the situation remained
largely unchanged. The UBS leadership continued to be optimistic and the Investment
Bank went on purchasing highly rated subprime paper while other banks were quickly
unloading their positions, regardless of whether or not they had been rated AAA. By
doing so, UBS had missed its last chance to act in time to prevent major losses. Not until
the 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. On
14 August it announced record earnings for the second quarter of 2007, but, at the same
time, issued a warning in anticipation of the difficult market conditions to be reckoned
with in the coming months. In October 2007, UBS reported that it was compelled to take
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write-downs of 4 billion Swiss francs due to the US mortgage crisis. At a single stroke, it
was 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 that
there were two different types of AAA ratings – one for truly safe securities, such as
three-month US treasury bills, and another for supposedly safe structured products? If
one compares the situation with that of Credit Suisse (CS), which had divested itself of its
risky positions at an early date, everything depended on the judgment of a few individual
members of the Bank leadership. CS was also compelled to accept write-downs in record
amounts, but it was able to cope without government assistance. What was the reason for
this marked difference between Switzerland’s two large international banks? Without
access to minutes of meetings held at CS, it is difficult to say with certainty. The
following four factors may, however, have played a decisive role:
1. Credit Suisse was possibly more cautious because it had been among the biggest
losers in the preceding financial crisis, when the Internet bubble burst. The sense of
having suffered a major rout was still so fresh in their minds that the bank’s management
was more attentive to signs of a new bubble. Conversely, UBS had survived the
preceding financial crisis without serious wounds. This had largely been a function of its
having incurred major losses only a few years earlier with the collapse of the hedge fund
LTCM, which had been taken by the Bank as a signal to proceed more prudently in the
future. While this caution had at first made UBS an object of reproach during the Internet
boom, it was later a source of much praise once the bubble had burst. It had no trouble in
wooing good teams away from other investment banks and was quickly able to improve
its standing on Wall Street. Had it been weakened in the same way as CS in the preceding
financial crisis, UBS would possibly have been more sensitive to the dangers of the
following boom.
2. Since the departure of John Costas, head of the Investment Bank from 2001 to
2005, no executive from the fixed-income business had been included in top-level
management. John Costas’ successor was Huw Jenkins, who had previously
distinguished himself as the head of UBS’s equities division, but was barely acquainted
with the business of securitized mortgage loans. At CS, by contrast, both CEO Oswald
Grübel and the head of the Investment Bank, Brady Dougan, had made their careers in
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the fixed-income business. It is noteworthy that, also in the cases of two US investment
banks that incurred significantly smaller losses than UBS, the top post at each was held
by a man from the interest rate business: John Mack at Morgan Stanley and Lloyd
Blankfein at Goldman Sachs. There is no 100 percent correlation, however. Lehman
Brothers’ head Richard Fuld had also made his career in the fixed income business, but
still managed to run his bank into the ground.
3. The founding and subsequent reintegration of the in-house vehicle for alternative
investments, DRCM, had a disruptive influence on the organization. In the summer of
2005, John Costas left his position as head of the UBS Investment Bank and moved to the
newly created DRCM, taking some 100 traders with him. He left behind an investment
bank that was obliged to build up its business in fixed-income investments from the
ground up, having lost good traders. In the time that followed, veritable rivalry developed
between 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, as
described above, was extremely costly, not least because John Costas and his traders had
negotiated high severance packages, and absorbed a great deal of senior management’s
time and energy. During the decisive second quarter of 2007, the main preoccupation was
with DRCM reintegration issues, distracting attention away from concentration on a
review of the Bank’s own risk exposure.
4. In historical retrospect, it is possible to observe that banks that try to burst their
way into the top ranks of the industry tend to suffer particularly large losses when a
financial crisis breaks out. In the period between the two World Wars, a number of large
Swiss banks fell victim simultaneously to their ambitious attempts to catch up in
Germany. Their goal had been to narrow the gap between themselves and the two leading
international Swiss banks at the time, the Swiss Bank Corporation (Schweizerischer
Bankverein) and Crédit Suisse (Schweizerische Kreditanstalt), both of which had
succeeded in establishing themselves in the international capital markets as early as the
end of the 19th century. No fewer than four large Swiss banks ended up shipwrecked: the
Banque d’Escompte Suisse of Geneva, the Basler Handelsbank (Commercial Bank of
Basle), the Eidgenössische Bank (Federal Bank) of Zurich, and the Schweizerische
Volksbank (People’s Bank of Switzerland) of Bern. The Geneva bank disappeared in
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1934; the Basler Handelsbank and the Eidgenössische Bank were taken over in 1945 by
the Swiss Bank Corporation and the Union Bank of Switzerland, respectively; and the
Volksbank, a cooperative bank, survived only thanks to an injection of 100 million francs
in equity capital from the Confederation, an amount representing roughly one fourth of
the Federal budget at the time. In the official Message of the Federal Council regarding
its financial contribution to the Volksbank, express mention was made of the bank’s
failure 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 towards
the end of 1929 and in the currency collapse. However, the circumstance that neither the
Volksbank’s cooperative form nor the organization and structure of its balance sheet were
suited for the undertaking of international business relationships, and that it disposed
neither 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 failed
strategies for catching up with the competition. The Swiss Bank Corporation attempted in
the late 1980s to establish a foothold in the international lending business, but soon
suffered large losses and a damaged reputation, having not been sufficiently critical in the
selection of its foreign clients. The Union Bank of Switzerland, in the 1990s launched an
effort to break into international investment banking, but was forced to undertake major
write-downs in the wake of the Asia crisis. The failed undertaking with the hedge fund
LTCM, mentioned above, was also the Union Bank’s doing. The actual losses did not
come to light until later, however, after the merger with the Swiss Bank Corporation. The
heavy losses with which the CS Investment Bank’s business ultimately ended up at the
end 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 was
slipping away from them.13 In 2004, Marcel Ospel, the Chairman of the Board of
Directors, announced in an interview that he was aiming for first place among Wall Street
investment banks.14 John Costas, still head of the UBS Investment Bank at the time, also
stated shortly thereafter that the goal for the coming years was to overtake the two front
runners in the field, Goldman Sachs and Morgan Stanley.15 UBS presented itself
increasingly, also internally, as a “growth company,” and oriented its compensation
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strategy more and more towards growth in volume and earnings. For this reason too little
attention was paid, particularly in the Investment Bank, to the quality and sustainability
of 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 investment
banks Goldman Sachs and Morgan Stanley. Like UBS, Citigroup only realized in the
third quarter of 2007 that it would have to take write-downs amounting to billions
because of the collapse in the prices for AAA paper. According to “The New York
Times,” Citigroup had assured the supervisory authorities as late as June 2007 that it had
not even subjected the AAA paper to a risk analysis, since the likelihood of losses on
such paper was so low.17
In view of these circumstances, the case of UBS appears, in retrospect, to have been
inevitable. At the same time, however, it ought never to be forgotten that the losses would
have been much smaller if the Bank’s leadership had taken control and shifted course in
March, 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 been
possible to try unloading problematic positions in the second quarter of 2007, or at least
to freeze the business at the level at which it stood, rather than continuing to take on more
positions. It was an open situation, in which the judgment of a very few individuals
decided everything.
3. UBS and the Cross-border Business with US Clients
At first glance, the mistakes made by UBS in the cross-border wealth management
business with US clients appear to have little to do with the losses in its investment
banking division. While the massive write-downs on subprime paper had their roots in
overly optimistic market assessments, the legal difficulties were the result of insufficient
compliance with new US regulations. From 2001 onwards, UBS as a so-called “Qualified
Intermediary,” was obliged to assist in the collection and remittance of withholding taxes
on US securities. The relationship between the US tax authorities and foreign banks that
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held the status of a Qualified Intermediary (QI), was governed by the terms of a QI
Agreement.
There were two concrete grounds for the conflict between UBS and the US
authorities. First, the Bank offered services that made it possible for individual US clients
to set up intermediary companies that obscured their true tax status. All together, some
300 clients fell into this category. Among them was Igor Olenicoff, whose UBS client
advisor Bradley Birkenfeld turned over secret UBS documents to the US Department of
Justice in June, 2007. Olenicoff himself contributed to an escalation of the affair with his
own confession, in December, 2007. Second, UBS client advisors continued travelling to
the USA to serve clients who had not identified themselves to the US tax authorities, but
nevertheless expected UBS to actively manage their assets for them in Switzerland. This
category included several thousand US clients.18
On closer examination, however, a parallel may be seen between the subprime
losses and the shortcomings in the conduct of the US cross-border business. In both
cases, the Bank’s leadership remained too complacent and was thus too late in
recognizing the problem. In its investment banking activities, UBS top management
relied for all too long on the assessments of its risk management and on the external
rating agencies. In spite of the awareness that housing prices were declining and that
subprime debtors were having increasing difficulties in meeting payments, there was a
hesitancy to question the positive results of the risk calculations and to assess the
situation independently. With regard to the wealth management business, the Bank’s
leaders believed for all too long that implementation of the QI agreement required only a
gradual 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 only
in the second half of the year 2007, when it was already too late, that UBS top
management resolved to make a clean sweep of things.
As in the case of the subprime losses, those who held the highest positions of
responsibility cannot be accused of having unthinkingly ignored all warning signs. On
contrary: the Bank’s leadership was aware from the beginning that the changes necessary
for compliance with the QI Agreement required a major effort. In the first months of
2000, the leadership created a large dedicated project designed to include all relevant
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business divisions. According to the SFBC/FINMA, repeated signals were sent from the
top 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, fully
cognizant of the fact that since the purchase of US wealth management company
PaineWebber, in 2000, UBS had a very strong interest making sure that it remained in
good standing with the US authorities.19
The real problem lay much more in the fact that UBS continued for far too long
using only standard procedures and refrained from taking unusual measures in the face of
unusual 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-border
business. Because the people at the highest level of responsibility failed to make things
clear from the outset, implementation took several years and remained, to the end,
incomplete. It was deemed sufficient to simply issue a clear order, without making
certain that all of the troops were, in fact, marching in the right direction. In proportion to
the entire wealth management business, the division in question, North America, was
small, 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 the
Bank’s leadership. Those in charge were not sufficiently conscious of the need for a
comprehensive change in the corporate culture, for which strict direction from above was
indispensible.
From an historical point of view, the extent of the paradigmatic change necessitated
by 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 were
obeyed. This was a result, among other things, of their frequent experience that foreign
political leaders, although eager to publicly denounce the ills of tax evasion, nevertheless,
when push came to shove, always refrained from taking drastic measures against Swiss
Banks and were unable in concert to compel Switzerland to relent. This had already been
observed in the 1920s, when the ascent of Swiss wealth management began. Political
turmoil following the end of World War I, high inflation and the rise in sovereign debt
led many German and French nationals to move large amounts of untaxed capital out of
the country. The main countries to benefit were the Netherlands and Switzerland, which
18
had remained neutral throughout the war, were politically stable, and had well developed
financial industries. As early as 1922, former warring countries Germany, France and
Italy had made a joint attempt, within the framework of the League of Nations, to
advance international cooperation in the combating of tax evasion. These efforts soon
proved ineffective, as not only Switzerland, but also the Netherlands and Great Britain
had expressed their opposition thereto. The Swiss envoy to The Hague wrote to Foreign
Minister Motta, in 1924, that Holland would never tolerate the abrogation of banking
secrecy. Such a thing, he claimed, was not compatible with the Dutch character.21
In the 1930s, German and French authorities intensified their efforts by sending
spies to Switzerland. In October 1932, moreover, employees of the Commercial Bank of
Basle 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 had
been dodging their taxes – among them well-known personalities from the worlds of
business, politics and the Church. Once again, the measures taken by the German and
French authorities showed little effect. Unmoved by pressures from abroad, in 1934 the
Swiss Federal Assembly passed the first Swiss Federal Banking Act, firmly anchoring
therein the principle of banking secrecy, violations of which were made punishable. A
bank employee who disclosed client information was held criminally liable, and could be
sentenced 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 Swiss
wealth management came under fire. However, with the Washington Agreement, signed
by the Allies and Switzerland in 1946, a way was found to satisfy the claims of the
victorious countries to German assets deposited in Switzerland, including stolen gold that
had been acquired by the Swiss National Bank, without the need to divulge client
identities. The Confederation paid 250 million francs and, in return, the United States
unfroze Swiss assets.
From that time, up until the 1990s, there were no further such concerted efforts on
the 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, no
international protest was heard. Following the country’s entry into the EU, in 1995, only
the provisions on the anonymity of savings accounts were repealed, but not the law
19
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 management
industry in the 1970s, without any fear of sanctions. Even when the Grand Duchy
introduced, in 1981, a law anchoring the principle of strict banking secrecy, on the Swiss
model, no veto was cast by Brussels, Bonn, or Paris. Lichtenstein decided in 1992 to
enter the European Economic Area (EEA) as it estimated the risk of negative
consequences 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 why
Germany, France, Italy or the United States tolerated the expansion of cross-border
wealth management for such a long time. Tax evasion was probably accepted, to a certain
extent, because strong economic growth in the 1950s and 1960s generated sufficient tax
revenues. Perhaps the authorities were also aware that the construction of a welfare state
was possible only if large taxpayers were not subject to all too much harassment.
Whatever the reason, wealth managers in Switzerland, in the European Principalities, and
on the British Isles, had the definite impression that in spite of their profession's poor
public image, their business was not fundamentally in danger. One needed only consult
the list of clients for confirmation that tax evasion was an extremely common practice
even in the very highest circles of the society.
Given the tradition in which this business stood, it is not particularly surprising that
the North America division of UBS Wealth Management would attempt to maintain
longstanding client relationships to the greatest possible extent. Older client advisors are
said to have been particularly reluctant to comply with the new requirements instituted by
the QI Agreement. Conversely, it is astonishing that the UBS leadership requested “zero
tolerance” with no deeds to follow their words. This can only be explained by the
assumption that they either underestimated the implications of the change in corporate
culture, or that they wished to delegate the responsibility.
Symptomatic of the UBS leadership’s ignorance of the problem was the
implementation of a new system of incentives at UBS in 2004, as mentioned by the
SFBC/FINMA. Bonuses were now contingent upon “New Net Money.” This created a
conflict for many US client advisors. On the one hand, they were expected to comply
20
strictly with the terms of the QI agreement while, at the same time, their superiors
expected them to rapidly acquire new client assets. Some client advisors concluded that
the Bank’s management was not, in fact, serious about the literal application of the new
US regulations, and no longer had any hesitations in the conduct of illicit advisory
activities.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 that
other Swiss banks have also experienced difficulties in adapting to the new circumstances
practices that had for decades been in regular use. According to the Suisse Romande
based broker Helvea, more than half of the European fortunes deposited in Swiss banks
are undeclared. Moreover, UBS is by no means the only bank to have been targeted by
foreign 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 Federal
Intelligence Service (Bundesnachrichtendienst; BND), among others. This led to a much
publicized search at the home of the then Chairman of the Board of the Deutsche Post, in
February 2008. An employee with HSBC Private Bank (Suisse), in Geneva, copied client
data onto a CD and offered it to French authorities in August 2009. Not many months
ago, German authorities also purchased stolen CDs containing confidential client
information.
Having entered a period in which large countries treat tax evasion by their citizens
with less and less tolerance, cross-border wealth management by Swiss Banks has
generally become more vulnerable. It would thus be wrong to see the errors committed
by UBS in its cross-border business with US clients as an isolated or unique case. It was
certainly more aggressive and less careful than others in the way it went about things. In
essence, however, it was all about a business practice that had a tradition established over
decades.
21
4. Conclusion and Perspectives
The present report is deemed to examine the question of how to assess the mistakes
committed by UBS in the US subprime market and in its cross-border business with US
clients from an economic and historical point of view. Based on a study of internal UBS
reports, 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 of
leadership personalities with a sense for detecting hidden risks. As far as investment
banking is concerned, for all too long a time, trust was placed in the notations given by
rating agencies and in the Bank’s own risk models, rather than once actually reflecting on
the fundamental issue of whether bundled subprime paper really was as safe an
investment as US government bonds. It was not until the prices for AAA subprime paper
began to retreat that the mathematical models were seriously questioned by senior
management and an attempt was made to arrive at an assessment independently of the
models. With regard to the cross-border business with US clients, UBS directors and
senior officers underestimated the risks that arose in connection with adapting operations
to the new US regulations. Even if the persons in the highest positions of responsibility
had no direct knowledge of systematic breaches of US law, it is incomprehensible that
they did not take steps to ensure, from the outset, that such a conduct was simply not
possible. A business sector that had operated in scorn of foreign law over a period of
decades could not be brought into full legal compliance by means of a few instructions
issued from above. Here again, a sense of judgment was lacking, which would have made
it possible to recognize the essential problems independently of legal opinions, internal
audits and business models. Overall, the top floor at UBS was characterized by a
technocratic management style, which in extraordinary circumstances proved not to be
flexible enough.
2. The errors committed by UBS were, in part, avoidable, since they were caused by
the mistaken assessments of a few individual members of senior management. Other
banks pulled out of the US subprime market in time and had their client advisors under
control, since the right decisions were made at the top. A historical comparison shows,
22
however, that none of the mistakes committed by UBS were unusual. Whenever financial
bubbles rise, a large number of market participants allow themselves to be tempted into
ignoring the time-honored rules of the banking business. In historical retrospect, the
errors in the cross-border business with US clients also seem to be less unusual than first
appeared. The fact that a Swiss bank would experience difficulties in adapting its
traditional wealth management activities to a dramatically tightened regulatory
environment was almost predictable, even if the damage that resulted thereof may not
have been. UBS acted only with particular carelessness, but not fundamentally differently
than the other banks that had been conducting cross-border business with foreign clients
for decades.
If this appraisal is correct, then it is of little use to repeatedly target the individuals
responsible. Public opinion in Switzerland would be better advised to discuss the
question of how the country’s two large international banks should position themselves in
the future. An honest assessment leaves only two alternatives: Either it is considered
desirable that Switzerland remain a financial center of international importance, also in
the future, in which case the two large banks will be permitted to further expand in the
sectors 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 pay
high salaries and bonuses and run the risk of once again incurring large losses or coming
into conflict with foreign governments. In other words, it is an illusion to believe that
Switzerland can continue to maintain its position as a center of international finance
without having to live with the attendant risks. The UBS crisis has clearly demonstrated
that errors in investment banking or in cross-border wealth management can cause
enormous damage at any time. Any attempt to classify the UBS crisis as a regrettable but
isolated incident necessarily underestimates the force of financial market dynamics and
the appetite of foreign tax authorities. Naturally, improvements in the regulation of
investment banking are possible and the standards applying to wealth management can be
raised. An increase in capital ratios and a tightening of liquidity requirements, as widely
favored by all sides, will certainly strengthen the ability of the large banks to resist in
times of crisis. Improvements in risk control methods, both at the large banks and by the
supervisory authorities, will presumably also have a positive effect. It is, however,
23
unrealistic to expect that a gradual optimization of all available instruments will be able
to prevent all future losses, once and for all. To the contrary, placing too much trust in
new rules might only increase the probability of further severe financial crises.
The second alternative places the entire weight on safety and imposes on the
financial industry a regulatory regime that renders investment banking and cross-border
wealth management unattractive. In choosing this path, one must be prepared to accept a
severe contraction in the Swiss financial industry and a loss in international prestige. This
option cannot provide full protection against bank crises, either. A domestic real estate
crisis, such as the one experienced by Switzerland in the 1990s, can also recur in the
future. However, the danger that losses by a single bank could come to threaten the
economy of the entire country would certainly be diminished.
It goes without saying that this view of the situation, like all other assessments expressed
in 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. One
thing, however, may already be stated without contest: the mistakes committed by UBS
cannot be explained solely by the behavior of its management; the wider environment
must also be taken into account. The present report has attempted to provide certain
markers. 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 worth
reading 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 Hill
1991. 4 Carmen Reinhart und Kenneth Rogoff, This time Is different: eight centuries of financial folly, Princeton
2009, p. 15. 5 Remarks by Chairman Alan Greenspan: Economic flexibility, Before the National Italian American
Foundation, Washington, D.C., October 12, 2005. 6 This is also the conclusion reached by the Swiss Federal Banking Commission, Subprime Crisis: SFBC
Investigation into the Causes of the Write-downs of UBS AG, Bern, 30 September 2008; Myret Zaki, UBS:
24
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 an
der Reorganisation der Schweizerischen Volksbank, 29 November 1933, Federal Gazette, vol. II, Bern
1933, p. 807. On the banking crisis in the 1930s, see, among others, Jan Baumann, Bundesinterventionen in
der Bankenkrise 1931-1937: Eine vergleichende Studie am Beispiel der Schweizerischen Volksbank und
der 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 place
financière et les banques suisses à l’époque du national-socialisme: Les relations des grandes banques avec
l'Allemagne (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 den
Bundesrat, Rivalen und ehrgeizige Ziele, Cash, 23 December 2004, p. 25. 15 Zoé Baches and Arno Schmocker, “Wir wollen unseren Marktanteil verdoppeln”: John Costas, CEO und
Chairman UBS Investment Bank, zur angestrebten Position der weltweiten Nummer eins, Finanz und
Wirtschaft, 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 York
Times, 23 November 2008, p. A1. 18 On the regulatory background and the violations of law committed by UBS, see FINMA, EBK
investigation of the cross-border business of UBS AG with its private clients in the USA, Bern, 18
February 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’évasion
fiscale, 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.
25
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 Banking
Secrecy 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 des
Bankgeheimnisses: Funktion und Risiko der moralischen Überhöhung des Finanzplatzes Schweiz, in:
Jakob Tanner/Sigrid Weigel (ed.), Gedächtnis, Geld und Gesetz: Vom Umgang mit der Vergangenheit des
Zweiten 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 of
Switzerland, see Claude Baumann und Werner E. Rutsch, Swiss Banking – wie weiter? Aufstieg und
Wandel der Schweizer Finanzbranche, Zurich 2008; Philipp Löpfe, Banken ohne Geheimnisse: Was vom
Swiss Banking übrig bleibt, Zurich 2010; Peter Hablützel, Die Banken und ihre Schweiz: Perspektiven
einer 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 is
presented by Urs Birchler, Diana Festl-Pell, René Hegglin, Inke Nyborg, Faktische Staatsgarantie für
Grossbanken: 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.