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 2010

Dr. Tobias Straumann, Lecturer, University of Zurich Address: Institute for Empirical Research in Economics Chair of Economic History Zrichbergstrasse 14 CH8032 Zurich straumann@iew.uzh.ch All opinions expressed in this study are the authors 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

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.

Contents 1. Introduction 2. UBS and the Subprime Crisis 3. UBS and the Cross-border Business with US Clients 4. Conclusion and Perspectives 3 5 15 21

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 Switzerlands 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 crossborder 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 Banks 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 Banks 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 Banks 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 3

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 Banks 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 Switzerlands 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 Switzerlands 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 Banks 4

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 Switzerlands 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, UBSs 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 5

management. The impression was created that the banks 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 6

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, Germanys 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. 7

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, 8

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 9

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 Banks 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 Banks 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. 10

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 banks management placed its trust in the supposed short positions and shifted its attention to other, seemingly bigger risks.11 The SFBC/FINMA later noted selfcritically, 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 11

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 Switzerlands 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 banks 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 UBSs equities division, but was barely acquainted with the business of securitized mortgage loans. At CS, by contrast, both CEO Oswald Grbel and the head of the Investment Bank, Brady Dougan, had made their careers in 12

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 managements 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 Banks 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 Crdit 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 dEscompte Suisse of Geneva, the Basler Handelsbank (Commercial Bank of Basle), the Eidgenssische Bank (Federal Bank) of Zurich, and the Schweizerische Volksbank (Peoples Bank of Switzerland) of Bern. The Geneva bank disappeared in 13

1934; the Basler Handelsbank and the Eidgenssische 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 banks 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 Volksbanks 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 Switzerlands 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 Banks 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 Banks 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 14

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 Banks 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 15

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 Banks 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 Banks 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 Banks 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 16

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 Banks 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 Banks 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 17

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 countrys entry into the EU, in 1995, only the provisions on the anonymity of savings accounts were repealed, but not the law 18

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 leaderships 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 19

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 Banks 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 Germanys 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.

20

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 Banks 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, 21

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 countrys 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, 22

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 2

FINMA, Financial market crisis and financial market supervision, Bern, 14 September 2009, p. 21. 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 Carmen Reinhart und Kenneth Rogoff, This time Is different: eight centuries of financial folly, Princeton Remarks by Chairman Alan Greenspan: Economic flexibility, Before the National Italian American This is also the conclusion reached by the Swiss Federal Banking Commission, Subprime Crisis: SFBC

1991.
4

2009, p. 15.
5

Foundation, Washington, D.C., October 12, 2005.

6

Investigation into the Causes of the Write-downs of UBS AG, Bern, 30 September 2008; Myret Zaki, UBS:

23

les dessous dun scandale: comment lempire aux trois cls a perdu son pari, Lausanne 2008; Lukas Hssig, Der UBS-Crash: Wie eine Grossbank Milliarden verspielte, Hamburg 2009.
7

For an overview of the losses, see UBS, Shareholder Report on UBSs Write-Downs, 18. April 2008, UBS, Shareholder Report on UBSs Write-Downs, 18 April 2008, p. 37. UBS, Shareholder Report on UBSs Write-Downs, 18 April 2008, p. 26. UBS, Shareholder Report on UBSs Write-Downs, 18 April 2008, p. 24. FINMA, Financial market crisis and financial market supervision, Bern, 14 September 2009, p. 23-24. Botschaft des Bundesrates an die Bundesversammlung ber die finanzielle Beteiligung des Bundes an

pp. 6-7.
8 9

10 11 12

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, Geschfte in spannungsgeladener Zeit: Finanz- und Handelsbeziehungen zwischen der Schweiz und Deutschland 1923 bis 1946, Weinfelden 2006; Marc Perrenoud, Rodrigo Lpez, Florian Adank, Jan Baumann, Alain Cortat, Suzanne Peters, La place financire et les banques suisses lpoque du national-socialisme: Les relations des grandes banques avec l'Allemagne (1931-1946), Zurich 2002.
13 14

Peter Wuffli, Ich habe nicht fahrlssig gehandelt, Bilanz, 24 September 2010, p. 54. Dirk Schtz, Unsere Investmentbank soll die Nummer Eins werden: Der UBS-Prsident ber den Zo Baches and Arno Schmocker, Wir wollen unseren Marktanteil verdoppeln: John Costas, CEO und

Bundesrat, Rivalen und ehrgeizige Ziele, Cash, 23 December 2004, p. 25.

15

Chairman UBS Investment Bank, zur angestrebten Position der weltweiten Nummer eins, Finanz und Wirtschaft, 8 January 2005, p. 18.
16 17

UBS, Shareholder Report on UBSs Write-Downs, 18 April 2008, pp. 41-42. Eric Dash and Julie Creswell, Citigroup Saw No Red Flags Even as It Mad Bolder Bets, New York On the regulatory background and the violations of law committed by UBS, see FINMA, EBK

Times, 23 November 2008, p. A1.

18

investigation of the cross-border business of UBS AG with its private clients in the USA, Bern, 18 February 2009; Lukas Hssig, 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, On the international structural changes, see Myret Zaki, Le secret bancaire est mort, vive lvasion Christophe Farquet, Le secret bancaire en cause la Socit des Nations (1922-1925), Traverse:

Bern, 18 February 2009, p. 16.

20

fiscale, Lausanne 2010.

21

Zeitschrift fr Geschichte Revue dhistoire 1 (2009), p. 110.

24

22

On the origins of banking secrecy in Switzerland, see Robert Vogler, Das Schweizer Bankgeheimnis:

Entstehung, Bedeutung, Mythos, Zurich 2005. See also Sbastien 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 berhhung des Finanzplatzes Schweiz, in: Jakob Tanner/Sigrid Weigel (ed.), Gedchtnis, 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 Lpfe, Banken ohne Geheimnisse: Was vom Swiss Banking brig bleibt, Zurich 2010; Peter Habltzel, 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, The literature on the regulatory issue has greatly expanded since the financial crisis. A good overview is

Bern, 18 February 2009, p. 15.

25

presented by Urs Birchler, Diana Festl-Pell, Ren Hegglin, Inke Nyborg, Faktische Staatsgarantie fr Grossbanken: Gutachten erstellt im Auftrag der SP Schweiz, Swiss Banking Institute, University of Zrich, 8 Juli 2010; Boris Zrcher, Too Big To Fail und die Wiederherstellung der Marktordnung, Avenir Suisse, Discussion Paper, Zurich, March 2010.

25