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

12

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

15

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

17

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.