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Thursday, Sep. 22, 2011

EDITORIAL

UBS takes a big hit

Arogue trader at the Union Bank of Switzerland's London office has cost the firm $2.3 billion as a result of unauthorized trades. The incident is an embarrassment for the banking giant and is one more reminder of the need for tighter controls on proprietary trading and risk management in financial institutions.

Bankers will fight back against such restrictions, but the regularity with which such incidents has occurred is proof that regulators must persist in their efforts.

Mr. Kweku Adoboli is a 31-year old investment banker who worked at UBS' Delta One desk, a part of the London office that executed trades for clients, usually helping them to speculate or hedge the performance of a basket of currencies. Delta One also trades the bank's own money.

Mr. Adoboli was arrested Sept. 15 and charged with three counts of fraud and accounting offenses. The bank says only its own money was lost, and none from its clients.

It is unclear what undid Mr. Adoboli. At this time, all that is known is that the unauthorized trading began in October 2008. The U.K. Financial Services Authority (FSA) and the Swiss Financial Market Supervisory Authority said they would also investigate the trading losses.

According to the FSA, the investigation will be carried out by a third party and will focus on "the control failures which permitted the activity to remain undetected" and "will include an assessment of the overall strength of UBS' controls to prevent unauthorized or fraudulent trading activity in its investment bank."

Although the $2.3 billion loss is stunning, it is about a third of the money lost by Mr. Jerome Kerviel, a derivatives trader at the French bank Societe Generale SA who had lost 4.9 billion ($6.7 billion) by the time he was arrested in 2008.

Mr. Adoboli's losses do surpass those of Mr. Nick Leeson, the Singapore based-trader whose $1.4 billion in bad bets led to the collapse of Barings Bank in 1995. Fortunately, UBS has sufficient reserves. While painful, the losses will not fatally wound the bank.

The scandal is not the first for UBS. In 2006, the bank agreed to pay ¥10 billion to Sumitomo Corp. to settle losses created when the Swiss giant worked with Chase Manhattan Bank to hide the losses of Mr. Yasuo Hamanaka, another trader who tried to corner the copper market.

That episode cost the bank $2.6 billion, giving it the dubious distinction of being the largest rogue trading scandal. In 2009, UBS was fined £8 million ($12.7 million) for not preventing employees in its U.K. international wealth-management business from making unauthorized trades with customer money in 2007.

While Mr. Adoboli is the perpetrator, attention is also focusing on UBS Chief Executive Officer Oswald Gruebel. Less than two months ago, Mr. Gruebel lauded his risk management unit as "one of the best" in the industry.

Obviously that judgment was flawed. There is already speculation that Mr. Gruebel's tenure will not survive this scandal.

The timing of the arrest could not be more propitious — at least as far as supporters of tighter regulation are concerned. Days before, the Vickers Commission had released its report on ways to strengthen financial regulation. Mr. John Vickers is a former chief economist of the Bank of England (the U.K.'s central bank), and the commission he chaired was set up to explore ways to insure against financial institution failures that could undermine the national or global financial system.

The Vickers Commission concluded that it makes the most sense to "ring-fence" or separate everyday banking operations (such as mortgages and loans) from the complex and dangerous investment trading activities that have done such damage in recent years.

British officials, including Chancellor of the Exchequer (Finance Minister) George Osborne, now have a poster child for bad behavior as well as the failure of in-house monitoring — only three years after the FSA had briefed some 50 banks on the Kerviel case and was told that many of them "had already put in place reviews to ensure that they identify any gaps in trading controls and close them as soon as possible."

Not surprisingly, the bankers are pushing back. They see those operations as a source of great revenue, and they are right — when they bet correctly. They also claim that it is impossible to stamp out all malfeasance: International finance is too complex, and banks too large, for any organization to ensure that a determined individual does not break the law. Finally, some bankers claim that restrictions on trading will increase the cost of lending to companies and slow economic growth.

Those arguments are correct in theory. But the banks do not acknowledge that such activities can have catastrophic consequences for the entire world. The global slowdown that began at the end of 2008 demonstrates just how interconnected global finance is and how contagion spreads.

The prospect of losses are not theoretical; they are the inevitable downside of the risks that financiers are all too ready to take — especially when they know the consequences are potentially so large that governments will have to pick up the pieces.

That knowledge has spurred risk taking that has led to spectacular private profits — and equally spectacular public losses. That is not right. The Vickers Commission's recommendations may slow some growth, but if that is the price of stability, it is a price worth paying.



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