At a loss: how did UBS miss $2.3b?

'We do know what we're doing," UBS's chief executive, Oswald Gruebel, told investors last year about plans to step up risk-taking to boost profit. "Risk is our business."

Ten months later, Switzerland's biggest bank revealed a $US2.3 billion loss from what it called "unauthorised trading". Kweku Adoboli, a 31-year-old trader at the company, appeared in court in London this week on charges of fraud and false accounting.

Now UBS is the subject of probes by British and Swiss regulators and is facing calls by investors to scale back its investment bank. "The reputation is now at its limit," said Guy de Blonay, a London fund manager at Jupiter Asset Management. "One more mistake and it could damage the reputation for good."

Gruebel, 67, was hired out of retirement to stabilise the lender, the flagship for Switzerland's wealth-management industry, after bets on US mortgage-backed securities backfired. The bank posted the biggest loss in Swiss corporate history and took a capital injection of 6 billion Swiss francs ($6.8 billion) from the government. Born in East Germany, he spent 37 years at Credit Suisse, earning the moniker "Saint Ossie" for helping restore that bank's profit and reputation, and for spotting the US subprime debacle early.

At UBS, he has put on the brakes and stepped on the gas. He began by cutting more than 7500 jobs and curbing risks - and missed the 2009 boom in fixed-income trading that allowed competitors such as New York-based Goldman Sachs and JPMorgan Chase to profit.

Then, in November 2009, he set a target of reaching CHF15 billion (Swiss francs) in pre-tax profit by 2014. To get there, Gruebel ramped up the bank's fixed-income unit under Carsten Kengeter, added 1700 employees at the investment bank and took on more risk. By November last year, Kengeter, 44, was in sole charge of the investment bank.

"We have to have risk to be able to make money," Gruebel said at the investor presentation in London at the time. "If ever anything goes wrong, at least you will not hear any of us say we didn't know."

That's just what UBS managers are saying now. The bank did not verify trades prosecutors say may date to 2008. "It's come at a horrendously bad time for UBS," John Cryan, 50, who served as chief financial officer from 2008 until June, said in an interview. "They're back to square one."

The latest setback stemmed from unauthorised trading in stock-index futures, UBS said this week. Adoboli said through his lawyer he was "sorry beyond words" for his "disastrous miscalculations" when he appeared at the City of London Magistrates Court.

He was not required to enter a plea and remains in custody pending an October 20 hearing. He faces a maximum 10-year jail sentence.

That the breakdown in controls accompanied a ramping up of risk does not surprise de Blonay. "The two problems are linked," he said. "You have a strategy where they want to bring the investment bank back to the top of the league table. You hire, you put the book back at risk and you try to get the numbers through. That means you have got to take more risk." The trading loss adds to pressure on Gruebel to shrink the investment bank and move UBS back to its roots in asset management, where earnings are more stable, says Lutz Roehmeyer, a Berlin fund manager.

The wealth-management units, which generate 41 per cent of UBS's revenue, have been attracting net new money over the past year after clients pulled assets in the credit crisis. UBS managed CHF2.47 trillion for affluent individuals as of the end of June. It is the world's third-largest private wealth manager, behind Bank of America and Morgan Stanley.

"Our near-term concern is the impact the recent turmoil will have on customer confidence in wealth management, which had been staging a gradual recovery in recent quarters," said Matthew Czepliewicz, an analyst at Collins Stewart Hawkpoint in London.

The $US2.3 billion trading loss is the latest misstep UBS executives have made in the past 13 years as they sought to expand the bank's reach outside Switzerland.

The 1998 combination of Union Bank of Switzerland with SBC Warburg allowed Marcel Ospel, then head of SBC, to turn UBS into the world's largest wealth manager.

The deal hit turbulence soon after it closed. The old UBS had made a $US1 billion investment in the US hedge fund Long-Term Capital Management, which was rescued by a group of banks soon after the merger.

Ospel, seeking to expand in the US, paid $US11.5 billion in 2000 for New York-based Paine Webber, then the fourth-biggest US retail broker. Ospel became chairman in 2001, and by 2002 the firm's foreign-exchange and cash-collateral-trading division was investing in US asset-backed securities. UBS posted writedowns of almost $US2 billion in 2007 after the market for those instruments froze.

Meanwhile, the bank's fixed-income proprietary trading desk, which earned $US700 million of pre-tax profit in 2005, was drawing attention. Under the leadership of John Costas, the firm spun off the unit as a UBS-backed hedge fund, Dillon Read Capital Management.

The operation's losses swelled to CHF150 million by the first quarter of 2007 after losing bets on securities backed by US subprime mortgages. In May that year, UBS closed the fund.

The investment bank's biggest bets came from the team that invested in collateralised debt obligations. CDOs pool bonds, loans and other fixed-income assets, channelling their income into securities of varying risk and return.

The group, instead of just securitising and selling the CDOs, was by early 2006 keeping the instruments on the bank's books so they could profit from the yields. The CDO desk recorded two-thirds of UBS's losses in 2007, or $US12.5 billion.

After its government rescue, UBS published two reports about its near-collapse, one in 2008 and a 2010 study by Tobias Straumann, a financial historian at the University of Zurich. He found the bank's management "complacent" and criticised it for relying too much on internal risk-management reports.

Ospel quit as chairman in April 2008, a period followed by asset sales, the bailout, restructurings and writedowns and losses that eventually totalled $US57 billion.

Gruebel, UBS's third CEO in less than two years, installed more stringent controls at the investment bank. He held weekly calls with risk officers and monitored traders' positions. The executives sought to reassure investors by saying UBS could take on more risks because it had a better handle on them.

The bank made bigger bets, increasing so-called value at risk (VaR), a measure of how much the firm could lose in securities markets on a single day. UBS's average VaR for the second quarter climbed to CHF75 million from CHF48 million in the previous corresponding period, according to filings. By comparison, VaR at JPMorgan's investment bank fell to $US77 million in the second quarter from $US90 million the previous year.

The push in investment banking did not pay off. UBS slipped among underwriters of global stock sales, dropping to eighth this year from fourth in 2009. In mergers, the firm rose to 10th this year from 12th in 2009, though the growth was not sufficient to offset declining industry revenue as the European debt crisis worsened.

Pre-tax profit at UBS's investment bank slumped to CHF376 million in the second quarter from CHF1.31 billion the previous corresponding period. The division's cost-to-income ratio, the highest among the nine biggest investment banks last year, rose to 86 per cent in the quarter.

It reversed course again, scrapping its profit target in July and announcing cost cuts after second-quarter net income because of a slump in earnings at the investment bank. UBS said last month it would cut 3500 jobs, 45 per cent of them in the investment bank.

The flaws in UBS's back-office operations that led to the latest loss puzzle industry veterans. Traders expressed surprise the bank failed to notice the trades sooner because of their size and because they would have been scrutinised by others: counterparty risk managers, as well as credit-valuation-adjustment, audit, risk-management and compliance teams.

"It's just too big a thing to not be noticed," said Aaron Brown, the author Red- Blooded Risk: The Secret History of Wall Street. "You can hide a lot of stuff - you've got millions of transactions every day. If somebody puts in 10 little fictitious transactions, that can be very hard to find. But things of this size, it's just hard to believe that somebody wouldn't notice them."

The loss came out of UBS's Delta One desk in London, which helps clients speculate on or hedge against the performance of a basket of securities. Traders bet with the bank's money as they put together packages and hedge risk.

When a bank writes a futures contract for a client, it may hedge the cost by buying an exchange-traded fund, securities linked to illiquid or complex baskets of assets.

The traders profit from the cost and margin differences between derivatives and their underlying securities, and by timing the purchase and sale of each element.

Delta One desks have triggered losses for banks before: Jerome Kerviel amassed ?50 billion ($69 billion) in unauthorised positions concealed with faked hedges before being discovered by his employer, France's Societe Generale, in January 2008. The bets cost the bank ?4.9 billion. Last year a Paris court ordered him to repay the loss and sentenced him to three years' jail.

UBS said its loss stemmed from trades in S&P500, DAX and EuroStoxx index futures over the past three months. The positions had been offset by "fictitious, forward-settling cash ETF positions, allegedly executed by the trader. These fictitious trades concealed the fact that the index futures trades violated UBS's risk limits," the bank said.

Risk management cannot be effective if there are not good operational controls in place, such as confirming trades, said Leon Metzger, a former hedge fund executive and now a lecturer at the Yale School of Management.

"People are saying it's a failure of financial risk management, but it sounds like it's more a failure of operational controls," he said. "There's going to be a change as a result of this. Firms are going to be wary of trades that can't be corroborated."

Dealmakers in Europe can buy ETFs on the over-the-counter market, allowing them to bypass exchanges and to agree on later settlement dates than the three days required by exchanges.

Once a trader places an order, responsibility passes to the back office, which would then complete the transaction. Banks have teams of people who corroborate the existence of a trade with the other party before settling the contract.

That process should have alerted risk officers to the phoney trades, traders said. UBS may have been slow in confirming over-the-counter trades, they speculated. Some banks in Europe do not confirm these types of cash ETF trades until they are settled, one said.

In that case, the trader might have described his fake ETF trades as having been executed with those banks in order to avoid being asked questions by UBS controllers about the lack of confirmations.

"UBS is strongly committed to improve its risk-control framework to prevent similar events from happening again," the bank said.

UBS is likely to scale back the most capital-intensive parts of its investment bank and those that help its wealth-management units the least, analysts said.

"The investment-banking businesses that make money for them are foreign exchange, equities, Asia and parts of Europe underwriting," said Huw van Steenis, of Morgan Stanley in London.

"Anything that is capital intensive, including the swaps business, the US credit business and rates business, is where there's very little synergy with the private bank."

Investors also may demand management changes once it becomes clear how the loss was incurred. Gruebel was criticised this week by the Government of Singapore Investment Corporation, its biggest shareholder, which expressed "disappointment and concern about the lapses".

"It was Gruebel's idea to beef up the investment bank, so if anyone should go it should be him," said Florian Esterer, a Zurich-based fund manager.

But Gruebel may keep his job for want of an obvious successor.

He is scheduled to talk to shareholders at an investor day in November. Analysts had expected him to announce a restructuring of the investment bank.

He may have to do more now to keep both his job and the bank's reputation intact.