Bailed-out UBS Trading Incident Could Lead to More Regulation

PHOTO: Kweku Adoboli was arrested in London, Sept. 15, 2011, in connection with allegations of rogue trading at Swiss banking giant UBS.
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After a securities trader was arrested and charged in London in connection with $2.3 billion in rogue trades at Swiss bank UBS, analysts have warned that more regulation is pounding its fist on bank doors.

With already fragile confidence in UBS, Switzerland's largest bank, critics point to the fact that UBS was the beneficiary of a bailout on the other side of the Atlantic. In the U.S., the Treasury stepped in with a $700 billion bailout of all the major banks during the financial crisis in 2008. New regulations followed here and in the United Kingdom in an effort to stem future taxpayer bailouts.

Kweku Adoboli, 31, was arrested on Thursday on suspicion of fraud and is still in police custody, according to the British newswires of the Press Association. He was charged on Friday with fraud and false accounting for the unauthorized deals.

Adoboli started working for UBS as a trainee investment adviser in March 2006 and has had no disciplinary action taken against him previously, according to the Financial Services Authority register of advisors, as reported by the Press Association.

Erin Davis, senior stock analyst with Morningstar, said it seems Adoboli worked in the back office until he was promoted to the trading floor, which points to "below average" risk controls at the bank.

"A lot of banks won't allow that kind of promotion explicitly to avoid creating this kind of opportunity. It appears that the trader, because of his back office experience, was able to by-pass the risk management systems," she said.

During the financial crisis, UBS lost nearly 30 billion Swiss francs, or $34.5 billion, and had to be bailed out due to its investments in low-quality assets, especially U.S. subprime mortgages. As a result, UBS raised over $5 bilion from the Swiss government and it was permitted to transfer up to $60 billion in distressed assets to a fund supported by Switzerland's central bank.

With the news of the rogue trader last week, Davis said more regulation is likely on its way.

Davis said the most obvious solution to prevent unauthorized trades, or other potentially risky situations for investment banks, would be for Switzerland to require its banks to "ringfence" its retail or "plain-vanilla" commercial banking operations from its investment bank, as the U.K. is trying to do.

The U.S. is also implementing a similar policy after the Dodd-Frank Act passed the Volcker rule. That policy prohibits American banks from executing particular speculative investments that could harm their customers.

Davis said the financial loss likely had a marginal impact on UBS' value, and it will likely be able to absorb the loss without resorting to raising capital or other "painful" measures.

However, Davis' policy prediction in Switzerland means UBS would operate its retail bank separately from the investment bank. Davis said the idea is if the investment bank experienced large losses or failed, retail deposits would not be at risk and therefore the government would face less pressure to step in and save the bank.

If regulation like that enfolds, she said UBS would probably also be required to issue debt separately from the two entities, so that the retail banks, and implicitly the government, is not guaranteeing the investment bank's debt.

"It's unfortunate when banks that were saved with taxpayer money turn around and do the same thing again, even if in smaller scale, but it's not surprising. Culture is very hard to change," Davis said. "I think that the banks that were bailed out during the financial crisis are probably more likely than other institutions to face losses during this round of the crisis for that reason."

Davis, who covers European banks, said a similar result is taking place with Societe Generale right now.

"Its exposures to peripheral Europe aren't particularly bad, but because they got caught having inadequate risk controls a few years ago, nobody trusts them," she said.

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