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UBS
Principal / Agent Framework
|University of Applied Sciences Northwestern Switzerland |
|MSc Business Information Systems |
| |
|Business Sciences / Economics Assignment |
| |
|Elaborated by: |
|- Odilia Müller |
|- Roger Böhlen |
|- Renato Melliger |
|- Marcel Dubach |
| |
|December 16th, 2008 |
Table of contents
Table of contents 2
Preface 3
Management Summary 4
1 Introduction 6
1.1 Purpose of this Document 6
1.2 Research Question 6
2 Introduction of UBS 6
2.1 Overview 6
2.2 Structure 6
2.3 History 6
2.4 Current Situation 7
3 Principal / Agent Frameworks 7
3.1 Principal / Agent: UBS Management / SNB and SFBC Framework 8
3.1.1 Role Allocation 8
3.1.2 What are Current Measurements in this Principal Agent Relationship 9
3.1.3 How does the UBS behave in Case of the Principle – Agent Framework 10
3.1.4 Result of the Principle Agent Framework 13
3.1.5 Proposal to resolve UBS Principal / Agent Problems 13
3.2 Principal / Agent: UBS / Customer Framework 14
3.2.1 Role Allocation 14
3.2.2 What are current Measurements in this Principal Agent Relationship 15
3.2.3 Hidden Information 16
3.2.4 Hidden Actions 17
3.2.5 Adverse Selection and Consequences 17
3.2.6 Situations of Moral Hazard / Unequal Risk 17
3.2.7 Proposal to resolve UBS Principal / Agent problems 17
3.2.8 Conclusion 18
3.3 Principal / Agent: UBS Employer / UBS Employee Framework 18
3.3.1 Role Allocation 18
3.3.2 What are Current Measurements in the Principal Agent Relationship 20
3.3.3 Hidden Information 20
3.3.4 Hidden Actions 21
3.3.5 Adverse Selection and Consequences 21
3.3.6 Situations of Moral Hazard / Unequal Risk and Consequences 22
3.3.7 Conclusion and Proposal to resolve UBS Principal / Agent Problems 22
3.4 Principal / Agent: UBS / UBS Shareholder Framework 23
3.4.1 Role Allocation 24
3.4.2 What are Current Measurements in the Principal Agent Relationship 25
3.4.3 Hidden Information 26
3.4.4 Hidden Actions 27
3.4.5 Adverse Selection 27
3.4.6 Situations of Moral Hazard / Unequal Risk 27
3.4.7 Proposal to resolve UBS Principal / Agent Problems 28
3.4.8 Conclusion 28
4 General Conclusion 28
Directories / Glossary 29
Illustration Directory 29
Table Directory 29
Glossary 29
References 30
Preface
This document has been elaborated during the study of Master in Business Information Systems. During the subject Business Economics, a group work considering the principal agent framework subject has been elaborated. The following document is constructed through the collaboration of four students. Each student had to choose and describe one principal agent framework from a real company. This document describes the principal agent framework of UBS.
Management Summary
The document describes different principal agent frameworks from UBS and answers the question if the principal agent framework helps UBS to adjust the control mechanism between the principals and agents in reference to hidden information, hidden action, adverse selection and moral hazard.
The following principal agent frameworks have been analyzed:
▪ UBS Management / Swiss National Bank and Swiss Federal Banking Commission (SFBC) Framework
▪ UBS / Customer Framework
▪ UBS Employer / Employee Framework
▪ UBS Management / Shareholder Framework
The following approach has been executed to answer the questions for each single principal agent framework:
▪ First: Allocating who is the principal and who takes the role of the agent
▪ Second: Define the objectives of the principal and the agent
▪ Third: Define the current measurements in the relationship
▪ Fourth: Describe hidden information, hidden action, adverse selection and moral hazard
▪ Fifth: Conclusion if UBS has to adjust the control mechanisms in reference to the different principal agent frameworks and a description of possible solutions
Conclusion:
Each single principal agent framework will be individually summarized and at the end of the document an overall conclusion will be provided.
UBS Management / Swiss National Bank (SNB) and Swiss Federal Banking Commission (SFBC):
The principal in the framework of UBS / Swiss National Bank and SFBC is the Swiss National Bank and SFBC. The reason for the principal role of the Swiss National Bank and SFBC is that they monitor and check the work of UBS. This concludes that they take the role of the principal and UBS the agent.
Currently four main control mechanisms between the Swiss National Bank and SFBC are present.
Reports, meetings, direct assessments and detailed assessments.
Swiss National Bank and SFBC are mainly interested in the continuous growth of the Swiss economy as well as limiting risks and maintaining a stable market. The main objective of the UBS management is growth and maximal profit which affects as well the management’s bonuses.
In case that UBS fails and goes bankrupt, the result for the Swiss economy would be disastrous. The Swiss economy would also collapse. Therefore UBS is too big to fail. Nobody, neither the Swiss government nor the Swiss National Bank and SFBC would accept a bankruptcy because the impact for Switzerland and the entire world would be dramatic. UBS misuses this status. This results in moral hazard. The Swiss National Bank and the SFBC obliged UBS to tackle the hidden action and hidden information problems in different areas already before the financial crisis had started.
Control mechanisms are present in the framework UBS / Swiss National Bank and SFBC. What is missing are the necessary sanctions that oblige UBS to address the problems and get them resolved once they are uncovered by control mechanisms.
UBS / Customer:
To narrow down the investigation of UBS / customer the focus has been set to Asset Management and their customers. In this relationship the customer acts as the principal and the Asset Manager as the agent because the customer hires the Asset Manager to invest its money. The customer expectations and objectives are appropriate assets based on the invested money after the transaction. The objectives of UBS are to maximize their profit from the deal with the client in the form of commissions from the investment placement and the treatment.
Currently no real measurement in this framework exists. There are indexes from UBS itself which show the customer’s profits or losses which the investment has provided.
Hidden information in this relationship is the different knowledge of Asset Mangers and clients as well as hidden commissions which the bank charges for deals and the current financial situation of the hired Asset Manger’s company. A hidden action activity is the Asset Manager’s placement of the customer’s money. The customer does not know if the Asset Manger has invested the money in the most promising deal. Adverse selection occurs in this framework if all of the customers have to pay the same amount of commission regardless of the customer’s investment intentions. If all customers have to pay the same amounts of fees without taking into consideration the amount of the intended investment, they would make the deal with another bank where clients gets better conditions for a bigger amount of money. Moral hazard occurs in this framework constellation if the Asset Manger takes higher risk with the client’s money than they would take with their own money because it is not theirs.
The composition and the total fees of every product and service should be communicated fully transparent. A step in this direction could be to adopt the Markets in Financial Instruments Directive (MiFID) in Swiss law. Additionally they must react by inventing new products where the client has more steering power if UBS wants to keep a market leader position.
UBS Employer / Employee:
In the UBS employer / UBS employee framework the employer takes the role as principal who hires the employee to perform a service for UBS. This indicates that the employee takes the role as agent. The main objective for the employer is to get maximum performance from the employee for a minimal amount of salary. The employee on the other hand wants maximal salary for minimal work effort.
In the relationship the focus for employee is led by the role of the Client Advisor. Only the bonus / incentive related factors have been investigated for this framework.
Currently the measurement between the employer and employee is executed by management through objectives. Objectives are agreed upon at the beginning of the year and compared and assessed at the end of the year against the results which have been achieved.
Hidden action occurs when the employee issues contracts with customers which violate UBS internal directives because the client is not able to cover the risk of the credit. The UBS employees are interested to issue such contracts to increase their own bonus because incentives for Client Advisors are normally granted on the number of issued contracts and the resulting profit of such contracts. If UBS is not operating with such incentives (bonus) the Client Advisors would not be interested to issue contracts at the highest limit which the clients are willing to pay because the Client Advisor is not getting something out of the deal with only a fix salary payment. Adverse selection occurs because UBS would only serve lazy Client Advisors if they would only operate with fix salaries because there is no incentive to make good deals for UBS. All the others rather prefer to move to competitors which work with such variable salary incentives. Therefore UBS is obliged to have a bonus system and can not skip it. The solution is to reinvent the bonus system in a more appropriate way and to extend the control mechanisms between employer and employees.
UBS Management / Shareholder:
Shareholders are defined as the principal as they have impact on the company's board of director’s election. UBS management plays the agent role, seeing as the part which possesses required knowledge and performs a service on behalf of the shareholders. The main objective of the principal is a high return on equity without risk. The UBS management wants a high salary with a minimum effort. The current measurement in this relationship is assessed with financial figures which are normally presented four times a year to the shareholders.
Hidden information occurs in this relationship, when the UBS management already sees the tendency of a negative profit and does not communicate it until the financial quarter review arrives. Moral hazard is present from both parties. If the management takes too high risks, the shareholders bear the risks and lose potentially their money.
In this principal agent framework the principal does not have enough information to control the UBS management activities and actions. It is hard for the principal to get a clear understanding of what the management actually decides and how they invest the money. To increase the control of the principal the management must be obliged to inform the principals more regularly and in more detail than currently.
Conclusion Principal Agent Framework for UBS
For all principal agent frameworks which have been investigated in this document the following conclusion can be provided.
All principal agent framework analyses show that the principal agent frameworks help UBS to analyze and strengthen their relationships. In that reference the research question which says that the principal agent framework doesn’t help UBS to adjust the control mechanism between the principals and agents and can be confused. Well, the opposite is the case. Control mechanisms are already available and the violations are obvious, but the components which are currently missing are appropriate sanctions for when the rules are violated. The missing sanctions and more detailed controls must apply for all of the four analyzed principal agent frameworks for UBS.
Introduction
The Introduction section gives an overview of what the assignment is about. The document is based on a company for which four different principal agent frameworks are described. In addition a research question must be answered. The research question is answered for each principal agent framework. The UBS company will be presented and the different principal agent relationships will be explained.
1 Purpose of this Document
The intention of this document is to describe different principal agent framework relationships of UBS.
First the question of who takes the role of the principal and who the role of the agent has to be answered. Further on the different interest and objectives will be described and methods are described how the relationships are currently measured. The second point is to show the factors hidden information, hidden action, moral hazard and adverse selection in these relationships, if they are present in these relationships. Finally a conclusion and proposal on how the factors can be mitigated or even erased will be described. In addition the research question will be answered in the conclusion and proposal of each individual principal agent framework.
2 Research Question
The research question which will be the basis for the principal / agent frameworks of UBS is:
“The principal agent framework doesn’t help UBS to adjust the control mechanism between the principals and agents”
This research question will be referenced for each individual principal agent framework in the conclusion and proposal.
Introduction of UBS
In this chapter UBS will be introduced including the bank’s structure, major businesses, its history and current problems with an additional short situation analysis between the fourth quarter of 2007 up to today.
In the past months UBS has been negatively affected by global market turmoil, related to US residential real estate related securities and other credit positions.
1 Overview
UBS AG is a diversified global financial services company, with its main headquarters in Basel and Zurich, Switzerland. UBS is a leading global wealth manager, global investment banking and securities firm, one of the largest global asset managers worldwide and the market leader in retail and commercial banking in Switzerland. UBS employs more than 80'000 employees all over the world thereof about 33% in Switzerland and 38% in America (per 31.12.2007). But with the current problems on the financial markets the total amount of employees is going to decrease. (UBS 2008a)
2 Structure
UBS is divided into four divisions: Global Wealth Management & Business Banking (Global WM&BB), Global Asset Management (Global AM), Investment Bank (IB) and Corporate Center. The Global WM&BB provides a wide range of products and services for wealthy clients around the world (Wealth Management) and retail individuals, corporate and institutions in Switzerland (Business Banking). Global Asset Management acts primarily as an investment manager for institutional (e.g. pension plans, foundations, insurance companies, governments, etc.) and financial intermediaries. It provides a broad range of investment capabilities and services and is one of the largest fund managers in Europe and the largest in Switzerland. UBS's Investment Bank is a global investment bank and security firm and consults their clients and other parts of UBS in financing investments, mergers and acquisitions and provides equity, currency, commodity, derivatives and research services. The Corporate Center supports UBS with providing shared services like risk control, legal and compliance activities, communications, branding, human resource and financial, tax and capital management. (UBS 2008b)
3 History
UBS originated from the merger between Union Bank of Switzerland and Swiss Bank Corporation (SBC) in June 1998. Two years later the acquisition of the US brokerage company PainWebber boosted their business in the USA. This and some other acquisitions have essentially transformed UBS into a global institution and one of the world's largest investment managers. In June 2003, the bank adopted the single UBS brand for all its main businesses in the world to pursue the 'one firm' philosophy.
In August 2008, due to the market turmoil in the prior months, UBS announced its new business model with the separation of its business divisions (Global WM&BB, Global AM and IB) into three autonomous units and an increase of operational authority and responsibility for each division. With this new business model, a reduction of balance sheet and risk positions and the transaction with Swiss National Bank and Swiss Confederation UBS tries to leave the crisis behind it. (UBS 2008c)
4 Current Situation
After the first turbulences in the middle of 2007 the UBS management announced several times that the bank went through the hard times and is again back on track and in positive profit. Well, at the beginning of 2008 the world financial crisis started more than ever in the U.S. and swapped over to Europe at the end of the first quarter in 2008. UBS as well as other companies were once again in turbulence. The worst moment in the financial crisis up to now was when UBS had to announce in October 2008 that they need governmental support in form of a financial package to stabilize their financial situation. The financial package is a 60 billion Swiss francs vehicle which was approved in October 2008 by the government. The picture which is shown reflects the percentages of the UBS share. It indicates the current direction of UBS. There is currently only one direction which is down market.
[pic]
Illustration 1: UBS Share Value over the last 5 Years
Source: (UBS Quotes 2008a)
UBS currently has different problems. One of these is trying to keep customer loyalty. A lot of customers have moved to other local Swiss banks with their money and have opened new bank accounts. This made the situation of UBS even tighter because UBS had to deal with a lot cash drain.
At the same moment, employees of UBS were and are still looking for other jobs because the local Swiss banks need additional employment power to serve all the new costumers. In addition the local Swiss banks are getting in a position where they are able to compete with the salaries of UBS to become even more attractive for such employees as well as clients. In addition the local Swiss banks can offer safe workplaces whereas currently UBS is struggling with dismissals.
Another problem is that UBS' conducts in relation to cross-border services provided by Swiss-based UBS Client Advisors to US clients during the years 2000 until 2007. This resulted in a retreat of UBS from offering cross-boarder private banking to US-domiciled clients.
UBS is not executing a bad job. Some of the departments are still or again profitable. But currently the whole U.S. market is not performing as usual and they have a lot of problems in finding new customers because the whole country is struggling with unprofitability and debts.
UBS is a major victim like a lot of other companies in the current financial crisis.
Principal / Agent Frameworks
Based on UBS the following principal agent frameworks will be described in this chapter:
▪ UBS Management / Swiss National Bank and SFBC Framework
▪ UBS / Customer Framework
▪ UBS Employer / Employee Framework
▪ UBS Management / Shareholders Framework
1 Principal / Agent: UBS Management / SNB and SFBC Framework
In this first sub chapter of the assignment the relationship between UBS Management and Swiss Federal Banking Commission (SFBC) / Swiss National Bank (SNB) will be established. Initially the idea was to write only about UBS Management – SNB, however, after a first high level investigation it was clear that SFBC is also needed to describe this principal agent relationship.
Because SFBC and SNB are related to each other, a Memorandum of Understanding makes clear the duties and responsibilities of each party. (Swiss Federal Banking Commission 2007)
1 Role Allocation
Naturally in a principal agent framework both a principal and an agent are needed. In theory, the agent has to behave in accordance with the agreement made with the principal. Because the principle doesn’t have all the information or is not able to monitor all the actions of an agent, asymmetric information arises. (IPC 2007)
If the definition of the principal / agent is applied to this case, SFBC / SNB have to monitor and check the work of UBS. Therefore the conclusion is that SFBC and SNB are the principal and the UBS Management the agent.
1 Principal
Both SFBC and SNB are defined as principal. In this part, it is explained why two principals instead of one is needed and what the objectives and interests of these principals are.
The main point why SNB and SFBC are not one entity is due to the separation of power principle. For SNB, which is responsible for the banknote press, it is prohibited to loan money to the Swiss government.
SFBC on the other hand is part of the government and in fact it is not allowed to be part of SNB. To guarantee the separation of power, SFBC and SNB are divided.
2 Objectives and Interests of the Principal
As mentioned on both principals’ websites, SFBC / SNB have a broad variety of objectives to fulfill. For the SFBC / SNB UBS principal agent framework the focus is on financial stability which is one part of SFBC / SNB’s objective.
Following the major objectives of SFBC / SNB in relation to the financial stability of the Swiss banking system will be described.
SFBC:
SFBC is an administrative authority of the Swiss Confederation. The SFBC’s original and oldest purpose is the supervision of banks for which it has been responsible since 1934. The supervision of banks is designed to contribute to the stability of the banking system to maintain public confidence, and to bolster the good reputation of the Swiss financial marketplace. The Banking Acts and Ordinances contain provisions concerning capital adequacy, diversification of risks and liquidity with the objective of maintaining financial stability. (Swiss Federal Baking Commission 2008a)
SNB:
The Swiss National Bank conducts the country’s monetary policy as an independent central bank. It is obliged by constitution and statute to act in accordance with the interests of the country as a whole. In the field of financial stability the SNB cooperates with the Swiss Federal Banking Commission (SFBC). A Memorandum of Understanding contains a clear division of the individual responsibilities of the two institutions and regulations on their cooperation. To achieve financial stability various activities are needed. (SNB 2008)
Analysis and research:
The SNB analyses the developments in the financial markets and in the area of financial market infrastructure. It pays special attention to the Swiss banking industry. (SNB 2008)
Promotion of an Appropriate Framework for the Financial Centre:
At a national level, the SNB – in conjunction with the Confederation and the Swiss Federal Banking Commission (SFBC) – participates in reform projects. At an international level, it is permanently represented on the Basel Committee on Banking Supervision and on the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) and participates in various international task forces that deal with financial stability issues. (SNB 2008)
Liquidity Assistance:
The SNB acts as lender of last resort (LoLR). In this function, it can – under certain conditions – provide liquidity assistance against collateral if domestic banks are no longer able to refinance their operations in the market. (SNB 2008)
To sum it up, SNB and SFBC are mainly interested in the steady growth of the Swiss economy as well as on maintaining stable financial markets. For this reason their main objective is to limit the risk for the Swiss economy.
3 Agent
The worst affected UBS business area of the financial crisis is the Investment Banking operation. Because the management was well informed about the actions of UBS Investment Bank and thus ultimately responsible for its actions, this part of the framework is focused completely on the actions of UBS Management.
The management has executive management responsibility for the group and is accountable to the board for the firm’s results. The management, and in particular the chief executive officer (CEO), is responsible for the implementation and results of the firm’s business strategies, for the alignment of the business groups to UBS’s business model and for the exploitation of synergies across the firm. The management fosters an entrepreneurial leadership spirit throughout the company. (UBS 2008)
4 Objectives and Interest of the Agent
The UBS management is mainly interested in maximizing profit, because more profit leads to higher total remuneration.
Of course the management is also interested in maintaining a good business situation for UBS, but as it will present in chapter: 3.1.3.1 Too Big to Fail a Case of Moral Hazard, for management it is clear that it is impossible for UBS to fail. A consequence of this is that management is maybe less risk averse and they are ready to make riskier business decisions.
Before it is explained why UBS management is ready to take higher risk than other management teams, the current regulatory agreements between UBS management and SFBC / SNB will be examined.
2 What are Current Measurements in this Principal Agent Relationship
A comparison between the management of UBS and the SFBC / SNB presents a picture of two completely different views concerning objectives.
Whereas the principle is interested in security, steady growth, and a stable economy, the agent is interested in profit and remuneration maximization. These differences are possible sources for asymmetric information. To prevent asymmetric information, SFBC / SNB have different methods / measurements with which they try to minimize or avoid such information asymmetries.
Because UBS is one of the two largest banks in Switzerland, with a high complexity and systemic relevance, it needs tighter control than smaller banks. SFBC is responsible to fulfill this monitoring and control duties. There are four main pillars on which the control is based on:
Reporting:
- The UBS management has the responsibility to report every quarter year to the SFBC, this report is called a standard report. The structure and information contained in the report is determined by the SFBC.
- Further, whenever a special event happens, UBS has report this immediately to SFBC. This is called a non-routine report. (Swiss Federal Baking Commission 2004)
Meetings:
Regular meetings between SFBC and the management of UBS take place to further compliment the reporting process. (Swiss Federal Baking Commission 2004)
Direct Assessment:
To get global, real time and close monitoring SFBC is also allowed to start its own assessments. Direct assessments help SFBC to form an opinion about the function or a division inside UBS. Such assessments take place at minimum once a year. These results are also contained within an internal report. UBS has an obligation to correct any identified vulnerabilities and have to inform SFBC on the progress of these actions. (Swiss Federal Baking Commission 2004)
Deeper Assessment
This assessment will normally be done in one specific business unit to assess the current risk situation and to create recommendations associated with any identified risks.
SFBC defines the subject, timeline and the complexity of the case depending on the current risk situation. SFBC also defines when meetings will be held and the subject of the reporting during these meetings.
The final report is summarized and a statement from the management is added. If any action is needed from the bank’s side, this will also be added in the report.
If the assessment shows vulnerabilities, SFBC will set a time frame to reach a satisfactory solution. (Swiss Federal Baking Commission 2004)
In all of the above mentioned regulations different numbers and key indicators are checked. If such key indicators need to describe the work, they will be mentioned during the work. A description of all measurements between the actors of the framework would result in an increased workload.
3 How does the UBS behave in Case of the Principle – Agent Framework
As already mentioned in sub chapter 3.1.1.4 Objectives and Interest of the Agent, the management of UBS is mainly interested in maximizing remuneration and for that the management is willing to take higher risks. Not only were they prepared to accept higher risks, but they were also confident that even if their high risk activities were to have catastrophic consequences the government would take action to rescue UBS. Now the question must be raised, how could the management be sure about that?
Why was the management so sure that in the case of a massive failure, UBS will still survive? The answer is quite simple - the theory of moral hazard.
1 Too Big to Fail a Case of Moral Hazard
Moral hazard exists if the principal takes the risk of the agent actions instead of the agent itself. A typical example of this behavior is the following case. UBS as one of the world’s biggest bank had a balance sheet value at the end of 2007 of approximately 2272 billion Swiss francs. This balance sheet value is roughly 5 times greater than the Gross Domestic Product (GDP) of Switzerland in 2007 (GDP of Switzerland in 2007 was 512,1 billion). When this comparison between these two figures is considered the potential problem can immediately be seen. (SEA 2004)
In case that UBS fails and goes bankrupt, the result for the Swiss economy would be dramatic. It is easy to conclude that in the case of a severe crisis at UBS, the Swiss government would try as hard as possible to help the bank survive, because bankruptcy would mean a death sentence for the Swiss economy.
The case which is described is not mere fiction, on October 16th 2008, after UBS made massive write downs in the preceding months; SNB announced a plan to support UBS with a 60 billion Swiss francs loan. SNB agreed to take over all the illiquid risk positions (toxic assets) from UBS up to a limit of 54 billion Swiss francs. The other 6 billion Swiss francs is equity capital in the new company formed as a holding company where all the illiquid papers Collateral Depths Organization (CDO’s) are held. In effect SNB made a decision to act as lender of last resort and ensured UBS’s continued liquidity.
This case describes that the UBS Management has anticipated correctly and at the end they were able to take inappropriate risk and maximize their remuneration. When the massive problems started, the SFBC / SNB reacted with the creation of a bailout package. The behavior of UBS endangered the financial stability of Switzerland and that is the reason why SFBC / SNB intervened and supported UBS.
This makes clear that the management of UBS was able to undertake high risk activities; the question here is how were they able to behave like that?
Normally regulations and controls are defined between both parties in a business to prevent overly risky or prohibited activities. Sometimes these controls / measurements are not enough to avert such a behavior, the agent still tries to hide information and actions from the principal. This leads to information asymmetries.
In the following chapters three possible hidden actions and information which UBS Management kept away from SFBC / SNB will be described.
2 Possible Asymmetric Information between UBS and SFBC / SNB
Asymmetric information occurs, when a principal does not have the same level of information as the agent. The agent tries to hide actions or information to help reach their aims. As described in detail in the previous chapter, UBS Management had the possibility to take huge risk without any punishment.
▪ Example 1: Problem balance sheet as risk indicator:
Description:
The management of UBS knew that their balance sheet was too high. UBS had at the end of 2007 around 2272 billion CHF of assets. SFBC and a lot of economic academics warned that UBS does not use its balance sheet value as an indicator for risk. The risk is really high in relation to the Swiss economy, because the balance sheet of UBS is multiple times larger than the GDP of Switzerland. In the case of bankruptcy the impact for the Swiss economy would be unimaginable.
Nevertheless the management of UBS had already discussions in 2005 with SFBC about their balance sheet size and promised to take actions to cut down its size. The picture below shows the growth of the balance sheet since 2002 up to 2007. The drop in 2007 is due to the financial crisis. If the financial crisis had never arrived, the growth would have been as high as the previous years before. (Swiss Federal Baking Commission 2008b) (Tagesanzeiger 2008a)
[pic]
Illustration 2: Balance Sheet of UBS
Source Figures: (UBS 2008e)
Example 1 Conclusion:
Both, UBS and SFBC / SNB knew that the UBS balance sheet was / is too high. The management of UBS has announced to cut down the size of the balance sheet, obviously (but to be honest) they were not interested in cutting its size or using it as a risk indicator, because they were more interested in expanding assets, and reinvesting this money, to increase earnings. Perhaps even some forms of remuneration were based on how much new assets they could get.
Of course, SFBC and SNB knew that the huge balance sheet of UBS could be a problem and they told that to UBS Management. The UBS Management on the other hand communicated that they will cut their balance sheet, but at the end they were hardly motivated to do it and were therefore not interested on following this action, which was a major mistake. Perhaps they merely communicated an intention to work on the balance sheet problem but behind the back of SFBC / SNB they still tried to attract new customers. As a summary, UBS Management was bearing a risk which they were not able to handle as soon as the financial crisis began.
▪ Example 2: Stress testing
Description:
The main control and leading instrument for measuring risk for UBS management were stress tests. An investigation showed, that in hindsight, the stress scenarios used were too optimistic. The UBS management didn't take much care to analyze the tests correctly. The mode and duration of the market rejection was surprising. Other more aggressive parameters which showed such peaks were not considered during the stress tests, because the management was of the opinion that they were unrealistic. The real market stress afterwards was much higher. (Swiss Federal Baking Commission 2008b)
Example 2 Conclusion:
The management was maybe not interested in other, more aggressive, scenarios because these scenarios would show much higher risk (which the management may have wanted to hide) and in the end potentially less earnings because they would have had to change strategy.
So, they just stuck with the ‘normal’ parameters, and didn’t check the problem cases. This behavior again supports our suspicions that UBS management was just interested in short term earnings (bonuses) and not in long-term rewards.
The conclusion here is that the management doesn’t inform anybody that more aggressive stress tests were not carried out. They just showed the results to SFBC and SFBC and stated that everything was correct. For SFBC it was clear that the stress tests were made, but the management of UBS hid the methodology about how these stress tests were made and that the aggressive parameters were not tested.
▪ Example 3: Super Senior Paper
Description:
UBS invested about 50 billion in Super Senior Paper. Super Senior papers are CDO’s with a rating of AAA. It seemed that this paper was really secure, but as house prices in the U.S. plummeted and defaults rose, UBS expectations of losses rose well into the range that would hit the triple-B investments. (The Wall Street Journal 2008)
Rating:
Illustration 3: CDO Rating, March 2007 Compared with Today’s
Source: (The Wall Street Journal 2008)
Of course, the approximate 50 billion invested by UBS was AAA rated paper, nevertheless this amount was absolutely too high. And here maybe a principal – agent problem would arise.
For this amount of Senior paper, normally a nominal limit has to be set up by a “New Business Initiative”. This initiative process would set up a nominal limit that acts as a risk boundary for these papers.
Another point, which follows from the previous point, is the fact that UBS assessed this Super senior paper as nearly zero risk. Although the positions were inserted into the risk system, they were never reported on the global risk reports. Because the rating was that good, this Senior paper was not reported and were no longer on the risk radar. (Swiss Federal Baking Commission 2008b)
Example 3 Conclusion:
The two points above show that UBS management should have known that they have holes in their risk management processes. But because the business with Senior paper was going well and the ratings were good, management was just interested in making more profits.
As a result they didn’t tell SFBC / SNB that their exposure to these Senior paper was much too high and that they are not rated / reported on the global risk report. The risk was not the rating but the amount held.
For example, if the New Business Initiative would be implemented, this would result in a limit on the paper held and prevented the huge losses experienced.
However because the business was reporting high profits the management was not interested in the risk case.
UBS maybe hid this information from SFBC intentionally, a claim which is also supported by the fact that exposure information was hidden from the global risk report. For SFBC it was not possible to check everything, because UBS is too big and complex to overview all of it’s operations closely.
4 Result of the Principle Agent Framework
The three cases of hidden action and hidden information lead to the conclusion that the highly risky behavior UBS management is mainly responsible for the problems UBS had and still have. With the intervention of SFBC and SNB which acted to support UBS (a case of moral hazard), a much worse case was prevented.
With the behavior of the UBS management who were able to undertake the actions described in the Asymmetric Information section of this paper, it can be concluded that all monitoring and regulation tools (described controls) were not successful in preventing such behavior. The information above shows that many reports and meetings were planned between UBS and SFBC to prevent such a crisis however the results were devastating.
In the next chapter a possible change in the measurement of risk and how this adapted measurement influences the success of hidden information and hidden actions by the UBS management will be explained. The aim of this measurement change is to prevent asymmetric information and helps to solve the problem of moral hazard.
5 Proposal to resolve UBS Principal / Agent Problems
To eliminate such a behavior in the future, there must be definite changes in the measurement procedure. SFBC / SNB had a lot of measurements to monitor the performance of UBS. The reports they get, showed a lot of numbers and figures. One measurement, which is used by UBS and SFBC / SNB checks the core capital quote, also called 'Tier 1'. This measurement compares the risk weighted assets with the core equity capital. Within the last 2 years (31.12.2005 – 31.12.2007) UBS has had a core capital quote between 9 – 13 %. A comparison between 52 international banks showed that UBS is one of the best and most secure banks worldwide, when they used this international accepted standard measurement.
The truth is a mixed blessing. The actual security of UBS is a subject of interpretation.
It looks completely different, if the unweighted equity capital is checked. In this case UBS slips back to one of the last places. According to ECO (an economy broadcast in the Swiss TV), UBS had an equity capital quote of only 1% in March 2008.
To compare this number, the equity capital quotes of the big Swiss banks conducted in the 30ties for the last century were around 20 percent and sunk afterwards continuously to 5 percent in the middle of the 60ies. After a long stable phase, the equity capital began to decrease again and reached the absolutely deepest point in 2008. According to Manuel Amman, Professor for financial market theory at the University of St. Gallen, the true reason is the higher profit thinking of the Swiss big banks. Shortly, less secure for more profit or and at the end more bonuses. (Zeitenwende 2008)
On the other hand when anybody relies on the core capital quote, which still showed UBS in official statements as a healthy company, they also rely on the experts who appreciate the risk correctly. With the beginning of the financial crisis, it would be clear, that this was not always done correctly.
A proposal to solve the principal – agent problem is to introduce a new measurement for the banks. The idea is to build up the equity ratio to a least 10% for each bank.
Formula Equity Ratio = Owners total Equity / Total Assets
With this action, a bank had two possibilities to make further business. The first possibility is to increase their equity capital; the second is to shorten their assets.
If the UBS management would go for the first option, they would need about 180 billion of new equity capital because they had a balance sheet of around 2272 billion and about 50 billion of equity capital at the end of 2007. This is not possible at the moment, because of the global crisis.
The other option is to cut down or split the balance sheet, one option requested by the SFBC / SNB and different economy professors. This scenario is much more likely and could also lead to the fact that the case of moral hazard could be solved.
The case of moral hazard could be avoided, because it would be possible for UBS to go bankrupt, without taking the whole economy down. The case of moral hazard could be avoided in the future. This is a main maxim of a liberal world view. When a bank struggles, maybe the economy falters, but it does not break.
If the problem of moral hazard could be solved, also the problem of asymmetric information could be solved, because it would no longer be possible for the UBS management to take higher risk and, through that, they are no longer interested in Hidden Information and Actions.
Concerning the research question, there are two possibilities. If UBS is able to bring 180 billion of new equity capital (which is really not realistic), the principal – agent framework could not be used to solve the UBS SFBC / SNB relationship.
On the other hand, and the more probable, UBS has to cut down their balance sheet, and this would lead to the result that the principal agent framework gives help to find a solution for such a problem.
All in all it can conclude, that the framework helps to analyze a situation and to find starting points which helps to solve a problematic relationship.
2 Principal / Agent: UBS / Customer Framework
This sub chapter analyses the relationship between UBS and its customers. As long as both parties have benefited from positive market biases this relationship was not an issue to talk about. This has changed with aggravations on financial markets at the end of 2007, more and more problems have appeared between the two parties. The consequence of those problems is a decrease of the asset under management of CHF 140 billion from January 2007 until the end of September 2008. (NZZ 2008a)
The problems are described in this sub chapter with a focus on UBS’ asset management, especially investments in funds. The whole analysis is based on the principle agent framework. The different objectives of the two parties will be presented, relevant asymmetric information depicted, the problem of moral hazard analyzed and problem solving approaches proposed. Finally the research question will be answered and recommendations for control mechanisms to mitigate the current problems will be commented upon.
1 Role Allocation
A global operating universal bank like UBS offers its customers a lot of different products and services like several accounts, credit cards, payment services, mortgages, loans, investment solutions, financings, etc. With this amount of products and services it is not possible to exclude every dissension between the bank and its customers. There is one obvious business where one party (the agent) acts on behalf of another party (the principle): asset management. Due to that fact, this brings high potential for principal agent problems. At the same time UBS is one of the largest private asset manager worldwide which means that an analysis of these problems can help to resume trust in their business.
Anyway, if a customer mandates a bank to manage his assets the result of these investments is not known upfront and the interests of the bank can strongly differ from that of the customer. Investment solutions offer possibilities to entrust the customer’s money to the bank which invests the money on the market to maximize the assets for the customer. This means that the customer mandates the bank to manage his assets and therefore the bank is hired by the customer. Hence, in this situation the customer acts as the principle and the bank takes the role of the agent.
1 Principal
On the customer side the principle can be either a private individual or a legal entity. A legal entity could be a pension fund, a company or another bank. Customers entrust the assets to the agent and expect an investment with much less risks and the achievement of a higher profit than if the customers had done it themselves. For this improvement of assets the customer is willing to pay a percentage rate of whole investment – called commissions – to the principle. These commissions depend on the investment product and are calculated as percentage fees of the managed amount of assets and not on the achieved yield. This is the root of the problem which will be analyzed in the following chapters.
This analysis focuses on a private client but not on a specific client segment because the client segmentation, means the client’s private assets, will be one of the key factors of the analysis.
2 Objectives and Interests of the Principal
Maximum profits on a minimum of fees with a maximum of security are the major goals of the customer. In contrast to the fees which are known from the beginning of the contract set up, it is impossible to forecast the achieved performance on the invested assets. As well for the risks it is only possible to appreciate prospective risks. Further it is a fact that profit and security have contrary behaviors. If a customer decides for a secure portfolio strategy the profit will be smaller than for a more risky strategy.
In bullish markets clients expect maximum of returns without losing the present danger of risk whereas in slackening markets clients ask for maximum of security. This indicates that the bank has to forecast the future market situation to satisfy the client’s expectations.
In other words the fees that customers pay, they expect that the overall performance is better than the market performance and better than the investment which they would do by themselves. If not there wouldn’t be a reason to mandate a third party and pay for that.
Additional goals for the principle are comprehensive consultancy and full transparency regarding the invested products and their costs.
3 Agent
On the bank’s side the agent can be UBS as a whole or only an employee of the bank, in this case an employee of UBS. The bank as a whole means the company with its predefined goals and strategy.
An employee could be an Asset Manager, an Investment Banker, a Fund Manager or a simple Client Advisor who – in best case – acts as a deputy in the interest of the bank or – in worst case – acts on own interests. But this is another example of a principle agent problem between the bank and its employees which is handled in another chapter. Therefore in this sub chapter to simplify matters it is assumed that the bank and its employees share the same interests.
The Asset Manager’s task is to invest the asset of the customer on the market to reach the largest possible profit. The Fund Manager’s job is to manage the asset of the fund in such a way that a maximum of return flows back to the customer. To achieve this, the bank employs a lot of financial specialists who study the economy, observe financial activities and know the market. With this know-how the bank has higher chances to make the right investment decisions than an inexperienced customer. This is also the reason why the customers don’t manage money by themselves. To obtain the goal of high profits, the Investment Manager takes a risk. As greater the risk, as greater the chance of maximizing the customer’s assets. But with higher risks the threat of losses arises.
This analysis is focused on Asset Managers who manages the customer’s assets and on Fund Managers who manages mutual funds.
4 Objectives and Interests of the Agent
As already mentioned before, to simplify we act on the assumption that UBS as a company and its employees totally have the same objectives. This allows us only to focus on the customer bank relationship.
The major objective of UBS is to reach a maximum return on investment and finally a maximum of its share price. Furthermore one of the main goals of each firm should be a successful and sustainable business. Exactly this missing sustainability was one of UBS biggest problems during the last years and they are jointly responsible for UBS’ current problems. But this analysis assumes that sustainability is one of UBS’ most important goals in anticipation of major future changes in UBS’ corporate culture.
To achieve these goals the bank has to reduce its costs and raise its revenues. But what does this imply in the scope of asset management? Cost reductions can be attained by economies of scale that means focus on a few products – especially on own products – and special conditions with particular third party products to reduce the fees due. On the other hand the bank raises revenues by selling its own products instead of third party products. Simultaneously the bank tries to convince its customers to invest their money instead of just leaving it in saving accounts. One example is the UBS Vitainvest. In early 2006 UBS launched a new public investment fund for Pillar 3a, called Vitainvest, which replaced the old Pillar 3a fund Fiscainvest. The objective of UBS is to bring preferably all customers to transfer their 3a saving to such a UBS Vitainvest fund. The intention behind that strategy is the commissions of the fund. Depending on the weight of equities a customer has to pay a flat fee between 1.44% and 1.64% per year. This is much more than the bank could achieve in contrary to use the money by its own (and pay an interest rate of 2.25% to the customer). (UBS 2008f)
In summary, when considering asset management UBS earns a maximum of money with a maximum of managed assets multiplied with a maximum of commission percentages.
2 What are current Measurements in this Principal Agent Relationship
Explicit control mechanisms do not exist which implies that it depends on the customer himself to control the party which manage his assets.
Agent’s success can be measured by the achieved yield on the customer’s assets, also called Average Annual Return. But due to the fluctuations in the financial market it will be much harder to achieve an adequate return during sinking prices and much easier to reach a satisfactory return when the stock-market prices rise. Hence the achieved yields should be measured relatively, meaning relative to an index. Such an index can provide a bias of the current market situation. Important is that the basis for the measurement is the net interest yield, meaning the yield achieved by the asset manager minus the charged fees. The problem that persists is to choose an appropriate index. (Geld-Extra 2008)
The above described measurement is a control mechanism and would be an approach to consolidate the incentives of the principle and the agent. Stupidly, in reality the charged fees are independent of the achieved yields, like this is the case in the above mentioned example with the UBS Vitainvest funds. This means that the customer is able to measure the performance of the asset manager even though this doesn’t change anything on the charged fees.
Another measure approach is the charged fees for an investment product and the composition of these fees. But this implies full transparency of the costs in advance.
In a broader sense the underwritten contract and enacted laws are control mechanisms as well.
3 Hidden Information
Normally hidden information is the foundation of dissensions between the agent and the principle.
One part of hidden information is the financial knowledge which enables the bank the essential advantage against the customer regarding the management of assets. Depending on the customer’s financial knowledge the difference between the bank and the client – and therefore the hidden information – is smaller or bigger. There exist a lot of customers with limited investment experiences and therefore with considerable hidden information. But this is not the source of the problem but rather the answer why the principle hires the agent.
Second important and relevant hidden information are hidden fees of the bank’s products and services because the investment advisors are often very discreet about that. In the context of asset management many investment fees are either not clear or not fully evident. These fees can be transaction costs that occur when the asset manager buys or sells assets. It is nearly impossible – especially for a layman – to compare various investments, in particular mutual funds and hedge funds.
In many investment products it is really difficult for a potential client to recognize the total charged costs in advance. (Investopedia 2008)
In conjunction with hidden fees a frequently discussed topic are agency fees (also called kickbacks), commission that the investment advisor – in our case UBS – gets for selling a product of another financial institution, investment or hedge fund. This information is important because on one hand it affects the consultancy of the investment advisor and on the other hand it mostly depends on the risk of an investment. One actual example for this was the products of Lehman Brothers. For the two universal Swiss banks UBS and Credit Suisse these products were the ones with the highest kickbacks – and now they are worthless. (Tagesanzeiger 2008b)
But also the total comprehension of a particular product could be hidden information. Many customers do not have enough financial knowledge to understand the products in which their assets are invested. One adequate example is the category of structured products, another are investment funds. After the last market crisis in 2001/2002 like many other banks UBS began to develop so called Absolute Return Funds. These funds have been sold as very secure and conservative investment products. Experts calculated with a minimum loss of 3% in worst case. (Sueddeutsche 2008) In November this year UBS announced the closure of three of their UBS Absolute Return Bond Funds because one of the three has sustained a loss of more than 20% since the market launch four years ago. (UBS Fund Gate – Switzerland 2008)
[pic]
Illustration 4: UBS Performance Chart (CHF-based, as of December 4, 2008)
Source: (UBS Fund Gate – Switzerland 2008)
A lot of structured products are too complex to understand, especially for lay people. With progressive movement of the financial crisis it seems that even the bank itself has not fully understood all of its structured products.
Additionally a customer doesn’t know the costs per transaction that occur on the bank’s side meaning the customer is not able to verify if the charged fees of a product are adequate.
A last part of hidden information could be the financial situation of the issuer of a product, especially in the case where the issuer of the product is the managing bank itself. At the moment in the case of UBS (and almost all investment banks) this is strongly important information because a potential bankruptcy of UBS would imply high losses for a customer investing in UBS products. The hidden financial situation of the large financial institutes is the biggest factor for the current mistrust on the market. An obscure example of such a case was the bankruptcy of Lehman Brothers in September this year.
4 Hidden Actions
In a relationship between asset manager and client, the investment decisions the assets manager makes are hidden actions. For the customer it is nearly impossible to observe if the asset manager has chosen the most promising investment decision for the customer’s assets. This could be doubtful because of the previously mentioned different incentives between bank and client. One problem of different incentives is the number of transactions fund managers conduct. Each transaction generates commission earnings for the bank on one hand and commission charges for the customer on the other hand. But for the client it is difficult to monitor the transactions the asset manager settles, even more difficult to verify if all transaction were promising and nearly impossible to attest that some conducted transactions were not in the interest of the customer.
5 Adverse Selection and Consequences
Adverse selection would exist if every customer has to pay the same price for a particular product independent of whether he is a good or a bad customer.
One example for an adverse selection in the relationship UBS customer could occur by granting loans. If the bank is not able to differ between profitable, low-risk clients and unprofitable, high-risk clients it has to set an average price which will be the same for all clients. But the low-risk clients will not be about to pay this higher price and will leave the bank, the risky clients remain. But firstly this hypothetical example has not directly to do with asset management and secondly banks have solved this problem with giving loans on securities. This means that higher client segments get easier and in many cases cheaper loans than the lower client segments.
A relevant example is the fees for products and services in general. Basically UBS charges each customer the same fees and commissions for transactions, account keepings, credit cards and many other services and products. These basic fees are an average between all customer segments.
Fact is that UBS makes a lot of money out of good customers with high custody account balances that are invested in active managed products and process a lot of transactions. On the other hand bad customers are customers that have a lower custody account balance and buy passive third party products which generate fewer transactions and accordingly lower management fees. But if UBS charged the same fees independent of the customers total asset situation UBS wouldn’t certainly be one of the largest wealth manager worldwide. This means that cause of the vulnerability of an average fee model and the risk of an adverse selection, UBS – like each other bank – established a fee model that allows the client advisor to adjust the fees downwards for high profitable clients. In UBS this fee model is called SOKO from the German ‘Sonderkonditionen’. It allows client advisors after an approval of a higher authority to give special conditions to particular customers. (UBS Quotes 2008b)
6 Situations of Moral Hazard / Unequal Risk
Moral hazard exists if the party that takes a risk is not the same as the party that bears the risk. Such a situation makes a relationship more difficult. Due to the fact that the asset manager trades with the money of the customer instead of his own and thus insulated from risk he may behave differently from the way he would behave if he were fully exposed to the risk. This means it is the prospect that the responsible manager takes more risk and acts less carefully than he would do with his own money because taking more risk gives him the chance to gain more revenues for the bank. If the investment goes wrong the manager does not bear the consequences of its actions but leaving the customer to bear the responsibility for the consequences. Exactly this happened in the case of UBS. Asset manager have lost the sensitivity for risks and only focused on maximum earnings. Additionally UBS internal risk processes failed. With eruption of the financial crisis and the associated price losses – especially of the high risk investments – the UBS clients have had to bear these losses.
7 Proposal to resolve UBS Principal / Agent problems
In contrast to the other principle agent relationships analyzed in this work it is not obvious that UBS has truly interests to solve the principle agent problem discussed in this chapter. It looks from the perspective of UBS that the mentioned principle agent situation between the bank and its customers could be the safeguard and the reason why UBS still earns money from its customers in such bad financial times as today. The reason for that is the already discussed independency of the charged commission fees to the investment performance. So the question is whether UBS benefits from the principle relationship problem in asset management?
As also mentioned before, one of UBS’ major future goals should be sustainability. With the current chosen direction concerning UBS funds it seems almost impossible to achieve this goal. Until now, many investors has subtracted their money from active managed funds like the UBS ones because the performance was lousy and nevertheless the fees high. But this is not just a UBS problem; many other financial institutions are faced with a bias from active managed products to passive managed products like index funds. The reason is that most active managed products have not beaten the referenced market index in the past even though the fees were obviously higher. A second answer for this bias is the lacking of transparency concerning the fees of investment products including the complexity of the products, especially for active managed products. (Geld Extra 2008)
If UBS will stop this movement a mutual accepted solution for the existing principle agent problem should be found. New innovative products should be launched and additionally UBS fund performance must get better relatively to its competitors independently of the principle agent problem.
One possibility to convince customers remains the dependency of performance and fees. This would consolidate the mutual objectives. At the same time this would be a huge challenge for UBS because the bank would only earn money from asset management if its performance was better than a referenced benchmark. But anyway in near future it will become more difficult to earn money. Beside the hard financial situation the margin for banking products and services will be obviously smaller.
Additionally the total fees of every product and service should be communicated with full transparency. One step in the direction of more cost transparency could be to adopt the MiFID (Markets in Financial Instruments Directive) in Swiss law. This European Union law provides an increment of competition and consumer protection in investment services. (Tagesanzeiger 2008b)
8 Conclusion
Like today also in future the objectives of UBS and its customers will distinguish. Commissions based on investment performance could be an approach which tries to develop incentives to conclude the two different objectives.
The knowledge difference between customer and bank will generally remain but there is a bias that customers will be better informed after such heavy losses. At the same time new enacted laws will tend to reduce the complexity of investment products and to increase transparency of risks, costs and the company’s financial situation. One example could be the ‘Markets in Financial Instruments Directive’. The problem of moral hazard will remain because as well in future UBS will manage assets on behalf of the customer.
Finally the framework of principle and agent acts as the basis to depict the problems between the bank and their customers concerning asset management and helps to establish new control mechanisms. Such arrangements would set a basis for getting back the previously lost trust in UBS.
3 Principal / Agent: UBS Employer / UBS Employee Framework
The understanding of the UBS employer / UBS employee framework means that the UBS employer acts as the employer and the UBS employees are the people who are hired by UBS to perform for it. In the following sub chapter the principal agent framework between UBS employer and UBS employee will be analyzed and described. To compare the expectations of the employer to the employee a Client Advisor role will be assigned and the bonus system between the Client Advisor and UBS will be investigated.
1 Role Allocation
The principal agent framework defines that the principal hires the agent whereas the agent performs for the principal.
In the principal agent framework of UBS employer / UBS employee the principal is the employer, whereas the agents are the firm’s employees. The actions of the employees create value in the form of financial services for UBS’s customers, but the revenues associated with the services accrue directly to UBS, not to its employees.
The principal UBS employer will be distinguished in the following sub chapter either as UBS or employer and UBS employee will be simply expressed as employee.
1 Principal
UBS is an institution which hires employees to execute financial services for its customers. The principal UBS offers all employees monthly salaries in exchange for their labor power. The employer typically maintains ownership of intellectual property created by an employee within the scope of employment. The intellectual work of an UBS employee becomes the property of UBS based on the concept known as works for hire.
UBS serves like all other companies employment contracts to define the responsibilities and rights of each party. Unfortunately UBS acts in a complicated environmental industry. The services and products which are offered by a bank are normally highly complex and need people with a high level of education. To describe complete job specifications or on the job contracts of such high educated and broad range operative employees it is almost an impossible challenge. To define complete contracts for this industry and for these workings are not feasible due to the variety of different and unforeseen tasks.
2 Objectives and Interests of the Principal
The principal UBS uses the agent’s labor power to pursue and achieve its own goals. UBS expects from its employees that they execute the instructed tasks which help to achieve the set goals of UBS and therefore not the goals of the employee itself. On the other hand UBS is only partially able to control the efficiency of the approach. Normally only the result can be measured.
Following an enumeration of UBS’ generic objectives and interests in reference to employees is presented.
Objectives / Interest
▪ Motivated, highly educated and performing employees
▪ A good mixture between experienced and junior employees to provide a continuity
▪ Maximum performance of the employees for a minimum of salary
▪ Longer workdays without compensation
▪ No job interruptions through accidents or illnesses
▪ Performance management processes for all employees throughout the year
▪ Are interested in skill development of employees paid by the employees themselves
▪ An open internal labor market
▪ General loyalty of the employee for the company
▪ Employee hires employee strategy -> cheap recruitment costs.
The employer has to be aware of the following Issues:
Employers have to take care of three main issues of employment relationships.
Executing control either output focused, focusing on desired targets which the managers define with their employees, and using, their own methods for reaching targets, or process controls, which specify the way in which tasks will be achieved. Employer and executive control within an organization is processed on many levels and has important implications for staff and productivity. This control is forming the fundamental link between desired outcomes and actual processes.
Motivation is the third and most difficult issue for employers to effectively manage in the employment relationship. Employee motivation can often be in direct conflict with control mechanisms of employers.
The employment relationship is thus a difficult challenge for employers to manage because all three facets are often in direct competition with each other, with interests, control and motivation often conflicting in the equally important quest for individual employee autonomy, employer command and control and ultimate profits.
3 Agent
In the principal agent framework employer / employee of the UBS enterprise the employee serves the role of the agent. The employee contributes to the UBS’ enterprise and creates added value for it. Although employees contribute to enterprises, the employer maintains control over the productive base of capital, and is the entity named in contracts.
As already mentioned in the sub chapter 3.3.1.1 Principal it is almost impossible to describe the entire subset of tasks in a contract of an employee. Due to the high inhomogeneous working field of a bank, for the employer who needs highly educated employees; it is even more complicated to set up a complete contract.
The following list shows a generic list of what the objectives and interests of UBS employees are. These objectives and interests are valid as well for Client Advisors.
Objectives / Interests
▪ Maximum salary for minimum work and work time
▪ Same salary for same work regardless of gender
▪ Incentives in general
▪ Profit by UBS benefits
▪ As much leisure time as possible
▪ As much vacation as possible
▪ Opportunities of self development and promotion
▪ Employee social and retirement plans
▪ Interest in the company in form of options or shares
▪ A safe and healthy workplace and work processes
▪ Good working conditions
▪ Appropriate training and equipment and use of the equipment during spare time
▪ Equal employment opportunities
▪ Opportunities for personal development and support from the company
2 What are Current Measurements in the Principal Agent Relationship
The following measurements between the employer’s expectations and their employee’s performances have been gathered from the UBS website. The following text describes how the current framework is measured.
All UBS employees have to participate in a yearly performance management process. This process assesses individual goals which are set at the beginning of the year between the employee and employer, with the achieved goals at the end of the year. This process has been introduced in 1996 in UBS and is now the main instrument to measure the expectations for behaviors and actions according to experience. This method is known as management by objectives. These objectives relate to clients, people and teams, economic goals and professional expertise. The objectives can be updated in the Premium Pension System (PPM) online application throughout the year which will normally be done in the mid year review. In the fourth quarter, the employee's achievements are assessed against these previously defined objectives. This process involves the employee and the line manager.
This performance management framework allows UBS to measure specific personnel development needs in its businesses and along specific types of employees.
A positive aspect of the PPM process itself is that the assessment of the objective is broadly the same for employees without a difference between the board of directors, members of the group executive board and members of the group management.
As already mentioned at the beginning, the PMM assessment is the main element defining individual incentive awards for all UBS employees. The amount of money provided by incentives for each employee is determined by the financial performance of the UBS Company, its individual business groups and the single performance of the employee. (UBS 2008g)
In addition to the PPM, UBS works with an annual employee survey. This survey is used to measure the employee’s engagement which is central for workforce retention and performance. In addition UBS measures the corporate culture, engagement and the incorporation of its core values into daily business activities. Due to the huge variety of business groups the employee serves provides a customized section for each group as well as a core set of questions and themes which are the same in order to provide a comprehensive view of employee’s responses across UBS.
Human Resource Measurements
The human resource management department additionally has other measurement methods. For example the percentages for loyalty of employment and employee fluctuation can be assessed. Even though these figures are not directly related to the measurement of the principal agent framework itself. These two figures express the cohesion of employees to a company. For larger companies it is more difficult to keep the percentage for loyalty high and the percentage fluctuation low. In such companies’ individual careers, job rotation and job opportunities, are much easier than in smaller ones. These are reasons why employees are much faster at interchanging in large companies than in smaller ones.
3 Hidden Information
Due to the high complexity of the financial service industry, jobs which are executed within this branch are hardly measurable, because the employer is not able to control the employee‘s quality (Client Advisor). It is not possible to measure the work on a day to day basis without being inefficient. It is almost only possible to see the end result of the work. Sometimes the result of the work can not be assessed at all because it is not clear if the employee’s actions were responsible for the end result or if the result was affected by other economic influences.
Following the hidden information of a Client Advisor in reference to the employer will be exposed. To narrow the different sections of hidden information only the bonus incentive related hidden information will be investigated.
Job Resignation
Due to the fact, that the Client Advisors have felt unsecure about their jobs with UBS during the financial crisis, they have looked for alternative employers. As already mentioned in the majority the main component of the senior Client Advisor’s salary is variable (bonus). Due to the financial crisis the UBS bonus pot payments reduced drastically because the business turned bad. The intended employer change of the UBS Client Advisor was not obvious for the UBS’ superiors and UBS’ management before the Client Advisors officially resigned from their jobs. When this trend turned commonly UBS lost not only the Client Advisors, in addition UBS lost the clients which moved together with the employee to the competitors. To stop this trend UBS has reacted with an immediately increase of the over average Client Advisors’ fix salary by 10 percent. (Tagesanzeiger 2008c) The increase of the Client Advisors’ salaries astonished a lot of individuals because a few days before UBS announced the salary rise of the Client Advisor, UBS requested a governmental financial package of 60 billion to survive the financial crisis. (NZZ 2008b)
How is the story linked to bonuses? Due to the fact, that the financial crisis has impacted the payments to the UBS bonus pot, Client Advisors have felt unsafe about their variable salaries which are normally a huge part of their income. If the performance of the bank is unsatisfying overall the single performances of the Client Advisors may not be bad as well. Nevertheless the variable salary of the Client Advisors will almost decrease to zero. The variable salary is nothing else than bonus payments. These circumstances resulted in the decisions of the Client Advisors to move to competitors or even only national banks.
4 Hidden Actions
In the principal agent framework of UBS as employer and Client Advisor as employee hidden action occurs when the agent knows what action s/he has taken but the principal is not able to observe this action or gets information about the action after the action has been executed. The following described hidden action is as well related to the bonuses incentives.
Violation of internal Directives
One case of hidden information is the source of too risky contracts between Client Advisor and customer. It is within the Client Advisor’s responsibility to check the creditworthiness of the customer before credit can be granted or declined. If the customer does not reach the expected creditworthiness set by UBS internal directives and the employee grants the credit regardless of this issue, the employee acts in an area where the employer is not able to control her / his action. Hidden information occurs. Even though some contracts are issued by a four eyes control mechanism, supervisors of Client Advisors might not be disapproved because the manager’s bonus is as well based on the amounts of contracts and the sum of it. The employer does not know that the employee has granted the credit even though the client is not able to bring the evidence of enough creditworthiness. If the Client Advisor has to fill out a credit form together with the client were the client has to record the securities, they just extend the truth of the client in an attempt to reach the expected creditworthiness.
Why are employees (Client Advisors) taking such risks? In the short term the employee is not benefiting from this credit aside from the effect that the employee may know the credit applier and make the client satisfied. In addition the reputation of the Client Advisor may rise in reference to the customer.
Another much more lucrative aspect for the employee themselves is the profit participation he or she gets in the form of bonus payments from the deal at the end of the year (long term).
The amount of bonus in UBS is dependant on different factors. UBS serves a bonus pot. This pot is filled by the three main business groups Global Wealth Management & Business Banking (Global WM&BB), Global Asset Management (Global AM), Investment Bank (IB). At the end of the year the different performances of the business groups are assessed and the pot is split by the performances of these business groups. The performance is measured by the accounting year end result of the business groups. After the year end result is known, the different groups get the bonus amounts out of the bonus pot. The pot is broken down to each individual employee. The performance of the employees is measured by the PPM which has already been described. For the Client Advisors the performance criteria are almost the same every year. The aggregated amount of all issued contracts as well as the amount of contacts is the main criteria. Senior Client Advisors which have a lot of “own” clients have a higher variable part of their salary as junior Client Advisors which have no, or just a few “own” clients. Own clients means that the clients are not with UBS because they believe in UBS, rather they are with UBS because the Client Advisor works for UBS. This strong relationship between employees and client has advantages as well as disadvantages for UBS. As soon as UBS hires a new senior Client Advisors new clients will follow the Client Advisors. The disadvantage of this relationship is the opposite affect. This disadvantage will be described in the next sub chapter hidden action.
5 Adverse Selection and Consequences
Adverse selection refers to asymmetric information between principal and agent before conclusion of a contract. Based on the bonus politic and the employer employee framework no adverse selection has been found.
Lazy and inadequate Client Advisors
Imagine that UBS would not pay a bonus to its top Client Advisors. This could have three different impacts. The employees of such positions wouldn’t be interested in issuing as many contracts as possible. They wouldn’t have an interest to pursue to sign the contracts at the maximum possible limit (walk away price of customer) which the customer is willing to pay. Due to these reasons UBS would lose a lot of potential assets.
On the other hand the main competitors work as well with such bonus systems which are based on the difference of the walk away price and the bound price (price on which the contract is issued). This difference and the amount of such contracts are normally the basis of the employee’s bonus. The consequences of these have different impacts.
If UBS wouldn’t work with these mechanisms good Client Advisors would resign from their jobs and apply for jobs with competitors because they may offer more money for excellent work. If UBS would offer only a fixed income the Client Advisors would either not perform because they get the salary anyway or issue the contracts not at the level of the maximum price which the customer is willing to pay. At the end, UBS would only employ lazy and inadequate Client Advisors.
With the approach to base the salary on issued contracts and the difference between minimum contract price and issued contract price the employees have an interest to sign the contracts not on the lowest price and are obliged to issue as much contracts as possible. (NZZ 2008c)
6 Situations of Moral Hazard / Unequal Risk and Consequences
Moral hazard exists if the party that takes a risk is not the same as the party that bears the risk. Such a situation makes a relationship more difficult.
Current UBS Bonus Politic
The bonus politic which is currently present in the financial sector and especially in UBS is not comprehensible for individuals. The current bonus system which UBS currently serves is responsible for moral hazard activities between employer and employee. Client Advisors issue contracts which should not be signed and violate UBS internal directives to gain more bonus.
Consequences of this behavior for UBS are huge like what recently occurred during the financial crisis. Employees can leave the company but the bad reputation stays with UBS. If UBS would rather be a proprietorship than an institution each individual employee would not take such risks which are not fully covered.
This behavior was not only executed on the level of Client Advisors. It had occurred as well in the top management when Marcel Ospel, previous chief executive officer (CEO) of UBS, still served the management board of UBS. To increase the assets of UBS generally, directives were violated on different levels. Not only directives which are provided by UBS itself. As well legal directives have been violated by UBS employees to increase assets by cross boarder services. This is the reason why UBS has different legal suits in U.S. which are currently running against UBS and single employees of UBS.
In summary UBS has currently in general a bad reputation globally and struggles still with the mis-management of Marcel Ospel and his management team. The individual management people left the company and are hardly in the newspapers whereas UBS is still dealing with the consequences of the mis-management and the bad risk management.
7 Conclusion and Proposal to resolve UBS Principal / Agent Problems
The current financial crisis has a huge impact on the principal agent framework employer / employee of UBS. Currently UBS gets pressure from different sources, internally as well as externally. Most pressure is currently executed from externally like customers and the government including Swiss National Bank. Under this pressure UBS has to react. The employees feel the pressure extremely. UBS has already dismissed employees and amended internal processes and control mechanisms.
As described in the previous sub chapter UBS has two main instruments, PPM and employee survey to measure the principal agent relationship of employer versus employee. To measure the factors is only one part of the task. The other parts are to comprehensively review the measurements and take actions from them. As already mentioned above UBS already took short term action and reduced the amount of employees in the different business groups.
The next step must be to set up long term consequences and especially control mechanisms. It seems that UBS lost track of these control mechanisms even though measurement instruments are available like the PPM, the customer survey and the human resources employee figures. The question is how the measurements can be translated into control mechanisms and how they can be assessed afterwards. The control mechanisms for violation of the UBS directives could easily be handled by a four eyes principal before a contract can be issued. The supervisor needs to spot check the work of the Client Advisor and must take action if the employee violates the internal directives. Another option to check the employees’ properness can be to invite the customer itself to report inappropriate behavior of UBS employees. If employees grant credits though the criteria parameters are not fulfilled a discount on the already signed credit can be granted additionally to the customer if they report such mis-behavior of UBS employees. Without such an additional discount or incentive for customers, they would not denote this attitude. In addition UBS has to guarantee that the clients who report the misbehavior can keep their signed contract conditions. The additional discount can be withdrawn from the departments’ bonus pot. This approach obliges the manager to control the work of the employee better where as the employee has to check the client’s creditworthiness even more carefully and in details. If directive violating contracts are issued this punishes the whole department because the bonus pot decreases. This procedure helps UBS to develop a kind of self regulation within the departments. Such directive violating behavior will not be suffered constantly. As soon as Client Advisors who act inappropriately have to reduce their bonus, they will begin to escalate such behavior.
The second point which UBS has to address and improve is the current bonus system. This system is currently aligned for short-term objectives and goals rather then for long term. Especially the percentages of fix and variable salary fragmentation must be discussed. Incentives are always a good instrument to tease out every day the maximum performance of each employee. If employees would earn only their annual agreed salary they would not have a reason to work more than they have to do because they get their wage anyway at the end of the month. The management of UBS especially has a bonus system which astonishes a lot of individual people. The management earns only a fractional amount of their salary as a fixed income. The majority of the income is variable. The variable part of the management’s salary is not only paid if the bank achieves a positive asset.
The fixed part of the management salary should be increased where as at the same moment the variable part of the salary must decrease. If the bank’s financial year ends in the red, all incentives for the management should be skipped. On a long term performance alignment must be agreed and be introduced rather than a short-term performance focus. A limit has to be set in reference to the amount of bonus payments regardless of the constitution of the bonus. Such a bonus directive limit would have to be applicable for all employees. A possible threat might be, if the limit is set at a too low level. Managers might be no longer interested to work for the company itself. The limit base for example can be in maximum an additional current year salary. To link the management decisions closer the to company performance the bonuses for the management can for example be paid in options with a blocking period between three to five years. This approach helps to force the management especially to think about the long term development of the company and not only the short term objectives and goals. How does it work to force the management to think about the long term performance and not only about the short term performance with option incentives? If a company must declare insolvency all options lose their value and are worthless. As presented in the analysis of Dr. Erik Lüders and Dr. Michael Schröder (ZEW 2008) about stock options, companies who pay incentives in the form of options have a lower insolvency ratio than others who pay the incentives in cash.
The only problem is that nobody allows that UBS has to declare insolvency as already described in the sub chapter 3.1.3.1 Too Big to Fail a Case of Moral Hazard.
What’s then the right incentive instrument for the UBS’s managers?
The best way is to pay the incentive for the UBS management in cash. UBS should keep the possibility to call back up to three quarter of the bonus incentive within five years of each management employee. If a mis-management issue pops up within a period of five years after the incentive has been granted the management should be obliged to pay back their incentives accordingly to the impact of the issue. To pay the bonuses to a blocked account can’t be a solution. This has the effect that a manager would get his bonus always with a delay of three to five years depending on the duration of the blocked duration. This approach helps to sensitize the management even more in their actions than with options because options can always be exchanged for cash after three or five years are over. The options only lose their value if a company goes to insolvency.
To come back to the research question if the principal agent framework doesn’t help UBS to adjust the control mechanism. As described in the conclusion of the principal agent framework UBS employer versus UBS employee, the principal agent framework can help to identify and align the control mechanism between the employer and the employee. Measurements of the relationships are available and present. The only part which has to be improved is the criteria of how the relationship is assessed and in addition on what the incentive is based. Most problems pop up because the bonus system is not set up in reference to the sustainable growth of the company. Currently the bonus system is focused on short term instead of a long term. Not only can a change of the bonus system help UBS to get more control of their employees and avoid moral hazards, hidden information and hidden action but it is also a good action to begin with.
4 Principal / Agent: UBS / UBS Shareholder Framework
Because even the best risk management strategies cannot guarantee against losses, banks cannot rely on deposits alone to fund their investments. In order to fund them, the bank managers administer the bank's equity capital, bank's assets composition and liabilities coming from the share owners' equity. Bank's shareholders are however residual claimants, in the sense that they may share in the bank's profits but also in any losses resulting from failed investments.
In this first sub-chapter the relationship between shareholders and UBS Management will be described, analyzing both parts with the principal agent framework. The analysis will be made considering the current situation of the bank. After a deep examination some proposals will be suggested as a solution to improve the relation between the two parties.
1 Role Allocation
After looking at the principal agent framework in general, the roles of each of these parts can be defined. Shareholders are defined as the principal part, because they have some impact on the company's policy, as they elect the board of directors. They transfer their capital to UBS, so that the bank with its experience can create value and maximize the share’s value.
On the other side, UBS Management plays the agent role, seeing as the part which possesses required knowledge and performs a service on behalf of the shareholders. UBS Management with its know-how of the business activities makes the decisions to enhance shareholders’ value.
1 Principal
A shareholder is a person, who owns stock in a company, in this case of the UBS. Shareholders are legal claimants on a percentage of the bank's earnings and assets, sharing the same level of limited liability as the bank, but also sharing the same probability of losses. If the bank goes bankrupt and has to default on loans, the shareholders are not liable in any way; they generally lose the entire value of their holdings.
“Ownership of UBS shares is widely spread. Most of the shareholders are individuals living in Switzerland. Shareholders are also located in Europe, North America and other countries. Each shareholder typically has a percentage of votes equal to the percentage of shares owned. So as long as the shareholders agree that the management is performing poorly they can elect a new board of directors which can then hire a new management team.” (UBS 2008i)
UBS places no restrictions on share ownership and voting rights. Nominee companies and trustees, who normally represent a great number of individual shareholders, may hold an unlimited number of shares, but voting rights are limited to a maximum of 5% of outstanding UBS shares in order to avoid the risk of unknown shareholders with large stakes being entered into the share register. In order to be recorded in the share register with voting rights, shareholders must confirm they acquired UBS shares in their own name and for their own account. Nominee companies / trustees are required to sign an agreement with UBS, confirming their willingness to disclose to the company, upon its request, individual beneficial owners holding more than 0.3% of all issued shares.” (UBS 2008h)
2 Objectives and Goals of the Principal
In every principal / agent relationship, principals and agents have different preferences. As a principal, UBS’s shareholders have several objectives, such as:
▪ Gain financial security and minimize risks
▪ High return on equity
▪ Win access to key corporate decision-making process
▪ Rapid earnings per share growth
▪ Long-term residual value of the business
▪ Enhance a transparent and efficient communication
3 Agent
Within this relationship UBS Management acts as an agent in the sense that managers have specialized knowledge with which they can lead the bank to success, protecting the interests of the shareholders and creating value for them. UBS Management, with its specific understanding of the business, looks at both required capital and available eligible capital and forecasts their future development. With some specific tools, such as dividend payments and capital securities, managers can administer the capital in a way that they can continue to create sustainable value for the shareholders.
“UBS fully subscribes to the principle of equal treatment of all shareholders, ranging from large investment institutions to individual investors, and regularly informs them about the development of the company of which they are co-owners. The annual general meeting offers shareholders the opportunity to raise any questions regarding the development of the company and the events of the year under review. The members of the Board of Directors and Group Executive Board, as well as the internal and external auditors, are present to answer these questions.” (UBS 2008h)
“According to UBS’s Regulation on the Registration of Shares, voting rights of nominees are restricted to 5%, while clearing and settlement organizations are exempt from this restriction. As of 31 December 2007, no other shareholders had reported holding 3% or more of all voting rights. Since 13 September 2002, UBS’s holdings of its own shares have been above the 3% threshold requiring disclosure under the Swiss stock exchange laws. UBS’s position in its own shares remained between 3% and 10% throughout 2007. At year-end 2007, UBS held a stake of 7.79% of acquisition positions consisting of 160,841,275 UBS registered shares and a total of 634,473 acquisition rights and granted disposal rights on UBS registered shares. At the same time, UBS held 10.32% of disposal positions relating to UBS registered shares.” (UBS 2008i)
4 Objectives and Interest of the Agent
As an agent, UBS has a number of shareholder objectives, which are to:
▪ Enhance shareholder value and provide returns that match or exceed the industry cost of capital
▪ Strive to outperform the efficiency and other objectives set in the business strategy
▪ Promote a performance-driven culture and adherence to ethical values
▪ Align the interests of its management with those of its shareholders
▪ Improve the company’s market position
▪ Make it as easy as possible for shareholders to take part in its decision-making process
▪ Reduce uncertainty for UBS shareholders
▪ Restore the bank’s financial standing and reputation
2 What are Current Measurements in the Principal Agent Relationship
UBS focuses on key performance indicators, which are designed to monitor the returns UBS delivers to shareholders and are calculated using results from continuing operations. These are:
▪ “Earnings per Share (EPS). Net earnings divided by common shares outstanding. May be diluted to account for the potential creation of common shares from convertible securities. See earnings per share, diluted.
▪ Return on Equity (ROE). The rate of return a company achieves on the things it owns. ROE is calculated by dividing the sum of a company's net income over the past four quarters by the average of its common stock equity over the past four quarters. The result is shown as a percentage. Unlike ROA, ROE subtracts a company's liabilities in its denominator.
▪ Cost / Income Ratio. Measures how costs are changing compared to income. It reflects changes in the cost / assets ratio and in interest margin.
▪ Net new money. Net amount of invested assets that are acquired by the bank from new clients, invested assets that are lost when clients terminate their relationship with UBS and the inflows and outflows of invested assets from existing UBS clients.
▪ Return on Assets (ROA). The rate of investment return a company achieves on its assets. ROA is calculated by dividing the sum of net income over the past four quarters by the average of total assets over the past four quarters. The result is shown as a percentage. Unlike ROE, ROA ignores a company's liabilities.
▪ Cash Flow. Net earnings before depreciation, amortization and non-cash charges. Sometimes called cash earnings, cash flow is calculated by adding depreciation to net earnings and subtracting preferred dividends. It is useful for determining how solvent a company is.
▪ Share price. Price of a single share of a company's stock in the market.
▪ Dividends. Cash payments made to a company's shareholders from its current or retained earnings. If a company's board has committed to dividend payments in the future, the latest reported dividend rate equals the number of times the company pays dividends per year times the latest dividend, expressed in dollars. If a company's board has not committed to dividend payments in the future, the latest reported dividend rate equals the total dividends paid in the past 12 months.” (SmartMoney 2008)
UBS’s performance against financial targets shows:
▪ “UBS’s annualized ROE from continuing operation was negative 44.4% in the first nine months of 2008 compared with positive 19.0% in the first nine months of 2007, primarily due to losses in the fixed income, currencies and commodities area of the Investment Bank.
▪ Diluted EPS from continuing operations were CHF 0.09 in third quarter 2008, compared with negative CHF 0.17 in second quarter 2008. This change was mainly driven by reduced losses in the Investment Bank. The EPS calculation assumes the issuance of the shares issuable upon conversion of the mandatory convertible notes issued on 5 March 2008.
▪ The cost / income ratio was 102.1% in third quarter compared with 200.7% in the prior quarter. Income in third quarter was affected by the factors mentioned above. Total operating expenses were down 26% from the previous quarter, mainly due to lower accruals for performance-related compensation in third quarter, and the provision of CHF 919 million for the repurchase of auction rate securities and associated fines made in second quarter.
▪ Third quarter 2008 saw net new money outflows of CHF 83.6 billion, compared with outflows of CHF 43.8 billion the prior quarter. At the end of third quarter, total invested assets stood at CHF 2,640 billion, of which CHF 1,932 billion was attributable to Global Wealth Management & Business Banking and CHF 708 billion was attributable to Global Asset Management.” (UBS 2008j)
[pic]
Illustration 5: UBS’s Key Performance Indicators
Source: (UBS 2008j)
The different graphics above illustrate the indicators that are used to measure the relation between UBS and its shareholders. As it can be seen, most of these indicators have negative numbers, which means that the value of the shareholders has diminished in the last quarters.
3 Hidden Information
The main motivation of the shareholder in providing capital to UBS is to increase its wealth. However, shareholders do not make the daily operating decisions that affect the performance of the bank. Managers who operate under authority delegated from the shareholders make these decisions. Because of the fact that the shareholders are removed from direct knowledge of what actions the managers are taking on their behalf, there is a risk that the managers will hide some information and will not make decisions that maximize the shareholder’s interest but their own.
An example of hidden information from UBS Management to the shareholders was the severity of the problems faced by the bank. In September 2006, UBS was aware of the first losses arising from the establishment of Dillon Read Capital Management (DRCM). However the bank didn’t disclose this information, until the severity was evident for all. When this project first started, managers knew in a certain way that it would be a big risk for the bank, even though they decided to set it up. They thought that the bank will be capable enough to avoid the risks.
In this same example, other hidden information was the amount of group funds that John Costas, head of investment banking, had at his disposal while running the DRCM. This information went public months later when the bad consequences appeared. UBS didn’t correctly weigh its strength as an organization against the interests and demands of a few individuals, and allowed exceptional levels of authority.
4 Hidden Actions
Shareholders trust UBS to run the company in such a way as to guarantee future prosperity. But shareholders cannot see every movement the UBS’s managers make, nor can they be informed about every accounting change. They are just able to see that the value of their shares diminishes when news breaks. Another hidden action is the risky projects UBS selects and in which the shareholders have no decision. They just see the consequences once the project is finished or failed with deficit.
In 2007 and in relation to the first quarter of 2008, UBS has made several announcements of losses incurred in relation to structuring, trading and investment activities in mortgage and asset-backed securities, in particular with respect to securities referencing US Subprime residential mortgages. UBS's governance problems were hidden by the bull market, this contributed to about CHF 90bn of shareholder value being destroyed over the past few months.
It is believed that poor governance was responsible for the problems because it accommodated those with too great an appetite for risk. “That was borne out in 2005 when John Costas, head of investment banking, was given the remit to set up the proprietary trading operation Dillon Read Capital Management. He came up with the idea of an internal hedge fund that, once it had proved its worth using the bank's own money, would later source funds from shareholders and clients. Although the bank never disclosed the amount of group funds Mr. Costas had at his disposal, the 2006 report and accounts show that CHF 80bn was transferred, via an inter-bank loan, from UBS to DRCM. The problem was that the sought-after high yields of fixed-income securities were largely being made in US sub-prime products - such as those now infamous collateralized debt obligations. DRCM soon began to feel the pain and, by May 2008, it had been shut down after losing CHF 120m of the bank's own money in just three months.” (Telegraph 2008)
5 Adverse Selection
Shareholders cannot adequately verify that the people hired by the bank have the skills or abilities necessary to do the job. They don’t participate in the processes concerning these decisions. In order to have the managers with the necessary skills, UBS needs to stimulate the managers through different incentives, such as bonuses, with which they can feel motivated to work productively. If UBS doesn’t provide its managers with such motivators, they could decide to leave the company and the bank will have only the “bad managers”.
Another assumption of adverse selection in this relationship is that managers are assumed to be rational self-interested performers, meaning that they incline to maximize their own interests by being dishonest, stealing, avoiding, and so forth, at the expense of the shareholders. Managers want to act in their own best interests, however if their interests can be made to coincide with those of shareholders, then by acting for themselves they will be acting for shareholders.
6 Situations of Moral Hazard / Unequal Risk
The conflict between shareholders and UBS becomes evident through some moral hazard problems associated with several inefficient management actions that compile to a decrease in the firm’s value in the market. In this relationship, moral hazard can be observed from two different perspectives, both of them focusing on the attitude of the parties towards risks.
From one side if the bank fails to maximize shareholder’s value, shareholder’s can simply decide to invest somewhere else. This means that if the managers make the wrong decisions and the value of the shares goes down, shareholders will take their capital and invest it in another company, whilst UBS cannot diversify away from specific risk.
On the other hand, managers invest in projects with shareholder’s funds not theirs; therefore they will not have the same attitude as the shareholders towards risk. Managers have nothing to lose and it could be possible that they may expend less effort than is required to maximize the shareholder’s value. They will look for their own benefit, in this case the bonuses, and once they get them they’ll not care about the exit or failure of the project.
7 Proposal to resolve UBS Principal / Agent Problems
As it was shown during the analysis in this chapter, there are some principal agent problems between these two parties. After analyzing the whole situation, some proposals are suggested in order to align the interests between the shareholders and UBS. Some solutions could be:
▪ Review of the Board of Director’s composition, in order to ensure that its members have the skills necessary to ensure the creation of the value for the shareholders. The Board of Directors is the main organ of the bank that ensures the shareholder’s rights; if its members are not capable enough, the interests of the shareholders will not be protected.
▪ Internal and external active control in the actions taken by the bank’s managers regarding the investments realized. The bank should monitor the investment activities realized by the managers to reduce the risk of losses for the both, the bank and the shareholders.
▪ Investment limits, in order to ensure sufficient capital liquidity. As shown in the section of hidden actions, the head of investment banking used the bank’s own money in an excessive way, which resulted in big losses. To prevent this in the future it is recommended to establish a limit on the usage of the funds.
▪ Transparent communication in the investment activities realized by the bank. UBS should create better communications with its shareholders in order to prevent hidden actions problems and insecurities from the shareholder’s side.
▪ Access to financial information to the shareholders. As a solution to have a better relation with the shareholders, UBS should let shareholders know about its current financial situation. Some of the information shown in UBS’s webpage it’s not actualized.
8 Conclusion
Based on the discussion presented in this chapter, it can be concluded that the principal agent framework is a valuable tool to evaluate and analyze the different objectives and interests of the two parties. In this case, UBS has advantages over the shareholders because UBS is in control of the information flow. This means that it is easy for UBS to hold back important data regarding the current stock market situation and therefore can manipulate the shareholders for its own profit.
Even though this principal agent framework accomplishes good results estimating the current situation, it does not provide a concrete action plan. Thus, it is not possible to present a solution to equilibrate the principal’s and agent’s interests based on this model. The presented proposals were inspired by the model however they are of a subjective nature.
General Conclusion
Different parties have different objectives. This fits as well for the principals and agents who have been analyzed in this assignment and is the source of the previously described heterogeneous frictions in every considered relationship. In only one objective exists agreement: the current situation is uncomfortable for all parties and a bankruptcy of UBS would have serious consequences for all involved. Hence one major common goal is to pursue stable financial markets and to return to healthy constant economic growth.
One difficulty during analysis of several relationships in the case of UBS is the definition of UBS and its objectives because UBS can be regarded as UBS’ employees, shareholders or management (who are employees as well). It is not easy to consider UBS AG as a whole and not as its CEO or president of the board of directors and not as some investment bankers driven by inadequate bonuses. UBS AG itself is a legal entity which pursues long-term profits, a good working environment for their employees and continuous growth.
In two of four analyzed relationships the role of the agent is taken by the UBS management, in one by UBS as an employer and in the fourth analysis by UBS company as a whole. The role of the principle is differently shared between customers, SNB and SFBC, employees and shareholders of UBS. Further more, other combination of the considered parties or completely other stakeholders would have been possible, e.g. UBS management related to the customers. At the same time other focuses would have been set for the analysis.
All four different principal agent frameworks show that demand for a more regulated and more transparent environment is present and will be present in the future. New laws which narrow the balance sheet and leverage ratio, the adoption of the Markets in Financial Instruments Directive (MiFID) from the European Union and more rights for shareholders to have input in salary and bonus questions would be a further step in the right direction. At the same moment the existing and new laws and regulation as well as control mechanisms must be consequently applied, monitored and accomplished. Additionally UBS should reduce the complexity of the internal structures and establish better, more transparent communication with its employees, customers and shareholders.
Anyway, the next few months will be essential and challenging for all affected parties: employees are afraid of losing their jobs, shareholders are faced with low share value, customers have to regain the trust in their investment manager and SNB and SFBC tremble in the billions of the UBS package.
The retrieval of trust in the financial market will be crucial for UBS to move towards a successful and sustainable future.
Finally, it can be concluded that the principal agent framework is a valuable tool to help UBS in several areas to conduct an analysis of such a complex cases and even to find proposals to reduce the risks. UBS defiantly profits from such analysis and in addition the principal agent framework does definitely help UBS to adjust the control mechanism between the principals and agents.
Directories / Glossary
In the following chapter the illustration and table directory will be summarized. In addition a glossary about mentioned words in this document are listed.
Illustration Directory
Illustration 1: UBS Share Value over the last 5 Years 7
Illustration 2: Balance Sheet of UBS 11
Illustration 3: CDO Rating, March 2007 Compared with Today’s 12
Illustration 4: UBS Performance Chart (CHF-based, as of December 4, 2008) 16
Illustration 5: UBS’s Key Performance Indicators 26
Table Directory
Table 1 - Glossary 30
Glossary
|Agency fees |Incentives for products sold to reward sales people. |
|Banking Acts and Ordinances |Part of Swiss Banking law |
|Bound price |Price on which a contract is issued |
|bull market |A financial market behavior where the market prices tend to increase. |
|Business groups |Division of UBS structure on highest level. |
|cash drain |Money which investors withdraw from an account, an investment, etc. |
|Collateralized debt obligations |Kind of investment product constructed from a portfolio of fixed-income assets |
|DRCM |Dillon Read Capital Management |
|EPS |Earnings per Share |
|Hedge fund |A private investment fund open to a limited range of investors |
|Index fund |Mutual fund which aims to replicate the movements of an index of a particular financial market (e.g. |
| |Swiss Market Index) |
|Kickbacks |see agency fees |
|lender of last resort |An institution willing to extend credit when no one else will. |
|Mutual fund |A professionally managed type of collective investment scheme which pools money from many investors to |
| |invest in different investment products. |
|Nominee company |A company formed by a bank or other organization which operates nominee accounts that is, the holding of|
| |shares for the beneficial owner. |
|NYSE |New York Stock Exchange |
|slackening market |A financial market behavior where the market prices tend to decrease. |
|Subprime |A Subprime borrower is one who has a high debt-to-income ratio, an impaired or minimal credit history, |
| |or other characteristics that are correlated with a high probability of default relative to borrowers |
| |with good credit history. It is generally accepted that a FICO score less than 620 is considered |
| |Subprime. In addition to having lower FICO scores, Subprime borrowers typically have a loan-to-value |
| |ratio ("LTV") in excess of 80%. |
|Tier 1 |The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets.|
| |Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk |
| |according to a formula determined by the Regulator (usually the country's Central Bank). Most central |
| |banks follow the Bank of International Settlements (BIS) guidelines in setting formulae for asset risk |
| |weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk |
| |weight of 100%. A good definition of Tier I capital is that it includes equity capital and disclosed |
| |reserves. For example UBS had at the 31.12.2007 total assets of about 2272 billion whereas 372 billion |
| |where risk weighted assets. In the same period UBS had an equity capital (Wikipedia, 2008a) |
|Tier 2 |Capital is a measure of a bank's financial strength with regard to the second most reliable form of |
| |financial capital, from a regulator's point of view. (Wikipedia, 2008b) |
|Trustee |A person appointed to manage and safeguard the assets of a trust. |
|Walk away price |Price which the costumer is willing to pay or a company is willing to over before one of the party |
| |dismisses the offer. |
Table 1 - Glossary
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