Banking StandardsWritten evidence from the Financial Services Authority

1. The FSA welcomes the opportunity to supply to the Parliamentary Commission on Banking Standards information relating to the FSA’s dealings with UBS in connection with LIBOR. In this memorandum we set out a narrative account of the FSA’s dealings with UBS in relation to LIBOR and other relevant information, in response to the Commission’s request on 2 January. Our memo includes:

executive summary;

background to LIBOR;

background to the FSA supervision of UBS in the UK;

FSA supervision of UBS in relation to LIBOR;

investigation into UBS’ LIBOR submissions;

current position re LIBOR submissions and UBS;

review by FSA Internal Audit; and

conclusion.

2. This response has been prepared in the short period of time made available to the FSA to enable the Commission to meet its intended timetable for parliamentary hearings. As a result, you should be aware that this note has been prepared on a “best efforts” basis and has not been subject to a detailed review process or audit for factual accuracy. We have relied predominantly on our written records from the period in question, supplemented by the recollection of FSA staff connected to the events where available, but have not had time to interview former staff, review email records or systematically review our files to challenge the narrative presented in this note.

Executive Summary

3. Concerns were raised about LIBOR submissions generally as a result of media articles in the US and an ongoing series of requests for assistance from the CFTC, starting in 2008. The FSA worked closely with the CFTC, exercising its statutory powers under FSMA to gather information about UBS’ (and other firms’) LIBOR submissions. The focus of these initial enquiries was on lowballing as opposed to trader manipulation.

4. UBS delivered information to the FSA in May 2009. Following this, in 2010 the firm commissioned an internal investigation of its LIBOR processes which resulted in UBS reporting in late 2010 that it had discovered indicators of substantial misconduct by traders and submitters in relation to its LIBOR submissions.

5. UBS gave a presentation to the FSA in March 2011 setting out its findings, which led to the firm being referred to the enforcement division very soon after, in April 2011.

6. From this point onwards, the LIBOR issues were mainly handled as an Enforcement issue. Supervisory activities in this period had some bearing on LIBOR given their focus on systems and controls, but were otherwise centred on the series of issues that impacted the firm’s ability to survive the financial crisis, and the need to respond to the underlying causes of these issues.

7. During the period in question, there has also been considerable supervisory focus on the firm’s legal entity structure in the UK and the risks that this presented to UK financial stability if the firm was to fail. This is now part of a wider regulatory effort to improve the resolvability of major firms operating in the UK.

8. Although these have been, and to some degree remain, the supervisory focus for the FSA, we have ensured that the firm has reviewed its systems and controls in relation to LIBOR submissions, and attested to the FSA that any necessary enhancements have been implemented.

9. This issue has been addressed by the recommendations of the Wheatley Review which includes introducing a new regulatory structure for LIBOR, accompanied by criminal sanctions for those who attempt to manipulate it.

10. LIBOR is an industry benchmark outside the regulatory framework and supervised by the British Bankers Association. During the period in question (the “Relevant Period” for the purposes of the FSA’s enforcement action ran from 1 January 2005 to 31 December 2010), whilst there were concerns shared by some market participants that LIBOR was no longer an accurate reflection of the funding costs of banks, it was not considered a high risk that LIBOR was open to manipulation or even likely to be the target of attempts at manipulation or collusion by traders seeking to improve the profitability of their swap books.

Background to LIBOR

11. LIBOR submission is not included within the scope of regulated activities covered by the Financial Services and Markets Act 2000 (“FSMA”). LIBOR itself is an industry developed benchmark rate. It is produced under the auspices of the British Bankers Association (“BBA”) and described by them as

“the primary benchmark for short term interest rates globally and is used as the basis for settlement of interest rate contracts on many futures and options exchanges. It is used in many loan agreements throughout global markets, including mortgage agreements; and is also considered a barometer to measure the health of financial money markets.” 1

12. The BBA is a trade association which is not authorised or regulated by the FSA (or any other body).

13. The BBA goes on to describe LIBOR as being used as:

“… the basis for a range of financial instruments. Derivatives based on LIBOR are now traded on exchanges such as LIFFE and the Chicago Mercantile Exchange (CME) as well as over-the-counter. LIBOR is also used as the basis for many types of lending, from syndicated and commercial lending to residential mortgages.”2

14. The submissions are compiled and monitored by Thompson Reuters which is the “Designated Distributor” of BBA LIBOR. Guidance on the submitting process and on what information should be taken into account by the person making submissions is issued by the BBA. Contributing panel banks are also required to undertake to the BBA that various systems and controls are in place, such as audits of their internal processes and to allow visits from the BBA LIBOR secretariat.

15. The submissions are made by between six and 18 banks for each currency. The individual banks are selected based upon three criteria:

scale of market activity;

reputation; and

perceived expertise in the currency concerned.

16. The submission process is not a regulated activity and is simply ancillary to the firms’ regulated activities. There is no explicit requirement from the BBA for the submitting bank to have a corporate entity in London (although this is likely given the criteria for selection as a panel bank set out above) or that the people making submissions on behalf of the submitting entity are based in London or the UK. Equally, there is no requirement that the submitter is approved by the FSA in any capacity or even working for an FSA regulated entity.

17. In April 2008, the BBA commenced a review of the LIBOR fixing process. The review specifically considered suggestions of inaccuracies regarding submissions in US Dollar (“USD”) LIBOR and a perceived disparity between the published LIBOR rate and the level at which firms could actually borrow.

18. The BBA published its initial consultation document on 10 June 2008. A number of proposals were made in the BBA’s draft consultation including: public communications; broadening or altering the definition of LIBOR; creating a credible oversight body; or ejecting certain panel members. The latter was deemed to have significant challenges especially around reputational risk during a period of intense media speculation. The BBA’s committee opted to “strengthen the oversight of BBA LIBOR”. The FSA’s Markets division (with Banking Sector involvement) discussed the first draft with them, highlighting three areas for attention:

the behaviour of banks in posting LIBOR fixings (ie accuracy of postings);

the process and timeliness of the annual review; and

ongoing monitoring to ensure LIBOR fixings are credible.

19. The FSA recommended explicitly to the BBA that they should look to “utilise mechanisms which will detect several banks collectively (ie as a pack) submitting off-market quotes.” The FSA suggested that these mechanisms could include taking a daily feed of all interbank cash deals traded through the brokers and monitoring in real time the FX swapped rate achievable between the major currencies.

20. The FSA continued to engage with the BBA in its further work on the LIBOR fixing process, particularly on governance and scrutiny. The BBA published a feedback statement on 5 August 2008 and a final paper on governance and scrutiny on 17 December 2008.

21. The FSA considered the BBA’s final paper on governance to have addressed a number of the FSA’s concerns over the governance and scrutiny of LIBOR. The next significant change to the LIBOR process will be the legislative and regulatory changes resulting from the Wheatley Review whose key points include:

statutory regulation of the administration of, and submission to, LIBOR;

a clear set of FCA rules for submitters and administrators of LIBOR, setting systems and controls expectations, conflicts of interest management, record keeping and regular external audits of submitters;

requiring panel banks to submit to LIBOR using an effective methodology with objective criteria and relevant information, in particular supported by transactions in the underlying market wherever possible;

a new code of conduct, developed by the administrator and providing clear guidance to submitters about complying with the FCA’s rules. In particular, it will guide panel banks on transactions that should take into account when making submissions; and

publication of individual LIBOR submission after three months rather than daily.

Background to the FSA Supervision of UBS in the UK

22. UBS operates in the UK predominantly through a branch of the main Swiss bank in the group, UBS AG. This branch provides a broad range of services including investment banking, asset management and wealth management.

23. In addition, the group has a number of subsidiaries incorporated in the UK and authorised to carry on financial services activities in the UK. This includes a series of asset management entities under the ownership of UBS Global Asset Management Holdings Ltd (see diagram below) as well as UBS Securities Limited (“UBSL”).

24. UBSL primarily provides investment banking services. Its main value to the wider group is that, as a UK authorised entity, it is able to take advantage of EEA directives to passport around the EEA providing services in these locations. UBS AG is not able to use these directives as it is incorporated in Switzerland, ie outside the EEA.

Simplified organisation chart for principal UK entities of the UBS group3

25. The consequences of this structure are:

On prudential issues, the prudential standards in the FSA Handbook do not generally apply to the business of UBS AG (Switzerland), other than with respect to liquidity risk in the UBS AG London branch. Instead, the FSA relies upon the prudential oversight carried out by the domestic regulator of UBS AG (Switzerland), the Swiss Financial Market Authority (“FINMA”).

On conduct issues, the London branch of UBS AG is subject to FSA Handbook systems and controls requirements. Conduct of business requirements in relation to the UK branch apply in full, ie these broadly replicate the requirements applying to UK incorporated banks.

UBSL (the UK subsidiary) is subject to full prudential and conduct regulation in the UK, although inevitably there is a degree of reliance on group-wide systems and controls that are monitored by the firm’s home regulator, FINMA. However, because this is a subsidiary any risk is carried in the branch.

General Supervisory Activity 2004-present4

26. Our supervisory activity can be broken down into three distinct periods:

Pre-2007: Prior to 2007 the FSA’s supervisors considered UBS to have adequate systems and controls in relation to those matters of which they had oversight and in relation to the risks they were considering. Reviews in this period highlighted potential enhancements to governance, systems and controls, but UBS was not identified as a high risk bank in either a prudential or conduct context.

2007–2009: In this period, the firm experienced losses of approximately USD 50 billion arising from the subprime crisis, which raised concerns about the firm’s ability to continue business. The focus of the FSA in this period was almost exclusively prudential in nature, with daily liquidity calls taking place with the firm, continuous monitoring of risk positions and capital, and constant dialogue about the changes to governance, strategy and controls required to stabilise the firm and return it to a sustainable path. There was also extensive liaison with overseas regulators given the potential consequences in a number of jurisdictions if the firm was to fail.

2010 onwards: The supervisory agenda continued to be heavily focussed on prudential issues but there was also an increasing focus on conduct issues. Supervisory concerns, on both the prudential and conduct sides, were increasing over this period as was the force with which they were expressed to the firm. Prudential regulation continued to focus on the pressing need to improve systems and controls around prudential matters but the FSA also articulated concerns regarding a need for better controls as conduct issues began to appear, such as the USD 2.3 billion unauthorised trading incident in 2011. A number of these issues, including LIBOR, resulted in referrals to Enforcement. The firm has subsequently undertaken a major review of its operations in the UK and is in the process of downsizing of its fixed income business.

27. A key part of the FSA’s supervisory approach at the time was the Advanced Risk Responsive Operating framework (ARROW) risk assessments which were undertaken during the period (although supervisors did also undertake other work outside of formal risk assessments including in the case of UBS and other banks significant contingency planning in the event the bank failed, and various section 166 reports. The FSA sent letters to UBS after ARROW assessments on 13 January 2005, 4 April 2006, 26 February 2007, 22 June 2010, 14 August 2012 (Prudential Business Unit of the FSA) and 10 September 2012 (Conduct Business Unit of the FSA). In addition’ joint feedback letters were sent following colleges with other regulators. These made a number of recommendations for improvements to systems and controls and corporate governance (with increasing degrees of concern being expressed) but did not make any recommendations regarding LIBOR. The letters have not been included as the information in them is confidential as defined by section 348 of FSMA.

28. The only references to LIBOR in ARROW letters were in the 2010 ARROW letter which made a reference to derivatives priced according to LIBOR (but which does not refer to any manipulation in the LIBOR rate) and the 2012 ARROW letter which was written following the beginning of the enforcement investigation. In a similar fashion, the correspondence between the enforcement team and UBS during the course of the investigation makes numerous references to LIBOR. We have not identified any section 166 reports that refer to LIBOR.5

29. There was a discussion between UBS and the FSA about the appropriateness of UBS’ LIBOR submissions. This was an email record of a daily liquidity update telephone call with UBS on 27 May 2008, during which a media article of the same date was discussed.

FSA Supervision of UBS in Relation to LIBOR

30. The FSA was, at the relevant time, an integrated supervisor responsible for both prudential and conduct supervision (subject to the limitations described above in relation to a non-UK firm).

31. The approach of regulators to prudential and conduct supervision differs. Prudential supervisors consider material within the firm such as its balance sheet and business model to make judgements about its sustainability and future prospects. They also set, often within the context of international requirements or agreements, rules relating to capital and liquidity. As we have previously set out we believe that many of those approaches were, during the relevant period, flawed.

32. The role of a conduct regulator is different. It is not possible for a conduct supervisor to carry out detailed day to day monitoring intended to identify, on a real time basis, inappropriate behaviour of single individuals or a group of individuals within a firm (particularly where some of those may be overseas). Supervisors will, instead, seek to check that there is a reasonable oversight mechanism run by the firm itself, to assess the firm’s overall culture and approach and to undertake review work, whether on a thematic cross firm basis or into an individual risk identified at a specific firm, to look in detail at a particular issue. This is resource intensive and therefore has to be targeted based on the assessment of risks by the supervisor, the firm and/or by issues identified through monitoring of, for example, trade data relating to equities trading in regulated markets. This is dependent on a mechanism for challenging the firm’s oversight processes and a robust enforcement process.

33. As set out above, the priority for FSA supervisors was to engage with the firm to ensure that governance and controls were appropriate and that prudential issues did not lead to large scale failures in relation to regulated business areas. The supervision team covering UBS throughout this period varied in size based on staff turnover and other factors. At its low point, it was around three people, but it generally averaged around four. It is currently staffed with five people within the prudential business unit and two people in the conduct business unit. These figures inevitably created some constraint on the focus that the FSA could put on LIBOR related matters in the period in question.

34. The FSA had no direct remit over the LIBOR process or over the BBA. A distinction can be seen between areas such as markets abuse, where the market itself is regulated by the FSA and the participants—including exchanges and authorised firms—have a duty to report misconduct, and where the FSA and exchanges invest heavily in monitoring the markets and the typical market for products tied to LIBOR which are usually wholesale products. They are often over-the-counter (“OTC”) products and there is no requirement that trading in them is reported to the FSA.

35. Where the FSA has a mandate, for example in the area of market abuse, it establishes a strategy for tackling issues, ranging from thematic work by supervisors to full use of enforcement powers. However, the mandate of the FSA to deal with LIBOR is currently much less direct as it is not a regulated activity and is only within the FSA’s scope by virtue of it being an activity conducted by regulated firms which is ancillary to their regulated activities. The recommendations of the Wheatley review, which are in the process of being implemented, will change this.

36. Once the FSA became aware that there were significant issues with firms’ LIBOR submission process it implemented a series of steps across all panel banks, including UBS.

37. In Autumn 2010, as a result of the information that was being discovered during the Barclays investigation it became apparent that there was a possibility that misconduct may have occurred in relation to broader areas—including currencies other than USD and for reasons other than lowballing (the initial enquiries had been focussed on this issue). As a result, in late 2010 the FSA decided to engage an external firm to undertake an analysis on behalf of the FSA of the submission data in 2007 and 2008 for all panel banks in USD, JPY and Sterling (“GBP”).

38. The purpose of the analysis was to seek to focus further enquiries (bearing in mind that there are many hundreds of LIBOR submissions made every single day) by identifying submissions which may have been inconsistent with other submissions made by the bank or other panel members. The most inconsistent submissions would then be referred to banks with a request for them to explain how the submission had been determined. In January 2011, following a tendering process, Ernst & Young (“E&Y”) were engaged and began the work. This was in parallel to work being undertaken by the firms, using external legal counsel, to review internal communications relating to LIBOR.

39. For UBS 56 submissions (36 JPY, 16 USD and 4 GBP) were identified which appeared anomalous and would have required explanation. However, as UBS had at this stage begun to disclose to the FSA its own evidence of wrongdoing and was being considered for a referral to the FSA’s enforcement division for investigation, a separate explanation was not required but the issues were considered in the context of that investigation.

40. At the same time, whilst the E&Y analysis was being used as an indicator as to which firms might have been involved in inappropriate behaviour in the past, the FSA was concerned to ensure that any misconduct which might have taken place had stopped and would in future be prevented or detected.

41. To that end, UBS (and all other LIBOR panel banks) were requested in February 2011 to attest to the adequacy of their (then) current systems and controls for the determination and agreement of their LIBOR submissions. UBS provided a positive attestation on 31 March 2011.

Investigation into UBS LIBOR Submissions

42. In the second quarter of 2008, a number of media articles were circulated within the FSA which suggested that LIBOR contributor banks including UBS were submitting inappropriate LIBOR fixings. Certain of those articles were summarised in Market Update emails circulated by the Bank of England to its own and FSA staff. 6

43. It is not uncommon where multiple regulators have an interest for one to take the lead initially. There were a number of communications between the FSA and CFTC in relation to LIBOR during 2008 and in October 2008, following those media articles expressing doubts about the accuracy of LIBOR submissions, the CFTC wrote to a number of firms (including UBS) asking them to provide information about their submission process. Because the majority of information was held at the banks’ London branches, on 3 December 2008 the CFTC asked the FSA to gather information to assist regarding firm’s LIBOR submissions. In addition, the FSA wrote to the BBA asking for information about LIBOR.

44. The FSA contacted a number of firms including UBS, requesting that they produce information to the FSA. At that stage the requests were focussed on USD only—and were in fact only sent to firms on the USD panel—and although they covered all LIBOR reporting the principle focus at that time was on “lowballing”—the suggestion that firms might have been making artificially low submissions in order to protect their reputations during the financial crisis.

45. The request to UBS specifically was issued on 11 December 2008.7 A second request was sent by the FSA to UBS on 5 March 2009. The requests comprised schedules of information that the firm was requested to produce and in response to which UBS delivered a very substantial amount of information to the FSA on 22 May 2009.8

46. Throughout 2008 and 2009 the enquiries were primarily focused on gathering and reviewing data and information. The FSA worked closely with the CFTC on these requests and was involved with them in reviewing material.

47. In April 2010, the CFTC requested that UBS, along with other banks, conduct an internal investigation relating to its USD LIBOR practices. During the course of this review UBS discovered indicators of serious misconduct in broader areas than those already under review. This caused the firm to widen the scope of its investigation and to look specifically for wider examples of misconduct and in further currencies.

48. UBS later notified the FSA that it had discovered evidence of more extensive wrongdoing. The firm also notified the FSA that it was making leniency applications to various competition authorities around the world, including the OFT, since the wrongdoing appeared to indicate breaches of various competition laws. Various discussions then ensued between the FSA and competition agencies (such as the OFT and DoJ) and between the firm and the FSA about restrictions imposed on the firm discussing its findings more widely as a condition of its leniency applications.

49. These led to the firm giving the FSA a presentation as to what it had found in shortly before UBS was referred to Enforcement. The investigation began with a scoping meeting on 9 May 2011 which explained to the firm the areas under investigation and how the investigation would proceed.9

50. The FSA Board was informed of the FSA’s investigation into Barclays, and the CFTC and SEC LIBOR investigations, in January 2011. The Board were told that the FSA’s investigations into other firms would take place in stages, with investigation of higher risk firms prioritised.

51. The Board were also told of the decision to engage an external firm to conduct an analysis of LIBOR submissions made between 2007 and 2008, and were told of the plan to require firms to make an attestation over LIBOR controls.

Current Position re LIBOR Submissions and UBS

52. Part of the failings set out in the FSA Final Notice relates to UBS’ failure to implement proper systems and controls, despite a number of internal and external reviews. In particular, reference is made to the fact that UBS Internal Audit reviewed the relevant parts of the firm on a number of occasions and did not recognise the problems which existed.

53. UBS has taken a number of steps to update its processes as set out in the Final Notice. It has also given a series of undertakings to the CFTC regarding future actions in this area.

54. The FSA Board was, in the normal course, kept updated about the overall issues surrounding LIBOR submissions. On 28 April 2011, the Board was provided with an update on the Barclays investigation and told that a formal UBS investigation had begun. A further update on Barclays and UBS was provided in July 2011. UBS has since only been discussed specifically post the referral of UBS to Enforcement, when the Board has been updated periodically on the progress of the investigation.10

Review by FSA Internal Audit

55. As Lord Turner explained in his letter to Andrew Tyrie of 24 July 2012, the FSA’s Internal Audit team has been reviewing the FSA’s records to set out the facts relating to contacts with the FSA or awareness within the FSA on the subject of LIBOR manipulation during the period 2007 to 2008. The period covered by Internal Audit’s review is 1 January 2007 to 31 May 2009 and the focus is on lowballing rather than on the manipulation of LIBOR submissions by traders. Within that period, however, Internal Audit has not found any communications to suggest that the FSA was aware of the manipulation of LIBOR submissions by traders.

56. Internal Audit is currently drafting the report which will be reviewed by the Audit Committee of the FSA Board and will go through a “Maxwellisation” process with key internal and external stakeholders. We aim to provide the final report to the Treasury Select Committee by the end of March 2013.

57. The review does have some overlap with the questions raised in the Parliamentary Commission’s information request in relation to contacts with the FSA from firms (including UBS) and other parties. While the Internal Audit review is not finalised we have, taken into account in preparing this response relevant material arising out of Internal Audit’s review.

Conclusion

58. During the relevant period, the FSA’s supervisory priorities and focus was on matters other than LIBOR given the fact that LIBOR was outside the regulatory framework. Once issues had been identified in relation to LIBOR at UBS, this was handled primarily as an Enforcement matter, whilst supervision remained focused on the ongoing issues with the firm’s business model, strategy, systems and controls, and legal entity structure in the UK.

59. The FSA investigation into UBS’ misconduct revealed serious wrongdoing and we have imposed a very substantial penalty—more than double that of Barclays which was itself nearly double the previously highest penalty. In addition, the FSA is assisting the Serious Fraud Office which has recently commenced criminal investigations into LIBOR related matters (having been previously keeping a “watching brief” following the FSA notifying it of issues relating to LIBOR) and has recently arrested a number of people in connection with those investigations.

60. In light of concerns that now exist regarding the integrity of LIBOR, a review of LIBOR was undertaken by FSA Managing Director Martin Wheatley at the request of the Chancellor. The Wheatley Review’s final report in September 2012 outlined a plan to comprehensively reform the setting and governance of LIBOR. A key recommendation was bringing LIBOR-related activity within the regulatory perimeter. As a result, the Government has inserted the appropriate clauses in the Financial Services Act 2012 and respective secondary legislation to create two new regulated activities: “providing information in relation to a regulated benchmark” and “administering a regulated benchmark”. In the first instance, the only regulated benchmark will be LIBOR, but an IOSCO report—co-chaired by Martin Wheatley and Gary Gensler of the CFTC is also considering other important benchmarks.

7 January 2013

1 http://www.bbalibor.com/bbalibor-explained/faqs

2 http://www.bbalibor.com/bbalibor-explained/faqs

3 The chart above includes the principal regulated entities of the UBS group operating in the UK. All of the entities are regulated by the FSA other than the two asset management holding companies shown.

4 This section is intended to answer Q6 – supervisory steps taken by FSA in relation to UBS in response to information about UBS conduct in relation to LIBOR

5 Answer to Q7 and Q9 – references to LIBOR in FSA correspondence with UBS on ARROW or Risk Mitigation Programmes or s.166 reports

6 Answer to Q7, 8 and 9 – references to LIBOR in correspondence with UBS

7 Answer to Q3 – steps taken by FSA in response to communications from CFTC about UBS conduct in relation to LIBOR; plus see following paragraphs

8 Answer to Q2 – information provided to the FSA about UBS’ conduct; plus see following paragraphs

9 Answer to Q5 – date on which enforcement action began

10 Answer to Q10 – FSA board papers that refer to UBS conduct in relation to LIBOR

Prepared 19th June 2013