UBS has identified the following contributory factors related to compensation and incentives:
• Structural incentives to implement carry trades: The UBS compensation and incentivisation structure did not effectively differentiate between the creation of alpha (i.e., return in excess of a defined expectation) versus the creation of return based on a low cost of funding. In other words, employee incentivisation arrangements did not differentiate between return generated by skill in creating additional returns versus returns made from exploiting UBS's comparatively low cost of funding in what were essentially carry trades. There are no findings that special arrangements were made for employees in the businesses holding Subprime positions. However, the relatively high yield attributable to Subprime made this asset class an attractive long position for carry trades. Further, the UBS funding framework amplified the incentives to pursue compensation through profitable carry trades. For example, several Super Senior trades had relatively thin overall positive carry.
• Asymmetric risk / reward compensation: The compensation structure generally made little recognition of risk issues or adjustment for risk / other qualitative indicators (e.g. for Group Internal Audit ratings, operational risk indicators, compliance issues, etc.). For example, there were incentives for the CDO structuring desk to pursue concentrations in Mezzanine CDOs, which had a significantly higher fee structure (approximately 125-150 bp) than High-Grade CDOs (approximately 30-50 bp). Similarly, the CDO desk had an incentive to pursue AMPS trades, as they provided, compared to NegBasis trades, a less expensive (and therefore higher return) form of hedging. Also, Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created. The reluctance to allow variations between financial reporting and management accounting made it less likely that options to vary the revenue attributed to traders for compensation purposes would be considered.
• Insufficient incentives to protect the UBS franchise long-term: Under UBS’s principles for compensation, deferred equity forms a component of compensation that generally increases with seniority. Although incentivisation of employees broadly builds in increasing levels of deferred equity for increasingly senior people, it remains the case that bonus payments for successful and senior IB Fixed Income traders, including those in the businesses holding Subprime positions were significant. Essentially, bonuses were measured against gross revenue after personnel costs, with no formal account taken of the quality or sustainability of those earnings.
Wednesday, 23 April 2008
UBS and the pay problem
It was interesting to see UBS publish its special audit (called for by activist shareholders). I have only skim-read the report, but it's notable that they blame their own remuneration policies for incentivising the wrong kind of behaviour. You can download it here, below are the conclusions from the 'compensation' section (page 41 onwards).