The Union Bank of Switzerland (UBS) says "unauthorised trading" by a staff member has cost it about $2bn in losses in this year's second fiscal quarter.
Police in London said they had arrested a 31-year-old man on suspicion of fraud, but did not confirm whether it was in relation to the UBS case.
British media have named the trader as Kweku Adoboli. UBS has declined to confirm his name.
UBS, Switzerland's largest bank, also said in a statement on Thursday that it may post a loss for the third quarter as well.
"UBS has discovered a loss due to unauthorised trading by a trader in its investment bank,'' it said.
The announcement sent UBS shares falling more than eight per cent in early trading on the Zurich stock exchange. By mid-morning shares were down five per cent at 10.38 Swiss francs ($11.83). It eventually closed at 9.75 Swiss francs ($11.23), down minus 10.8 per cent at the end of the day.
The bank provided little information on the unauthorised trading, saying it was still under investigation. But it also said that no customer money was affected.
"UBS's current estimate of the loss on the trades is in the range of $2bn," it said. "It is possible that this could lead UBS to report a loss for the third quarter of 2011."
Yves Kaufmann, a UBS spokesman, declined to say where the unidentified trader was based, or whether UBS had pressed criminal charges against its employee.
Any losses in its investment bank risk scaring the bank's rich clients and a further flight from its huge private bank, the core of its business.
UBS's loss caused shock among market operators, coming so soon after Jerome Kerviel, former trader of Societe Generale, the largest European bank based in Paris, racked up a $6.7bn loss in unauthorised deals.
SocGen unveiled the loss in 2008. Kerviel was sentenced to three years in prison in October 2010.
UBS has in the past two years tried to rebuild the investment bank that nearly felled it during the financial crisis, when losses on US subprime mortgage-related securities led it to a state bailout.
"UBS has had a real tough times in recent years, and they have been working really hard to rebuild the bank and win back clients," Kevin Dunning, an economist in London told Al Jazeera. "The Swiss banking system has prided itself on being a conservative, safe place to bank, and this incident is very embarrassing for them."
The Swiss bank has hired hundreds of traders, in a bid to boost its bond business, but the weak performance of the unit and tough capital rules in Switzerland had already caused intense scrutiny over how UBS will cope, with analysts calling for a retrenchment of the investment bank.
UBS had started to see client confidence return this year after it had to be rescued by the Swiss state in 2008 following massive losses on toxic assets held by its investment bank.
UBS said last month it was to cut 3,500 jobs to save $2.3bn off annual costs as it joined rivals in reversing a post-crisis hiring binge and preparing for a tough few years.