Risk Management and Control

The problems which surfaced in the US sub-prime mortgage market in the first two quarters spilled over into markets more broadly from late July through August. Credit markets saw a "flight to quality". Rapid de-leveraging by some market participants resulted in intra-market dislocations, particularly in equities, and central banks intervened to counter the general drying up of liquidity. Primary market activity was minimal for most of August and, while the equity and corporate debt markets had broadly recovered by quarter end, the securitization market remained closed. Against this background, credit spreads on the highest rated (AAA) home equity products reached unprecedented levels with associated increases in volatility, and there was severe dislocation between cash and derivatives sectors. While moves in other markets were within historical ranges, there was an increase in volatility compared with the most recent periods of relatively benign conditions.

Investment Bank Value at Risk (VaR-10-day, 99% confidence based on 5 years of historical data) ended the quarter at CHF 676 million, up from CHF 454 million at the prior period end, mainly driven by increased market volatility. The largest contributor to Investment Bank VaR at quarter end was credit spread on mortgage-related positions.

Average 10-day VaR, by contrast, was lower at CHF 447 million compared with CHF 520 million in second quarter. The change in market conditions, which began in August, is only partly reflected in third quarter average VaR - the full impact will not be felt until fourth quarter.

"Backtesting" compares 1-day VaR calculated on positions at the close of each business day with the revenues arising on those positions on the following business day (excluding intraday trading revenues, fees and commissions). In the first histogram on the left below, daily backtesting revenues are shown alongside full revenues for the 12 months ended in September 2007. In the second histogram we compare the daily backtesting revenues with the corresponding VaR over the same 12-month period, for days when the backtesting revenues are negative. When backtesting revenues are negative and greater than the previous day's VaR, a "backtesting exception" occurs.

In third quarter we suffered our first backtesting exceptions - 16 in total - since 1998. Given market conditions in the period, the occurrence of backtesting exceptions is not surprising. Moves in some key risk factors were very large, well beyond the maximum level expected statistically with 99% confidence. Some of the negative backtesting revenues resulted from ‘jump events' which reflect either a step change in market conditions, such as the mass downgrade of highly rated home equity-related securities, or the cumulative impact over several days or weeks of new information and change of conditions in markets with diminished liquidity. Since VaR is derived from historical market data, it is not expected to predict the losses seen in unusual stressed conditions of this type - which is why we do not rely on VaR alone but, rather, on a wider framework including stress loss measures and other controls. As always, however, we learn from experience and especially from extreme events, such as we have seen this quarter. Consistent with our philosophy of continuous improvement, we are reviewing all aspects of market risk measures and processes to further strengthen the framework, including stress loss and concentration controls and the dimensions in which we aggregate risk to identify potentially highly correlated exposures.

Average VaR for UBS as a whole decreased to CHF 444 million from CHF 518 million in the previous quarter. Once again, Corporate Center exposures have tended to provide some offset to Investment Bank positions, and UBS VaR was slightly lower than Investment Bank VaR on a number of occasions.