Credit risk

Credit loss expense

Our financial statements are prepared in accordance with IFRS, under which credit loss expense charged to the financial statements in any period is the sum of net allowances and direct write-offs minus recoveries arising in that period, i.e. the credit losses actually incurred. By contrast, in our internal management reporting and in the management discussion and analysis section of our financial report, we measure credit loss expense based on the expected loss concept described on page 58. To hold the Business Groups accountable for credit losses actually incurred, we additionally charge or refund them with the difference between actual credit loss expense and expected loss, amortized over a three-year period. The difference between the amounts charged to the Business Groups (“adjusted expected credit loss_) and the credit loss expense recorded at Group level is reported in Corporate Center (see note 2 to the financial statements).

The table below shows both credit loss expense recorded under IFRS, and the adjusted expected credit loss charged to the Business Groups. The discussion which follows covers only the credit loss expense recorded under IFRS.

In 2005, we experienced a net credit loss recovery of CHF 375 million, compared to net credit loss recovery of CHF 241 million in 2004 and net credit loss expense of CHF 102 million in 2003. Releases in country allowances and provisions of CHF 118 million reflected the generally positive macro-economic environment in key emerging markets. This favorable result was achieved in a period which saw a benign environment for credit markets globally. Economic expansion in the US provided a strong stimulus for growth worldwide. Almost without exception, credit spreads contracted in all the major developed and emerging capital markets, as healthy expansion of cash flows allowed the corporate sector to de-leverage and build liquidity.

Net credit loss recovery at Global Wealth Management & Business Banking amounted to CHF 223 million in 2005 compared to net credit loss recovery of CHF 94 million in 2004 and net credit loss expense of CHF 70 million in 2003. The benign credit environment in Switzerland where the corporate bankruptcy rate has receded in 2005 coupled with the measures taken in recent years to improve the quality of our credit portfolio have resulted in a continued low level of new defaults while our success in managing the impaired portfolio has resulted in a higher than anticipated level of recoveries.

The Investment Bank realized a net credit loss recovery of CHF 152 million in 2005, compared to net credit loss re- covery of CHF 147 million in 2004 and credit loss expense of CHF 32 million in 2003. This continued strong performance was the result of minimal exposure to new defaults and strong recoveries of previously established allowances and provisions, as we actively sold impaired assets at better than anticipated terms.

Impaired loans, allowances and provisions

As shown in the table below, allowances and provisions for credit losses decreased by 36.5%, to CHF 1,776 million on 31 December 2005 from CHF 2,797 million on 31 December 2004. Note 9b to the financial statements provides further details of the changes in allowances and provisions during the year. In accordance with IAS 39, we have assessed our portfolios of claims with similar credit risk characteristics for collective impairment. Allowances and provisions for collective impairment on 31 December 2005 amount to CHF 86 million, including CHF 48 million in allowances and provisions for country risk. Total allowances and provisions related to emerging market exposures were CHF 65 million on 31 December 2005, compared to CHF 183 million on 31 December 2004.

Impaired loans have decreased to CHF 3,434 million on 31 December 2005 from CHF 4,699 million on 31 December 2004. Over the same period, non-performing loans have also decreased, to CHF 2,363 million from CHF 3,555 million on 31 December 2004.

The ratio of impaired loans to total loans has improved continuously over the past years to 1.1% on 31 December 2005 from 1.7% on 31 December 2004 and 2.8% on 31 December 2003, while the non-performing loans to total loans ratio improved to 0.8% on 31 December 2005 from 1.3% on 31 December 2004 and 1.9% on 31 December 2003. This continuing positive trend is testament to our success in applying stringent risk management and control throughout the firm, resulting in relatively few new impaired and non-performing loans, and to our efforts to conclude proceedings and reach settlement on existing non-performing loans.

In general, Swiss practice is to write off loans only on final settlement of bankruptcy proceedings, sale of the underlying assets, or formal debt forgiveness. By contrast, US practice is generally to write off non-performing loans, in whole or in part, much sooner, thereby reducing the amount of such loans and corresponding provisions recorded. A consequence of applying the Swiss approach is that, for UBS, recoveries of amounts written off in prior accounting periods tend to be small, and the level of outstanding impaired loans and non-performing loans as a percentage of gross loans tends to be higher than for our US peers.

As explained on page 66, we subject all impaired claims, regardless of their accounting treatment, to the same work-out and recovery processes. The table above right sets out our portfolio of impaired assets, comprising impaired loans, impaired off-balance sheet claims and defaulted derivatives contracts by geographical area and by aging on 31 December 2005. CHF 2.2 billion, or 59% of the gross portfolio of CHF 3.7 billion relates to positions that defaulted more than three years ago, reflecting the benign environment across global credit markets in recent years. Considering allocated specific allowances, provisions and valuation reserves of CHF 1.8 billion plus the estimated liquidation proceeds of collateral (predominantly Swiss real estate property) of CHF 1.4 billion, net impaired assets amounted to CHF 0.5 billion.