Investment Bank

Huw Jenkins | Chairman and CEO Investment Bank

In 2006, the Investment Bank's pre-tax profit was CHF 5,943 million, up 15% from a year earlier. Revenues increased in all three business areas, particularly in equities and investment banking. This was matched by higher costs, for both personnel and general and administrative expenses, as we continued to expand our range of products and services.

Components of operating income

The Investment Bank generates operating income from:

– commissions on agency transactions and spreads or markups on principal transactions;

– fees from debt and equity capital markets transactions, leveraged finance, and the structuring of derivatives and complex trans- actions;

– mergers and acquisitions and other advisory fees;

– interest income on principal transactions and from the loan portfolio; and

– gains and losses on market making, proprietary, and arbitrage positions.

As a result, operating income is affected by movements in market conditions, interest rate swings, the level of trading activity in primary and secondary markets and the extent of merger and acquisition activity. These and other factors have had, and may in the future have, a significant impact on results of operations from year to year.

2006

Key performance indicators

The cost / income ratio rose to 72.9% in 2006 from 70.5% a year earlier. The increase in performance-related personnel expenses and higher general and administrative expenses was only partly offset by revenue growth in all of our three businesses.

The full-year compensation ratio, at 52.3%, fell 0.8 percentage points between 2005 and 2006. Higher revenues more than offset higher performance-related compensation and increased staff levels.

Average Value at Risk (VaR – 10-day, 99% confidence, 5 years of historical data) increased to CHF 420 million, up from CHF 346 million in 2005. Year-end VaR was also higher at CHF 473 million, up from CHF 355 million a year earlier, following the integration of Pactual from 1 December 2006.

Total gross lending portfolio at the Investment Bank was CHF 134 billion on 31 December 2006 compared with CHF 97 billion on 31 December 2005, reflecting our expanding prime brokerage and exchange traded derivatives businesses. The gross impaired lending portfolio to total gross lending portfolio ratio fell to 0.1% from 0.2% in the same period.

The return on allocated regulatory capital was 29.4% in 2006, up from 28.6% a year earlier, reflecting the increase in profit. Risk-weighted assets grew, mainly driven by higher credit exposures from OTC derivatives, collateral trading and the leveraged finance portfolio, in line with the rise in business activity. Goodwill and excess intangible assets rose compared with last year due to the acquisitions of ABN AMRO's futures and options business and Pactual.

Results

This was our most profitable year ever. Pre-tax profit in 2006 was CHF 5,943 million, up 15% from 2005. This result was driven by strong revenues in equities (up 35%), due to the improved market conditions starting in second half 2005 and continuing throughout 2006. It was also helped by our investment banking business (up 31%), which saw strong performances across all regions. The increase in fixed income, rates and currencies (up 14%) reflects progress in our plan to expand our global syndicated finance, mortgage-backed securities, structured credit and commodities businesses as well as strong revenues in foreign exchange and cash and collateral trading. DRCM‘s business activities ­managed on behalf of the Investment Bank achieved revenues at a level consistent with 2005. We also invested in our IT infrastructure and incurred more professional fees.

Operating income
Total operating income in 2006 was CHF 21,787 million, up 25% from CHF 17,484 million a year earlier.

Equities revenues, at CHF 9,397 million in 2006, were up 35% from CHF 6,980 million in 2005. Overall, cash equity revenues were higher, with results benefiting from positive market conditions generating strong revenues in emerging markets. Increased cash commissions were partially offset by greater facilitation requirements from our clients. Revenues in our derivatives business increased globally due to higher business demand. Equity capital markets revenues rose with increased capital raising activities. Prime brokerage services continued to grow as client numbers and balances increased. Exchange-traded derivatives revenues rose, boosted by the impact of the acquisition of ABN AMRO's global futures and options business towards the end of the year. Our proprietary as well as our equity-linked businesses contributed also higher returns compared to the previous year.

Fixed income, rates and currencies revenues were CHF 9,056 million, up 14% from CHF 7,962 million a year earlier. Revenues in the rates business were up against the prior year as a result of higher revenues in energy trading and mortgage backed securities, partially offset by lower income from derivatives. Credit fixed income saw strong growth in structured credit and secondary loan activity. Syndicated finance also recorded higher income as the business benefited from increased market activity. Credit default swaps hedging loan exposures recorded a loss of CHF 245 million compared with gains of CHF 103 million a year earlier. While municipal securities revenues were lower in 2006, the foreign exchange and cash collateral trading business, especially the metals business, saw a significant increase in revenues.

Investment banking revenues, at CHF 3,273 million in 2006, increased 31% from CHF 2,506 million a year earlier. This reflected growth in each region, especially in Asia. The debt and equity capital markets groups reported significant gains over the prior year. Our leveraged finance franchise continued to grow, demonstrating our strengthened commitment to this part of the business. Revenues from the advisory business also increased compared with last year, as clients took advantage of strategic opportunities.

Operating expenses
Operating expenses rose by CHF 3,541 million to CHF 15,844 million in 2006, a 29% increase from CHF 12,303 million a year earlier.

Personnel expenses, at CHF 11,353 million in 2006, increased 23% from a year earlier, reflecting an increase in the bonus accrual and additional salaries due to higher staff ­levels. Share-based compensation rose 30% from prior year as a result of higher share awards in 2006, and the increased fair value of options granted in 2006 – driven by the rise in UBS's share price.

General and administrative expenses were CHF 3,260 million in 2006, up 47% from 2005's CHF 2,215 million. In 2006 we recorded a number of new provisions. IT and other outsourcing costs as well as professional fees rose, driven by higher project spending in support of future business growth in fixed income, prime brokerage and emerging markets. Administration, travel and entertainment and, to a lesser extent, occupancy expenses, increased as well. Provision levels in 2006 rose from 2005.

Charges from other business units increased to CHF 956 million in 2006 from CHF 640 million in 2005. The rise reflects the charges by Global Asset Management for managing the Investment Bank's funds invested in DRCM as well as higher charges from ITI (IT infrastructure unit) as a result of the increased levels of staff.

Depreciation rose by 49% to CHF 203 million in 2006 from CHF 136 million in 2005 due to higher IT write-offs, office expansion and renewal costs.

The amortization of intangible assets, at CHF 72 million in 2006, was up 36% from CHF 53 million a year earlier due to the two acquisitions – ABN AMRO's futures and options business and Pactual.

2005

Key performance indicators

The cost / income ratio fell to 70.5% in 2005 from 71.3% a year earlier. Revenue growth, driven by strong performances in investment banking and equities, was partly offset by higher personnel expenses.

The full-year compensation ratio, at 53.1%, rose 2.4 percentage points between 2004 and 2005. This reflects higher performance-related compensation and increased staff levels. Share-based compensation was also higher, since awards made in 2005 for the 2004 financial year contained an increased proportion of stock.

Market risk for the Investment Bank, as measured by the 10-day 99% Value at Risk (VaR), ended the year at CHF 355 million and averaged CHF 346 million for 2005, a slight increase on the 2004 year-end value of CHF 332 million but below the 2004 average of CHF 358 million.

The total gross lending portfolio was CHF 97 billion on 31 December 2005 compared with CHF 78 billion on 31 December 2004, reflecting our expanding prime brokerage and equity finance businesses as well as increased underwriting activity. The gross impaired lending portfolio to total gross lending portfolio ratio fell to 0.2% at the end of 2005 from 0.5% on 31 December 2004.

The return on allocated regulatory capital in 2005 was 28.6%, down 1.9 percentage points from the return of 30.5% a year earlier, despite the growth in pre-tax profit. This reflects the 30% increase in risk-weighted assets which rose due to currency movements and in line with increased lending activity to the Investment Bank's growing client base.

Results

Pre-tax profit was CHF 5,181 million, up 12% from 2004. The result was driven by strong revenues in investment banking (up 31%) and in equities (up 18%), reflecting our successful expansion in significant growth areas such as M&A, in particular in Asia Pacific, equity derivatives and prime brokerage. Results in the fixed income, rates and currencies business were slightly lower than last year. Lower revenues in structured credit – mainly driven by lower volumes and following the turmoil in the automotive sector in second quarter 2005 – were offset by an increase in the rates business. At the same time, costs increased as our business continued to expand, partially offset by the cessation of goodwill amortization.

Operating income
Total operating income in 2005 was CHF 17,484 million, up 9% from CHF 16,083 million a year earlier.

Equities revenues, at CHF 6,980 million in 2005, were up 18% from CHF 5,906 million in 2004. Significant drivers of the increase were the derivatives business in the Asia Pacific region and Europe as well as prime brokerage, where we saw an impressive revenue gain in the US. Our proprietary and equity-linked businesses contributed slightly lower returns than the previous year.

Fixed income, rates and currencies revenues were CHF 7,962 million, down 4% from CHF 8,269 million a year ­earlier. Revenues in the rates business were up against the prior year as a result of rising revenues in energy trading and derivatives. Credit fixed income saw lower revenues in structured credit, notably in the US and in credit trading as well as in the high-yield sector. Credit default swaps hedging loan exposures recorded gains of CHF 103 million compared with losses of CHF 62 million a year earlier.

The foreign exchange business decreased as derivatives trading was negatively impacted by historically low vola­tility levels. This was partially offset by rising cash and collateral trading revenues due to higher market share and volumes.

Investment banking revenues, at CHF 2,506 million in 2005, increased 31% from CHF 1,915 million a year earlier. This reflected growth in each region. Advisory revenues grew significantly, in line with the strong momentum in the M&A business and our increased presence in important transactions. During 2005, our Investment Bank advised on a total of 343 transactions with a deal volume of USD 496 billion, more than doubling from a year earlier. Revenues in the capital markets business rose as well, mainly in debt underwriting and in global syndicated finance, reflecting improved market conditions and our strengthened competitive position.

Operating expenses
Higher personnel costs and increased allocated costs ­prompted total operating expenses in 2005 to rise to CHF 12,303 million, a 7% increase from CHF 11,473 million a year earlier.

Personnel expenses, at CHF 9,259 million in 2005, increased 14% from a year earlier, reflecting an increase in the bonus accrual and additional salaries from higher staff levels. Share-based compensation rose 17% from prior year due to an increase in share-based awards and the higher UBS share price in 2005 compared with 2004.

General and administrative expenses were CHF 2,215 million in 2005, down 13% from 2004's CHF 2,538 million. Provisions were lower than in 2004, when we recorded a civil penalty levied by the Federal Reserve Board relating to our banknote trading business. This was partially offset by an increase in IT and other outsourcing costs. Services from other business units increased to CHF 640 million in 2005 from CHF 226 million in 2004. Depreciation eased 44% to CHF 136 million in 2005 from CHF 243 million in 2004 due to the transfer of further IT infrastructure functions into our central ITI unit in Corporate Center. There was no amortization of goodwill in 2005, following a change in accounting. In 2004, amortization of goodwill totaled CHF 278 million. Amortization of intangible assets was CHF 53 million in 2005, up 47% from CHF 36 million a year earlier due to the inclusion of the rest of Brunswick and the capital markets division of Charles Schwab, acquired in third quarter 2004, and the purchase of our remaining stake in Prediction, which became part of UBS in 2005.