Credit risk

Components of credit risk

Credit risk exists in every credit engagement. In measuring credit risk at a counterparty level we reflect three components:

– the "probability of default", which is an estimate of the likelihood of the client or counterparty defaulting on its contractual obligations

– the current exposure to the counterparty and its likely future development, from which we derive the "exposure at default" and

– the likely recovery ratio on the defaulted claims, based on which we derive the "loss given default".

These components are the common basis for internal measurement of credit risk in all our portfolios. They are also the basis for the regulatory capital calculation under the Advanced Internal Rating Based approach of the new Basel Capital Accord, which we intend to adopt when it comes into force in 2008. In line with our own internal governance standards and the requirements of the new regulatory capital framework, we subject all models developed for credit risk measurement, including the components of such measures, to independent verification by a specialist team in Corporate Center prior to implementation. The model owners in the Business Groups are responsible for monitoring per­formance once the models are deployed.

Probability of default

We assess the likelihood of default of individual counterparties using rating tools tailored to the various categories of counterparty. At the Investment Bank, rating tools are differentiated by broad segments. Our Swiss banking portfolio includes exposures to both larger and small- and medium-sized enterprises, and the rating tools vary accordingly. All rating tools have been developed internally and combine statistical analysis with credit officer judgment. Clients are segmented into 15 rating classes, two being reserved for cases of impairment or default. The UBS rating scale, which is shown above, reflects not only an ordinal ranking of our counterparties, but also the range of default probabilities defined for each rating class. This means that, in principle, clients migrate between rating classes as our assessment of their probability of default changes. We regularly validate the performance of our rating tools and their predictive power with regard to default events. Where statistical analysis suggests that the parameters of a model require adjustment, we reflect such changes in our external reporting once the recalibration of the rating tool is confirmed and implemented. In the interim, we account for the impact of such changes in our internal credit risk measures.

We use external ratings, where available, to benchmark our internal credit risk assessment. The ratings of the major rating agencies shown in the table above are linked to our rating classes based on the long-term average default rates for each external grade. Observed defaults per agency rating category vary year-on-year, especially over an economic cycle, and therefore UBS does not expect the actual number of defaults in its equivalent rating band in any given period to equal the rating agency average. As we validate our own internal rating tools for their ability to predict defaults, we also monitor long-term average default rates associated with external rating classes. If we observe that these long-term averages have changed, we adjust the mapping of the external ratings to our rating scale, and reflect them in our external reporting once our analysis proves that the changes are material and permanent.

Exposure at default

Exposure at default is based on the amounts we expect to be owed at the time of default. For a loan this is the face value. For a commitment, we include any amount already drawn plus the further amount which may have been drawn by the time of default, should it occur. For repos and securities borrowing and lending transactions, we assess the net amount which could be owed to or by us following adverse market moves over the time it would take us to close out all transactions ("close out exposure"). Exposure on OTC derivative transactions is determined by modeling the potential evolution of the value of our portfolio of trades with each counterparty over its life – "potential credit exposure" – taking into account legally enforceable close-out netting agreements where applicable. From this model we can derive both an "expected future exposure" profile and a "maximum likely exposure" profile measured to a specified confidence level. These profiles reflect potential changes in exposure over time resulting from market movements and from maturing contracts, and take into account the ability to call collateral and any collateral actually held.

Loss given default

Loss given default (LGD) or loss severity represents our expectation of the extent of loss on a claim should default occur. It is expressed as percentage loss per unit of exposure and typically varies by type of counterparty, type and seniority of claim, and availability of collateral or other credit mitigation.