Credit risk

Limits and controls

The Business Groups and Corporate Center apply disciplined approaches to ensure prompt identification, accurate assessment, proper approval and consistent monitoring and reporting of credit risk. We manage, limit and control concentrations of credit risk wherever we identify them, in particular to individual counterparties and groups, and to industries and countries, where appropriate.

We set limits on our credit exposure to both individual counterparties and counterparty groups. These limits are applied to all exposure types, including the close out exposure on repos and securities borrowing and lending and the maximum likely exposure on OTC derivatives. The Investment Bank also uses, as a management tool, a measure which translates all exposures into a benchmark loan equivalent, taking into account expected changes in exposure profile of traded products and credit rating migration of the counterparty, with the possibility that exposure reduction through syndication, sale or hedging may be required if maximum guidelines are exceeded.

In our OTC derivatives business, we operate almost exclusively under bilateral master agreements allowing for the close out and netting of all transactions in the event of default by the other party. Provided such agreements are judged to be enforceable in insolvency, we measure our exposure after netting values in our favor against values in the counterparty's favor. We can then set limits on the basis of net exposure, permitting higher volumes of business than would be possible without the benefit of netting. The measurement of potential credit exposure (the future evolution of replacement values over time) reflects the step changes that can occur – which can be both increases and decreases – as market risk factors change and as individual transactions or cash flows roll off.

We additionally apply limits in a variety of forms to portfolios or sectors where we consider it appropriate to restrict credit risk concentrations or areas of higher risk, or to control the rate of portfolio growth. Typically, these situations arise in the Investment Bank.

Temporary versus take and hold exposures

In the Investment Bank, where it is most relevant, we differentiate between "temporary" exposures accepted with the intention of syndicating, selling or hedging within a short period, and "take and hold" positions.

For temporary exposures, the critical factor is the potential for distribution, which is rigorously assessed as part of any transaction approval. All commitments must be agreed by the distribution function, as well as the originating business unit, and approved by both business management and risk control. With continued high flows of capital into funds raised by financial sponsors, we have seen further increases in the number, size and leverage of buy-out transactions, which are the source of many of our temporary exposures. As a result, the portfolio has lower average credit ratings and higher risk concentrations than our other lending businesses but exposures are generally reduced to modest levels within a short time by syndication or secondary market hedging or sale. There are comprehensive limits covering the portfolio, including a variety of stress loss limits, which encourage rapid distribution in order to free up capacity for further transactions, and which can be adjusted if market conditions or our own performance suggest that contraction or expansion of activity is appropriate.

For take and hold exposures, by contrast, the quality of the credit over the prospective term of the engagement is the primary credit risk consideration and we assess, on an ongoing basis, the way the credit risk (both in aggregate and in sub-portfolios) is evolving over time. We actively manage this portfolio, which includes the retained portions of loans which we have originated primarily for distribution.

Risk mitigation

We employ risk mitigation techniques for most of our credit portfolios, typically by taking security in the form of financial collateral (cash or marketable securities) or other assets, or through risk transfers or the purchase of credit protection. Credit risk mitigation is reflected – depending on the product and type of mitigation – by recognizing its existence in determining the exposure we are prepared to carry or by directly reflecting its risk-reducing effect in reported credit exposure.

Taking security is the most common form of risk mitigation. Some of our businesses, such as Lombard and mortgage lending, are – by definition – conducted only on a secured basis, but in other businesses we often, as a matter of policy, ask for sufficient security to cover our claims, in particular where we deal with lower rated counterparties. In assessing the mitigating effect of security we always adopt prudent valuation standards.

Where we take financial collateral in the form of marketable securities, we generally apply discounts ("haircuts") to the market value, reflecting the quality, liquidity, volatility – and in some cases complexity – of the individual instruments. Exposures and collateral positions are continuously monitored, and margin calls and close-out procedures are enforced when the market value of collateral falls below predefined levels. Collateral concentrations within individual client portfolios and across clients are also monitored where relevant.

In the Investment Bank's OTC derivative business, we enter into two-way collateral agreements with major market participants, in line with general market practice. Under such agreements, either party can be required to provide financial collateral when exposure exceeds a pre-defined level. Both sides thus benefit from continued flow of business without creating undue concentrations of credit risk. The Investment Bank's traded products business with lower rated counterparties, including hedge funds, is conducted almost entirely against the provision of financial collateral by the counterparty.

Financial collateral is the main form of security for Lombard loans to private individuals by our Wealth Management business units, but the largest secured business of Global Wealth Management & Business Banking is property financing, where we take a mortgage over the property we finance to secure our claim. The majority of our exposure consists of home loans to private individuals, but we also finance income-producing real estate, primarily apartment buildings and, to a lesser extent, commercial properties. In all cases we apply prudent loan to value ratios and consider the ability to service the debt from income. In Business Banking Switzerland, where we lend to corporations of all sizes, we may, depending on our assessment of their creditworthiness, also require our claim to be secured.

The Investment Bank uses risk transfers, purchase of credit protection and securitization as part of its active management of credit risk to avoid concentrations of exposure to individual names or sectors or in specific portfolios. Most of this credit hedging is achieved by transferring underlying credit risk to high-grade market counterparties using single name credit default swaps, executed under bilateral netting agreements and generally also under collateral agreements. We also use credit-pooling vehicles to transfer risk to outside investors via credit linked notes.

Most forms of credit risk mitigation create operational risks. To control these risks, we apply strict standards on legal documentation, including collateral and netting agreements, and robust controls around the large-scale and high volume processes of daily valuation and adjustment of collateral positions.