Credit risk

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 under "Portfolio risk measures". 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 on page 74 / 75 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 2006, we experienced a net credit loss recovery of CHF 156 million, compared to a net credit loss recovery of CHF 375 million in 2005. This result reflects the favorable credit market environment that has prevailed over a prolonged period. World economic growth continued to be robust, despite a moderate slowdown in the US. Credit spreads remained very tight in almost all major developed and emerging capital markets, as healthy expansion of cash flows allowed the corporate sector to reduce leverage and build liquidity. The ongoing positive macro-economic environment in key emerging markets allowed the release of CHF 48 million of collective loan loss provisions for country risk.

Net credit loss recovery at Global Wealth Management & Business Banking amounted to CHF 109 million in 2006 compared to net credit loss recovery of CHF 223 million in 2005. The benign credit environment in Switzerland, where the corporate bankruptcy rate continued to fall in 2006, coupled with the measures taken in recent years to improve the quality of our credit portfolio has again resulted in a low level of new defaults. The management of our impaired portfolio, which continues to shrink, has also contributed to this result.

The Investment Bank realized a net credit loss recovery of CHF 47 million in 2006, compared to a net credit loss recovery of CHF 152 million in 2005. This continued strong performance was the result of further recoveries of previously established allowances and provisions from the workout of the impaired portfolio, and no new defaults in 2006.

Impaired loans, allowances and provisions

As shown in the table on page 74 / 75, allowances and pro­visions for credit losses decreased by 25%, to CHF 1,332 million on 31 December 2006 from CHF 1,776 million on 31 December 2005. Note 10b to the financial statements provides further details of the changes in allowances and provisions for credit losses 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 2006 amount to CHF 38 million.

Impaired loans have decreased to CHF 2,628 million on 31 De­cember 2006 from CHF 3,434 million on 31 December 2005.

The ratio of the impaired lending portfolio to the total lending portfolio (both measured gross) has improved continuously over recent years to 0.7% on 31 December 2006 from 1.1% on 31 December 2005 and 1.7% on 31 December 2004. This continuing positive trend is testament to our success in applying stringent risk management and control throughout the firm, resulting in relatively few new impairments, and to our efforts to conclude proceedings and reach settlement on existing impaired 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 allowances 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.

The table above right shows the geographical breakdown and aging of our impaired assets portfolio on 31 December 2006. This portfolio includes not only impaired loans, but also impaired off-balance sheet claims and defaulted derivatives contracts, which are subject to the same workout and recovery processes. CHF 1.9 billion, or 66% of the gross portfolio of CHF 2.9 billion, relates to positions that defaulted more than three years ago, reflecting the benign environment across global credit markets in recent years. After deducting allocated specific allowances, provisions and valuation reserves of CHF 1.4 billion and the estimated liquidation proceeds of collateral (predominantly Swiss real estate) of CHF 1.1 billion, net impaired assets amounted to CHF 0.4 billion.