Credit risk

Credit risk is the risk of financial loss resulting from failure by a client or counterparty to meet its contractual obligations to UBS. This can be caused by factors directly related to the counterparty, such as business or management problems, or from failures in the settlement process, for example on foreign exchange transactions where UBS has honored its obligation but the counterparty fails to deliver the counter-value ("settlement risk"). Alternatively, it can be triggered by economic or political difficulties in the country in which the counterparty or issuer of the security is based or where it has substantial assets ("country risk").

Sources of credit risk

Credit risk is inherent in traditional banking products such as loans, commitments to lend and contingent liabilities (for example, letters of credit) as well as in "traded products": derivative contracts such as forwards, swaps and options; repurchase agreements (repos and reverse repos); and securities borrowing and lending transactions. The risk control processes applied to these products are fundamentally the same, although the accounting treatment varies, as they can be carried at amortized cost or fair value, depending on the type of instrument and, in some cases, the nature of the exposure.

Many of the business activities of Global Wealth Management & Business Banking and the Investment Bank expose UBS to credit risk, while credit risk exposure is a less material concern to Global Asset Management. Global Wealth Management & Business Banking offers private and corporate customers in Switzerland and wealth management clients internationally a variety of credit products, although the majority of credit risks are well secured by financial collateral or other assets. The Investment Bank gives corporate, institutional, intermediary and alternative asset management clients access to a full range of credit and capital markets instruments across all product classes, and engages with other professional counterparties in its trading and risk management activities.

Credit risk control

Limits and controls

Concentrations of credit risk can arise if clients are engaged in similar activities, or are located in the same geographical region or have comparable economic characteristics such that their ability to meet contractual obligations would be similarly affected by changes in economic, political or other conditions. To avoid, as far as possible, undue credit risk concentrations, UBS has established limits and operational controls to constrain credit exposure to individual counterparties and counterparty groups. Where appropriate, it has also established industry and country limits and guidelines at portfolio and sub-portfolio levels.

At the level of the individual counterparty and counterparty group, limits are established covering banking and traded products. These limits put constraints not only on the current outstanding amount but also on contingent commitments and the potential future exposure of traded products. Credit engagements may not be entered into without the appropriate approvals and adherence to these limits.

In the Investment Bank, at a portfolio level a distinction is made between those exposures which are to be held to maturity ("take and hold exposures") and those which will be held only over the short term, pending distribution or risk transfer ("temporary exposures"). Most limits and operational controls constrain the credit exposure of a sub-portfolio, but UBS also has limits that restrict the credit risk of a whole portfolio using credit risk measures such as stress loss, as described below. Such limits are applied for instance to the Investment Bank's leveraged lending portfolio, where the impact of variations in default rates and asset prices is considered, together with market liquidity and UBS's distribution capabilities.

Risk mitigation

Taking collateral is the most common way to mitigate credit risk. Loans to wealth management clients ("lombard lending") are made against the pledge of sufficient eligible marketable securities or cash. For real estate financing, a mortgage over the relevant property is taken to secure the claim. The Investment Bank also takes financial collateral in the form of marketable securities in much of its over-the-counter (OTC) derivatives activities and in its securities financing business (securities lending and borrowing or repurchase and reverse repurchase). To ensure with a high degree of certainty that the collateral value will cover the exposure, discounts ("haircuts") are generally applied to the current market value. These reflect the quality, liquidity, volatility and, in some cases, the complexity of the individual instruments. Exposures and collateral values are continuously monitored, and margin calls or close-out procedures are enforced, when the market value of collateral falls below a predefined trigger level. Concentrations within individual collateral portfolios and across clients are also monitored where relevant and may affect the discount applied to a specific collateral pool.

The OTC derivatives business is generally conducted under bilateral master agreements, which typically allow for the close-out and netting of all transactions in the event of default. UBS also has two-way collateral agreements with all -major market participants, under which either party can be required to provide collateral in the form of cash or marketable securities when exposure exceeds a predefined level. The OTC derivatives business with lower-rated counterparties is generally conducted under one-way collateral agreements where only the counterparty is required to provide UBS with cash or very liquid collateral. For certain counterparties, like hedge funds, UBS may use two-way collateral agreements. UBS has policies for netting and collateral agreements, including requiring a legal opinion that contracts are enforceable in the case of insolvency in the relevant jurisdictions.

The Investment Bank also utilizes credit hedging to actively manage the credit risk of its portfolios, with the goal of reducing concentrations in individual names, sectors or specific portfolios. The Investment Bank utilizes a number of different hedging measures which include single name credit default swaps (CDS), index CDS, credit linked notes and total return swaps. Single name CDS are generally executed under bilateral netting and collateral agreements, with high-grade market counterparties. For the purposes of monitoring against limits, UBS observes strict standards. Credit hedges are only recognized as a risk mitigant if they are single name credit default swaps, total return swaps or credit linked notes. They must cover potential credit exposure increases to a high level of confidence, and offer protection against a wide range of credit events. Other credit risk mitigants such as proxy hedges (credit protection on a correlated but different name) or index CDS are not recognized for the purposes of monitoring against limits.

Buying credit protection creates credit exposure against the hedge provider. The exposure to credit protection providers and thus the effectiveness of credit hedges is monitored as part of the overall credit exposure against the relevant names. Where there is significant correlation between the counterparty and the hedge provider (so-called "wrong-way risk"), UBS's policy is not to recognize any benefit in credit risk measures.

Credit risk measurement

Credit risk measurement is an essential component of the credit risk control framework. The measurement of credit exposure from a loan which is fully drawn is straightforward. By contrast, the estimation of credit exposure on a traded product, the value of which varies with changes in market variables, interim cash flows and the passage of time, is more complex and requires the use of models. The assessment of portfolio risk also entails estimations of the likelihood of defaults occurring, of the associated loss ratios if they do, and of default correlations between counterparties.

UBS has developed tools to support the quantification of the credit risk of individual counterparties, applying the three generally accepted parameters: probability of default, exposure at default and loss given default. Models are also used to derive the portfolio risk measures expected loss, statistical loss and stress loss.

Credit risk parameters

Three parameters are used to measure and control individual counterparty credit risk:

- The probability of default is an estimate of the likelihood of the client or counterparty defaulting on its contractual obligations. This probability is assessed using rating tools tailored to the various categories of counterparties. These categories are also calibrated to the UBS 15-class Masterscale (UBS's proprietary credit rating scale) to ensure consistency in the quantification of default probabilities across counterparties. Besides their use for credit risk measurement, ratings are an important element in setting credit risk approval authorities.

- Exposure at default is derived from the current exposure to the counterparty and its possible future development. For traded products such as OTC derivatives, the exposure at default is not a definitive number - it must be derived by modeling the range of possible outcomes. In measuring individual counterparty exposure against credit limits, UBS considers the maximum likely exposure measured to a high confidence level over the full life of all outstanding obligations. However, when aggregating exposures to different counterparties for portfolio risk measurement, the expected exposure to each counterparty at a given time horizon (usually one year) generated by the same model is used.

- The loss given default is determined based on the likely recovery rate of defaulted claims, which is a function of the type of counterparty and any credit mitigation or support (such as security or guarantee).

These parameters are the basis for most internal measures of credit risk. They are also key inputs to the regulatory capital calculation under the advanced Internal Rating Based approach of the new Basel Capital Accord (Basel II), which UBS adopted from 1 January 2008, when the accord came into force.

Refer to the discussion on rating system design and estimation of credit risk parameters below for a more detailed description of the three credit risk parameters discussed above

Expected loss

Credit losses must be anticipated as an inherent cost of doing business. But the occurrence of credit losses is erratic in both timing and amount, and those losses that do arise usually relate to transactions entered into in previous accounting periods. In order to reflect the fact that future credit losses are implicit in today's portfolio, UBS uses the concept of "expected loss".

Expected loss is a statistical concept which is used to estimate the annual costs that are expected to arise, on average, from positions in the current credit portfolio that become impaired. The expected loss for a given credit facility is a function of the three components described above: probability of default, exposure at default and loss given default. The expected loss figures for individual counterparties are aggregated to derive the expected credit loss for the whole portfolio.

Expected loss is the basis for quantifying credit risk in all portfolios. It is an input used to value or price some products. Expected loss is also the starting point for the measurement of portfolio statistical loss and stress loss.

Refer to the discussion on credit loss expense below for more information

Statistical loss

UBS uses a statistical model - credit Value at Risk ("credit VaR") - to estimate the potential loss on the portfolio over one year measured to a specified level of confidence. The shape of the modeled loss distribution is driven by systematic default relationships amongst counterparties within and between segments. The results of this analysis provide an indication of the level of risk in the portfolio, and the way it develops over time. It is also an important input to the overall risk measures earnings-at-risk and capital-at-risk.

Refer to the discussion on earnings-at-risk and capital-at-risk in the "Risk management and control" section of this report for more information

Stress loss

Stress loss is a scenario-based measure which complements the statistical model. It is used to assess potential loss in various extreme but plausible scenarios in which it is assumed that one or more of the three key credit risk parameters deteriorates substantially according to a pattern that is typical for the chosen scenario. Stress tests are run regularly, and on an ad hoc basis as necessary, in order to identify adverse portfolio situations, particularly risk concentrations. All scenario results are monitored, and for certain portfolios and segments, stress loss is subject to limits.

Composition of credit risk - UBS Group

The measures of credit risk used by UBS may differ depending on the purpose for which exposures are aggregated: financial accounting under the International Financial Reporting Standards (IFRS); determination of regulatory capital; or UBS's own internal management view (i.e. the economic risk of the credit portfolio which reflects how that risk is managed by UBS). The table "Exposure to credit risk - UBS Group" below begins with the IFRS view ("maximum exposure to credit risk"), and shows the adjustments required to reconcile to the internal management view ("Credit exposure before hedges").

In the tables in this section the internal management view of credit risk exposure is based on a revised measurement methodology for traded products compared with 2007. The 2007 numbers have been restated accordingly. The methodology was refined to reflect the internal reporting methods used in the business divisions.

In general, the exposures shown in the tables are gross and do not reflect the benefit of security held or other risk mitigation employed, such as hedging and risk transfers. The main differences between the internal management and IFRS views of gross credit exposure are:

- Cash collateral posted by UBS against negative replacement values of derivative instruments and other positions is reported on a gross basis for IFRS purposes. For internal management purposes these exposures are treated on a net basis after factoring in an assessment of the counterparty risk on the underlying positions.

- For internal management purposes netting is applied for positive and negative replacement values with the same counterparty, where the business is conducted under a legally enforceable netting agreement. Under IFRS, netting is applied on a more restrictive basis. Refer to "Note 1 Summary of significant accounting policies" in the financial statements of this report for further information on IFRS netting.

- Under IFRS, securities lending / borrowing and repurchase / reverse repurchase transactions are shown on the balance sheet as UBS's full claim on the counterparty without recognizing the counterclaim which the counterparty has for return of cash or securities on the same transactions. By contrast, for internal risk control purposes, the claims on and counterclaims from each counterparty are considered on each transaction on a net basis, and further netted across transactions where such netting is considered to be legally enforceable in insolvency.

- All positions that were reclassified in fourth quarter from the "held for trading" to the "loans and receivables" category are included as loans under the IFRS reported exposures. Refer to the "Financial performance" section and "Note 29 Measurement categories of financial assets and liabilities" in the financial statements of this report for more information. However, for the purposes of providing a breakdown of UBS's lending portfolios, only the loan underwriting positions are included in the internal management view of loan exposures. All reclassified positions are subject to appropriate portfolio limits and risk controls, including earnings-at-risk and capital-at-risk metrics. The redesignated assets comprised: monoline protected assets (USD 5.7 billion); US reference-linked program (USD 1.1 billion); US commercial real estate (USD 3.4 billion); leveraged finance (USD 2.3 billion); student loan auction rate securities (USD 7.9 billion); and other assets (USD 2.3 billion). Exposure amounts provided were the carrying values on 31 December 2008. The exposures relating to monoline-protected assets, leveraged finance and student loan auction rate securities are included in the respective asset class disclosures in the "Risk concentrations" section of this report.

Note that under US Generally Accepted Accounting Principles (GAAP), a greater degree of netting is permitted than under IFRS for OTC derivatives replacement values and for securities lending / borrowing and repurchase / reverse repurchase transactions. UBS's balance sheet figures for these types of transactions are not directly comparable with those of firms which report under US GAAP.

As explained in the credit risk measurement section, UBS also measures, and generally applies limits to, credit exposures to individual counterparties and counterparty groups. It also measures risk across counterparties at various portfolio and sub-portfolio levels. In these calculations UBS further considers the potential development of replacement values of traded products over time as market risk factors change, interim payments are made and transactions mature, all of which can significantly alter the risk exposure profile. These potential developments are not reflected in the various tables in this section, which reflect only the current exposures.

The credit risk exposure reported in the table "Exposure to credit risk - UBS Group" in this section excludes UBS's participation in the deposit insurance guarantee scheme under Swiss banking law, according to which Swiss banks and securities dealers are required to jointly guarantee an amount of up to CHF 6 billion for privileged client deposits in the event that another Swiss bank or securities dealer becomes insolvent. For the period 20 December 2008 to 30 June 2009 FINMA has established UBS's share in the deposit insurance as CHF 1,192 million.

Total gross credit exposure amounted to CHF 670.3 billion on 31 December 2008, a decrease of CHF 2.6 billion since the end of the previous year. Banking products decreased by CHF 33 billion mainly driven by reductions in loans and undrawn irrevocable commitments partially compensated by higher balances with central banks, while the traded products category increased by CHF 31 billion due to a significant increase in the derivatives line of CHF 43 billion, partially compensated by a reduction of CHF 12 billion for securities financing transactions. The reduction in loan exposure was mainly due to a reduction in the collateralized lending activity in Global Wealth Management & Business Banking. The Investment Bank continued to actively reduce credit risk.

The quality of the gross unimpaired credit portfolio improved as the investment grade component (internal rating grades 0-5) remained at 79%.

The table "Gross credit exposure by business division" on the previous page shows the gross credit exposure (i.e. without recognition of credit hedges, collateral or other risk mitigation) by business division.

The largest contributor to gross credit exposure at CHF 291 billion is the lending portfolio (due from banks CHF 19 billion, loans CHF 264 billion, and "financial assets designated at fair value" CHF 8 billion) which represents 43% of total gross credit exposure and 73% of total banking products exposure. Within this lending portfolio, CHF 233 billion (80%) is attributable to Global Wealth Management & Business Banking. Traded products exposure is incurred predominantly by the Investment Bank. The sections below provide further details of products, industry and rating distributions in the business division portfolios.

The property financing portfolio is diversified and limits per counterparty ensure that no single property exposure presents an undue concentration.

Exposure to providers of credit protection, usually in the form of credit derivatives, is controlled by the overall credit limit for the counterparty, which is typically a high-grade financial institution.

Composition of credit risk (business divisions)

Global Wealth Management & Business Banking

The total gross banking products exposure of Global Wealth Management & Business Banking was CHF 268 billion on 31 December 2008 down by CHF 9.0 billion or 3% from a year earlier. The high quality of the banking products exposure, with 64% in the investment grade category is demonstrated by the rating distribution on the next page. The introduction of a revised credit risk framework was aimed at improving statistical credit risk measurement and reinforcing the link between the credit assessment and pricing. This resulted in a decrease in counterparty rating on average by one rating class as shown in the table on the next page by the increase in category 6 sub-investment grade exposures. The distribution of the exposure across UBS's internal rating and loss given default (LGD) buckets as displayed in the table on the next page shows that the majority of the exposure is from products attracting the lowest LGDs, demonstrating the continued improvement in the quality of this portfolio (refer to the "UBS internal rating scale and mapping of external ratings" table in the "Rating system design and estimation of credit risk parameters" section for more information).

Global Wealth Management & Business Banking's gross lending portfolio (due from banks and loans) on 31 December 2008 amounted to CHF 233 billion, of which CHF 142 billion (60%) was secured by real estate and CHF 62 billion (27%) by marketable securities. The pie chart on the previous page shows that exposure to real estate is well diversified, with 40% of the gross lending portfolio being secured on single family homes and apartments, which generally have exhibited a low risk profile. The 11% of exposure secured by residential multi-family homes consists of rented apartment buildings. Loans and other credit engagements with individual clients, excluding mortgages, amounted to CHF 91 billion and are predominantly extended against the pledge of marketable securities. The volume of collateralized lending to private individuals decreased by CHF 16 billion or 20% from the previous year. This was mainly due to substantial deleveraging by clients. As of 31 December 2008 more than 80% of loans secured by marketable securities were attributed to business outside Switzerland, of which nearly one-third relates to Wealth Management US.

The Swiss lending portfolio (excluding mortgages) within the Business Banking area amounted to CHF 23 billion, representing 9% of Global Wealth Management & Business Banking's total gross banking products exposure. It is widely spread across industries, with the majority of exposures being to banks and financial institutions, followed by public authorities. The increase in exposures to banks and financial institutions was driven by additional lending to UBS fund entities.

Investment Bank

A substantial majority of the Investment Bank's gross credit exposure falls into the investment grade category (internal counterparty rating classes 0 to 5) both for gross banking products (77%) and for traded products (91%). The counterparties are primarily banks and financial institutions, multinational corporate clients and sovereigns. The increase in category 3 resulted from the loan to the fund managed by BlackRock. Refer to the "Loan to BlackRock fund" sidebar for more information.

Banking products exposure

On 31 December 2008, the Investment Bank's total gross credit exposure from banking products amounted to CHF 125.6 billion or CHF 79.0 billion net, taking credit hedges into account. This represents a significant reduction compared to CHF 151.3 billion gross and CHF 100.7 billion net for 2007. The exposure held for distribution also reduced significantly as a consequence of the market deterioration, which resulted in mark downs of existing commitments and a substantial reduction in new lending. The table "Investment Bank: banking products" below shows the composition of the Investment Bank's gross banking products exposure, the hedges and other risk mitigation and the net exposure in total.

As described in the discussion on risk mitigation, the Investment Bank has engaged in a substantial credit risk hedging program and on 31 December 2008 had CHF 45 billion of credit hedges in place against banking products exposure. In addition certain loans captured on an accrual basis are hedged with mark-to-market hedges.

To illustrate the effects of credit hedging and other risk mitigation, the first graph on the next page shows the exposures by counterparty rating before and after application of risk mitigation.

Additionally, the matrix on page 142 shows the distribution of the Investment Bank's net banking products exposure after application of risk mitigants, across UBS internal rating classes and loss given default buckets. Mitigants include risk participations and single name credit default swaps. No offset is given for portfolio hedges. There is a concentration in the 26-50% bucket where most senior secured and unsecured claims fall. Sub-investment grade exposure in aggregate was reduced by CHF 3.3 billion (21%). It should be noted that exposure distributions shown elsewhere in this section refer only to gross or net exposure and do not take recovery expectations into account (refer to the "UBS internal rating scale and mapping of external ratings" table in the "Rating system design and estimation of credit risk parameters" section below for more information).

Net banking products exposure after application of credit hedges continues to be diversified across industry sectors. At 31 December 2008, the largest exposures were to regulated banks (30%) and financial institutions (28%). The increase in bank exposures resulted from higher nostro (a bank's current account with another bank) positions and the loan to the fund managed by BlackRock resulted in an increase in the financial institutions category. Refer to the "Loan to BlackRock fund" sidebar for more information.

Settlement risk

Settlement risk arises in transactions involving exchange of value when UBS must honor its obligation to deliver without first being able to determine that the counter-value has been received. UBS continues to reduce its actual settlement volume by the same proportions as in previous years through the use of multilateral and bilateral agreements.

In 2008 settlement risk on 78% of gross settlement volumes was eliminated through risk mitigation. The most significant source of settlement risk is foreign exchange transactions. UBS is a member of Continuous Linked Settlement (CLS), a foreign exchange clearing house which allows transactions to be settled on a delivery versus payment basis, thereby significantly reducing foreign exchange-related settlement risk relative to the volume of business. The proportion of UBS's overall gross volumes settled through CLS increased to 55% during 2008 compared to 53% in 2007. In 2008 UBS's CLS volume with other CLS settlement members was 72%, which is comparable to 2007. While the number of CLS settlement members is relatively stable, in 2008 the number of third-party participants that UBS dealt with increased considerably from 2007.

Risk reduction by other means - primarily account to account settlement and payment netting - fell correspondingly to 23% of gross volumes in 2008 compared to 26% in 2007.

The avoidance of settlement risk through CLS and other means does not, of course, eliminate the credit risk on foreign exchange transactions resulting from changes in exchange rates prior to settlement. Such counterparty risk on forward foreign exchange transactions is measured and controlled as part of the overall credit risk on OTC derivatives.

Country risk

UBS assigns ratings to all countries to which it has exposure. Sovereign ratings express the probability of occurrence of a country risk event that would lead to impairment of UBS's claims. The default probabilities and the mapping of external ratings of the major rating agencies are the same as for counterparty rating classes (as described under "Probability of default"). In the case of country ratings, rating classes 10 to 13 are designated "very high risk" while the lowest rating class 14 contains countries in outright default.

For all countries rated three and below, UBS sets country risk ceilings approved by the Board of Directors or under delegated authority. The country risk ceiling applies to all UBS's exposures to clients, counterparties or issuers of securities from the country, and to financial investments in that country. Country risk measures cover both cross-border transactions and investments, and local operations undertaken by all UBS branches as well as by subsidiaries in countries where the risk is material. Extension of credit, transactions in traded products and positions in securities may be denied on the basis of a country ceiling, even if exposure to the name is otherwise acceptable.

From a country risk control perspective, exposures to emerging markets are considered the most relevant, therefore additional information is provided in this section covering exposure to countries that UBS groups under the emerging market category.

Losses due to counterparty or issuer default resulting from multiple insolvencies ("systemic risk") or general prevention of payments by authorities ("transfer risk") are the most significant effects of a country crisis, but for internal measurement and control of country risk UBS also considers the probable financial impact of market disruptions arising prior to, during and following a country crisis. These might take the form of a severe deterioration in the country's debt and equity markets and asset prices, and a sharp depreciation of the currency.

The potential financial impact of severe emerging markets crises is assessed by stress testing. This entails identifying countries that might be subject to a potential crisis event and determining potential loss and making conservative assumptions about potential recovery rates depending on the types of transaction involved and their economic importance to the affected countries.

Country risk exposure

Exposure to emerging market countries amounted to CHF 32.7 billion on 31 December 2008, compared with CHF 41.3 billion on 31 December 2007. Of this amount, CHF 24.6 billion or 75% was to investment grade countries based on UBS's internal ratings-based approach. The reduction of CHF 8.5 billion in total emerging markets exposure arose to a large extent in Asia.

The pie chart on the previous page shows UBS's emerging market country exposures (excluding those which are temporary exposures) on 31 December 2008, based on the main country rating categories. The table on the previous page analyzes emerging market country exposures by major geographical area and product type on 31 December 2008 compared with 31 December 2007. Temporary exposures arising from loan underwriting in these markets are shown separately in the table.

Impairment and default - distressed claims

UBS has a number of classifications for distressed claims. A loan carried at amortized cost is considered to be "past due" when a significant payment has been missed. Any claim, regardless of accounting treatment, is classified as "impaired" if UBS considers it probable that a loss will result on that claim due to the obligor's inability to meet its obligations according to the contractual terms, and after realization of any available collateral. "Obligations" in this context include interest payments, principal repayments or other payments due, for example under an OTC derivative contract or a guarantee.

The recognition of impairment in the financial statements depends on the accounting treatment of the claim. For products carried at amortized cost, impairment is recognized through the creation of an allowance or provision, which is charged to the income statement as credit loss expense. For products recorded at fair value such as derivatives, impairment is recognized through a credit valuation adjustment, which is charged to the income statement through the "Net trading income" line.

UBS has policies and processes to ensure that the carrying values of impaired claims are determined in compliance with IFRS on a consistent and fair basis, especially for those impaired claims for which no market estimate or benchmark for the likely recovery value is available. The credit controls applied to valuation and workout are the same for both amortized cost and fair-valued credit products. Each case is assessed on its merits, and the workout strategy and estimation of cash flows considered recoverable are independently approved.

Credit officers monitor derivative counterparties for default or impairment using generally the same principles and processes as used for loans. In the event that a derivatives counterparty defaults on its obligations a specific credit valuation adjustment (CVA) is established by the credit officer.

Portfolios of claims carried at amortized cost with similar credit risk characteristics are also assessed for collective impairment. A portfolio is considered impaired on a collective basis if there is objective evidence to suggest that it contains impaired obligations but the individual impaired items cannot yet be identified. Portfolios considered impaired on a collective basis are not included in the totals of impaired loans in the tables shown in the discussion of the composition of credit risk for business divisions in the "Credit risk" section of this report.

The assessment of collective impairment differs depending on the nature of the underlying obligations. In UBS's retail businesses, where delayed payments are routinely seen, UBS typically reviews individual positions for impairment only after they have been in arrears for a certain time. To cover the time lag between the occurrence of an impairment event and its identification, collective loan loss allowances are established, based on the expected loss measured for the portfolio over the average period between trigger events and their identification for individual impairments. Collective loan loss allowances of this kind are not required for corporate and investment banking businesses because individual counterparties and exposures are continuously monitored and impairment events are identified at an early stage.

Additionally, for all portfolios, UBS assesses each quarter - or on an ad hoc basis if necessary - whether there have been any previously unforeseen developments which might result in impairments that cannot be immediately identified individually. Such events could be stress situations such as a natural disaster or a country crisis, or they could result from structural changes in, for example, the legal or regulatory environment. To determine whether an event-driven collective impairment exists, a set of global economic drivers is regularly assessed for the most vulnerable countries and, on a case-by-case basis, the impact of specific potential impairment events since the last assessment is reviewed. Again, the expected loss parameters of the affected sub-portfolios are the starting point for determining the collective impairment, adjusted as necessary to reflect the severity of the event in question.

Past due but not impaired loans

Past due but not impaired loans have suffered missed payments but are not considered impaired because UBS expects ultimately to collect all amounts due under the contractual terms of the loans or with equivalent value.

Compared with 31 December 2007, the past due exposure decreased CHF 0.5 billion at 31 December 2008.

Impaired loans, allowances and provisions

The table below shows that allowances and provisions for credit losses increased 184%, to CHF 2,927 million on 31 December 2008 from CHF 1,031 million on 31 December 2007. Refer to "Note 9b Due from banks and loans" in the financial statements of this report for more information on the changes in allowances and provisions for credit losses during the year.

The gross impaired lending portfolio increased significantly to CHF 9,145 million on 31 December 2008 from CHF 2,392 million on 31 December 2007. This was largely driven by the reclassification of certain financial instruments, some of which carried impairments, in addition to various real estate-related positions that were also considered impaired during the year. Refer to "Note 29 measurement -categories of financial assets and liabilities" in the financial statements and the "Financial performance" sections of this report for more information.

The ratio of the impaired lending portfolio to the total lending portfolio (both measured gross) deteriorated to 2.2% on 31 December 2008 from 0.6% on 31 December 2007.

Loans or receivables with a carrying amount of CHF 224 million and CHF 126 million were reclassified from impaired to performing during 2008 and 2007 respectively. This reclassification was made either because the loans had been renegotiated and the new terms and conditions met normal market criteria for the quality of the obligor and type of loan, or because there had been an improvement in the financial position of the obligor, enabling it to repay any past due amounts such that future principal and interest are deemed to be fully collectible in accordance with the original contractual terms.

Collateral held against the impaired loans portfolio consists in most cases of real estate. It is UBS policy to dispose of foreclosed real estate as soon as practicable. The carrying amount of foreclosed property recorded in the balance sheet under "Other assets" at the end of 2008 and 2007 amounted to CHF 280 million and CHF 122 million respectively.

UBS seeks to liquidate collateral in the form of financial assets in the most expeditious manner, at prices considered fair. This may require that it purchases assets for its own account, where permitted by law, pending orderly liquidation.

The table "Impaired assets by type of financial instrument" above includes not only impaired loans, but also impaired off-balance sheet claims and defaulted derivatives and repurchase / reverse repurchase contracts, which are subject to the same workout and recovery processes.

The impaired assets of CHF 15.7 billion increased significantly as a consequence of the market turbulence in 2008.

After deducting allocated specific allowances, provisions and credit valuation adjustments of CHF 7.2 billion and the estimated liquidation proceeds of collateral of CHF 3.9 billion, net impaired assets amounted to CHF 4.5 billion in 2008.

Credit loss expense

UBS's financial statements are prepared in accordance with IFRS. Under IFRS the credit loss expense charged to the income statement 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 experienced.

In 2008, UBS experienced a net credit loss expense of CHF 2,996 million, of which CHF 1,329 million was due to impairment charges taken on reclassified financial instruments in the Investment Bank. This was mainly due to an impairment charge taken against a client in the petrochemical industry, excluding any benefit from hedges. In comparison, UBS recorded a net credit loss expense of CHF 238 million in 2007.

The Investment Bank recorded a net credit loss expense of CHF 2,575 million for 2008, compared with a net credit loss expense of CHF 266 million in 2007. Excluding the credit loss expense from reclassified financial instruments of CHF 1,329 million, the credit loss expense amounted to CHF 1,246 million, mainly driven by new allowances on securities financing transactions, real estate loan positions and asset backed securities as a consequence of the deteriorations in the financial markets.

Global Wealth Management & Business Banking reported a net credit loss expense of CHF 370 million for 2008, compared with a CHF 28 million net credit loss recovery for 2007. This significant increase in credit loss expenses was mainly due to collateral shortfalls against lombard lending resulting from the turmoil in the financial markets in the fourth quarter of 2008 with sharp moves in securities prices and an unprecedented decrease in the liquidity of certain asset categories.

Rating system design and estimation of credit risk parameters

Probability of default

UBS assesses the likelihood of default of individual counterparties using rating tools tailored to the various counterparty segments. Probability of default is summarized in the UBS internal rating scale and mapping of external ratings (Masterscale), shown on the next page, which segments clients into 15 rating classes (0 to 14), one of which is reserved for default. The UBS Masterscale reflects not only an ordinal ranking of counterparties, but also the range of default probabilities defined for each rating class. Also, in order to ensure consistency in determining default probabilities, all rating tools must be calibrated to the common Masterscale. This approach means that clients migrate between rating classes as UBS's assessment of their probability of default changes. The performance of rating tools, including their predictive power with regard to default events, is regularly validated and model parameters are adjusted as necessary.

External ratings, where available, are used to benchmark UBS's internal default risk assessment. The ratings of the major rating agencies shown in the table are linked to the internal rating classes based on the long-term average one-year default rates for each external grade. Observed defaults per agency rating category vary from year to 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. UBS monitors the long-term average default rates associated with external rating classes. If these long-term averages were observed to have changed in a material and permanent way, their mapping to the Masterscale would be adjusted.

At the Investment Bank, rating tools are differentiated by broad segments. Current segments include banks, sovereigns, corporates, funds, hedge funds, commercial real estate and several more specialized businesses. The design of these tools follows a common approach. The selection and combination of relevant criteria (financial ratios and qualitative factors) are determined through a structured analysis by credit officers with expert knowledge of each segment, supported by statistical modeling techniques where sufficient data are available.

The Swiss banking portfolio includes exposures to both large and small- to medium-sized enterprises, and the rating tools vary accordingly. For segments where sufficient default data are available, rating tool development is primarily based on statistical models. Typically, these "score cards" consist of eight to 12 criteria combining financial ratios with qualitative and behavioral factors which have proven good indicators of default in the past, are accepted by credit officers and are easy to apply. For smaller risk segments with few observed defaults the approach relies more on judgment and expertise, similar to that applied at the Investment Bank. For the Swiss commercial real estate segment and for lombard lending, which is part of the retail segment, the probability of default is derived from simulation of potential changes in the value of the collateral and the probability that it will fall below the loan amount.

Default expectations for the Swiss residential mortgage segment are based on the internal default and loss history, where the major differentiating factor is the loan-to-value ratio (i.e. the amount of the outstanding obligation expressed as a percentage of the value of the collateral).

Exposure at default

Exposure at default represents the amounts UBS expects to be owed at the time of default.

For outstanding loans, the exposure at default is the drawn amount or face value. For loan commitments and for contingent liabilities, it includes any amount already drawn plus any additional amount which is expected to be drawn at the time of default, should it occur. This calculation is based on a "credit conversion factor" - a fixed percentage per product type derived from historical experience of drawings under commitments by counterparties within the year prior to their default.

For traded products, the estimation of exposure at default is more complex, since the current value of a contract or portfolio of contracts can change significantly over time and may, at the time of a future default, be considerably higher or lower than the current value. For repurchase and reverse repurchase agreements and for securities borrowing and lending transactions, the net amount which could be owed to or by UBS is assessed, taking into account the impact of market moves over the time it would take to close out all transactions ("closeout exposure"). For exchange-traded derivatives (ETDs), the exposure at default is derived from the difference between the initial margin and the current variation margin. Exposure at default on OTC derivative transactions is determined by modeling the potential evolution of the replacement value of the portfolio of trades with each counterparty over the lifetime of all transactions ("potential credit exposure"), taking into account legally enforceable closeout netting agreements where applicable.

For traded products, excluding ETDs, the exposure at default is derived from a Monte Carlo simulation (a statistical technique involving a large number of simulations) of potential market moves in all relevant risk factors, such as interest rates and exchange rates, based on estimated correlations between the risk factors. This ensures a scenario-consistent estimation of market value across all traded products at counterparty and portfolio level. The randomly simulated sets of risk factors are then used as inputs to product-specific valuation models to generate valuation paths, taking into account the impact of maturing contracts and changing collateral values.

The resultant distribution of future valuation paths supports various exposure measures. All portfolio risk measures are based on the expected exposure profile. By contrast, in controlling individual counterparty exposures UBS limits the potential "worst case" exposure over the full tenor of all transactions, and therefore applies the limits to the "maximum likely exposure" generated by the same simulations, measured to a specified high confidence level.

Cases where there is material correlation between the factors driving a counterparty's credit quality and the factors driving the future path of traded products exposure ("wrong-way risk") require special treatment. In such cases, the potential credit exposure generated by the standard model is overridden by a calculation from a customized exposure model that explicitly takes this correlation into account. For portfolios where this risk is inherently present, for instance for the hedge funds portfolio, UBS has established special controls to capture these wrong-way risks.

The performance of exposure models is monitored by backtesting and benchmarking whereby model outcomes are compared against actual outcomes, based on UBS's internal as well as external historical experience.

Loss given default

Loss given default or loss severity represents UBS's expectation of the extent of loss on a claim should default occur. It is expressed as a percentage loss per unit of exposure and typically varies by type of counterparty, type and seniority of claim and the availability of collateral or other credit mitigation. Loss given default estimates cover loss of principal, interest and other amounts due (including workout costs), and also consider the costs of carrying the impaired position during the workout process.

At the Investment Bank loss given default estimates are based on expert assessment of the risk drivers (country, industry, legal structure, collateral and seniority), supported by empirical evidence from internal loss data and external benchmark information where available. In the Swiss portfolio, loss given default differs by counterparty and collateral type and is statistically estimated using internal loss data. For the residential mortgage portfolio, a further differentiation is derived by statistical simulation based on loan-to-value ratios.

Debt investments

Debt investments classified for IFRS as "financial investments available-for-sale" can be broadly categorized as money market instruments and debt securities, which are mainly held for statutory, regulatory or liquidity reasons. Debt investments also include non-performing loans, which were purchased in the secondary market by the Investment Bank.

The risk control framework applied to debt instruments classified as "Financial investments available-for-sale" varies depending on the nature of the instruments and the purpose for which they are held.

Where applicable, debt investments are reflected in reports to senior management of consolidated credit exposures and in "large exposure" reports to FINMA.

Composition of debt investments

On 31 December 2008, debt financial investments classified as "Financial investments available-for-sale" consisted of money market paper of CHF 2,165 million and other debt investments of CHF 1,402 million. The increase in money market instruments is due to UK Treasury Gilts held in UBS Ltd.

At 31 December 2007, the equivalent positions were CHF 349 million money market instruments and CHF 1,034 million other debt investments.

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