Liquidity and funding management

UBS defines liquidity risk as the risk of being unable to raise funds to meet payment obligations when they fall due. Funding risk is the risk of being unable, on an ongoing basis, to borrow funds in the market at an acceptable price to fund actual or proposed commitments and thereby support UBS's current business and desired strategy. Liquidity and funding are not the same, but they are closely related. Both are finite resources that are critical for a financial institution.

Liquidity must be continuously managed to ensure that the firm can survive a crisis, whether it is a general market event, a localized difficulty affecting a smaller number of institutions, or a problem unique to an individual firm. An institution that is unable to meet its liabilities when they fall due may collapse, even though it is not insolvent, because it is unable to borrow sufficient funds on an unsecured basis, or does not have sufficient good quality assets to borrow against or liquid assets to sell to raise immediate cash.

Market liquidity overview: 2008

The financial and credit market crisis, which had its origins in the US residential mortgage market in the second half of 2007, spread and gained in intensity throughout 2008, as a broader economic crisis developed and pointed towards a severe global downturn. A precipitous fall in trading volumes in some previously highly liquid markets accompanied a sharp reduction in asset market values. After the failure of one of the major US investment banks in mid-September, the tenor of the interbank lending market was dramatically reduced. Although other short-term funding remained available at this time, it was largely limited to tenors within one month, while in secured funding markets certain assets were subjected to significantly higher haircuts and in some cases were no longer accepted as collateral. Access to other longer-term wholesale funds was also severely constrained, as the level of credit spreads surged, and companies' financing costs reached new heights.

In an attempt to contain the sustained and growing crisis, which resulted in significant bank failures or forced restructurings of several major financial institutions throughout the year, central banks and governments were induced to intervene on a large scale to support both specific institutions and the global financial system as a whole. These public sector initiatives included a series of restructurings, recapitalizations - both direct and indirect - and the introduction, then subsequent expansion, of broad-based credit and liquidity support facilities. New policies were implemented in many major economies to permit direct government investment in banks, loan and bank debt guarantees, as well as the provision of large volumes of additional liquidity to their financial systems via extraordinary financing facilities. Certain major banks became majority-owned by their governments. Several countries announced that they would insure all domestic bank deposits and others substantially increased the insurance protection for their deposits and bank debts, pressuring the deposits and debts of banks covered by weaker protection schemes. In the fourth quarter, the Swiss government announced a number of steps to support its banking system, including a strengthening of the country's bank deposit insurance scheme and a willingness to guarantee interbank liabilities if and when deemed necessary. Throughout most of the fourth quarter, public bond market issuance was largely limited to banks whose debt was government-guaranteed.

UBS's response to the ongoing crisis

Despite the very challenging conditions, UBS maintained its access to funding at all times, primarily as a result of its broadly diversified funding base. In addition, in anticipation of an extended period of market turbulence, UBS proactively undertook several measures starting in 2007 and continuing in 2008 to further strengthen and safeguard its liquidity position. Short-term funding targets were adjusted, and increased focus was placed on asset reduction. Combined with the broad diversity of its funding sources, its contingency planning processes and its global scope, these additional measures have enabled UBS to maintain a balanced asset / liability profile. UBS also maintains a substantial multi-currency portfolio of unencumbered high-quality short-term assets and has available and unutilized collateralized liquidity facilities at several major central banks.

Like many other major financial institutions, UBS saw decreased access to wholesale term funding and a decline in client deposits during 2008. This was counterbalanced by ongoing asset reductions - mostly in the Investment Bank - which reduced UBS's overall funding needs. As part of these asset reductions, the trading portfolio was pared back by CHF 462 billion compared with year-end 2007.

The transaction with the SNB, which was announced in fourth quarter 2008, further bolsters the firm's liquidity and funding position by reducing overall funding requirements.

Liquidity and funding risk management framework

A new liquidity and funding risk management framework was approved by the Board of Directors (BoD) of UBS in 2008. This new framework outlines the principles, roles and responsibilities, models, methodologies and tools UBS uses to manage liquidity and funding risk. The framework describes a target state; many of these measures have already been, or are in the process of being implemented. The benefits of the new framework are the following:

- First, sustainable profits will be achieved through allocation of the real costs of funding to the business that generates the funding requirement. There will be no more cross-subsidization of one business division by another, allowing an unbiased and more accurate view of the firm's profitability.

- Second, liquidity and funding risk are being reduced as UBS limits the size of its balance sheet, funds illiquid assets long-term and reduces reliance on short-term unsecured funding.

- Finally, UBS is establishing best practice liquidity and funding risk management processes. The new framework is designed to keep the firm in line with industry best practice, and prepare it for further changes in regulatory requirements and oversight.

The approach taken by UBS will proceed in parallel: tactically addressing a number of key initiatives in the short term, while developing the framework into a target liquidity and funding model to be strategically integrated into each business division, region and entity within the Group.

Liquidity approach

UBS's approach to liquidity management, which covers all branches and subsidiaries, aims to ensure that it will always have sufficient liquidity to meet liabilities when due, under both normal and stressed conditions, without incurring unacceptable losses or risking sustained damage to its various business franchises.

Central to the integrated framework is an assessment of all material, known and expected cash flows and the level of high-grade collateral that could be used to raise additional funding. It entails both careful monitoring and control of the daily liquidity position, and regular liquidity stress testing. Limits are set at Group level by the BoD risk committee, while the Executive Committee of the Group Executive Board (GEB) is responsible for the allocation of resources to the business divisions and sets limits for each of the business divisions. These limits are monitored by Group Treasury, who reports the results and trends on a regular basis to the BoD risk committee and the Executive Committee of the GEB. Contingency plans for a liquidity crisis are incorporated into UBS's wider crisis management process.

The liquidity position and asset and liability profile are continuously tracked. This involves monitoring the balance sheet contractual and behavioral maturity profiles and projecting and modeling the liquidity exposures of the firm under a -variety of potential scenarios - encompassing both normal and stressed market conditions. UBS considers the possibility that its access to markets could be impacted by a stress event affecting some part of its business or, in the extreme case, if it was to suffer a severe rating downgrade combined with a period of general market uncertainty. The results are factored into the overall contingency plans of UBS.

UBS's major sources of liquidity are channeled through entities that are fully consolidated.

Liquidity management

UBS manages its liquidity position in order to be able to ride out a crisis without damaging the ongoing viability of its business. This is complemented by the firm's funding risk management which aims to achieve the optimal liability structure to finance its businesses cost-efficiently and reliably. The long-term stability and security of UBS's funding in turn helps protect its liquidity position in the event of a UBS-specific crisis.

The firm's business activities generate asset and liability portfolios which are intrinsically highly diversified with respect to market, product and currency. This reduces UBS's exposure to individual funding sources, and also provides a broad range of investment opportunities, which in turn reduces liquidity risk.

UBS adopts a centralized approach to liquidity and funding management to exploit these advantages to the full. The liquidity and funding process is undertaken jointly by Group Treasury and the foreign exchange and money market (FX&MM) unit within the Investment Bank's fixed income, currencies and commodities (FICC) business area. Group Treasury establishes a comprehensive control framework, while FX&MM undertakes operational cash and collateral management within the established parameters.

This centralization permits close control of both UBS's global cash position and its stock of highly liquid securities. The central treasury process also ensures that the firm's general access to wholesale cash markets is concentrated in FX&MM. Funds raised externally are largely channeled into FX&MM including the proceeds of debt securities issued by UBS, an activity for which Group Treasury is responsible. FX&MM in turn meets all internal demands for funding by channeling funds from units generating surplus cash to those requiring finance. In this way, UBS reduces its external borrowing and use of available credit lines, and presents a consistent and coordinated face to the market.

Liquidity modeling and contingency planning

For the purpose of monitoring its liquidity situation, UBS employs the following main measures:

- A cash ladder, which is used by FX&MM to manage the firm's funding requirements on a daily basis within limits that are set by the BoD risk committee and controlled by Group Treasury. This cumulative cash ladder shows the daily liquidity position - the net cumulative funding requirement for a specific day - projected for each business day from the current day forward six months.

- A contractual maturity gap analysis of UBS's assets and liabilities.

- A behavioral maturity gap analysis under an assumed severe liquidity crisis scenario.

- A cash capital model which measures the amount of stable funding in relation to the amount and composition of its assets.

The breakdown of the contractual maturity of UBS's assets and liabilities serves as a starting point for stress testing analyses. One such breakdown is shown in the "Maturity analysis" table at the end of this section. This maturity analysis is an accounting view. It does not fully represent a liquidity risk management perspective, which would also include behavioral stress analyses and a more detailed breakdown of asset and liability types.

The aforementioned liquidity crisis scenario combines a firm-specific crisis with market disruption and focuses on a time horizon starting with overnight and extending up to one year. This UBS-specific scenario envisages large drawdowns on otherwise stable client deposits, an inability to renew or replace maturing unsecured wholesale funding and limited capacity to generate liquidity from trading assets. Liquidity crisis scenario analysis supports the liquidity management process so that immediate corrective measures, such as the use of a liquidity buffer to absorb potential sudden liquidity shortfalls, can be put into effect.

Since a liquidity crisis could have a myriad of causes, UBS focuses on a scenario that encompasses all potential stress effects across all markets, currencies and products.

The assessment includes the likelihood of maturing assets and liabilities being rolled over in a UBS-specific crisis within an otherwise stressed market environment, and gauges the extent to which the potential crisis-induced shortfall could be covered by available funding. This would be raised on a secured basis against available collateral, which includes securities eligible for pledging at the major central banks, or by selling liquid inventory. In both cases UBS applies crisis-level discounts to the value of the assets. It assumes that it would be generally unable to renew any of the Group's wholesale unsecured debt, including all its maturing money market paper (outstanding volume CHF 112 billion on 31 December 2008) and that no contingency funding could be raised on an unsecured basis. Since liquidity needs may also result from commitments and contingencies, including credit lines extended to secure the liquidity needs of customers, UBS regularly monitors undrawn committed credit facilities and other latent liquidity risks and factors these potential liquidity outflows into the scenario analysis. Particular emphasis is placed on potential drawdowns of committed credit lines.

If UBS's credit rating were to be downgraded, "rating trigger" clauses, especially in derivative contracts, could result in an immediate cash outflow due to the unwinding of derivative positions, or the need to deliver additional collateral. UBS also analyzes the potential impact on its net liquidity position of adverse movements in the replacement value of its over-the-counter (OTC) derivative transactions which are subject to collateral arrangements and includes potential outflows in its crisis scenario. Given the diversity of UBS's derivatives business and that of its counterparties, there is not necessarily a direct correlation between the factors influencing net replacement values with each counterparty and a firm-specific crisis scenario.

Liquidity limits and controls

Liquidity and funding limits are set by senior management, taking into consideration UBS's business model and strategy, the prevailing market conditions and the firm's tolerance for risk. Structural limits focus on the composition and profile of the balance sheet, while supplementary limits are designed to drive the utilization and allocation of funding resources. The supplementary limits, which consist of three categories - operational, funding and regulatory - are monitored and performance is regularly communicated to senior management. Operational limits focus on structural liquidity risk for terms from intra-day out to one year including stress testing, while funding limits focus on the liability mix. The principles underlying UBS's limit framework aim to maximize and sustain the value of its business franchise and appropriately balance the asset / liability structure in light of prevailing market conditions. Group Treasury is responsible for the control and oversight of the liquidity and funding limits.

To complement and support the limit framework, regional teams monitor the markets in which UBS operates for potential threats and regularly report any significant findings to Group Treasury.

UBS has also developed detailed contingency plans for liquidity crisis management, the cornerstone of which is the Group's substantial liquidity reserves, including a large multi-currency portfolio of unencumbered high-quality and short-term assets as well as available and unutilized liquidity facilities at several major central banks.

The liquidity contingency plan is an integral part of the global crisis management concept, which covers all types of crisis events. Its implementation falls under the responsibility of a core crisis team with representatives from Group Treasury, from FX&MM and from related areas including the functions responsible for payments and settlements, market and credit risk control, collateral and margin management, and information technology and infrastructure. FX&MM's centralized global management model lends itself naturally to efficient liquidity crisis management. Should a crisis require contingency funding measures to be invoked, Group Treasury takes responsibility for coordinating liquidity generation together with representatives from FX&MM and the relevant business areas.

UBS manages its relationships with the major central banks as part of its general policy, which is to base contingency plans on having sufficient liquidity reserves at its disposal and to raise contingency funding on a secured basis against provision of collateral.

Funding

UBS's domestic retail and global wealth management businesses continue to be valuable, cost-efficient and reliable sources of funding. These businesses contributed CHF 340 billion, or 72% of the CHF 475 billion total customer deposits shown in the UBS asset funding diagram below. Compared with the CHF 340 billion of net loans as of 31 December 2008, customer deposits provided 140% coverage. In terms of secured funding, i.e. repurchase agreements and securities lent against cash collateral received, UBS borrows less cash on a collateralized basis than it lends, leading to a surplus of net securities sourced (and rehypothecable) - shown as the CHF 231 billion cash-equivalent surplus in the diagram below. Furthermore, through the establishment of short-, medium- and long-term funding programs in Europe, the US and Asia, UBS can provide specialized investments to its customers through which it can efficiently raise funds globally from both institutional and private investors, minimizing its dependence on any particular source. A maturity breakdown of UBS's long-term straight debt portfolio of CHF 58 billion is shown further below.

Through broad diversification of its funding sources (by market, product and currency), UBS maintains a well--balanced portfolio of liabilities, which generates a stable flow of financing and provides protection in the event of market disruptions. This, together with its centralized funding management, enables UBS to efficiently fund its business activities.

Funding approach

Medium- and long-term funding activities are planned by assessing the overall funding profile of the balance sheet, taking due account of the effective maturity of the asset base and the amount of maturing debt that will have to be replaced. The ability to continue to fund ongoing business activities through periods of difficult market conditions is also factored in. Prior to the outbreak of the current crisis, at the beginning of 2007, UBS decided to further strengthen its funding profile through public issuance of senior, straight, long-term debt and to thereby enhance the overall diversification of its funding sources. Despite the persistent turbulence prevailing in the capital markets throughout the year, UBS raised CHF 24 billion of proceeds through public senior debt issuance during 2008 (compared with CHF 15 billion during 2007). Two recent examples of this funding diversification effort were the inaugural Samurai domestic Japanese Yen issuance (totaling JPY 91.5 billion) in June 2008 and the approximately CHF 2 billion Swiss covered bond (Pfandbrief) issuance via the Swiss Mortgage Bond Bank in December 2008.

In addition, the extraordinary capital strengthening measures implemented during 2008 in response to the losses incurred during the current crisis - such as the CHF 13.0 billion mandatory convertible notes (MCNs) issued in March 2008, the EUR 1 billion proceeds from the issue of perpetual preferred securities in April 2008, the net proceeds from the June 2008 rights issue of CHF 15.6 billion and the issue of CHF 6.0 billion MCNs to the Swiss Confederation in December 2008 - contributed funding to UBS.

Refer to the "Shares and capital instruments" section of this report for more information about capital instruments

To ensure that a well-balanced and diversified liability structure is preserved, Group Treasury routinely monitors UBS's funding status and reports its findings on a monthly basis to the GEB. A key measure employed among UBS's main analysis tools is an assessment of its "cash capital". This concept is designed to ensure that illiquid assets are being financed by long-term sources of funding.

UBS seeks to run a cash capital surplus (i.e. an excess of cash capital supply over cash capital consumption). The cash capital supply consists of long-term sources of funds: unsecured funding with remaining time to maturity of at least one year; shareholders' equity; and core deposits (the portion of customer deposits deemed to have a "behavioral" maturity of at least one year). Cash capital consumption reflects the illiquid portion of the assets, which is defined as the portion of assets that could only be transformed into cash by sale or secured funding in more than one year. In the case of secured funding, the illiquid portion is the difference (the "haircut") between the carrying value of an asset on the balance sheet and its effective cash value when given as collateral. The potential funding needs that could arise from off-balance sheet exposures, such as undrawn committed credit lines that UBS has sold, are also included in the total cash capital consumption.

UBS also regularly monitors its main funding portfolios for any concentration risks - including an assessment by individual counterparty.

Funding position and diversification

UBS continues to maintain a balanced portfolio of liabilities that is broadly diversified by market, product and currency. The vast product offerings and global scope of the firm's business activities are the primary reasons for funding stability. Funding is provided through numerous short-, medium-, and long-term funding programs in Europe, the US and Asia, which provide specialized investments to institutional and private clients. UBS's domestic retail and global wealth management businesses are also a valuable source of funding.

The overall composition of UBS's funding sources, as illustrated in the graphs below, has remained stable. These sources amount to CHF 1,016 billion on the balance sheet comprising repurchase agreements, securities lending against cash collateral received, due from banks, money market paper issued, due to customers and long-term debt (including financial liabilities at fair value). In terms of currencies, 48% of these funds are denominated in US dollars, while 22% are in euros and 15% in Swiss francs.

The proportion of funding raised on a secured basis, primarily through repurchase agreements (and to a lesser extent through cash collateral received for securities lent), has dropped to 11% from 22% since year-end 2007, primarily due to continued asset reductions (in particular trading assets and reverse repurchases / securities borrowed that were financed through repurchase agreements).

UBS's unsecured funding base remains well diversified. At year-end 2008, savings and demand deposits amounted to 24% of UBS's funding sources, up from 19% a year earlier. The proportion of funding raised through long-term debt was stable, accounting for 18% of funding sources (up slightly from 17% a year ago), as was the proportion of money market paper, which was likewise marginally higher, at 11% (up from 10%). Compared with year-end 2007, the proportion of funding from time deposits remained constant, at 17%, as did fiduciary deposits, at 6%. The relative share of short-term interbank borrowing was 12%, up from 9% a year earlier.

UBS, like many other major financial institutions, experienced decreased access to medium- and longer-term funds in the wholesale debt markets during 2008. Moreover, UBS did not raise any public long-term debt during fourth quarter 2008 as public issuance was practically limited to banks with government-guaranteed debt. While this contributed to a shortening of the maturity profile of UBS's debt issued during 2008, this was compensated by UBS's sale of a significant volume of illiquid positions during the year (to the fund managed by Black Rock, the SNB StabFund and to the market in general).

UBS Ratings

The table above summarizes UBS's long- and short-term debt ratings as of 31 December 2008 (refer to the "Credit ratings" sidebar).

Maturity breakdown of long-term straight debt portfolio

The graph below shows a contractual maturity breakdown of the portion of UBS’s long-term debt portfolio consisting of straight debt (and therefore excluding all structured debt, which is predominately booked as “financial liabilities designated at fair value”). This amounted to CHF 55 billion on 31 December 2008, and is accounted for on the balance sheet as part of the CHF 197 billion shown on the “Debt issued” line (which in addition includes money market paper issued and the December 2008 MCN issuance). UBS’s longterm straight debt portfolio is composed of CHF 42 billion of senior debt (including both publicly and privately placed notes and bonds as well as Swiss cash bonds) and CHF 13 billion of subordinated debt. CHF 5 billion, or 9%, of the positions mature during 2009.