Capital management

Sufficient capital must be in place to support business activities, according to both UBS's own internal assessment and the requirements of its regulators, in particular its lead regulator the Swiss Financial Market Supervisory Authority (FINMA; until 31 December 2008 Swiss Federal Banking Commission).

UBS aims to maintain sound capital ratios at all times, and it therefore considers not only the current situation but also projected developments in both its capital base and capital requirements. The main tools by which UBS manages the supply side of its capital ratios are active management of shares, capital instruments and dividend payments.

Capital adequacy management

Ensuring compliance with minimum regulatory capital requirements and targeted capital ratios is central to capital adequacy management. In this ongoing process, UBS manages towards tier 1 and total capital target ratios. In the target setting process UBS takes into account the regulatory minimum capital requirements, regulators' expectations that UBS holds additional capital above minimum requirements, UBS's internal assessment of aggregate risk exposure in terms of capital-at-risk (refer to "Earnings-at-risk and capital-at-risk" in the "Risk management and control" section of this report), the views of rating agencies, and comparison with peer institutions considering UBS's business mix and market presence.

Regulatory requirements

On 1 January 2008, UBS adopted the Basel II capital framework of the Basel Committee on Banking Supervision of the Bank for International Settlements (BIS). (Refer to the "General description of risk exposure measures and capital requirements" in the "Basel II Pillar 3" section of this report for details regarding UBS's implementation of Basel II.) The introduction of Basel II led to a decrease in UBS's overall capital requirements, as measured by risk-weighted assets (RWA). Eligible capital calculations have also been modified by the introduction of new deductions from tier 1 capital and total capital, resulting in lower eligible capital.

To allow for comparability, published RWA are determined according to the rules of the BIS Basel II framework. UBS's regulatory capital requirements are based on the regulations of FINMA, which lead to higher risk-weighted assets compared with BIS guidelines (refer to the additional capital management disclosure in the "Basel II Pillar 3" section of this report). Eligible capital is the same under BIS guidelines and FINMA regulations.

In 2008, UBS complied with all externally imposed capital requirements.

Developments

As publicly announced, in fourth quarter 2008 FINMA enhanced the capital requirements under Basel II, Pillar 2, for UBS and Credit Suisse. The new regulatory measures will have to be implemented progressively until full applicability on 1 January 2013.

First, FINMA will increase the capital buffer (the regulatory excess capital expected to be held over and above the regulatory minimum requirement) from 20% to 50%-100% over the cycle. At the same time, FINMA will allow for enlarged recognition of hybrid capital.

Second, FINMA will introduce a minimum leverage ratio, defining the minimum amount of tier 1 capital required for a given balance sheet size. For this calculation, the IFRS balance sheet is adjusted for a number of factors: replacement values determined according to the rules of IFRS are substituted by the corresponding values under Swiss Generally Accepted Accounting Principles (Swiss GAAP), allowing for increased recognition of netting benefits, similar to US GAAP. Moreover, the Swiss loan book, certain cash and balances with central banks and specified reverse repurchase agreements where the repurchase price is payable in Swiss francs will be excluded from the balance sheet. Furthermore, a number of adjustments will be made to avoid double-counting of assets that are already deducted from tier 1 capital, most notably goodwill and intangible assets. FINMA will require a minimum leverage ratio of 3% on Group level, with an expectation that the ratio will be well above the minimum requirements in normal times.

The table on the next page shows the calculation of the FINMA consolidated leverage ratio as of 31 December 2008.

In January 2009, the Basel Committee on Banking Super-vision issued consultative documents on proposed revisions to the Basel II market risk framework. Broadly, the committee aims to address perceived shortcomings of the current Value at Risk (VaR) framework, most notably by enhancing capital requirements to incorporate effects of "stressed VaR" and by introducing new capital charges for price risks that are incremental to any default and event risks already captured by VaR models used by banks. Furthermore, the Basel Committee also plans to update - for regulatory capital purposes - the prudent valuation guidance for illiquid positions accounted for at fair value. It is envisaged that the revised requirements will have to be implemented by the end of 2009 and 2010, respectively.

Finally, in January 2009 the Basel Committee issued a consultative document on further enhancements to the Basel II framework, with revised requirements for securitization exposures and, in particular, higher risk weights for re-securitization positions.

Capital ratios

The BIS ratios compare the amount of eligible capital (in total and tier 1) with the total of risk-weighted assets.

At year-end 2008, the BIS tier 1 ratio amounted to 11.0% and the total capital ratio to 15.0%, compared with 9.1% and 12.2%, respectively, under Basel I rules at year-end 2007. In this period, risk-weighted assets declined from CHF 374.4 billion (Basel I) to CHF 302.3 billion, while tier 1 capital decreased from CHF 34.1 billion to CHF 33.2 billion.

Eligible capital and capital ratios were restated following a change in accounting policy on pension and other post-retirement benefit plans (refer to "Note 30 Pension and other post-retirement benefit plans" in the financial statements of this report for more information). Due to this restatement, tier 1 capital and total capital increased by approximately CHF 1.6 billion and the corresponding capital ratios by 40 basis points at year-end 2007.

Capital requirements

UBS's capital requirements are generally based on its consolidated financial statements in accordance with IFRS. Under IFRS, subsidiaries and special purpose entities that are directly or indirectly controlled by UBS must be consolidated, whereas for regulatory capital purposes, different consolidation principles apply. For example, subsidiaries that are not active in the banking and finance business are excluded.

Refer to the additional capital management disclosure in the "Basel II Pillar 3" section of this report

On 31 December 2008 risk-weighted assets were CHF 302.3 billion, compared with CHF 374.4 billion (Basel I) at year-end 2007. Figures by component are as follows:

Credit risk

Risk-weighted assets for credit risk amounted to CHF 222.6 billion at 31 December 2008, compared with CHF 323.3 billion under Basel I on 31 December 2007. The introduction of Basel II led to considerably lower risk-weighted assets for credit risk. However, the impact on individual business divisions varied: Global Wealth Management & Business Banking saw lower risk-weighted assets for customer loans, mortgages and lombard lending, while the Investment Bank was subject to higher capital requirements for over-the-counter (OTC) derivatives and repo-style transactions (i.e. repurchase / reverse repurchase and securities, lending and borrowing transactions).

Refer to the "Credit risk" section of this report for more information

Non-counterparty related assets

Risk-weighted assets for non-counterparty related assets amounted to CHF 7.4 billion at 31 December 2008, compared with CHF 9.0 billion under Basel I on 31 December 2007.

Market risk

In 2008, risk-weighted assets for market risk decreased by CHF 14.5 billion to CHF 27.6 billion on 31 December 2008, due to lower regulatory VaR. The decrease resulted primarily from the transfer of certain illiquid assets from the trading book to the banking book on 1 January 2008 and was partially offset by increases in VaR following higher market volatility and enhancements made to the VaR model.

Refer to the "Market risk" section of this report for further information

Operational risk

The new Basel II capital requirement for operational risk amounted to risk-weighted assets of CHF 44.7 billion on 31 December 2008.

Refer to the "Operational risk" section of this report for further information

Eligible capital

The capital available to support risk-weighted assets - eligible capital - consists of tier 1 and tier 2 capital. Tier 1 capital is required to be at least 4% of risk-weighted assets and total capital (tier 1 plus tier 2) at least 8%. To determine eligible tier 1 and total capital, adjustments have to be made to shareholders' equity as defined under IFRS, most notably by deducting goodwill and investments in unconsolidated entities engaged in banking and financial activities.

Tier 1 capital / UBS shares

On 31 December 2008, the regulatory eligible tier 1 capital was CHF 33.2 billion, down CHF 0.9 billion compared with year-end 2007. This is the net effect of: CHF 21.3 billion in losses incurred during 2008; reversal for capital purposes of CHF 4.5 billion gains recognized under IFRS related to the accounting for the mandatory convertible notes (MCNs) issued in March and December 2008 (refer to the "IFRS equity to BIS tier 1 capital" section below for more information); CHF 3.8 billion reductions of capital related to own shares; CHF 2.9 billion losses recognized directly in equity; additional deductions of CHF 2.6 billion for intangible assets and other Basel II deductions; and the reversal of CHF 2.3 billion of gains on own credit for capital purposes. These negative effects were compensated by the issue of CHF 13.0 billion MCNs on 5 March 2008, proceeds of EUR 1.0 billion from the issuance of perpetual preferred securities on 11 April 2008, the net proceeds from the rights issue of CHF 15.6 billion on 17 June 2008, and the issuance of CHF 6.0 billion MCNs on 9 December 2008.

Hybrid tier 1 capital

Hybrid tier 1 instruments are perpetual instruments that can only be redeemed if they are called by the issuer. The payment of interest is subject to compliance with minimum capital ratios and any payment missed is non-cumulative. As of 31 December 2008, UBS's hybrid tier 1 instruments amounted to CHF 7.4 billion. Under IFRS, these instruments are accounted for as equity attributable to minority interests.

Tier 2 capital

Tier 2 capital consists mainly of subordinated long-term debt that ranks senior to both UBS shares and hybrid tier 1 instruments but is subordinated to all senior obligations of UBS. Tier 2 capital accounted for CHF 12.2 billion in total capital as of year-end 2008.

Refer to the "Shares and capital instruments" section of this report for details about UBS's issuance of capital securities during 2008, including hybrid tier 1 instruments and tier 1 instruments

Intragroup transfer of capital

UBS enters into intragroup transactions in order to manage funding and capital of individual UBS entities. As at 31 December 2008, UBS was not aware of any material restrictions, or other major impediments, concerning the transfer of funds or regulatory capital within the Group apart from those which apply to these entities by way of local laws and regulations.

IFRS equity to BIS tier 1 capital

The key adjustments made to IFRS equity attributable to shareholders to determine tier 1 eligible capital result from:

- An increase in IFRS share premium of CHF 7.0 billion and retained earnings of CHF 3.8 billion from the recognition of CHF 13.0 billion MCNs issued in March 2008, versus an increase of tier 1 capital (recognized in BIS share premium) by CHF 13.0 billion. Refer to "Note 26 Capital increases and mandatory convertible notes" in the financial statements of this report for more information.

- The different treatment of MCNs placed with the Swiss Confederation in December 2008 for IFRS and regulatory capital purposes: IFRS equity attributable to UBS shareholders decreased overall by CHF 2.9 billion, which reflects the net effect of a reduction to share premium of CHF 3.6 billion and a positive impact on retained earnings of CHF 0.7 billion. In contrast, tier 1 capital increased by CHF 6.0 billion. Refer to "Note 26 Capital increases and mandatory convertible notes" in the financial statements of this report for more information.

- A negative impact on BIS share premium of CHF 0.9 billion from adjustments for the recognition of interest payments on both MCNs for capital purposes.

- The inability to recognize, for tier 1 capital, fair value changes recorded directly in equity under IFRS from financial investments available-for-sale and cash flow hedges (reduction of CHF 1.3 billion).

- Further corrections in retained earnings for gains on own credit of CHF 3.0 billion relating to the application of the fair value option under International Accounting Standard (IAS) 39 for capital adequacy purposes.

- Removing minority interests of entities not consolidated for regulatory capital purposes, causing a further reduction of regulatory capital by CHF 0.5 billion.

- A positive adjustment of CHF 1.7 billion primarily for the ability to net, for capital purposes, treasury shares held as hedges against obligations from employee stock options granted prior to August 2006.

Equity attribution framework

In first quarter 2008, UBS implemented a new framework for attributing equity capital to its businesses. This reflects UBS's overarching objectives of maintaining a strong capital base and guiding businesses towards activities with the best balance among profit potential, risk and capital usage. In this framework, the Group Executive Board (GEB) attributes equity to the businesses after considering their risk exposure, asset size, goodwill and intangible assets.

The design of the equity attribution framework enables UBS to:

- Calculate and assess return on attributed equity (RoaE) in each of its businesses. With effect from first quarter 2008, RoaE and return on BIS risk-weighted assets (RoRWA) are disclosed for all business groups and units and replace the previously disclosed "return on allocated regulatory capital" measure.

- Integrate Group-wide capital management activities with those at business group and business unit level.

- Measure performance in a consistent manner across business divisions and business units.

- Make better comparisons between the Group's businesses and those of competitors.

The framework operates as follows: First, each business is attributed an amount of equity equal to the average book value of goodwill and intangible assets, as reported for that business division or business unit according to IFRS. Next, the GEB considers a number of factors that drive required capital, including:

- Equity requirements based on aggregated risk exposure, including the potential for losses exceeding UBS's earnings capacity as defined by the firm's "capital-at-risk" concept.

- Regulatory capital requirements which are based on risk-weighted asset usage of the businesses and also take into account the different market standards for tier 1 ratios associated with "pure-play" competitors of each of the businesses.

- The asset size of the businesses.

After reviewing the results of this formulaic approach, the GEB makes adjustments to the final tangible equity attribution to reflect the amount of equity it believes is appropriate for each business. This assessment is based on the expectations of the business's clients and the business environment, including allowing for sufficient capital to support the business's underlying risks and sustain extreme stress scenarios. The amount of equity attributed to all the businesses corresponds to the amount that UBS believes is required to maintain a strong capital base and support its businesses adequately. If the total equity attributed to the businesses differs from the Group's actual equity during a particular period, the surplus or deficit is shown in the Corporate Center.

As reflected in the table below, during 2008, the amount of average equity attributed to the Investment Bank was reduced by CHF 2 billion due to lower risk exposures. In the fourth quarter, the average equity attributed to Global Wealth Management & Business Banking grew by CHF 1 billion, mainly reflecting actual and projected increases in capital needs for operational risks in Wealth Management US. Global Asset Management's average attributed equity was CHF 3 billion during 2008.

In the table below, equity attributable to UBS shareholders includes the CHF 13 billion nominal value of the MCNs issued in March 2008. However, the CHF 6 billion nominal value of the MCNs issued in December 2008 will be included in this figure only when the notes will be converted or if certain other conditions are met which make it appropriate to include the December 2008 MCNs in equity.