Risk factors

Certain risks, including those described below, can impact UBS's ability to carry out its business strategies and directly affect its business activities, financial condition, results of operations and prospects. Because the business of a broad-based international financial services firm such as UBS is inherently exposed to risks that only become apparent with the benefit of hindsight, risks of which UBS is not presently aware could also materially affect its business activities, financial condition, results of operations and prospects. The sequence in which the risk factors are presented below is not indicative of their likelihood of occurrence or the potential magnitude of their financial consequences.

Risks related to the current market crisis

UBS, like many other financial market participants, was severely affected by the financial crisis that unfolded in 2007 and worsened in 2008. The deterioration of financial markets in 2008 was extremely severe by historical standards, and UBS recorded substantial losses on legacy risk positions. UBS has taken a series of measures to reduce its risk exposures, including the sale of up to USD 38.6 billion of illiquid and other positions to a fund owned and controlled by the Swiss National Bank (SNB) as announced in the fourth quarter. However, UBS continues to hold positions identified as risk concentrations (refer to the "Risk concentrations" section of this report for more information on these positions, as well as positions in other asset classes that might be negatively affected by the current market crisis). In addition, UBS is exposed to the general systemic and counterparty risks that are exacerbated by the ongoing market crisis and related instability of financial institutions and of the financial system as a whole.

UBS holds positions which may be adversely affected by the ongoing financial crisis and economic climate

As discussed in the paragraphs below on general risk factors, the development of market conditions and the overall economic environment, as well as factors affecting particular assets, may lead to reductions in the market or carrying value of UBS's assets. Although UBS's exposure to the US mortgage market (including residential sub-prime, Alt-A and prime) was reduced dramatically in 2008, UBS remains exposed to that market, albeit on a reduced scale. In addition, certain of its monoline-insured positions are exposed to the US residential mortgage market as described below. The markets for most US mortgage-related securities have so far remained illiquid and it is impossible to determine whether and how long current market conditions will persist, or whether they will further deteriorate.

UBS relies on credit protection from third parties, including monoline insurers, that may not be effective

UBS's business entails exposure to counterparty credit risk, including to monoline insurers and other providers of credit protection. UBS's credit exposure to the monoline sector arises from over-the-counter (OTC) derivative contracts - mainly credit default swaps (CDSs) which are carried at fair value - in respect of mortgage related and "monoline-wrapped" securities. The fair value of these CDSs - and thus UBS's exposure to the counterparties - depends on the valuation and the perceived credit risk of the instrument against which protection has been bought. Monoline insurers have been very adversely affected by their exposure to US residential mortgage-linked products, resulting in credit rating downgrades and the need to raise additional capital. UBS has recorded large credit valuation adjustments on its claims against monoline counterparties. If the financial condition of these counterparties or their perceived creditworthiness deteriorates further, UBS could record further credit valuation adjustments on the CDSs bought from monoline insurers.

UBS could also incur losses in connection with restructurings of monoline insurers, including possible losses on third party hedge protection which UBS may incur as a result of changes in the corporate structure of the insurers. UBS also trades securities issued by and derivatives related to monoline insurers, including CDSs, and the value of these securities and derivatives is subject to market volatility.

UBS holds positions in asset classes that have been or might be negatively affected by the current market crisis

In 2007 and 2008, UBS incurred substantial losses (realized and mark-to-market) on its holdings of securities related to the US residential mortgage market. The market dislocation that began in 2007 has been progressively felt in asset classes beyond US residential mortgages. In 2008, UBS recorded markdowns on other assets carried at fair value, including auction rate securities (ARS), leveraged finance commitments, commercial mortgages in the United States and non-US mortgage- and asset-backed securities (ABSs). UBS has recorded and in the future could record negative fair value adjustments on these assets and on other asset classes which may be affected by the crisis in the credit markets. Such securities may also be wrapped by monoline insurers and therefore could give rise to losses if the difficulties in the monoline sector persist or increase (see the previous risk factor on monoline exposures).

UBS's inventory of ARS is likely to increase in the future as a result of its commitment to repurchase client-owned ARS, as further described in the "Risk management" section of this report. UBS is also exposed to the risk of losses and write-downs on its leveraged finance commitments. UBS holds positions related to real estate markets in countries other than the United States on which it could also suffer losses. These include exposures to non-US residential and commercial real estate and mortgages and non-US ABS programs. For example, as described in the "Credit risk" section of this report, UBS has a very substantial Swiss mortgage portfolio which is booked in Global Wealth Management & Business Banking. UBS is also exposed to risk when it provides financing against the affected asset classes such as in its prime brokerage, reverse repo and lombard lending activities.

Risk factors related to UBS's business activity

Performance in the financial services industry depends on the economic climate - negative developments can adversely affect UBS's business activities

The financial services industry prospers in conditions of economic growth, stable geopolitical conditions, capital markets that are transparent, liquid and buoyant and positive investor sentiment. An economic downturn, inflation or a severe financial crisis (as seen in 2008) can negatively affect UBS's revenues and it may be unable to immediately adjust all of its costs to the resulting deterioration in market or business conditions.

A market downturn can be precipitated by a number of factors, including geopolitical events, changes in monetary or fiscal policy, trade imbalances, natural disasters, pandemics, civil unrest, war or terrorism. Because financial markets are global and highly interconnected, even local and regional events can have widespread impact well beyond the countries in which they occur. A crisis could develop, regionally or globally, as a result of disruption in emerging markets, which are particularly susceptible to macro-economic and geopolitical developments, or as a result of the failure of a major market participant. As UBS's presence and business in emerging markets increases, it becomes more exposed to these risks.

Adverse and extreme developments of this kind have affected UBS's businesses in a number of ways, and may continue to have further adverse effect on the firm's businesses:

- a general reduction in business activity and market volumes affects fees, commissions and margins from market-making and customer-driven transactions and activities;

- a market downturn is likely to reduce the volume and valuations of assets UBS manages on behalf of clients, reducing its asset- and performance-based fees;

- reduced market liquidity limits trading and arbitrage opportunities and impedes UBS's ability to manage risks, impacting both trading income and performance-based fees;

- assets UBS holds for its own account as investments or trading positions could continue to fall in value;

- impairments and defaults on credit exposures and on trading and investment positions could increase, and losses may be exacerbated by falling collateral values; and

- if individual countries impose restrictions on cross-border payments or other exchange or capital controls, UBS could suffer losses from enforced default by counterparties, be unable to access its own assets, or be impeded in - or prevented from - managing its risks.

The developments mentioned above can affect the performance of both the Group and its business units. As such, there is a risk that the carrying value of goodwill of a business unit might suffer impairments.

Due to its sizeable trading inventory, trading activities and the counterparty credit risks in many of its businesses, UBS is dependent upon its risk management and control processes to avoid or limit potential losses

Controlled risk-taking is a major part of the business of a financial services firm. Credit is an integral part of many of UBS's retail, wealth management and Investment Bank activities. This includes lending, underwriting and derivatives businesses and positions.

Changes in interest rates, equity prices, foreign exchange levels and other market fluctuations can adversely affect UBS's earnings. Some losses from risk-taking activities are inevitable but, to be successful over time, UBS must balance the risks it takes with the returns it generates. It must therefore diligently identify, assess, manage and control its risks, not only in normal market conditions but also as they might develop under more extreme ("stressed") conditions, when concentrations of exposure can lead to severe losses.

As seen in 2008, UBS is not always able to prevent losses arising from extreme or sudden market events that are not anticipated by its risk measures and systems and affect sizeable inventory positions and therefore lead to serious losses. Value at Risk (VaR), a statistical measure for market risk, is derived from historical market data, and thus, by definition, could not have predicted the losses seen in the stressed conditions in 2008. Moreover, stress loss and concentration controls, and the dimensions in which UBS aggregates risk to identify potentially highly correlated exposures, proved to be inadequate.

UBS's tools and processes for market and credit risk control, including country risk, its approach to risk management and control, and the steps UBS has taken to strengthen its risk management and control framework are described in the "Risk management" section of this report.

Notwithstanding such steps, UBS could suffer further losses in the future if, for example:

- it does not fully identify the risks in its portfolio, in particular risk concentrations and correlated risks;

- its assessment of the risks identified, or its response to negative trends, proves to be inadequate or incorrect;

- markets move in ways that are unexpected - in terms of their speed, direction, severity or correlation - and UBS's ability to manage risks in the resultant environment is therefore restricted;

- third-parties to whom UBS has credit exposure or whose securities it holds for its own account are severely affected by events not anticipated by UBS's models and the bank accordingly suffers defaults and impairments beyond the level implied by its risk assessment; or

- collateral or other security provided by its counterparties proves inadequate to cover their obligations at the time of their default.

UBS also manages risk on behalf of its clients in its asset and wealth management businesses. Its performance in these activities could be harmed by the same factors. If clients suffer losses or the performance of their assets held with UBS is not in line with relevant benchmarks against which clients assess investment performance, UBS may suffer reduced fee income and a decline in assets under management or withdrawal of mandates.

If UBS decided to support a fund or another investment sponsored by UBS in its asset or wealth management business it might, depending on the facts and circumstances, incur charges that could increase to material levels. UBS does not currently foresee the likelihood of material losses as a result, but the possibility cannot be definitively ruled out.

Investment positions - such as equity holdings made as a part of strategic initiatives and seed investments made at the inception of funds managed by UBS - may also be affected by market risk factors. These investments are often not liquid and are generally intended or required to be held beyond a normal trading horizon. They are subject to a distinct control framework (described in the "Risk and treasury management" section of this report). Deteriorations in the fair value of these positions would have a negative impact on UBS's earnings.

The valuation of certain assets relies on models. For some or all of the inputs to these models there is no observable source

Where possible, UBS marks its trading book assets at their quoted market price in an active market. In the current environment, such price information is not available for certain instruments and UBS applies valuation techniques to measure such instruments. Valuation techniques use "market observable inputs" where available, derived from similar assets in similar and active markets, from recent transaction prices for comparable items or from other observable market data. For positions for which some or all of the reference data is not observable or has limited observability, UBS uses valuation models with non-market observable inputs. "Note 27 Fair value of financial instruments" in the financial statements of this report provides detailed information on the determination of fair value from valuation techniques. There is no single market standard for valuation models in this area. Such models have inherent limitations; different assumptions and inputs would generate different results, and these differences could have a significant impact on UBS's financial results. UBS regularly reviews and updates its valuation models to incorporate all factors that market participants would consider in setting a price, including factoring in current market conditions. Judgment is an important component of this process. Changes in model inputs or in the models themselves could have a material impact on UBS's financial results.

Credit ratings and liquidity and funding management are critical to UBS's ongoing performance

Moody's Investors Service, Fitch Ratings and Standard & Poor's all lowered their long-term credit rating of UBS, on one or more times in 2008 and 2009. A further reduction in UBS's credit rating could increase its funding costs, in particular with regard to funding from wholesale unsecured sources, and reduce access to capital markets. Some of these ratings downgrades have resulted, and additional reductions in the credit ratings would result, in UBS having to make additional cash payments or post additional collateral. These events may increase UBS's need for funding to ensure that it will always have sufficient liquidity to meet liabilities when due, while reducing its ability to obtain such funding. UBS's credit ratings also have an impact on the performance of UBS's businesses. Along with UBS's capital strength and reputation, both of which are described in greater detail in the risk factors below, UBS's credit ratings contribute to maintaining client and counterparty confidence in UBS.

Liquidity is essential to UBS's businesses. A substantial part of UBS's liquidity and funding requirements are met using short-term unsecured funding sources, including wholesale and retail deposits and the regular issuance of money market securities. The volume of these funding sources has generally been stable, but may change in the future due, among other things, to general market disruptions. Any such change could occur quickly and without notice. If such a change were to occur, UBS could be forced to liquidate assets, in particular from its trading portfolio, to meet maturing liabilities or deposit withdrawals. Given the depressed prices of many asset classes in current market conditions, UBS might be forced to sell assets at discounts that could adversely affect its profitability and its business franchises.

In 2008, UBS's credit spreads increased substantially, in line with the general trend for the financial services industry. If these trends continue, or if UBS maintains substantially elevated levels of liquidity for an extended period of time, the combination of an increase in UBS's borrowing costs and lower margins could have an adverse impact on the firm's profitability.

Refer to the "Risk and treasury management" section of this report for more information on UBS's approach to liquidity and funding management

UBS's capital strength is important to support its client franchise

UBS's capital position measured by the BIS capital ratios is and has traditionally been strong, both in absolute terms and relative to its competitors. Capital ratios are determined by (1) risk-weighted assets (RWAs) (balance sheet, off-balance sheet and other market and operational risk positions, measured and risk-weighted according to regulatory criteria) and (2) eligible capital.

Both RWAs and eligible capital are subject to change. Eligible capital, for example, could experience a reduction in case of financial losses, acquired goodwill or as a result of foreign exchange movements. RWAs, on the other hand, will be driven by UBS's business activities and by changes in the risk profile of these assets. They could furthermore be subject to a change in regulatory requirements or the interpretation thereof. For instance, substantial market volatility, a widening of credit spreads (the major driver of UBS's VaR), a change in regulatory treatment of certain positions (including, but not limited to, the definitions of assets allocated to the trading or the banking books), stronger foreign currencies, increased counter-party risk or a further deterioration in the economic environment could result in a rise in RWAs or a change in capital requirements and thereby potentially reduce UBS's capital ratios.

Operational risks may affect UBS's business

All UBS's businesses are dependent on the bank's ability to process a large number of complex transactions across multiple and diverse markets in different currencies, in addition to being subject to the many different legal and regulatory regimes of these countries. UBS's operational risk management and control systems and processes, which are described in the "Operational risk" section of this report, are designed to ensure that the risks associated with the bank's activities, including those arising from process error, failed execution, unauthorized trading, fraud, systems failure and failure of security and physical protection, are appropriately controlled. If these internal controls fail or prove ineffective in identifying and remedying such risks, UBS could suffer operational failures that might result in losses.

Legal claims and regulatory risks and restrictions arise in the conduct of UBS's business

In the ordinary course of its business, UBS is subject to regulatory oversight and liability risk. It is involved in a variety of other claims, disputes and legal proceedings and government investigations in jurisdictions where UBS is active, including the United States and Switzerland. These types of proceedings expose UBS to substantial monetary damages and legal defense costs, injunctive relief, criminal and civil penalties and the potential for regulatory restrictions on UBS's businesses. The outcome of these matters cannot be predicted and they could adversely affect UBS's future business. Currently, UBS is responding to a number of government inquiries and investigations, and is involved in a number of litigations and disputes, related to the sub-prime crisis, sub-prime securities, and structured transactions involving sub-prime securities. These matters concern, among other things, UBS's valuations, disclosures, writedowns, underwriting and contractual obligations.

UBS has been in active dialogue with its regulators concerning remedial actions that it is taking to address deficiencies in its risk management and control, funding and certain other processes and systems. UBS will for some period be subject to increased scrutiny by the Swiss Financial Market Supervisory Authority and its other major regulators, and accordingly will be subject to regulatory measures that might affect the implementation of its strategic plans.

UBS recently announced that it had entered into a Deferred Prosecution Agreement with the US Department of Justice and a Consent Order with the US Securities and Exchange Commission in connection with its cross-border private banking services provided to US private clients. The US Internal Revenue Service has issued a civil summons seeking information concerning UBS's cross-border business, including records located in Switzerland, and recently filed a petition for enforcement of this summons. It is possible that this and other governmental actions will lead to changes which could affect cross-border financial services and the application of Swiss financial privacy law, and this could adversely affect the future profitability of UBS's cross-border banking businesses. Following disclosure of the US cross-border matter, moreover, it is possible that tax or regulatory authorities in various jurisdictions will focus on the cross-border wealth management services provided by UBS and other financial institutions. It is premature to speculate as to the scope or effect of any such reviews.

Refer to "Note 21 provisions and litigation" in the financial statements of this report for more information on legal proceedings in which UBS is involved

UBS might be unable to identify or capture revenue or competitive opportunities, or retain and attract qualified employees

The financial services industry is characterized by intense competition, continuous innovation, detailed (and sometimes fragmented) regulation and ongoing consolidation. UBS faces competition at the level of local markets and individual business lines, and from global financial institutions comparable to UBS in their size and breadth. Barriers to entry in individual markets are being eroded by new technology. UBS expects these trends to continue and competition to increase in the future.

The competitive strength and market position of UBS could be eroded if the firm is unable to identify market trends and developments, does not respond to them by devising and implementing adequate business strategies or is unable to attract or retain the qualified people needed to carry them out.

In particular, the efforts required to address the current market crisis and related challenges might diminish the attention UBS devotes to managing other risks including those arising from its competitive environment. The changes recently introduced with regard to UBS's balance sheet management, funding framework and risk management and control, as well as the repositioning of the fixed income, currencies and commodities business, are likely to reduce the revenue contribution of certain activities that require substantial funding or focus on proprietary trading.

Following the losses incurred in 2008, UBS very significantly reduced the variable compensation granted to its employees for that year. It is possible that, as a result of this reduction or other factors, key employees will be attracted by competitors and decide to leave UBS, or that UBS may be less successful in attracting qualified employees.

UBS's reputation is key to its business

UBS's reputation is critical in maintaining its relationships with clients, investors, regulators and the general public. The reputation of UBS can be damaged, for instance, by misconduct by its employees, by activities of business partners over which UBS has limited or no control, by severe or prolonged financial losses or by uncertainty about its financial soundness and its reliability. This could result in client attrition in different parts of UBS's business and could negatively impact its financial performance. Maintaining the firm's reputation and addressing adverse reputational developments are therefore key factors in UBS's risk management efforts.

UBS's global presence exposes the bank to other risks, including currency fluctuation

UBS operates in more than 50 countries, earns income and holds assets and liabilities in many different currencies and is subject to many different legal, tax and regulatory regimes.

UBS's ability to execute its global strategy depends on obtaining and maintaining local regulatory approvals. This includes the approval of acquisitions or other transactions and the ability to obtain and maintain the necessary licenses to operate in a local market. Changes in local tax laws or regulations and their enforcement may affect the ability or the willingness of UBS's clients to do business with the bank, or the viability of the bank's strategies and business model.

In its financial accounts, UBS accrues taxes but the final effect of taxes on earnings is only determined after completion of tax audits (which generally takes a number of years) or the expiration of statutes of limitations. In addition, changes in tax laws, judicial interpretation of tax laws or policies and practices of tax authorities could have a material impact on taxes paid by UBS and cause the amount of taxes ultimately paid by UBS to differ from the amount accrued.

Because UBS prepares its accounts in Swiss francs, while a substantial part of its assets, liabilities, assets under management, revenues and expenses are denominated in other currencies, changes in foreign exchange rates, particularly between the Swiss franc and the US dollar (US dollar income represents the major part of UBS's non-Swiss franc income) have an effect on its reported income and shareholders' equity. UBS's approach to management of this currency risk is explained in the "Treasury management" section of this report.

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