Liquidity and funding management

Liquidity risk is 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 and both are critical to 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 on an unsecured basis, or does not have sufficient good quality assets to borrow against or liquid assets to sell to raise immediate cash.

During 2007, liquidity management became a challenge following the dislocation of the US residential mortgage market, which led to a sharp reduction in trading volumes in some previously highly liquid markets. In the repo market, certain assets were subject to higher haircuts, and were sometimes not accepted. Despite these challenging conditions, UBS was able to maintain access to funding, primarily as a result of its broadly diversified funding base. In addition, in anticipation of an extended period of market turbulence, several measures were taken to further strengthen UBS's liquidity position during this period. Short-term funding targets were adjusted accordingly, and increased focus was placed on balance sheet management.

Liquidity approach

UBS's approach to liquidity management, which covers all branches and subsidiaries, is 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. Risk limits are set by the Group Executive Board (GEB) and monitored by Treasury, and contingency plans for a liquidity crisis are incorporated into UBS's wider crisis management process.

The liquidity position is assessed and managed 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.

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.

UBS's business activities generate liability portfolios which are intrinsically highly diversified with respect to market, product and currency. This provides a broad range of investment opportunities for UBS's clients and thus reduces the firm's exposure to individual funding sources, 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 Treasury and the foreign exchange and money market (FX&MM) unit within Investment Bank fixed income, currencies and commodities (FICC). 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 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 minimizes its external borrowing and use of available credit lines, and presents a consistent and coordinated face to the market.

Liquidity modeling and contingency planning

The daily liquidity position – the net cumulative funding requirement for a specific day – is projected under cautious assumptions for each business day from the current day out to one month to produce a cumulative "cash ladder". The short-term cash ladder is the tool used by FX&MM to manage net daily funding requirements efficiently, while Treasury monitors liquidity exposure against limits set by the GEB.

UBS also regularly assesses the impact of a liquidity crisis scenario, combining a firm-specific crisis with market disruption and focusing on a time horizon starting with overnight and extending up to one year. This UBS-specific scenario envisages large draw-downs 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 build-up of a liquidity buffer to absorb potential sudden liquidity gaps, can be put into effect.

The starting point for stress testing analyses is a breakdown of the contractual maturity of UBS's assets and liabilities. One such breakdown is shown in the 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 stress analyses and a more detailed breakdown of asset and liability types.

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, 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 papers (outstanding volume CHF 152.3 billion on 31 December 2007) and that no contingency funding could be raised on an unsecured basis. It also factors in potential liquidity outflows from contingent liabilities, in particular those resulting from the drawdown of committed credit lines. Exposures to other contingent commitments, such as guarantees and letters of credit, are included in this analysis, although they are not as vulnerable since they are generally not unconditional but, rather, are linked to other, independent conditions being fulfilled.

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.

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's contingent exposure arising directly from these rating triggers is judged not to be material compared to its liquidity-generation capacity, even in a crisis situation. UBS also analyzes the potential impact on its net liquidity position of adverse movements in the replacement values of its over-the-counter (OTC) derivative transactions which are subject to collateral arrangements and includes the potential outflows in its crisis scenarios. 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

While its estimated capacity to generate liquidity when required will naturally vary, UBS generally applies a constant limit structure, which imposes a ceiling on the projected net funding requirement along the cash ladder. Limits are based on the amount of cash UBS believes it could raise in a firm-specific crisis.

The limits vary by time zone since access to liquidity will depend on the time of day – at the beginning of the global trading day, during Asia Pacific trading hours, the limits are less severe since more time is available to mobilize funding sources or, if necessary, initiate asset sales to generate additional liquidity. As the day proceeds and currency zones begin to close, the limits become tighter, with the strictest limits applied later in the day when only the US markets are available. FX&MM's day-to-day liquidity management is based on global books that are handed over from time zone to time zone, ensuring 24-hour coverage. Compliance with the risk limits and actual credit liquidity exposures are regularly reported to the GEB.

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 Treasury.

UBS has also developed detailed contingency plans for liquidity crisis management, the cornerstone of which is the Group's access to secured funding either from the market or from the major central banks, coupled with the ability to turn sufficient liquid assets into cash within a short time frame.

The liquidity contingency plan is an integral part of the global crisis management concept, which covers all types of crisis events. It would be implemented under a core crisis team with representatives from 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.

UBS is continuing to strengthen its relationships with the major central banks, consistent with its general policy, which is to base contingency plans on secured funding against pledges of high-quality collateral, rather than relying on third-party credit lines.

Liquidity ratios

In addition to the limits and controls described above, UBS also measures three ratios to monitor liquidity risk – the ratio of trading assets (trading portfolio assets and positive replacement values on derivatives) to total assets, the ratio of "level 1" trading assets to total assets, and the ratio of customer savings and deposits to mortgages. Level 1 trading assets are those for which fair values can be obtained from observable market prices and which are therefore considered to be the most liquid. These ratios are largely driven by UBS's two largest business groups, the Investment Bank and Global Wealth Management & Business Banking. The first two ratios show the proportion of UBS's total assets that are of a trading nature and are dominated by the Investment Bank's activities. The third ratio is mainly driven by Global Wealth Management & Business Banking and shows the extent to which UBS is effectively funding its largest Swiss asset portfolio with customer deposits (savings and deposit accounts only), which are a stable funding source – the higher this percentage, the less the bank is reliant on wholesale funding for these potentially longer-term assets.

Funding

UBS's domestic retail and global wealth management businesses have proven in the past to be valuable, cost-efficient and reliable sources of funding. 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.

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 pursue a strategy of efficient funding of 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. At the beginning of 2007, UBS decided to further strengthen its funding profile through public issuance of senior, straight, long-term debt and thereby enhance the overall diversification of its funding sources.

To ensure that a well-balanced and diversified liability structure is preserved, Treasury routinely monitors UBS's funding status and reports its findings on a quarterly basis to the GEB. Two main analysis tools are employed – "cash capital" and "secured funding capacity". UBS complements these analyses with regular assessments of any concentration risks in its main funding portfolios.

Cash capital is the excess of UBS's long-term funding over the total of illiquid assets. "Long-term" and "illiquid" both refer to a time horizon of one year. The secured funding capacity concept ensures that short-term, unsecured (wholesale) funding is effectively only invested in freely marketable assets. UBS seeks to maintain a minimum stock of unencumbered assets and cash that exceeds its outstanding short-term unsecured wholesale borrowings.

Funding position

UBS's secured funding base reduces its exposure to periods of stressed market conditions when the ability to raise unsecured funding could be temporarily restricted.

The charts below show a breakdown by product type and by currency of UBS's secured and unsecured funding as of 31 December 2007. Of the total, 22% was raised on a secured basis and 78% unsecured. The unsecured funding base is well diversified, with 19% of total funding stemming from savings and demand deposits, 17% from long-term debt, 17% from time deposits, 9% from short-term interbank borrowing, 10% from money market papers and 6% from fiduciary deposits. Around half of UBS's funding is originated in US dollars, with substantial portions in Swiss francs and euros, roughly mirroring the currency breakdown of its assets. Around 19% of funding was denominated in other currencies (primarily UK sterling and Japanese yen). UBS does not rely on buying committed credit facilities from third-party banks, but instead bases its contingent funding sources on its ability to raise secured funding through the use of high-quality collateral.

The Group enters into commitments to extend credit lines to secure the liquidity needs of customers. From the outstanding undrawn irrevocable credit facilities, approximately one-fifth mature within 12 months while four-fifths mature beyond 12 months.