Capital management

In managing its capital, UBS considers a variety of requirements and expectations. Sufficient capital must be in place to support current and projected business activities, according to both UBS's own internal assessment and the requirements of its regulators, in particular its lead regulator the Swiss Federal Banking Commission (SFBC).

Capital is also managed in order to achieve sound capital ratios, to ensure strong external credit ratings and to ensure that UBS remains one of the best capitalized firms in the international banking sector. This is crucial in retaining clients' confidence in UBS's financial strength and also supports UBS's funding position and favorable borrowing costs in the international financial markets.

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 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 and regulators' expectations that UBS holds additional capital above the minimum, UBS's internal assessment of aggregate risk exposure in terms of Capital-at-risk, the views of rating agencies, and comparison to peer institutions, considering UBS's business mix and market presence.

Capital requirements

At year end 2007, UBS was subject to regulatory guidelines based on the original – Basel I – framework established by the Basel Committee on Banking Supervision ("BIS guidelines / ratios"). The capital it is required to hold is determined by its risk-weighted assets – its balance sheet, off-balance sheet and market risk positions, measured and risk-weighted according to criteria defined by its lead regulator, the SFBC. Under BIS guidelines, a financial institution's eligible capital must be at least 8% of its total risk-weighted assets.

UBS's published capital ratios and risk-weighted assets are determined according to BIS guidelines, which differ in certain respects from the regulations of the SFBC. The most important differences are:

– where BIS guidelines apply a maximum risk weight of 100%, the SFBC applies risk weights above 100% to certain asset classes (for example real estate, fixed assets, intangibles, and non-trading equity positions); and

– where the BIS guidelines apply a 20% risk weight to obligations of Organization for Economic Co-operation and Development (OECD) banks, the SFBC applies risk weights of 25% to 75%, depending on maturity.

As a result of the differences in regulatory rules, UBS's risk-weighted assets are higher and capital ratios (total and Tier 1) are lower when calculated under SFBC regulations than under BIS guidelines. UBS has always had total capital and Tier 1 capital in excess of the minimum requirements of both the BIS and the SFBC.

UBS measures on- and off-balance sheet claims according to regulatory formulas. Claims are weighted according to type of counterparty and collateral. The least risky claims, such as claims on OECD governments and claims collateralized by cash, are weighted at 0%, meaning that no regulatory capital support is required, while the claims deemed most risky, including unsecured claims on both corporate and private customers, are weighted at 100%, meaning that 8% capital support is required.

Securities not held for trading are treated as claims, based on the net position in the securities of each issuer, including both actual holdings and exposures from derivative instruments. UBS's investments in entities which are consolidated under International Financial Reporting Standards (IFRS) and which are not active in the field of banking and finance (including consolidated industrial holdings) are treated for regulatory capital purposes as positions in securities not held for trading.

Claims arising from derivatives transactions have two components – the current replacement values, and "add-ons" to reflect the potential future exposure. Where UBS has entered into a master netting agreement that is considered legally enforceable in insolvency, positive and negative re- placement values with individual counterparties can be netted. Off-balance sheet claims arising from contingent commitments and irrevocable facilities are converted into credit equivalent amounts based on percentages of nominal value specified by the regulators.

Regulatory capital is required to support market risk arising on all foreign exchange, energy, metal and other commodity positions, and on all positions held for trading purposes, including equities and traded debt obligations held in the trading book. For most market risk positions, UBS derives its regulatory capital requirement from its internal Value at Risk (VaR) model which is approved by the SFBC. It is based on 10-day VaR, which is subject to a multiplier reflecting the regulator's view of the robustness of the VaR model. This multiplier is increased in response to backtesting exceptions. For some small positions, market risk regulatory capital is computed using the standardized method defined by the regulators. Unlike the calculations for credit risk, the market risk measure produces the capital requirement itself rather than the amount of risk-weighted assets. In order to compute a total capital ratio, the total market risk capital requirement is converted to a "risk-weighted asset equivalent" such that the capital requirement is 8% of this risk-weighted asset equivalent, i.e. the total market risk capital requirement is multiplied by 12.5.

Other assets, most notably property and equipment, and intangibles are not subject to credit or market risk, but they represent a risk to the Group in respect of their potential for writedown and impairment and therefore require capital underpinning in accordance with regulatory formulas.

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

On 31 December 2007 risk-weighted assets were CHF 372.3 billion, up 9% from CHF 341.9 billion at year-end 2006. Roughly 55% of the increase was driven by exposures from the Investment Bank, in particular increased capital requirements for market risk resulting from higher market volatility and an increase in the regulatory multiplier, higher positive replacement values of derivatives, and an increase in the syndicated loan portfolio, partially offset by a decrease in risk-weighted assets for undrawn commitments and securities lending and borrowing activities. Global Wealth Management & Business Banking contributed the remainder of the risk-weighted asset increase, mainly related to increased collateralized lending.

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 finance activities.

Eligible capital is the same under BIS guidelines and SFBC regulations.

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Tier 1 capital / UBS shares

The majority of Tier 1 capital comprises retained earnings attributable to UBS shareholders. As of 31 December 2007, total IFRS equity attributable to UBS shareholders amounted to CHF 35,585 million, which serves as the basis for determining the regulatory eligible Tier 1 capital. The mandatory convertible notes (MCNs), which were announced on 10 December 2007 did not contribute to eligible capital as of 31 December 2007, but became eligible capital after the approval of the issue of MCNs at the EGM, which took place on 27 February 2008.

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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. UBS's hybrid Tier 1 instruments are accounted for under equity attributable to minority interests and amounted to CHF 6,387 million as of 31 December 2007, representing approximately 19.5% of eligible Tier 1 capital.

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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 with respect to all senior obligations of UBS. Tier 2 instruments accounted for CHF 14,071 million in total capital as of year-end 2007.

UBS's eligible capital is based on its consolidated financial statements prepared under IFRS. As illustrated in the table on the opposite page, shareholders' equity is subject to a number of adjustments to arrive at regulatory eligible capital.

On 31 December 2007, BIS Tier 1 capital was CHF 32.8 billion, down from CHF 40.5 billion at year end 2006, reflecting primarily the negative effects of the loss in 2007, accruals for share based compensation plans and foreign exchange translation differences. In 2007, UBS issued EUR 600 million of innovative Tier 1 capital instruments (Trust Preferred Securities).

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:

– the ability to net treasury shares held as hedges against obligations from employee stock options granted prior to August 2006 (reducing deductions for treasury shares by CHF 6,230 million);

– the inability to recognize fair value changes recorded directly in equity under IFRS from financial investments available-for-sale and cash flow hedges (reduction of CHF 1,509 million);

– a reduction in retained earnings relating to the application of the fair value option under International Accounting Standard (IAS) 39 for capital adequacy purposes, which was partially offset by adjustments for differences in the scope of consolidation (reducing retained earnings by net CHF 564 million); and

– removing minority interests other than trust preferred securities, causing a further reduction of CHF 564 million.

Capital ratios

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

The combination of the 9% risk-weighted assets increase and the 19% reduction in BIS Tier 1 capital resulted in a decrease of BIS Tier 1 ratio by 3.1 percentage points to 8.8% at the end of December 2007, down from 11.9% at year-end 2006. In the same period, the total capital ratio decreased from 14.7% to 12.0%.

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Introduction of Basel II

Upon implementation of Basel II on 1 January 2008, UBS expects the overall impact on its BIS Tier 1 ratio to be negative, depending on the further development of the business mix, in particular the profile of the loan book. This expectation is based on a direct comparison between capital ratios under regulations effective at year-end 2007 and the corresponding ratios at the same date under Basel II rules.

Overall, the implementation of Basel II will introduce capital requirements that are more accurate and sensitive to underlying risk positions: not only is the type of counterparty considered when determining the risk-weighted assets; both the counterparty rating and the type of transaction, including collateralization, are taken into account. A new capital requirement for operational risks will also be introduced as part of Basel II.

In addition, with the advent of Basel II, the calculation of the eligible capital will be tightened through the introduction of new deductions from Tier 1 capital and total capital. This will lower the capital ratios, but at the same time clearly improve the quality of capital available to support risks.

Future capital ratios will depend on, among other factors, developments in financial markets and their impact on profit and loss, valuations and capital requirements for market risk; the development of the credit quality of UBS's obligors and counterparties; future issuances of capital instruments and the management of treasury shares; capital requirements for operational risk; and future changes in the regulatory frameworks.