Risk factors

Certain risks, including those described below, can impact UBS's ability to carry out its business strategies and directly affect its earnings. As a consequence, the revenues and operating profit of UBS have varied from period-to-period – and are likely to continue to vary – and revenues and operating profit for any particular period will not be indicative of future results.

Risks related to the current market crisis

UBS, like many other financial market participants, was severely affected by the progressive market dislocation during 2007. The deterioration of the US residential mortgage market in 2007 was more sudden and severe than any such event in recent market history. As a result, the securitized markets became illiquid and UBS's positions, including securities that had been assigned high credit ratings, lost substantial value. The losses incurred in 2007, and the positions held by UBS on 31 December 2007, are detailed in the "Risk concentrations" section of Risk, Treasury and Capital Management 2007.

UBS continues to hold positions exposed to the US residential mortgage market

As discussed in the paragraphs below on general risk factors, the values of all the assets UBS holds on its own account depend on the development of market conditions and the overall economic environment, as well as factors affecting particular assets. UBS still holds sizeable positions related to the US residential mortgage market, in particular residential mortgage-backed securities (RMBS) and super senior tranches of collateralized debt obligations (CDO) backed by RMBSs. While UBS continues to manage, trade and hedge these positions, the markets for most of these securities have so far remained illiquid. In 2007, UBS incurred substantial losses (realized and mark-to-market) on its holdings. The firm may record further realized losses upon the sale of any assets, or upon liquidation following a default under CDO structures to which it is exposed, and may record additional mark-to-market losses in the event of adverse developments specific to its positions (such as the deterioration of remittance data in underlying mortgage pools). In addition, the value of UBS's holdings has been and may be further reduced by various factors affecting the overall mortgage market or the US mortgage and real estate markets in general. These factors include deteriorating loss assumptions with respect to mortgage-related assets generally, even those assets that are not themselves experiencing difficulties, due to higher levels of mortgage borrower defaults and the possible forced sale of inventories by other market participants.

UBS has bought protection from monoline insurers that may not be effective

UBS's business entails exposure to counterparty credit risk.

UBS's credit exposure to the monoline sector arises from over-the-counter (OTC) derivative contracts – mainly credit default swaps (CDS) which are carried at fair value. 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. Towards the end of 2007, monoline insurers were adversely affected by their exposure to US residential mortgage-linked products, and UBS recorded credit valuation adjustments on the claims against monoline counterparties. If the financial condition of these counterparties or their perceived credit worthiness deteriorates further UBS could record further credit valuation adjustments on the CDSs bought from monoline insurers.

UBS is also actively trading issued securities and derivatives of monolines including CDSs and the value of these contracts is subject to market volatility.

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

The market dislocation in 2007 has been progressively felt in asset classes beyond US sub-prime mortgages. In 2007, UBS recorded markdowns on other assets carried at fair value including leveraged underwriting commitments – particularly commitments made prior to the credit market dislocation in July 2007 – and positions related to Alt-A residential mortgages and commercial mortgages in the US. In the future, UBS could record negative fair value adjustments on these assets and on other asset classes to which the effect of the crisis in the credit markets may spread, such as other US asset-backed securities or securities issued by US states and municipalities and student loan programs, including auction rate certificates (ARCs) and others. Such securities may also be wrapped by monoline insurers and therefore could incur losses if the difficulties in the monoline sector persist or increase (see the previous risk factor on monoline exposures).

As a sponsor of ARCs programs, UBS has provided liquidity to their auction processes. Due to the decreasing demand for ARC securities in light of recent market concerns about the financial status of monoline insurers and the continued deterioration of credit markets, the firm's inventory in these securities has increased and is subject to valuation uncertainties. UBS holds positions related to real estate markets in countries other than the US and these exposures could also record losses.

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 2007) would negatively affect UBS's revenues and it would be unable to immediately adjust all its costs to the resulting deterioration in market or business conditions.

A market downturn can be precipitated by 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.

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

Risk-taking is a major part of the business of a financial services firm. UBS derives a substantial part of its revenues from market-making and proprietary trading in cash and derivatives markets. 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.

Interest rates, equity prices, foreign exchange levels and other market fluctuations can adversely affect its 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. UBS's approach to risk management and control and its tools and processes for market and credit risk control, including country risk, are described in Risk, Treasury and Capital Management 2007. The steps UBS is taking to strengthen its market risk framework are also described in the same report.

As seen in 2007, UBS is not always able to prevent losses arising from extreme and sudden market dislocations 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 2007. However, stress loss and concentration controls, and the dimensions in which UBS aggregates risk to identify potentially highly correlated exposures, proved to be inadequate.

UBS is taking steps to strengthen its risk management and risk control frameworks in the affected areas, but the firm could suffer further losses in future if:

– 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; and

– 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.

Investment positions – such as equity holdings made as a part of strategic initiatives, for revenue generation, held in support of UBS's business activities, and seed investments made at the inception of funds managed by UBS – may also be affected by market risk factors. These investments, however, 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 Risk, Treasury and Capital Management 2007). Deteriorations in the fair value of these positions would have a negative impact on UBS's earnings.

The valuation of certain assets, including many of the positions related to the US sub-prime residential mortgage market, rely on models. For some or all of the inputs to these models there is no observable source

Where possible, UBS marks its assets at their quoted market price in an active market. In the current environment, such price information is not available for certain instruments linked to the US residential mortgage market 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. These positions include super senior RMBS CDO tranches related to the US residential mortgage market. Note 26 in Financial Statements 2007 provides detailed information on the determination of fair value from valuation techniques. There is no single market standard for valuation models in this area and such models have inherent limitations, and different assumptions and inputs would generate different results, and these differences could have a significant impact on UBS's financial results. UBS is obliged to regularly review and update its valuation models to incorporate all factors that market participants would consider in setting a price – this includes factoring in current market conditions. Judgment is an important component of this process and UBS carefully considers whether the assumptions and inputs of its models remain appropriate to establish a fair value for the instrument. Changes in model inputs or in the models themselves could have a material impact on UBS's financial results.

Liquidity and funding management are critical to UBS's ongoing performance

A substantial part of UBS's funding requirement is met using short-term unsecured funding sources, including wholesale and retail deposits and the regular issuance of money market paper. The volume of these funding sources is largely stable. If this situation were to change, UBS could be forced to liquidate assets, in particular from its trading portfolio, to meet maturing liabilities or deposit withdrawals. UBS might be forced to sell them at discounts that could adversely affect its profitability and its business franchises.

A reduction in its credit rating would adversely increase UBS's cost of borrowing, in particular from wholesale unsecured sources, and reduce its access to capital markets. It would also result in UBS having to make additional cash payments or post collateral, or in the premature termination of contracts with rating trigger clauses. These events may further increase UBS's liquidity needs, while reducing its ability to obtain funding.

In 2007, UBS's credit spreads increased substantially, in line with the general trend for the financial services industry. The losses UBS incurred in 2007 have put its credit ratings under pressure. If these trends continue, the combination of an increase in UBS's borrowing costs and lower margins could have an adverse impact on the firm's profitability.

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 risk-weighted assets – balance sheet, off-balance sheet and market positions, measured and risk-weighted according to regulatory criteria – and eligible capital. UBS's capital ratios could come under pressure due to financial losses, as seen towards the end of 2007, or due to an increase in risk-weighted assets. For instance, substantial market volatility, a widening of credit spreads (the major driver of UBS's VaR) or a change in regulatory treatment of certain positions could result in a rise in risk-weighted assets and thereby 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 Risk, Treasury and Capital Management 2007, 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 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 claims, disputes and legal proceedings and regulatory investigations where UBS is active, including the US, Switzerland and other jurisdictions. Regulatory activity and legal claims have increased as a consequence of the current market crisis, and are expected to increase further. Such 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.

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, in 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.

Despite the losses incurred in 2007, UBS has sought to reward its employees appropriately based on competitive compensation schemes. Given the competitiveness of the financial industry, however, the possibility cannot be excluded that 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. The firm's reputation is therefore a key factor in its risk management efforts.

UBS's global presence exposes the bank to other risks

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 the necessary licenses to operate in a local market. Changes in local tax laws or regulations 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 might take 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, revenues and expenses are denominated in other currencies, changes in foreign exchange rates have an effect on its reported income, particularly between the Swiss franc and the US dollar (US dollar income represents the major part of UBS's non-Swiss franc income). UBS's approach to management of this currency risk is explained in the corporate currency management system in Risk, Treasury and Capital Management 2007.