Credit risk control

Limits and controls

Disciplined processes are in place within the Business Groups and Corporate Center to ensure prompt identification, accurate assessment, proper approval and consistent monitoring and reporting of credit risk. We manage, limit and control concentrations of credit risk wherever we identify them, in particular to individual counterparties and groups and to industries and countries, where appropriate.

We set limits on our credit exposure to both individual counterparties and counterparty groups. Credit limits for individual counterparties are applied to all exposure types, including the close out exposure on repos and securities borrowing and lending and the maximum likely exposure on OTC derivatives. The Investment Bank also uses, as a management tool, a measure which translates all exposures into a benchmark loan equivalent, taking into account expected changes in exposure profile of traded products and credit rating migration of the counterparty, with the possibility that exposure reduction through syndication, sale or hedging may be required if maximum guidelines are exceeded.

We apply limits in a variety of forms to portfolios or sectors where we consider it appropriate to restrict credit risk concentrations or areas of higher risk, or to control the rate of portfolio growth. Typically, these situations arise in the Investment Bank.

In the Investment Bank, where it is most relevant, we differentiate between “take and hold_ and “temporary_ exposures, the latter being those accepted with the intention of syndicating, selling or hedging within a short period.

For take and hold exposures, the quality of the credit over the prospective term of the engagement is the primary consideration and we assess on an ongoing basis the way in which the credit risk in these portfolios (both in aggregate and in sub-portfolios) is evolving over time.

For temporary exposures, by contrast, a more critical factor is the potential for distribution. In a disciplined approach to underwriting, we make a rigorous assessment of current market conditions and the marketability of the assets, and all commitments must be agreed by the distribution function, as well as the originating business unit, and approved by both business management and risk control. Many of our temporary exposures arise from leveraged buyout (LBO) financings which are used by financial sponsors (typically private equity firms) to acquire or recapitalize entire companies. As capital has been attracted to the sector over recent years, the number and size of transactions have grown significantly, and leverage has increased, with the result that average credit ratings are lower and risk concentrations higher than the average in our lending portfolio. Given the focus on distribution in our commitment process, these large concentrations are generally brought down within a few months to a relatively modest retained exposure to individual counterparties. Any stale or sticky positions are closely monitored and the business may be required to sell or hedge them in the secondary market. There are comprehensive limits covering the portfolio, including a variety of stress loss limits, which encourage rapid distribution in order to free up capacity for further transactions, and which can be adjusted if market conditions or our own performance suggest that contraction or expansion of activity is appropriate.

Risk mitigation

In our Wealth Management business, loans to private individuals are typically secured by portfolios of marketable securities. We apply appropriate discounts (“haircuts_) to the current value of collateral in determining the amount we are prepared to lend against securities, reflecting their liquidity and volatility. Exposures and collateral positions are continuously monitored and strict margin call and close-out procedures are enforced when the market value of collateral falls below predefined levels. Collateral concentrations across client portfolios are monitored and reported. Over time the types of financial instrument that our clients ask us to accept as eligible collateral has broadened and, in line with market practice, we are now accepting more complex instruments, but the haircuts we apply reflect the additional risks and our disciplined processes continue to be strictly applied.

In Business Banking, loans to corporations may, depending on our assessment of the credit capacity and quality of the borrower, be extended on an unsecured basis, but often benefit from collateral in the form of real estate or other assets.

In addition to these lending activities, property financing is an important part of the business of Global Wealth Management & Business Banking. The majority of our exposure consists of home loans to private individuals. We are also active in financing income producing real estate, primarily apartment buildings and, to a lesser extent, commercial properties. In all cases we apply prudent loan to value ratios and consider the ability to service the debt from income.

Loans made by the Investment Bank to corporates are not typically supported by collateral or other security but over the past five years we have engaged in a substantial credit risk hedging program for our banking product take and hold exposures. For the most part, we have effected these hedges by transferring underlying credit risk to high-grade market counterparties using single name credit default swaps. We have also created a number of credit-pooling vehicles to transfer a portion of our global credit risk portfolio via credit linked notes to outside investors. We use such tools as part of our general strategy of avoiding undue concentrations of risk to individual names or sectors, or in specific portfolios.

The OTC derivatives market continues to grow and with the consolidation of financial institutions through mergers and takeovers outstanding transaction volumes with individual professional counterparties have the potential to be very large, although credit exposure is only a small fraction of these amounts. In the Investment Bank, we conduct our OTC derivatives business almost without exception under master agreements, which generally allow for the close out and netting of all transactions in the event of default by the other party. Provided such agreements are judged to be enforceable in insolvency in the jurisdiction of the counterparty, we measure our exposure after netting values in our favor against values in the counterparty’s favor, permitting a much higher volume of business than would otherwise be the case. In line with general market practice we have also entered into two-way collateral agreements with market participants, under which either party can be required to provide collateral in the form of cash or marketable securities when exposure exceeds a pre-defined level. Under such two-way agreements, both sides benefit from continued flow of business without creating undue concentrations of credit risk. OTC derivatives business with lower rated counterparties is generally conducted under one-way collateral agreements under which the counterparty provides collateral to UBS. Some of the businesses of the Investment Bank, in particular our OTC derivatives and securities financing business with hedge funds, are conducted almost entirely against the provision of collateral. In the case of hedge funds, this allows us to continue expanding our client base and the business we conduct in this important and dynamic sector, while maintaining credit risk at acceptable levels and avoiding undue credit risk concentrations.

The mitigation of credit risk in this way creates operational risks because it generally requires the execution of legal agreements and, in the case of collateral agreements, daily valuations and adjustments of collateral positions. The controls around these activities must be robust and strictly enforced, especially where the activity is on a large scale and volumes are high, as is the case with our hedge fund and OTC derivatives businesses. We have strict standards for netting and collateral agreements, including assurance that contracts are legally enforceable in insolvency in the relevant jurisdictions. The Investment Bank has rigorous systems and processes in a dedicated unit in the operations group to measure and monitor the value of both underlying credit instruments and collateral to ensure that the potential loss in the event of a counterparty default is within approved limits and tolerances on an ongoing basis. Concentrations in collateral type are also monitored where relevant.

Global Wealth Management & Business Banking

Global Wealth Management & Business Banking’s gross loans on 31 December 2005 amounted to CHF 217 billion, of which CHF 136 billion (62%) were secured by real estate and CHF 56 billion (26%) by marketable securities. The pie chart above shows that exposure to the real estate sector is well diversified with 40% of loans being secured on single-family homes and apartments, which, historically, have exhibited a low risk profile. The 13% of exposure secured on residential multi-family homes consists of rented apartment buildings. Loans and other credit engagements with individual clients, excluding mortgages, amounted to CHF 75 billion and are predominantly extended against the pledge of marketable securities. The volume of collateralized lending to private individuals rose by CHF 14 billion or 34% from the previous year, as the low interest rate environment triggered an increase in demand for this product and as we accepted a slightly broader and more complex range of investment instruments as eligible collateral.

Unsecured loans consist predominantly of exposures to corporate clients in Switzerland. They are widely spread across rating categories and industry sectors, reflecting our position as a market-leading lender to this segment of mostly small- to medium-sized enterprises in Switzerland. During 2005 we have continued to focus on improving the quality of our credit portfolio, reducing both individual and sector concentrations.

The table above shows credit exposure across counterparty ratings and loss given default (LGD) buckets. The concentration in the rating grade 5 and LGD bucket 0–25% reflects the dominant residential mortgage business.

Investment Bank

A substantial majority of the Investment Bank’s credit exposure falls into the investment grade category (internal counterparty rating grades 0 to 5), both for banking products gross (64%) and for traded products (96%). The counterparties are primarily sovereigns, financial institutions, multinational corporate clients and investment funds.

The Investment Bank’s total banking products exposure on 31 December 2005 was CHF 162.7 billion, as reported in accordance with IFRS, of which CHF 86.6 billion was loans, compared with CHF 68.4 billion loans on 31 December 2004. Part of the increase of CHF 18.2 billion over the course of 2005 was the result of our expanding prime brokerage and equity finance businesses, and part reflects increased underwriting activity as we capitalized on our strengthened business franchise in advising corporate clients. Note that disclosures in this section present the credit exposure from a risk management and control perspective, which differs from disclosure under IFRS. In particular, gross banking products exposure in risk terms amounts to CHF 130.9 billion, a difference of CHF 31.8 billion to the CHF 162.7 billion reported for the Investment Bank in the table on page 61. This difference is mainly made up of cash collateral posted by UBS against negative replacement values and other positions which, from a risk perspective, do not classify as loans but where the underlying credit risk is incorporated into our traded products measurement methodologies. On the other hand, in our internal risk control view we consider certain US residential mortgage financing conducted under repo- / reverse repo-like agreements as banking product exposures. The table on the next page shows a reconciliation between the IFRS and risk views of banking products exposure of the Investment Bank.

As described on page 59, the Investment Bank has engaged in a substantial credit risk hedging program through which we have hedged our banking products exposure. The table on page 64 shows that on 31 December 2005 an amount of CHF 24 billion of credit hedges was in place against our banking products exposure. To illustrate the effects of credit hedging and other risk mitigation, the rating distribution graph on page 64 shows exposures before and after application of risk mitigants. Additionally, in the matrix below right, we show the distribution of Investment Bank’s take and hold banking products exposure after application of risk mitigants across rating grades and LGD buckets. LGDs in this portfolio are assigned based on benchmark LGDs which are 40% for senior secured claims, 50% for senior unsecured claims and 70% for subordinated claims. There is thus a concentration in the 26–50% bucket. The significant exposure in the sub-investment grade 0–25% bucket is mainly comprised of short term loans to US mortgage originators, secured on their mortgage portfolios, pending securitization or sale. Note that exposure distribution across counterparty ratings shown elsewhere in this section refers only to gross exposure and probability of default, without reference to the likely severity of loss or loss mitigation from collateral or credit hedges.

Banking products exposure after application of credit hedges continues to be widely diversified across industry sectors. At 31 December 2005, the largest exposure (37%) was to financial institutions.

A significant proportion of the Investment Bank’s credit risk arises from its trading and risk management activities and from the provision of risk management solutions to clients, which includes the use of derivative products.

The graph opposite shows the Investment Bank’s traded products exposure by counterparty rating on 31 December 2005. Further details of derivative instruments are provided in note 22 to the financial statements and details of securities borrowing, securities lending, repurchase and reverse repurchase activities can be found in note 10 to the financial statements.

Investment Bank: credit hedging, banking products