"Traditional improvements in first-quarter activity levels and trading volumes may fail to materialize fully, which would weigh on overall results for the coming quarter, most notably in the investment bank," UBS said on Tuesday.

Shares in UBS fell 1.1 percent after the bank said fourth-quarter net profit shrank to 393 million Swiss francs from 1.66 billion francs in the 2010 period and compared with a forecast for 737 million in a Reuters poll.

Investment banks had a torrid time last year as trading and advisory income was hammered as clients pulled back from markets due to the euro zone debt crisis, and stopped doing deals. The outlook is set to remain tough as tougher regulations and economic slowdown bite.

U.S. rivals including Goldman Sachs (GS.N) and JPMorgan (JPM.N) posted weak fourth quarter income, and Deutsche Bank (DBKGn.DE) also fell to a fourth quarter loss due to a slump in bond trading.

UBS, which announced in November it would scale back its investment bank business to focus on its flagship private bank, said it had cut risky assets by 20 billion Swiss francs in the fourth quarter with "no significant impact on profitability."

Kepler Capital Markets analyst Dirk Becker welcomed the reduction in risky assets but said there were still questions over the future of the investment bank.

"Revenues have recovered from the really poor Q3 levels, but are still too low to feed a division with still over 17,000 employees," he said.

"The downsizing plans of the management will reduce this revenue base further and make it impossible to achieve satisfactory returns for this division, which will still consume the largest part of the capital."

UBS said it saw a few "bright spots" in the performance of its investment bank, which was hit by a $2 billion rogue trader scandal uncovered in September but pared its pretax loss to 256 million from a loss of 650 million the previous quarter.

UBS said it was making progress on delivering on plans to cut total headcount by almost 4,000, with total staff down 1,101 in the quarter to 64,820 at the end of 2011, but said it would have to slash more costs if market conditions worsen.

BRIGHT SPOTS?

"The investment bank clearly did better than feared with better than expected revenue streams, however, wealth management clearly suffered from weak client activity," said Vontobel analyst Teresa Nielsen.

Inflows at the UBS flagship private banking arm slipped to 3.1 billion Swiss francs ($3.4 billion) in the fourth quarter from 3.8 billion in the previous quarter, better than expected.

UBS financial head Tom Naratil said uncertainty in the euro zone was doing more to dampen activity by wealthy clients than the trading scandal: "The trading incident is not something clients are talking to us about today."

The affair surrounding former UBS trader Kweku Adoboli will linger as he is set to stand trial in September after pleading not guilty to trades the Swiss bank says were unauthorized.

UBS stressed its eurozone exposure was relatively low, in comparison to Deutsche Bank which recently posted a fourth-quarter loss amid one-off charges such as Greek debt writedowns into the quarter.

Bonuses, a hot-button issue, will fall 60 percent in the investment bank and 40 percent in UBS overall for 2011, Naratil said.

Naratil said UBS would issue loss-absorbing capital to meet tough new Swiss capital rules fairly quickly, but that it still prefers non-dilutive forms of capital such as write-down debt over contingent convertible bonds, or CoCos.

He told a news conference the bank was initially considering issuing around $1 billion in dollar denominated capital.

UBS said it had been granted some immunity by Switzerland's antitrust authority in return for cooperating with its probe into the potential manipulation of LIBOR.

Several countries are investigating "improper attempts" to manipulate LIBOR rates, which is the benchmark price big banks set for interbank borrowing costs. WEKO said last week it was investigating 12 banks, including UBS.

($1 = 0.9227 Swiss franc)

(Writing by Emma Thomasson; Editing by Sophie Walker)

• A Permanent Economic Emergency