Credit
Expected loss: PD, LGD and EAD
Estimate expected loss for a loan book from probability of default, loss given default and exposure at default, and size the provision.
Learning objectives
- Calculate exposure at default for term loans and revolving facilities
- Calculate expected loss as PD × LGD × EAD for single loans and a portfolio
- Estimate the provision charge needed to bring the allowance up to expected loss
Every loan book loses some money: a few borrowers will default each year. Banks can't know which ones, but they can estimate how much on average. That expected loss drives the cost of risk in the income statement, the credit component of loan pricing and the size of the loss allowance on the balance sheet.
The standard decomposition separates three questions: how likely is default, how much is owed when it happens, and how much of that is lost.
EL = PD × LGD × EAD EAD = Drawn + CCF × Undrawn
- PD
- probability of default over the horizon (here one year)
- LGD
- loss given default: the share of the exposure lost after recoveries from collateral, guarantees and workout
- EAD
- exposure at default: what the borrower owes when it defaults
- CCF
- credit conversion factor: the share of an undrawn limit expected to be drawn before default
- Allowance
- the balance-sheet provision; the year's charge tops it up to the new estimate
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That's the last lesson in Banking and Treasury
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