The expected loss is the sum of all potential losses multiplied by the profitability of the loss. The expected loss of lending is changing for various reasons like loan repayment over time, and collateral value changes over time, etc. The expected loss is the average credit loss that the bank expects from exposure or a portfolio. The expected losses are calculated using the formula with a quantitative approach,
Expected Loss = PD * EAD * LGD
Where,
PD – Probability of Default
EAD – Exposure at Default
LGD – Loss Given Default
Probability of Default
Probability of default (PD) is the borrower’s chance to not pay required installments for a given duration, usually one year. The probability of default (PD) depends on the characteristics of the borrower and also on the economic climate.
Probability of Default (PD) is a credit risk parameter which used to find out at the time of lending to know the default chances as lender generally want to charge a higher rate of interest to compensate for considering higher default risk, as lender aims to earn maximum from the beginning before the account defaults. The borrower’s credit rating applies the Probability of Default (PD). The probability of Default (PD) is also estimated by using borrower historical data and a financial institution’s historical data and statistical techniques.
An example of a finding is –
- Mr. P has applied for a bank A; the Executive of bank A has checked the customer’s credit history and finds out that the customer had 3 default loans account out of 12 loans accounts. In this case,
Thus,
PD by Mr. P = 25%
- If Mr. P’s credit history is regular and satisfactory and he applied for a loan in scheme 1 in bank A. Total advances in scheme 1 in bank A is Rs.10,00,00,000/- out of which Rs.90,00,000/- is the default amount. In this case,
Thus,
PD in scheme 1 in bank A = 9%
Exposure at Default
Exposure at Default (EAD) refers to the cumulative amount of loans a bank fails to obtain. Exposure at Default (EAD) exposure forecasts a bank’s loss sum when a debtor fails to accept a loan. For every loan, banks measure an EAD value based on the total probability of default for each loan. Exposure at Default (EAD) is a complex number dependent on the reimbursement of the creditor.
Financial institutions calculated risk using the internal ratings-based (IRB) approach and used internal risk management default models to estimate Exposure at Default (EAD). Exposure at Default (EAD) is known as credit exposure outside the banking industry.
Exposure at Default (EAD) is a credit risk parameter used to find out after default to know the default exposure. Exposure at Default (EAD) is simply the current outstanding amount for fixed loans (Example Term Loan accounts), and Exposure at Default (EAD) is divided into drawn and undrawn amounts for revolving products (Example Cash Credit Accounts). Banks determined the drawn and undrawn estimation amounts (Prediction of future use of the borrower’s remaining amount).
An example of finding Exposure at Default (EAD) is –
- There is bank A in which borrower Mr. P has taken a loan of Rs.4,00,000/- and after making few installments for years, the borrower is facing financial difficulties and defaults when the outstanding loan balance is Rs.2,50,000/-. In this case, Exposure at Default (EAD) is Rs.2,50,000/-.
Loss Given Default
Loss Given Default (LGD) is the sum of money that a financial institution loses when it defaults on a loan and uses this as a percentage of overall exposure when it fails. Loss Given Default (LGD) is measured in a financial institution by way of total debt and exposure after reviewing all outstanding loans.
The financial institution needs to consider various variables during the calculation of Loss Given Default (LGD). For example, Suppose one bank has financed Rs.40,00,000/- to Company XYZ, and the company defaults, then that bank loss is not necessarily precisely Rs.40,00,000/- as another factor just like the amount of collateral held by that bank, present outstanding after repayment, etc. are taken into account, means that bank has sustained a far more minor loss than the initial Rs.40,00,000/- loan.
Loss Given Default (LGD) is a credit risk parameter used to find out after default to know the loss. According to Basel II requirements, Loss Given Default (LGD) is an essential factor of risk models and is often used to find out economic capital, anticipated losses, and regulatory capital.
Loss Given Default (LGD) is mainly calculated using the gross calculation method among various methods because of its simple formula, as the gross calculation method are not considering the value of finance of the loan and considers the amount of the potential or actual loss to the total amount of exposure at the time of default. Example of finding Loss Given Default (LGD) is –
- There is bank A in which borrower Mr. P has taken a loan of Rs.4,00,000/- and after making few installments for years, the borrower is facing financial difficulties and defaults when the outstanding loan balance is Rs.2,50,000/- (same as Exposure at Default (EAD) amount), Bank A can foreclose this loan account after selling collateral is available with a bank of Rs.2,00,000/-. In this case,
Thus,
LGD = 20%
As the Probability of Default (PD) is 25%, Exposure at Default (EAD) is Rs.2,50,000/- and Loss Given Default (LGD) is 20%, The expected loss is –
Expected Loss = 25* Rs.2,50,000 * 20%
Thus,
Expected Loss = Rs.12,500
That indicates that the expected loss is 3.12% of a loan amount of Rs.4,00,000/-.
