Exposure at Default vs. Probability of Default vs. Loss Given Default (EAD vs. PD vs. LGD)
We look at the differences between Exposure at Default (EAD), Probability of Default (PD), and Loss Given Default (LGD).
Key Takeaways – EAD vs. PD vs. LGD
- Exposure at Default (EAD) quantifies the total value at risk when a borrower defaults.
- It focuses on the outstanding exposure, including committed but undrawn funds.
- Probability of Default (PD) assesses the likelihood of a borrower defaulting on their obligations.
- Used for pricing risk and setting credit terms.
- Loss Given Default (LGD) measures the percentage of EAD that isn’t recovered after a default.
- Stresses the importance of collateral quality and recovery efforts in limiting potential losses.
Exposure at Default (EAD)
Exposure at Default (EAD) is a metric in risk management in the context of credit risk.
It quantifies the total value a bank is exposed to when a loan defaults.
EAD isn’t a static figure; it can vary over the life of a loan.
This variance is due to changes in drawn amounts, undrawn lines of credit, and fluctuations in interest rates or currency values affecting the principal.
For institutions, accurately estimating EAD is important for assessing potential losses and for determining capital reserves under regulatory frameworks like Basel III.
Components Influencing EAD
- Current Exposure – The current balance of the loan or credit facility.
- Potential Future Exposure – Additional amounts the borrower might draw before default.
- Collateral Fluctuations – Changes in the value of collateral that can affect the exposure amount.
- Mitigating Factors – Features like credit limits or loan covenants that limit potential exposure.
Probability of Default (PD)
Probability of Default (PD) is the likelihood that a borrower will default on a loan within a specific timeframe.
PD is determined by analyzing historical default data and considering variables such as:
- borrower credit ratings
- financial health
- industry sector, and
- macroeconomic factors
Determinants of PD
- Credit History – A borrower’s past credit behavior.
- Financial Health – Metrics like debt-to-income ratio and cash flow stability.
- Industry Risk – Sector-specific risks impacting the borrower.
- Economic Conditions – Macroeconomic indicators that influence credit risk.
Loss Given Default (LGD)
Loss Given Default (LGD) represents the amount of loss a lender faces when a borrower defaults, expressed as a percentage of the total exposure at default.
LGD takes into account the recovery rate, which is the amount a lender can recoup through actions like seizing collateral or pursuing legal remedies.
LGD is used for estimating the total potential loss and setting aside appropriate capital reserves.
Factors Affecting LGD
- Collateral Quality – The value and liquidity of assets securing the loan.
- Recovery Efforts – Effectiveness of the lender’s actions to recover funds post-default.
- Seniority of Debt – Priority of the debt in the borrower’s capital structure.
- Legal and Operational Considerations – Jurisdictional laws and the efficiency of the recovery process.
- Borrower’s Financial Health – Overall financial condition of the borrower at the time of default.
- Industry/Market Conditions – The economic health of the industry in which the borrower operates and overall market conditions can influence LGD.
- Loan Structure and Terms – Specific features of the loan (e.g., covenants, loan maturity, and interest rate).
- Guarantees and Insurance – Third-party guarantees or insurance can reduce LGD.
- Economic/Regulatory Environment – Macroeconomic factors and changes in regulatory policies can influence recovery rates.
- Time to Resolution – The duration of the recovery process impacts LGD, as longer recovery times can lead to higher costs and lower net recoveries due to the depreciation of assets and legal fees.
Importance in Risk Management
EAD, PD, and LGD are interconnected and collectively provide a comprehensive view of credit risk.
While EAD estimates the extent of exposure at the point of default, PD assesses the likelihood of that default occurring.
LGD then estimates the extent of the loss if the default does occur.
These metrics are important for credit risk assessment, loan pricing, and for meeting regulatory compliance requirements.
Accurate estimation of these factors enables financial institutions to maintain financial stability and allocate capital efficiently.