Exposure, Loss Given & Probability Defaults

What is Exposure at Default, Loss Given Default and Probability of Default?

Exposure at Default (EAD):

It is the total value that a bank is exposed to at default. It represents the amount of potential exposure that is at risk.

Loss Given Default (LGD):

It is a factor that determines the severity of a loss, i.e. which part of the exposure at default results in a loss given a default event occurring.
LGD is expressed as a percentage of the exposure outstanding on the date of classification of an obligor.

Probability of Default (PD):

Probability of Default measures the likelihood of a default event arising due to a borrower failing to repay a debt occurring during a specific period. It is a term describing the likelihood of a counterparty default over an observed period, usually 12 months, so an estimate of the probability that a debtor will not be able to meet its debt obligations in time or in full.

Example

A bank may calculate its expected loss by taking the product of EAD, PD, and LGD.

Expected Loss = EAD * PD * LGD

Why are Exposure at Default, Loss Given Default and Probability of Default important?

In the aftermath of the global financial crisis of 2007-2008, the banking industry enacted international standards to reduce the risk of default. Estimates of EAD (Exposure at Default) and LGD (Loss Given Default) are important inputs in calculating expected and unexpected credit losses, as well as credit risk capital (regulatory and economic).

Following the financial crisis, the Basel Committee on Bank Supervision (BCBS) proposed a regulatory framework (Basel III) to improve the banking sector’s ability to deal with financial and economic stress shocks.