Exposure at default (EAD) is the total value a bank is exposed to when a loan defaults. Using the internal ratings-based(IRB) approach, financial institutions calculate their risk. Banksoften use internal risk management default models to estimate respective EAD systems. Outside of the banking industry, EAD is known as credit exposure.
Key Takeaways
- Exposure at default (EAD) is the predicted amount of loss a bank may be exposed to when a debtor defaults on a loan.
- EAD is dynamic; as a borrower's risk and debt profile change, lenders often reassess exposure risk.
- Exposure at default, loss given default, and the probability of default are used to calculate the total credit risk capital of financial institutions.
- EAD is important in assessing financial risk, preserving financial stability, and avoiding cascading defaults due to overexposed lending positions.
- As a result of the 2008 Global Financial Crisis, legislation and government policies attempt to monitor and oversee the banking industry's ability to manage stress.
Understanding Exposure at Default
EAD is the predicted amount of loss a bank may be exposed to when a debtor defaults on a loan. Banks often calculate an EAD value for each loan and then use these figures to determine their overall default risk. EAD is adynamic number that changes as a borrower repaysa lender.
There are two methods to determine exposure at default. Regulators use the first approach, which is called foundation internal ratings-based (F-IRB).This approach to determining exposure at risk includes forward valuations and commitment detail, though it omits the value of any guarantees, collateral, or security.
The second method, called advancedinternal ratings-based (A-IRB), is more flexible and is used by banking institutions. Banks must disclose their risk exposure. A bank will base this figure on data and internal analysis, such as borrower characteristics and product type.EAD, along with loss given default (LGD) and the probability of default (PD), are used to calculate the credit risk capital of financial institutions.
Banks often calculate an EAD value for each loan and then use these figures to determine their overall default risk.
Special Considerations
The Probability of Default and Loss Given Default
PD analysis is a method used by larger institutions to calculate their expected loss. A PD is assigned to each risk measure and represents, as a percentage, the likelihood of default. A PD is typically measured by assessing past-due loans. It is calculated by running a migration analysis of similarly rated loans. The calculation is for a specific time frame and measures the percentage of loans that default. The PDis then assignedto the risk level, and each risk level has one PD percentage.
LGD, unique to the banking industry or segment, measures the expected loss and is shown as a percentage. LGD represents the amount unrecovered by the lenderafter selling the underlying assetif a borrower defaults on a loan.An accurate LGD variable may be difficult to determine if portfolio losses differ from whatwas expected. An inaccurate LGD may also be due to the segment being statistically small. IndustryLGDsare typically available from third-party lenders.
Also, PD and LGD numbers are usually valid throughout an economic cycle. However, lenders will re-evaluate with changes to the market or portfolio composition. Changes that may trigger reevaluation includeeconomicrecovery,recession, andmergers.
A bank may calculate its expected loss by multiplyingthe variable, EAD, withthePD and the LGD:
EAD x PD x LGD = Expected Loss
Exposure at Risk Example
Modern economies have become increasingly intertwined. What happens in one country is more likely to financially impact others, especially when a wide-scale calamity is experienced.
Consider the impact of Lehman Brothers' bankruptcy filing in 2008. As a result of subprime mortgage loans that heightened the company's exposure at default, Lehman Brothers' credit rating was downgraded, forcing the Federal Reserve to summon several banks to negotiate the financing for its reorganization. Congress also passed a $700 billion rescue bill in response to the widespread financial risk the collapse of the firm could have.
In response to the credit crisis of 2007–2008, the banking sector adopted international regulations to lessen its exposure to default. The Basel Committee on Banking Supervision'sgoal is to improve the banking sector's ability to deal with financial stress. Through improving risk management and bank transparency, the international accord hopes to avoid a domino effect of failing financial institutions.
Frequently Asked Questions (FAQs)
How Do You Calculate Exposure at Default?
There are two main approaches to calculating exposure at default: the foundation approach and the advanced approach.
The foundation approach is guided by regulators and is calculated by considering the asset, forward valuation, and commitment details. The foundation approach does not consider the value of any guarantees, collateral, or security.
The advanced approach lets banks determine how EAD is calculated based on each individual exposure. These types of calculations may vary across loan types or borrower characteristics, as the lender is able to assess value as it sees fit.
What Does Exposure on a Loan Mean?
Exposure is the maximum potential loss a lender may incur if the borrower defaults. It's a risk measurement technique to assess the position of the lender, the characteristics of the borrower, and the possibility of loss. Exposure is a natural part of lending; in return for being exposed to risk, lenders charge interest to be compensated for their willingness to take on risk.
How Can I Reduce My Credit Exposure?
If you're a lender and want to reduce your credit exposure, consider the types of loans you're offering and who you are loaning to. Riskier, longer-term loans will increase your credit exposure as there is often a greater chance of default.
To minimize your exposure at default, consider shorter-term loans, loans substantiated by operating cash flow, loans to higher creditworthy customers, and conduct more thorough due diligence prior to issuing a loan.
The Bottom Line
Lending is an inherently risky undertaking. Banking institutions use metrics like EAD to make wise choices about who they lend to since they ultimately must answer to their investors. Credit exposure is an issue in most industries, and EAD is one of the banking world's primary tools to combat loan loss.
