CREDIT RISK LOSSES AND
CREDIT VAR
ESTIMATING CREDIT LOSSES
EXPECTED LOSS - Expected loss is the
value of a possible loss times the
probability of that loss occurring. Examples:
In banking lending (homes, autos, credit
cards, commercial lending, etc.)
FORMULA:
EL = PD * LGD * EAD
Where:
PD or Probability of default - is the
likelihood that a loan will not be repaid and
will fall into default. It must be calculated for
each borrower. The credit history of the
borrower and the nature of the investment
must be taken into consideration when
calculating PD.
Example: A borrower (Company X) takes The recovery rate for Bank ABC =
out a loan from Bank ABC for $10 million
$3 million/ $10 million = 30%
(EAD). Company X pledges $3 million
collateral against this loan (for simplicity, So % LGD= 1- 0.30 = 0.70 or 70%.
lets say the collateral is cash). The
$ LGD= 70% of a $10 million (EAD) loan is
Companys PD is determined by analyzing
equal to $7 million.
their credit risk aspects (evaluate the
financial health of the borrower, taking into LGD = $7million
account economic trends, borrower
EAD or Exposure at default is the amount
relationship with the bank, etc.) For
Company X, lets say the PD is 0.99. This that the borrower owes to the lending
means that the Company is extremely risky; institution at the time of default.
the probability of them defaulting on the EAD = $10million (amount of loan)
loan is 99%.
LGD or Loss given default is the fractional
loss due to default. ANSWER:
EL = PD * LGD * EAD
If Company X defaults (is unable to pay
back the $10 million to Bank ABC), the EL= 0.99* 70% * $10 million
Bank will be able to recover $3 million (this
EL = $6.93 million
is the cash-secured collateral).
LGD = 1 Recovery Rate (RR) Bank ABC can expect to lose $6.93
million.
RR = Value of Collateral/Value of the Loan