Expected Loss

In this article, we will try to explore Expected Loss and its components.

So, let’s get started!

It is expected that some amount of credit loss will be there and lenders will incur them over the given period of time.

So, there’s a certain amount of credit risk associated with every borrower (yes, even you and me!).

This expected loss can be driven by due to borrower specific or economic environment. Expected loss is an amount the lender might lose by lending to a borrower. So how we can frame this in a formula?

Expected Loss= PD X LGD X EAD

PD: Probability Of Default, LGD: Loss Given Default, EAD: Exposure At Default

Now, let me define these components one by one.

PD: It is the likelihood that borrower will not repay the amount/debt in time.

LGD: As the name suggests, once the loss has occurred, it is the proportion of the total exposure that can not be recovered by the lender.

EAD: The total value that a lender is exposed to when a default is occurred. One point to note here is that it is the maximum a bank can lose when the borrower defaults.

Now, let’s see this through a simple example:

We know that:

EL=PD X LGD X EAD

Now consider, the house value is $100K, now the bank funds 90% of this value which will be: $90K. Now, for the sake of understanding, let’s say borrower defaults after paying $10K, the remaining amount will be EAD: $80K

Now, let’s suppose that banks through given historical data confirms that 1 in 5 borrowers defaults, then the PD will be: 20%

The bank has the right to sell the house given the borrower has defaulted to recoup the losses. The bank sells this to another party at suppose $60K. Now the EAD will be: $80K-$60K=$20K

The LGD will be, then: $20K/$80K= 25%

Since, we have now all the values of the components of Expected Loss, lets calculate EL now:

EL=PD X LGD X EAD

=20%*25%*80= $4K

Let’s go deeper in the Credit Risk with upcoming articles, make sure you follow each of them! You practice the EL calculation by using your own example, happy learning!