Exposure at default
Exposure at Default is an important component while calculating the CREDIT RISK CAPITAL.
EAD can be defined as: what is the exposure of the financial institution when a customer fails to pay the monthly installment against its Loan/Credit Card for 3 consecutive months.
In this article we cover as to WHY and HOW is Exposure at default calculated.
WHY : Given the 2008-2009 financial crisis, a financial institution is expected to calculate new Impairment with a forward looking ‘expected credit loss’ framework as opposed to the current incurred loss model, which could not realize credit loss at a early stage and under estimated the loss during economic downturns.
Now as part of the Impairment calculation- the financial institution calculates the amount of loss the financial institution is exposed to when a borrower default.
HOW : first let’s understand EAD with a simple example:
Suppose- you give a loan of Rs.2,00,000 to Mr. A. He pays you back Rs.55,000 and then defaults. The total exposure the bank has: Rs.1,45,000 (i.e. 2,00,000-55,000)
Now, this defers weather it’s a loan products or a Revolving product(i.e. Credit Card). In case of a Credit card the entire credit limit is divided into drawn and Undrawn amount.
EAD can be calculated in the following 2 ways:
- LEQ: Loan equivalent quotient – is calculated for a revolving product, its the ratio of the difference between default balance and cohort balance to the undrawn limit.
- BR: Balance Ratio- is calculated for a loan product, its the ratio of the default balance to the cohort balance.
Latest balance: is the current outstanding amount
Cohort balance – is the total balance of the observation months taken
Undrawn Balance- is the amount of balance not withdrawn by the customer.