# Loan Equivalent Factor or Credit Conversion Factor

3
952

Exposure at Default: We estimate EAD at the level of obligors by estimating the outstanding balance of an account, not only at the time of default but at over the entire loan period.

For example, EAD for credit cards not only depends upon the outstanding balance at the time of default but also on the open to buy amount. Let us suppose a credit limit on a particular card is \$ 1000. At the time customer defaulted to make payment outstanding on credit card was \$ 500. Even though customer did not make last month payment but customer still has ability to make purchase of another \$ 500.

While developing EAD model, we have to include not only current outstanding but we need to predict what percentage of unused credit limit will be used by the customer.

Loan Equivalent Factor (LEQ): The probability of drawing the undrawn portion in the next 12 months is defined as the loan equivalency factor (LEQ). Since a probability always has values from 0 to 1, LEQ is constrained into a range of 0 to 1. The LEQ is defined as a ratio of the change in the amount drawn at default to the current undrawn commitment.

LEQ = {Out (t)-Out (t-1)}/{L(t-1)-Out(t-1)}

Out (t) – Outstanding at default at time t

Out (t-1) – Outstanding at a date one year prior to default

L (t-1) – Limit to the borrower at a date one year prior to default

Credit Conversion Factor (CCF): The credit conversion factor (CCF) converts the amount of a free credit line and other off-balance-sheet transactions to an EAD (exposure at default) amount. This function is used to calculate the exposure at default.

CCF = = {Out (t)-Out (t-1)}/Out (t-1)}

Out (t) – Outstanding at default at time t

Out (t-1) – Outstanding at a date one year prior to default

The final EAD is calculated by the following formula:

EAD = Current Drawn + (LEQ * Current Undrawn)

Or

EAD = Current Drawn + (CCF * Current Undrawn)