Probability of Default describes the likelihood of default of a customer on the due payments over a given period. The term PD (Probability of Default) gives an estimation of chances that customer might not be able to pay back the debt obligations.
PD usually is estimated over the period of one year (Basel Requirements) but lately IFRS has mandated for the banks to calculate PD over the life time of the loans.
Let’s try to understand PD with an example. A person wants to buy a home for residential purpose but he does not afford the cost of the house. Now, the person will approach a bank to get the home financed from the bank. The Bank would charge certain percentage for lending money to the customer over the period of mortgage (Home Loans). Charging certain percentage for lending money is just one aspect of lending money and making profit out the transaction. What if, Customer does not have the ability to pay back the loan? Exactly at this point, the requirement of the estimation of customer defaulting on payment arises.
Probability of default does not merely depend upon the borrower’s paying ability which includes income or wealth etc. but also on the Economic conditions prevalent in the given period. While disbursing the loan the Economic conditions might be good and the borrower has a high paying job. But, in economic downturn the borrower might lose his job and result might be customer ends up as a defaulter.
PD is generally calculated in two phases, one while disbursing the loan which is also known as PD at Acquisition of an account (Percentage charged to customer is a source of income and helps bank to grow) and second during the life of loan which is a part of account management where we try to assess the PD for a customer on regular basis (generally monthly) to ascertain the loss we could expect from a customer depending upon the current economic conditions.