Credit Risk
Expected Credit Loss
Background Expected credit loss (ECL), in simple term, is the amount of loss a bank may suffer by lending to a borrower. In other words, this type of loss arises […]
Background
Expected credit loss (ECL), in simple term, is the amount of loss a bank may suffer by lending to a borrower. In other words, this type of loss arises to a bank when a borrower makes defaults in payment of interest or installment in accordance with agreed terms of financing. As credit risk is inherent in any lending business, it is natural for a bank to expect loss from such business.
The expected loss is taken into account by banks while extending credit to borrowers. Regulators require banks to maintain capital for unexpected loss. Such a capital is also called economic capital. However, in case of severe economic downturn, regulatory minimum capital may not be sufficient for bank’s survival.
Basel II and Expected Credit Loss
Under Basel II accord, banks following standardized approach required to make general provisions and specific provisions at the rates prescribed. However, banks following internal ratings-based (IRB) approaches need to provide for expected credit loss (ECL). We can compute ECL using following formula:
Expected Loss (EL) = Probability of Default (PD) x Loss Given Default (LGD) x Exposure at Default (EAD)
Probability of Default (PD)
Probability of default, also known as expected default frequency (EDF), is the risk that a borrower will not be able meet timely payment obligations to lending bank over a given time horizon. Banks are required to formulate their own internal ratings models in order to classify the credit risk and estimate the probability of default (PD).
Loss Given Default (LGD)
Loss given default is the risk that a bank will incur loss in case of default event. LGD takes into account any collateral or guarantee provided against the loan under default because collateral and guarantees decrease loss severity. This component of risk is inversely related with recovery rate and therefore we can also compute it as:
LGD = 1 – Recovery Rate
Exposure at Default (EAD)
Exposure at default is the amount of loan that is subject to default. The EAD for funded exposure of a bank is equal to the amount of loan outstanding. On the other hand, we can compute the EAD for off-balance-sheet exposure by translating off-balance-sheet items into on-balance-sheet as per Basel conversion factors.
Foundation vs. Advanced IRB Approaches
Under the foundation approach, banks provide their own estimates of PD while they follow supervisory estimates for LGD and EAD. However, under the advanced approach, banks provide their own estimates of PD, LGD and EAD. Therefore, banks must have robust system capable of generating all three components of credit risk.
ldmahat
LD Mahat is a Chartered Accountant, Financial Adviser and Risk Management Specialist possessing over 29 years of diverse experience across several sectors covering a wide spectrum of assurance, business advisory and taxation disciplines. LD is a committed, highly motivated and result-oriented professional, consistently developing and nurturing client relationship and building long-lasting relationships with diverse clients. He has the ability to define issues, propose customized solutions that significantly add value and contribute to client’s success.
LD has got master’s in risk management form New York University, Stern Business School. He has undergone executive education at Harvard Business School and Insead Business School. He was risk management specialist in several Asian Development Bank Funded projects. He has provided risk management advisory services in various Nepalese corporate sectors.
LD has worked on large projects jointly with big 4 international accounting firms ~ PwC, Deloittee, Ernst & Young and KPMG in the field of Assurance, Diagnostic Review, Capacity Building, e-Government Procurement, e-Governance, Special Review, Investment Climate, and IFRS Implementation.
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