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.