Deep dive into PD, LGD, and EAD calculations
The Expected Credit Loss is calculated as the product of three main components, each capturing a different dimension of credit risk:
Probability of Default
Likelihood of borrower defaulting
Loss Given Default
Percentage lost if default occurs
Exposure at Default
Amount exposed when default occurs
PD represents the likelihood that a borrower will default on their obligations within a specified time horizon. Under IFRS 9, PD should be point-in-time (PIT) and forward-looking.
Reflects current economic conditions and forward-looking information. Required for IFRS 9.
Averages default rates across economic cycles. Used in Basel regulatory capital.
For lifetime ECL calculations, PD must be projected over the remaining life of the exposure. This requires building a PD term structure.
| Concept | Definition | Formula |
|---|---|---|
| Marginal PD | Probability of default in a specific period, given survival to that period | PD(t) = 1 - S(t)/S(t-1) |
| Cumulative PD | Probability of defaulting by time t | CPD(t) = 1 - S(t) |
| Survival Probability | Probability of surviving (not defaulting) to time t | S(t) = (1-PD)^t |
Sample annual PD rates by credit rating:
| Rating | Description | Annual PD (TTC) | Risk Category |
|---|---|---|---|
| AAA | Prime/Highest quality | 0.01% | Minimal Risk |
| AA | High quality | 0.02% | Very Low Risk |
| A | Upper medium grade | 0.05% | Low Risk |
| BBB | Lower medium grade | 0.20% | Moderate Risk |
| BB | Non-investment grade speculative | 1.00% | Substantial Risk |
| B | Highly speculative | 4.00% | High Risk |
| CCC | Substantial risks | 15.00% | Very High Risk |
LGD represents the percentage of exposure that will be lost if a default occurs. It accounts for expected recoveries from collateral, guarantees, and other credit enhancements.
| Product Type | Collateral | Typical LGD Range |
|---|---|---|
| Residential Mortgages | Property (LTV 80%) | 10% - 25% |
| Corporate Secured | Mixed collateral | 30% - 45% |
| Corporate Unsecured | None | 45% - 75% |
| SME Loans | Mixed/None | 40% - 60% |
| Credit Cards | None | 75% - 90% |
| Personal Loans | None | 60% - 85% |
IFRS 9 requires consideration of economic conditions at the time of default. During economic downturns, collateral values may decline and recovery rates may be lower, resulting in higher "downturn LGD" estimates.
EAD is the expected amount that will be owed at the time of default. For drawn balances, this is straightforward. For undrawn commitments, a Credit Conversion Factor (CCF) is applied.
CCF estimates the percentage of undrawn commitments that will be drawn before default:
| Commitment Type | CCF Range | Rationale |
|---|---|---|
| Unconditionally cancellable | 0% - 20% | Can be cancelled before drawdown |
| Committed credit lines | 50% - 75% | Borrowers tend to draw more before default |
| Letters of credit | 20% - 50% | Trade-related, contingent |
| Guarantees | 50% - 100% | Typically called upon default |
For term loans with scheduled repayments, EAD considers the amortization profile:
Here's how the components integrate into the ECL calculation:
| Principal | $500,000 |
| Current Balance | $450,000 |
| Undrawn Commitment | $50,000 |
| Credit Rating | BBB |
| Collateral Value | $400,000 |
| Stage | Stage 1 |
| 12-Month PD (BBB) | 0.20% |
| CCF | 75% |
| EAD | $487,500 |
| Collateral Haircut | 20% |
| Adjusted Collateral | $320,000 |
| LGD | 34.4% |
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