Credit risk is the risk of financial loss resulting from a counterparty’s failure to fulfill their contractual obligations, such as a borrower defaulting on a loan payment or a customer failing to settle an outstanding trade invoice.
The Foundational Expected Loss Model
To quantify credit risk across a loan portfolio or commercial counterparty book, risk teams use a standard credit loss calculation model:
Expected Loss = Probability of Default * Loss Given Default * Exposure at Default
Where:
- Probability of Default (PD) = The statistical likelihood that a borrower will experience a default event within a set time horizon (expressed as a percentage).
- Loss Given Default (LGD) = The percentage of the total exposure that will be permanently lost if a default occurs, after accounting for collateral sales and legal recoveries.
- Exposure at Default (EAD) = The total dollar value owed by the counterparty at the exact moment the default event occurs.
Credit Loss Calculation Example
If a commercial client has an outstanding credit facility with an Exposure at Default of $10,000,000, an assigned Probability of Default of 5% (0.05), and the bank’s secured collateral reduces the Loss Given Default to 40% (0.40), the credit risk calculation is:
Expected Loss = 0.05 * 0.40 * 10,000,000 = 0.02 * 10,000,000 = $200,000