Let’s discuss what does Risk means. Risk is simply called uncertainty. For example, when you lend money to your friend and there is a risk when you are not sure about getting back since he lost his job recently.
Similarly, when you consider banking, their main business is to make people deposit in their bank and lend money to others. Credit risk arises due to uncertainty of collecting back the money from borrowers. Credit risk can be high when the credit quality of the borrower is low. Due to lower credit quality and non-repayment of borrowed loans, Banks can expect losses. These losses are calculated as Expected Loss
As most of my experience is into credit risk, I have worked under different credit risk projects. One of which is when I was working for one of the big four companies. It was in an auditing project where an external audit company like Big four, analyse the rating given by the banks to its customers/counterparties. When analyzing the customer rating, it is important for us, as part of external auditors, to check the customers past history of repayment schedule and various other credit risk factors to justify the customers ratings.
What is expected loss?
To calculate the expected loss(EL), we will need to compute three different factors such as Loss given default (LGD), Probability of default (PD) and exposure at default (EAD).
Exposure at default (EAD) is the total outstanding amount/exposure the banks are exposed to when a borrower defaults. Let’s take a simple example that the borrower has borrowed $150 Mn and has repaid $50Mn. Now if the borrower defaults then the exposure is $100Mn. If the borrower has not paid interest amount in the past, then the accrued interest amount is also added along with the outstanding amount to calculate EAD.
Probability of default (PD) is the chance that the borrower might default. For example, whether the borrower has a 50% chance that he might default. Here 50% is PD.
Loss given default (LGD) is the loss that the bank might incur when the borrower default considering the collateral and guarantee provided. For example, the borrower might have given a collateral of $80Mn property for a $100Mn loan. Here the loss is reduced due to the collateral provided. LGD is also measured in percentage. Assume that the borrower has defaulted. Now the bank can sell the collateral and get $80Mn. The loss given default will just be $20Mn which is 20% of 100Mn.
Now we can calculate expected loss by multiplying the above three factors (PD*LGD*EAD). Looks simple! Right! However the reality is different.
sometimes big banks use various statistical models to calculate PD. EAD calculation also differs based on product types and whether it is on-balance sheet or off-balance sheet items.
Credit Conversion Factor:
We know that contingent exposures get reported in the off-balance sheet exposure. For example, the bank might have committed to a customer that it will lend a $200Mn loan. The contract has been signed to lend the money but the borrower has not received the money yet. There might be a time gap between the contract signed and the money is actually lent. The borrower might or might not borrow the money. Therefore we use a factor called credit conversion factor(CCF) when calculating EAD for off-balance sheet exposures. If the credit conversion factor is 50%, then the EAD is equal to the outstanding exposure $200Mn multiplied by CCF 50% which is $100Mn.
So far, we have discussed the expected loss. Banks will keep allowance for the expected loss. Allowance is just an amount set aside in the bank to use when there is an expected loss.
There is also something called as unexpected loss which is the loss that exceeds the expected loss. And we maintain capital amount to withstand the unexpected loss. Lets discuss this in the next article.
Until Next time!