What Is Exposure at Default?
Let me explain Exposure at Default, or EAD, directly to you: it's the total value a bank is exposed to when a loan defaults. As someone diving into financial risk, you should know that banks calculate this using the internal ratings-based approach. They often rely on their own internal models to estimate EAD for risk management. Outside banking, you might hear it called credit exposure.
Key Takeaways on EAD
EAD predicts the amount of loss a bank could face if a debtor defaults on a loan. Remember, it's dynamic—you'll see lenders reassess it as the borrower's risk and debt profile evolve. Banks use EAD, along with loss given default and probability of default, to figure out their total credit risk capital. This metric is crucial for assessing financial risk, maintaining stability, and preventing cascading defaults from overexposed positions. After the 2008 Global Financial Crisis, laws and policies stepped in to monitor how banks handle stress.
Understanding Exposure at Default
EAD is the predicted loss amount when a debtor defaults. Banks calculate an EAD for each loan and use those to gauge overall default risk. It's not static; it changes as the borrower repays. There are two methods: the foundation internal ratings-based (F-IRB), guided by regulators, which looks at forward valuations and commitments but skips guarantees or collateral. The advanced internal ratings-based (A-IRB) is more flexible for banks—they base it on their data, like borrower traits and product types. EAD combines with LGD and PD to calculate credit risk capital.
Important Note
Banks calculate EAD per loan to determine overall default risk—that's a core practice you need to grasp.
Special Considerations: Probability of Default and Loss Given Default
Larger institutions use PD to calculate expected loss—it's a percentage showing default likelihood, based on past-due loans and migration analysis over a time frame. Each risk level gets its PD. LGD measures expected loss as a percentage, the unrecovered amount after selling assets if default happens. Getting LGD right can be tough if losses vary or the segment is small; third-party data helps. PD and LGD hold through economic cycles, but reevaluate during changes like recessions or mergers. Expected loss? Multiply EAD by PD by LGD.
Exposure at Default Example
Modern economies are linked, so one country's issue affects others, especially in big crises. Take Lehman Brothers' 2008 bankruptcy: subprime loans boosted their EAD, leading to a downgrade and Fed intervention. Congress passed a $700 billion bill to curb widespread risk. Post-crisis, banks adopted Basel Committee regulations to cut default exposure, improve stress handling, and avoid domino failures through better risk management and transparency.
Frequently Asked Questions
How do you calculate EAD? Use the foundation approach (regulator-guided, considering assets and commitments, ignoring collateral) or the advanced approach (bank-determined, varying by loan or borrower). What does exposure on a loan mean? It's the max potential loss if default occurs—a risk measure based on lender position and borrower traits; lenders charge interest for this risk. How can I reduce credit exposure? As a lender, opt for shorter-term loans, those backed by cash flow, to creditworthy customers, and do thorough due diligence.
The Bottom Line
Lending is risky by nature. Banks use EAD to decide wisely on loans, as they answer to investors. Credit exposure affects many industries, and EAD is a key tool in banking to fight loan losses.
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