Estimate expected credit loss from exposure at default, probability of default, and loss given default.
Credit Parameters
Input exposure and risk estimates
Formula: The Expected Loss Equation
EL = EAD × PD × LGD
LGD = 1 - Recovery Rate
Expected Loss (EL) is the reliable "cost of credit" that should be priced into the loan's interest rate. It combines the size of the loan (EAD), the likelihood of failure (PD), and the severity of loss (LGD).
Expected Loss (EL) is the cornerstone of modern banking and credit risk management. It represents the inevitable cost of lending money, which must be covered by interest income and loan provisions.
The likelihood that a borrower will default over a specific horizon (usually 1 year). It measures Counterparty Risk.
LGD (Loss Given Default)
The portion of the exposure that will not be recovered if a default occurs. It measures Severity Risk. (1 - Recovery Rate).
EAD (Exposure at Default)
The total value likely to be drawn down at the moment of default. It measures Size Risk.
The EL Formula Explained
The calculation is straightforward multiplication:
EL = PD × LGD × EAD
For example: If you lend $1,000,000 (EAD) to a company with a 2% chance of default (PD), and you expect to recover only 60% of funds from the collateral (LGD = 40%): EL = $1,000,000 × 0.02 × 0.40 = $8,000.
This $8,000 is not a "surprise"; it is a statistical expectation. The bank should charge enough interest to cover this $8,000 "cost of goods sold" plus a profit margin.
Expected vs. Unexpected Loss
Expected Loss (EL) is the average loss rate. It is covered by Provisions (reserves) set aside from profits.
Unexpected Loss (UL) is the volatility of loss—the risk that losses could be much higher than average in a bad year. It is covered by Risk Capital (Equity).
Regulatory Capital requirements are based on the Unexpected Loss component (via Risk Weighted Assets).
Basel III & IFRS 9 Frameworks
Basel III: Focuses on Capital adequacy. Banks must hold enough capital to survive a severe 1-in-1000 year recession (Ultimate Unexpected Loss).
IFRS 9 / CECL: Focuses on Accounting. Banks must recognize Expected Losses upfront.
Stage 1: 12-month Expected Discounted Loss.
Stage 2 & 3: Lifetime Expected Loss (if credit degrades).
Risk Mitigation Strategies
How can a lender reduce Expected Loss?
Reduce PD: Lend only to higher quality borrowers or require guarantees.
Reduce LGD: Require more collateral (lower LTV) or senior creditor status.
Reduce EAD: Lower credit limits or reduce "undrawn" committed lines.
Frequently Asked Questions
Common questions about Credit Models
How is PD determined?
For corporate borrowers, PD is effectively linked to their Credit Rating (e.g., AAA = 0.01%, B = 5.0%). For retail, it comes from credit scores (FICO).
Is LGD constant?
No. In a recession ("Downturn LGD"), asset prices fall, making collateral worth less. Regulators often require using "Downturn LGD" estimates which are higher than average LGD.
What happens if I ignore EL?
If you don't price for EL, your loans will effectively be unprofitable. The gross interest income will eventually be wiped out by defaults over the long term.
What is the difference between specific and general provisions?
Specific provisions are for loans already known to be impaired (Stage 3). General provisions are for the statistical expectation of loss on the performing portfolio (Stage 1 & 2).
How does EAD differ from Outstanding Balance?
EAD includes the current balance PLUS a "Credit Conversion Factor" (CCF) of any undrawn credit lines. Borrowers typically draw down fully just before defaulting.
Can EL be negative?
Technically no, as PD and LGD are probabilities/percentages bounded by 0. A "negative loss" would imply a guaranteed profit from default, which is impossible.
What is "Risk-Adjusted Return on Capital" (RAROC)?
RAROC = (Revenue - Expenses - Expected Loss) / Risk Capital. It helps banks decide if a loan is generating real economic value.
Does EL assume correlation?
EL itself is just a sum (A+B+C). However, the *volatility* of that loss (Unexpected Loss) is heavily dependent on correlation.
How often should EL be recalculated?
At least quarterly for reporting, but ideally whenever the borrower's rating (PD) or collateral value (LGD) changes.
Is this applicable to crypto lending?
Yes, the math is identical. However, in crypto, LGD is often 0% (if overcollateralized and liquidated instantly) or 100% (if unsecured/hack). PD is very volatile.
Summary
The Credit Risk Expected Loss Calculator allows lenders to quantify the specific cost of credit risk.
It provides assessments for both the Expected Loss (provisioning) and Unexpected Loss (capital).
Use this tool to price loans accurately and ensure adequate capital buffers.
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Estimate expected credit loss from exposure at default, probability of default, and loss given default.
How to use Credit Risk Expected Loss Calculator
Step-by-step guide to using the Credit Risk Expected Loss Calculator:
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Frequently asked questions
How do I use the Credit Risk Expected Loss Calculator?
Simply enter your values in the input fields and the calculator will automatically compute the results. The Credit Risk Expected Loss Calculator is designed to be user-friendly and provide instant calculations.
Is the Credit Risk Expected Loss Calculator free to use?
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Are the results from Credit Risk Expected Loss Calculator accurate?
Yes, our calculators use standard formulas and are regularly tested for accuracy. However, results should be used for informational purposes and not as a substitute for professional advice.