Exposure at Default (EAD)

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Exposure at Default (EAD): Definition, Calculation, and Risk Management

What is Exposure at Default (EAD)?

Exposure at Default (EAD) is the estimated monetary amount a lender stands to lose when a borrower defaults on a loan. It reflects the outstanding balance and any additional credit that may be drawn before default. EAD is a core input in credit-risk measurement and capital calculations, together with Probability of Default (PD) and Loss Given Default (LGD).

Why EAD matters

  • It helps banks determine capital requirements and expected losses.
  • It informs pricing, underwriting, and portfolio-management decisions.
  • Because EAD can change as borrowers repay or draw down credit lines, it is treated as a dynamic estimate that should be updated as borrower and market conditions change.

Approaches to estimating EAD

There are two primary regulatory approaches for calculating EAD:

  • Foundation Internal Ratings-Based (F-IRB)
  • Regulator-guided method.
  • Uses asset values, forward valuations, and commitment details.

  • Typically excludes the value of guarantees, collateral, or other credit mitigants.

  • Advanced Internal Ratings-Based (A-IRB)

  • Allows banks to use internal models and historical data to estimate EAD.
  • More flexible; estimation can vary by product type, borrower characteristics, and observed behavior (e.g., utilization of undrawn credit lines).

Banks that use internal models must document and disclose their methodologies.

Relationship with PD and LGD

EAD is used with two other variables to calculate expected loss:

  • Probability of Default (PD): the likelihood a borrower defaults over a defined horizon. PDs are often derived from historical migration and default rates for similarly rated borrowers.
  • Loss Given Default (LGD): the portion of exposure not expected to be recovered after default, expressed as a percentage of exposure (post-sale of collateral, after recovery costs).

Expected Loss = EAD × PD × LGD

PD and LGD estimates are typically evaluated over economic cycles and updated when portfolio mix or market conditions change (e.g., recession, recovery, mergers).

Example and historical context

Large, interconnected financial exposures can cause systemic stress—Lehman Brothers’ 2008 bankruptcy illustrates how concentrated credit exposures and downgrades can cascade across markets. In response, global regulators (notably through Basel Committee standards) strengthened capital and risk-management rules to reduce banks’ vulnerability to default and to improve transparency.

How lenders can reduce EAD and credit exposure

  • Offer shorter-term loans to limit future drawdown risk.
  • Prefer loans supported by reliable operating cash flow.
  • Tighten underwriting and due diligence to lend to higher-credit-quality borrowers.
  • Use credit limits and monitor utilization of undrawn commitments.
  • Apply collateral, guarantees, and credit derivatives where appropriate, and model their impact (noting F-IRB limitations).

FAQs

Q: How is EAD different from outstanding balance?
A: EAD may include the current outstanding balance plus expected future draws on committed facilities up to default, so it can be higher than the current balance.

Q: Do guarantees and collateral always reduce EAD?
A: Under some regulatory approaches (F-IRB) guarantees/collateral may be excluded from EAD and treated separately (affecting LGD). Under A-IRB, banks can incorporate credit mitigants into their internal EAD estimates where permitted.

Q: How often should EAD be updated?
A: Regularly—at least when borrower credit quality, loan terms, portfolio composition, or macroeconomic conditions change materially.

Conclusion

EAD is a fundamental, dynamic measure of a lender’s potential loss on default. Together with PD and LGD, it drives expected-loss estimates and capital planning. Robust estimation, ongoing monitoring, and prudent underwriting are essential to control credit exposure and to maintain financial stability.