Explain loss given default (LGD), exposure at default (EAD), and Maturity (M). Describe how they are related to the expected loss of a credit asset? (10)
Loss given default (LGD)
Loss given default (LGD) refers to the outstanding amount or balance at the time of default, which the bank will not be able to recover in the event that the borrower fails to pay back the money or defaults. Bandyopadhyay (2016) argues that loss given default measures the severity of the default loss. The loss given default can be calculated as LGD = 1-Recovery Rate, in which case the recovery rate will or is part of the credit asset that will or can be recovered. Taking an example, assuming the default outstanding amount of R100 and the bank having the ability to recover R30, the recovery rate will be 30% and the loss given default (LGD) will be 70%. Bandyopadhyay (2016) went on and said that loss given default measures the severity of likely loss on exposure, expressed as a percentage of the exposure at default.
According to Joseph (2013) recovery rate can sometimes be called value given default, which is the recoverable part of the credit asset. Joseph (2013) went on and said that the recovery rate is based on many different factors like the nature and purpose of the afforded credit facility, the facility structure, type of the product, preferred rights in the event of bankruptcy, realizable value of the collaterals, “possible liquidation of the unencumbered assets in the balance sheet of the customer, evoking guarantees, the integrity of the obligor” (Joseph: 2013). In some cases, it might be difficult to liquidate the assets of the borrower and thus increase the loss given default of the financial institution.
Exposure at default (EAD)
The loss is contingent upon the amount to which the bank was exposed to the borrower at the time of default, commonly expressed as Exposure at Default (EAD). According to Bandyopadhyay (2016), EAD is the amount of loss that a bank may face due to default, at an unknown future date. Bandyopadhyay (2016) went on and said that EAD is contingent upon the amount to which the bank was exposed to the borrower at the time of default and thus exposure at default. Exposure at default differs based on the line of credit offered to the client. This for a normal term loan, the exposure risk tends to be reasonably regarded as small, since normal term loans do have a fixed repayment schedule (which is usually called the amortization plan). With the amortization plan, the exposure of risk will be limited and fixed for each year (Bandyopadhyay: 2016).
This is not true to other lines of credit (also known as a revolver or a commitment) like the guarantee, overdraft, and letter of credit, since the borrower may draw on the lines of credit within the limit set by the bank as and to a larger extent when the borrowing needs arise. In regard to how the EAD is related to expected loss, Bandyopadhyay (2016) argued that the bigger the EAD size, the higher will be the expected loss. On revolver type of credit line, the borrower is the one that sets the maximum amount of exposure, with the ability to set the upper limit, based on the needs of the borrower and more importantly pays as he (borrower) wishes. As a result, the bank won’t be able to ascertain the exposure at default.
Maturity (M)
As of today, what is the anticipated loss from the client of the bank?
Expected Loss
The expected loss is the average annual loss rate which represents the foreseeable cost of doing business and it is to be absorbed by the credit pricing of any credit asset. LGD and EAD are used in calculating expected loss. According to Joseph (2013) PD time LGD will give us the asset’s expected loss. Which is what the bank would expect to lose on average over a long period of time. Joseph (2013) went on and said that the expected loss is regarded as the cost of doing business, such that credit pricing should absorb the expected loss, and thus, the higher the expected loss, the higher the pricing. Expected loss can easily be calculated using the following equation as adapted from (Joseph: 2013).
References
Bandyopadhyay. A. 2016. Managing portfolio credit risk in banks. Cambridge University Press. 4843/24, 2nd Floor, Ansari Road, Daryaganj, Delhi 110002, India Cambridge University Press is part of the University of Cambridge.
Joseph. C. 2013. Advanced Credit Risk Analysis and Management. John Wiley & Sons, Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom.