What it means
A loan balance today is not always what a lender will be owed at the time of default. Borrowers who are in difficulty often draw down their unused credit lines in a rush, so the exposure can be larger than the current balance.
Exposure at default (EAD) tries to estimate that figure in advance. For a term loan with a fixed balance, EAD is close to the outstanding amount.
For a revolving facility, such as an overdraft or credit card, it is the drawn balance plus a share of the undrawn limit. That share is called the credit conversion factor and reflects how much of the unused amount borrowers usually draw before they fail.
EAD is one of three building blocks of expected credit loss. The others are probability of default, which is how likely the borrower is to fail, and loss given default, which is the share of the exposure the lender will not recover.
Multiplying the three together produces an expected loss figure for the loan. Regulators require banks to estimate EAD when calculating capital requirements, and accounting standards use it in provisioning for expected credit losses.
Companies that lend to customers on credit terms, such as trade creditors, can use a simplified version by looking at the invoices outstanding plus those likely to be raised. A good estimate relies on historic data about drawdown behaviour in stressed situations.
Models should be reviewed regularly, because customer behaviour in a downturn may differ from behaviour in good times. Not every exposure is a plain loan.
Guarantees, letters of credit and derivatives can also create exposure, and each needs its own conversion method because the amount at risk may be uncertain. For derivatives the exposure depends on market movements, so banks often model a range of possible values rather than a single number.
In practice
Real-world examples
Example 1
A bank has lent $5,000,000 on a fixed-term loan with no further drawdowns. Its EAD is simply the outstanding balance, since nothing more can be taken. No conversion factor is needed because the contract does not allow the borrower to take more.
Example 2
A manufacturer has an overdraft limit of $200,000 and currently owes $50,000. The bank estimates that in distress the firm would draw 75% of the unused $150,000, so EAD is $50,000 + $112,500 = $162,500. The bank holds capital and provisions based on that higher figure.
Example 3
A wholesaler extends credit terms to retailers and has $300,000 of invoices outstanding. It expects another $100,000 of invoices to be raised before a troubled customer is cut off, so its exposure estimate is $400,000. The sales director is told to slow shipments so that the exposure does not grow further.
Think of it
Imagine lending someone your car. Your current risk is just the car itself. But if they also have a key to your garage where a spare motorbike sits, your exposure at default includes both the car and the motorbike, because they could take the bike before you realise there is a problem.
Formula
Calculation
EAD = Drawn balance + (Credit conversion factor x Undrawn commitment)
Expected loss = Probability of default x Loss given default x EAD
Westbank, a fictional lender, has given a business a $1,000,000 revolving facility of which $600,000 is drawn and $400,000 is undrawn. Past defaults suggest that borrowers draw 50% of the unused amount before failing. EAD is $600,000 + (50% x $400,000) = $600,000 + $200,000 = $800,000. With a 2% probability of default and 40% loss given default, expected loss is 0.02 x 0.40 x $800,000 = $6,400.Case study
Seen in the real world
Summit Credit is an illustrative, fictional lender with a portfolio of revolving credit lines for small firms. Its risk team had been calculating losses using only the drawn balances.
During a regional downturn, several borrowers drew almost all of their undrawn limits just before they defaulted. Losses came in at 35% above what the model predicted, because exposure at default had been much higher than the balances shown.
In the illustrative review, the risk team introduced a credit conversion factor based on observed behaviour and recalculated its provisions. The new figures raised reserves in the short term but gave the board a far more realistic view of the potential losses on the book. Summit Credit now reviews its conversion factors every year using the latest default data, so the estimates keep pace with changing borrower behaviour.
Watch out
Common mistakes
- Using the current drawn balance as the exposure, ignoring that unused limits may be drawn before default.
- Applying one credit conversion factor to every product, when overdrafts, credit cards and guarantees behave differently.
- Confusing exposure at default with loss, when the loss is only the part that cannot be recovered.
Questions
People also ask
What is exposure at default used for?
It feeds into expected credit loss calculations and regulatory capital requirements for banks.
What is a credit conversion factor?
It is the percentage of an undrawn commitment that is expected to be drawn before the borrower defaults.
Is exposure at default the same as loss given default?
No. Exposure at default is the amount owed when default occurs, while loss given default is the proportion of that amount that will not be recovered.