What does 'Exposure At Default - EAD' mean

Exposure at default (EAD) is the total value that a bank is exposed to at the time of a loan’s default. Using the internal ratings board (IRB) approach, financial institutions often use their own risk management default models to calculate their respective EAD systems. Exposure at default, along with loss given default (LGD) and probability of default (PD), is used to calculate the credit risk capital of financial institutions.

BREAKING DOWN 'Exposure At Default - EAD'

EAD is the expected amount of loss a bank may be exposed to when a debtor defaults on a loan. Banks often calculate an EAD value for each loan and use the figures to determine their overall default risk.

Probability of Default Analysis

Probability of default (PD) analysis is a method used by larger institutions when calculating expected loss. A PD is already assigned to each risk measure and represents the percentage expectation for default, typically measured by assessing past-due loans. Loss given default (LGD), unique to the industry or segment, measures the expected loss, net of recoveries, expressed as a percentage.

Calculating Expected Loss

When combined with the variable EAD or current balance at default, the expected loss calculation is expressed in the following formula: Expected Loss = EAD x PD x LGD. PD is typically calculated by running a migration analysis of similarly rated loans over a specific time frame and measuring the percentage of loans that default. The PD is then assigned to the risk level. Each risk level has one PD percentage.

An accurate LGD variable may be difficult to determine if portfolio losses differ from what was expected or if the segment is statistically small. Industry LGDs are typically available from third-party lenders. In addition, PD and LGD numbers are typically valid throughout an economic cycle. However, the numbers should be reevaluated periodically or in the event of economic recovery or recession, merger or significant changes in portfolio composition.

Example of Exposure at Default

In June 2016, the House of Representatives passed a bill helping Puerto Rico restructure its $70 billion debt load in an attempt to avoid defaulting on more of its debt payments. Rather than providing direct financial assistance, the bill established a seven-person advisory board that is responsible for negotiating with the island’s creditors to avoid a potentially long, expensive court battle. The bill also created a federal task force responsible for finding ways that Puerto Rico can get out of the economic challenges it has been experiencing for decades.

Part of the reason for the collapse was Congress’ 1996 decision to end a tax break that led U.S. pharmaceutical and petrochemical companies to establish subsidiaries in Puerto Rico. When the tax break ended, companies began leaving the island.

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