Exposure at Default (EAD)

"Money is a poor man's credit card." - Marshall McLuhan

For on-balance sheet exposures, such as term loans, instalment loans, and mortgages, the EAD is defined as the nominal outstanding balance.

The EAD is predetermined for some loans and variable for others like credit lines and loans with flexible payment schedules.

• Credit lines (e.g., credit card) generally have a limit and a drawn amount. The borrower can draw on the line up to the limit. At the end of a period, the borrower is required to repay the drawn amount, after which it is set back to zero. Please see below a 6-month time series example for a credit card with a limit of € 1.000 and variable Drawn and Undrawn Amounts. It seems that the holder of this credit card usually repays its credit card by the end of the month, except in the months of April and June:

In this case the on-balance is the drawn amount, the amount effectively used by the customer suing the credit card. The off-balance amount is the undrawn amount, the total amount committed (the limit of the credit card) but not used by the client. At the end of June, the on-balance of this credit card is €800 and the off-balance is €200.

• Loans with flexible payment schedules with a prepayment and a redraw option. A prepayment option allows the client to pay down more than the scheduled amount, while a redraw option allows the client to draw on prepayments and/or principal repayments.?

Off-balance-sheet exposures include contingent credit exposures (e.g., credit guarantees and loan commitments) covered in this article but also and counterparty credit risk in relation to over the counter (OTC), i.e., bilateral, derivative agreements on future deliveries. These topics were already covered in another article.

For off-balance sheet exposures, you need to take into account what portion of the undrawn amount is likely to be converted into credit upon the default of the client. There are different measures for EAD, but the one we will focus on is based on the CCF (credit conversion factor):

The credit conversion factor (CCF) is defined as the portion of the undrawn amount that will be converted into credit. Note that the undrawn amount is equal to the limit minus the drawn amount. The EAD thus becomes the drawn amount plus the CCF times the limit minus the drawn amount.

What’s the EAD of the above referred credit card as of end of June considering a CCF of 20%?

Other measures to convert drawn amounts and limits are:

• Credit Equivalent (CEQ): EAD = Drawn + CEQ*Limit
• Limit Conversion Factor (LCF)/Loan Equivalent (LEQ): EAD = LCF*Limit
• Used Amount Conversion Factor (UACF): EAD = UACF*Drawn

For off-balance sheet items, exposure is calculated as the committed but undrawn amount multiplied by a CCF. In the F-IRB approach, banks can estimate the PD themselves but should use the regulatory values for both LGD and EAD. In the A-IRB approach, the bank can estimate all three risk parameters (PD, LGD, and EAD) and it is for that approach that banks should model their EAD/CCF.

EAD Modeling

Once the drawn amount is known, the CCF can be calculated as the ratio of the EAD minus the drawn amount, and the limit minus the drawn amount:

There are several key problems from a practical standpoint:

1. The determination of the time lag between the observed exposure amount at default and the observed drawn amount and limit. The standard to prescribed by regulators is usually one year unless banks can demonstrate that another period would be more conservative.
2. Which products or segments to used to aggregate and assign these CCF in the calculation process. The above calculation is done for a transaction i. Typically the calculation of the final parameters is given by:

Where n is an instance of the product/segment j.

4. Which caps and floors to used in the calculation and at which level (transaction or product/segment).

5. Other cases product specific features should also be considered. From a practical point of view, bank’s usually have some challenges to connect restructured loans with its original loan, but without this connection and solving this operational issue the CCF calculation might be misleading. A commonly used formula for these case would be:

Sources:

Credit Risk Analytics: Measurement Techniques, Applications, and Examples in SAS, 2016