Expected loss is the sum of the values of all possible losses, each multiplied by the probability of that loss occurring.
In
bank lending
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that d ...
(homes, autos, credit cards, commercial lending, etc.) the expected loss on a loan varies over time for a number of reasons. Most loans are repaid over time and therefore have a declining outstanding amount to be repaid. Additionally, loans are typically backed up by pledged collateral whose value changes ''differently'' over time vs. the outstanding loan value.
Three factors are relevant in analyzing expected loss:
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Probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variet ...
(PD)
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Exposure at default
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
Outside ...
(EAD)
*
Loss given default
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
It is a common parameter in risk models and also a parameter used in the calculation of economic capital, expected loss or regulatory capital under Basel II ...
(LGD)
Simple example
* Original home value $100, loan to value 80%, loan amount $80
** outstanding loan $75
** current home value $70
** liquidation cost $10
*
Loss given default
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
It is a common parameter in risk models and also a parameter used in the calculation of economic capital, expected loss or regulatory capital under Basel II ...
= Magnitude of likely loss on the exposure /
Exposure at default
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
Outside ...
** -$75 loan receivable write off
Exposure at default
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
Outside ...
** +$70 house sold
** -$10 liquidation cost paid =
** -$15 Loss
** Express as a %
** -15/75 =
** 20%
Loss given default
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
It is a common parameter in risk models and also a parameter used in the calculation of economic capital, expected loss or regulatory capital under Basel II ...
*
Probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variet ...
** Since there is negative equity 50 homeowners out of 100 will "toss the keys to the bank and walk away", therefore:
** 50%
probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variet ...
* Expected loss
** In %
*** 20% x 50% =10%
** In currency
*** currency loss x probability
*** $15 * .5 = $7.5
**check
***
loss given default
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
It is a common parameter in risk models and also a parameter used in the calculation of economic capital, expected loss or regulatory capital under Basel II ...
*
probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variet ...
*
Exposure at default
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
Outside ...
***20% * 50% * $75 = $7.5
Recalculating expected loss
Expected loss is not time-invariant, but rather needs to be recalculated when circumstances change. Sometimes both the probability of default and the loss given default can both rise, giving two reasons that the expected loss increases.
For example, over a 20-year period only 5% of a certain class of homeowners default. However, when a systemic crisis hits, and home values drop 30% for a long period, that same class of borrowers changes their default behavior. Instead of 5% defaulting, say 10% default, largely due to the fact the LGD has catastrophically risen.
To accommodate for that type of situation a much larger expected loss needs to be calculated. This is the subject to considerable research at the national and global levels as it has a large impact on the understanding and mitigation of
systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the ...
.
See also
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Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the ...
*
Loss function
**
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Potential future exposure {{Unreferenced, date=March 2007
Potential future exposure (PFE) is the maximum expected credit exposure over a specified period of time calculated at some level of confidence (i.e. at a given quantile).
PFE is a measure of counterparty risk/credit ...
References
Financial risk
Loans
Credit risk
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