Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

Module II: Key Risks and their Measurement

Section A: Credit Risk

Chapter 4. Prediction of Exposure at Default (EAD)

Dr Arindam Bandyopadhyay

Objectives
After studying the chapter and the relevant reading, you should be able to understand:
 The concept of CCF and UGD and their influence on EAD
 Relate LEQ with UGD concept
 How credit utilization can provide useful signal to a credit risk officer
 Methods for estimation of ex-ante EAD
Contents
4.1. Introduction
4.2. EAD Estimation
4.3. Prediction of EAD
4.4. EAD Prediction Examples
4.5. EAD under Basel Standardized Approach
4.6. EAD under Basel AIRB Approach
4.7. Key Learning Questions

4.1. Introduction
Exposure at Default (EAD) refers to the expected outstanding amount in the event of the
counterparty's default. This is an important driver of credit risk. While EAD values are
prescribed by regulators in the Standardized Approach and also in Foundation Internal
Rating Based Approach, under IRB Advanced Approach, banks can assign their own EAD
values. However, the prediction model should meet the minimum standard.
For certain loan facilities, there may be uncertainty in their utilization pattern and may
have cyclical variations. The EAD may vary depending upon the type of facility. In the
simple case of a term loan, the exposure is normally assumed to be fixed for each year
and hence can be derived from the agreed amortization plan. However, overdraft
facilities tend to be overdrawn in the case of defaulting customers. In the case of non-
funded facilities, the effective exposure (or credit equivalent) is calculated assuming

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

exposure at default at 20% or 50% depending upon the nature of the non-funded
facility. This may also depend on the nature of covenants attached with the loans and
credit rating of the facility.

4.2. EAD Estimation

The part of loan products that are by definition fully drawn (e.g. bullet or amortizing
term loans) has generally no chance to further increase its exposure in excess of the set
transaction limit. Hence, in the event of default, the exposure for such transactions is
given by the current outstanding (i.e. book value of the loan).
EAD = Outstanding Equation 4.1
The off balance sheet lending products like cash credit, overdraft, revolving line of
credit (credit card) and working capital loans are characterized by an external limit and
an average of the utilization of the month (outstanding) under consideration. It can be
expected that a counterparty close to default tends to increase its utilization, while the
bank will have to work against this by reducing available limits. Therefore, it becomes
necessary to predict a portion of the unutilized or free limit in the EAD.
Thus, for line of credit, EAD equation will look like:
EAD= outstanding +CCF× (Limit-Outstanding) Equation 4.2
In a simpler language,
EAD=Drawn line+ credit conversion factor × undrawn credit line
The credit conversion factor (CCF) is the ratio between increases in exposure over the
time period (say 1 year) to available funds at the start of the period. Exposure of loans
with undrawn limits are expected to change over time due to the availability of
unutilized limit (or the balance amount). There may be uncertainty in the drawal
pattern. That is why prediction of CCF is crucial.
Note that the credit conversion factor (CCF) is also termed as usage given default (UGD).
Thus, the most uncertain part in the above equation is CCF or UGD part which needs to
be estimated from the internal model. Chart 1 illustrate difference in exposure pattern
for funded/single drawdown exposures vs. revolving credit facilities.
Chart 4.1: EAD Measure-Term Loan vs. Revolving Credits

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

Since credit line utilization increases significantly as borrower credit quality

deteriorates, the amount outstanding might become significantly higher in the event of
default, resulting in an EAD much higher than outstanding at the time of capital
calculation.
Under the Basel AIRB framework, EADs typically are to be measured for various
“segments” of accounts. Segments, in turn, are defined by various factors such as credit
rating, facility default status (or reason), constitution, region, security, etc.

4.3. Prediction of EAD

In order to estimate CCF from the past default data, the following standard formula is
used by the banks:
𝑂𝑢𝑡𝑠𝑡𝑛𝑑𝑖𝑛𝑔𝑑 −𝑂𝑢𝑡𝑠𝑡𝑛𝑑𝑖𝑛𝑔 𝑑−1
𝐶𝐶𝐹 = {0, } Equation 4.3
𝐿𝑖𝑚𝑖𝑡𝑑−1−𝑂𝑢𝑡𝑠𝑡𝑛𝑑𝑖𝑛𝑔 𝑑−1

Thus, the CCF shows the proportion of free limit being utilized by the borrower during
default. The notation d is the time of default and d-1 is the preceding year of default.
This is also termed as fixed horizon approach where the reference point is fixed number
of days before default (say 1 year). A bank can also use variable time horizon approach
where many EADs may be calculated using different reference points say 3/6/9 months
prior to default. Fixed time horizon approach is a special case of variable time horizon
method.
For example, for a defaulted letter of credit (LC) sanctioned in 2016, loan limit was
$1000 and drawn amount in 2016 was $500. The loan has defaulted in in 2017 and the
outstanding amount is $700. The post defaulted or ex-post CCF or UGD estimate would
be:
$700−$500 $200
= $1000−$500=$500=40%

This way, CCFs need to be estimated for various type of facilities from the past data. At
least a seven year’s data history will enable banks to gather necessary information on
the past CCF utilization pattern. This method is also termed as loan equivalent or LEQ.
Many studies have found that LEQ rate increases when borrower approaches to default.
Banks need to monitor the LEQ rate.
For each facility or rating grade, CCFs of the related transactions have to be averaged to
find a temporal trend (mean or median trend) that will predict future or ex-ante EAD.
Finally the predicted EAD will be used in the calculation of expected loss, unexpected
loss and IRB regulatory risk weight. Furthermore, the EAD prediction exercise through
past granular data will enable the IRB banks to differentiate the CCF trend on the basis
of facility type, by rating class, average days delinquent, committed size, security wise
etc. Tracking the EAD and CCF pattern offers great benefits since banks will be able to
get early warning signals about deteriorating credit quality of borrowers.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

In the advanced methodology, the bank itself determines the appropriate EAD to be
applied to each exposure, on the basis of robust data and analysis which is capable of
being validated both internally and by supervisors.
For a risk weight derived from the IRB framework to be transformed into a risk
weighted asset, it needs to be attached to an exposure amount. This can be seen as an
estimation of the extent to which a bank may be exposed to counterparty in the event of,
and at the time of, that counterparty's default. In many banks' internal credit systems,
this is expressed as estimated exposure at default (EAD).
4.4. EAD Prediction -Examples
To illustrate the EAD concept, assume a bank has a $100 unsecured, fully drawn, two-
year term loan with $10 of interest payable at the end of the first year and a balloon
payment of $110 at the end of the term. Suppose it has been six months since the loan’s
origination, and accrued interest equals $5. The EAD of this loan would be equal to the
outstanding principal amount plus accrued interest, or $105.This $105 will now form
the basis for calculation of expected loss (EL), unexpected loss (UL) and risk weighted
assets (RWA).
Now consider the case of an open-end revolving credit line of $100, on which the
borrower had drawn $70 (the unused portion of the line is $30). Current accrued but
unpaid interest and fees are zero. The bank internally calculates that, during economic
downturn conditions, 20% of the remaining un-drawn amounts are drawn in the year
preceding a firm’s default. Therefore, the bank’s estimate of future draws is $6 (=20% x
$30). In sum, EAD =$70 + $6= $76.
Further, the bank’s internal estimate shows on average, during downtime, such a facility
can be expected to have accrued at the time of default unpaid interest & unpaid fees=3
months of interest against the drawn amount (=$2.5) and 0.5% against the undrawn
amount (=$0.15). The total is assumed to be=$2.65.
In sum, now the EAD should be the drawn amount plus estimated future accrued but
unpaid fees plus the estimated amount of future draws=$70+ $6+$2.5+$0.15= $78.65.
4.5. EAD under the Basel Standardized Approach:
Under the standardized approach, CCF will be supplied by the regulator. For Indian
banks, the CCF values are given in the recent July1, 2016 NCAF guidelines of RBI (see
annexure A). For example, CCF for cash credit facility is 20%, for documentary letter of
credit (LC) it is also 20%. For performance guarantee, the prescribed CCF is 50%.
However, for non-documentary LC, CCF is 100%. Furthermore, an irrevocable
commitment with an original maturity of 15 months (50 per cent - CCF) to issue a six
month documentary letter of credit (20 per cent - CCF) would attract the lower of the
CCF i.e., the CCF applicable to the documentary letter of credit viz. 20 per cent.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

4.6. EAD under the Basel AIRB Approach

Both on and off-balance sheet exposures are measured gross of specific provisions or
partial write-offs. An authorized institution which uses the foundation IRB approach
(FIRB) shall, in relation to an on-balance sheet exposure of the institution:
(a) use the current drawn amount of the exposure, after taking into account the credit
risk mitigating effect of any recognized netting as specified the Basel document, as
an estimate of the EAD of the exposure such that the EAD of the exposure is not less
than the sum of :
(i) the amount by which the institution's core capital would be reduced if the
exposure were fully written-off; and
(ii) any specific provisions and partial write-offs in respect of the exposure; and
(b) not take into account any discount in respect of the exposure in calculating the risk-
weighted amount of the exposure.
An authorized institution which uses the foundation IRB approach shall, for the
purposes of estimating the EAD of an off-balance sheet exposure of the institution
specified in Basel II guidelines (June 2006), calculate the credit equivalent amount of
the exposure by multiplying the principal amount of the exposure by the CCF specified
in the document depending on the type of off-balance sheet exposure.
All estimates of EAD should be calculated gross of any specific provisions a bank may
have raised against an exposure.
These requirements are very similar to those for own-estimates of LGD. Banks are free
to use their own estimates of EAD on facilities with uncertain drawdown, subject to
meeting these requirements. As with LGD, these requirements are not prescriptive in
terms of the factors which banks must consider in the assignment of exposures to EAD
categories (e.g. facility types). Instead, the onus is on the bank to demonstrate that the
criteria it uses are plausible and intuitive and can be supported by evidence.
In terms of assigning estimates of EAD to broad EAD classifications, banks may use
either internal or external data sources. Given the perceived current data limitations in
respect of EAD (in particular external sources) a minimum data requirement of 7 years
has been set by RBI.
One can closely examine the following chart that explains UGD trend of two categories
of loans.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

Chart 4.2. Credit Line Usage Pattern

The dotted line represent the utilization pattern of the defaulted firm. From the
diagram, it can be seen that the dotted line has suddenly increased from year -1 (i.e. one
year before default) to year 0 (the year firm defaults). As firms approach default, their
credit utilization rate increases significantly until they default and stays constant after
that. This becomes exposure at default (EAD) at the time of default. But in the case of
non-defaulted firms, as revealed in the solid line, their credit utilization increases
slightly in a bad macroeconomic cycle, but tapers off after the end of the cycle.
Therefore, it is necessary to record and track the utilization pattern of various credit
facilities to catch early warning signals. This is the essence of estimating EAD. Banks can
calculated ex-anted EADs using models which used ex-post data for already defaulted
firms. For this, banks will have to use their internal EAD data of defaulted borrowers.
The main task in EAD estimation is predicting the usage given default (UGD) which tells
how much of the free limit will be utilized until default takes place.
For a risk weight derived from the IRB framework to be transformed into a risk
weighted asset, it needs to be attached to an exposure amount. Thus, EAD is the basis
for calculation of credit risk capital (both regulatory as well as economic capital).

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

4.7. Key Learning Questions:

a. As per the RBI norms under Basel II/III Standardized Approach, CCF for short
term cash credit facility is
i) 100%
ii) 50%
iii) 30%
iv) 20%
v) None of the above
b. For a defaulted facility, the last year outstanding was $ 97, limit was $100 and
the limit has been enhanced before six months to $110, the outstanding amount
at default year is $105, the estimated CCF will be :
i) 0%
ii) –ve
iii) Infinity
iv) 0-100%
v) >100%
c. For a defaulted facility, the last year outstanding was $ 97, limit was $100 and
the limit has been enhanced before six months to $110, the outstanding amount
at default year is $105, the estimated CCF will be :
vi) 0%
vii) –ve
viii) Infinity
ix) 0-100%
x) >100%
d. Is there any difference in EAD estimates for term loans and a revolving line of
credit facility? If so, why?
e. What are the key determinants of EAD? Why EAD estimation is important for
banks?
References
1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”, Cambridge
University Press. Chapter 4.
2. RBI (2011), Implementation of the Internal Rating Based (IRB) Approaches for
Calculation of Capital Charge for Credit Risk, December 22, 2011.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

3. RBI (2015), Master Circular-Prudential Guidelines on Capital Adequacy and Market

Discipline-New Capital Adequacy Framework (NCAF), July 1.

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