Whenever a bank lends money, there is a possibility that the borrower will not repay the loan. To understand and manage this risk, banks estimate three key risk parameters:
Together, these parameters form the foundation of modern credit risk management and are essential for calculating expected losses, determining regulatory capital requirements, and ensuring the stability of the banking system.
PD measures the likelihood that a borrower will default over a specified time horizon, typically one year. A PD of 2% means the bank estimates a 2% chance that the borrower will default within the next year.
LGD measures the percentage of the exposure that is expected to be lost if a borrower defaults after considering recoveries such as collateral, guarantees, or collections.
EAD represents the amount that is expected to be outstanding when default occurs. For revolving products such as credit cards, EAD may exceed the current outstanding balance because customers can continue drawing funds before default.
Example:
Expected Loss = $800
These estimates help banks price loans appropriately, monitor portfolio quality, assess concentration risk, estimate future credit losses, and support lending decisions.
The Basel Committee on Banking Supervision introduced international standards requiring banks to quantify credit risk. Under the Basel II and Basel III frameworks, banks using the Internal Ratings-Based (IRB) approach estimate PD, LGD, and EAD to calculate regulatory capital requirements.
Within the European Union, these requirements are implemented through the Capital Requirements Regulation (CRR) and supervised by national regulators and, for significant institutions, the European Central Bank (ECB).
PD, LGD, and EAD are fundamental building blocks of modern banking. They influence lending decisions, loan pricing, expected credit loss calculations, stress testing, and regulatory capital. Reliable estimation of these parameters is therefore essential for both effective risk management and financial stability.