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How is a loan’s expected loss determined?

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The quality of the credit approval process is determined by the best possible identification and evaluation of the credit risk resulting from a possible exposure.  Credit risk is typically measured in terms of expected lossExpected loss (EL) is the amount of a credit exposure that a creditor (lender, lessor) can expect to lose in the event of default on the exposure equal to the exposure less the value of the collateral.

EL is the value of a possible loss times the probability of that loss occurring and is reflected in risk-based pricing and viewed as part of the cost of credit extension.  Since it is additive, the expected loss on a portfolio of financial assets (loans, leases) is the sum of the EL on all transactions.

The quantitative factors and risk components used to determine the expected loss on a credit exposure are probability of default (PD), loss given default (LGD) and exposure at default (EAD).

Expected Loss Formula
EL = PD x LGD x EAD
Where:
EL = Expected loss
PD = Probability of default
LGD = Loss given default
EAD = Exposure at default

The expected loss formula and probability of default on exposures assumes a standard period of one year.  This is reflected in the default studies, credit rating transition models and rating transitions published by credit rating agencies.

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