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 loss. Expected 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.
|Expected Loss Formula|
|EL = PD x LGD x EAD|
|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.