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.
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.