Page 41 - Banking Finance May 2021

ARTICLE

2. Exposure at Default (EAD) EL= PD*EAD*LGD
It's the gross exposure under a facility at the time of default. Where PD and LGD is expressed in terms of percentage and
Normally it is the total outstanding in case of fixed exposures EAD in amount.
like term loans. For running accounts or revolving facility,
we can divide the facility into drawn and undrawn exposure. EXAMPLE: XYZ PRIVATE LIMITED has a term loan of Rs 100
crore with the bank. The PD for 1 Year is estimated at 2.5%
The undrawn commitment is arrived at by multiplying it with
and LGD at 65%
a conversion factor.
EL= 2.5%*65%*100CRORE = 1.625 CRORE
Example: If there is an exposure of Rs 1 crore financial
guarantee which is a non-fund based facility then a CCF of 5. Unexpected Loss (UL)
100% will be applied to it and is converted to funded It is defined as a risk on a specific time horizon around the
exposures 1 crore. expected loss. This is measured by standard deviation of the
asset value or loss incurred in the case of default. It's the
Under internal rating-based approach the database should
be for minimum 7 years. volatility of potential loss around expected loss. The standard
deviation of PD about the expected loss shall generate
3. Loss Given Default (LGD) unexpected loss. Normally banks depend on their comfort
It is the proportion of exposure that will be lost if a default requirement or as prescribed by regulatory authorities,
occurs in an exposure. It normally indicates the magnitude multiply the unexpected losses arrived as above by the sigma
of loss and expressed in percentage norms. It depends number for the desired confidence level as mentioned below,
primarily on the type of collateral, value of collateral and to arrive at the economic capital requirement for credit risk
security coverage ratio. LGD is facility-specific and different of the bank.
facilities to the same borrower may have different LGDs. 1.0 sigma - 68% confidence
The LGD may be floored to zero (RBI floored at min 20%)
1.65 sigma - 95% confidence
and capped at 100%. Under (Indian Accounting Standards)
Ind AS 109 Expected Credit Loss (ECL) is computed to arrive 2.33 sigma - 99% confidence
at the provisioning requirement for loans and advances. LGD 3.00 sigma - 99.87% confidence
is one of the key inputs for ECL computation.
Going Forward
Recovery rate is the amount that can be recovered through The baseline for all these concepts is to effectively predict
foreclosure or bankruptcy procedures in the event of how much capital is required to effectively manage a
default. It is generally expressed in percentage norms. healthy asset portfolio keeping a view on regulatory as well
as economic capital. The main focus of Indian banks is on
4. Expected Loss (EL) the regulatory capital which alone is enough to take care
Expected loss of an asset is average loss that the bank can of the expected losses. It may or may not be the actual risk
expect to loss over the period up to a specific horizon. and should not be a base for pricing a loan asset. On the
contrary economic capital is based on statistical model and
aims to absorb the unexpected losses to a certain
confidence level. The economic capital should be the
yardstick to price a certain asset portfolio as it factors into
the unexpected losses and provides a clear picture. Another
model which is now gaining importance and Banks are taking
into account beyond a threshold level is Risk Adjusted Return
On Capital (RAROC). It is calculated by adjusting net return
from an asset with the expected amount of unexpected
losses arising from it and discounting it by economic capital.

RAROC = (Net income-operating expense-Expected losses)/
Economic capital. T

BANKING FINANCE | MAY | 2021 | 41