Exposure at Default: a Worked Example

A term loan is simple: what is owed is the balance, plus accrued interest and fees. A revolving line is different, because the borrower decides how much of it to use and the decision is correlated with distress. A healthy company might run its line at 30%. A company a few months from failure pays suppliers and wages from the same line until it is full. Guarantees and bonds behave in a related way: they use no cash until the customer fails to perform, which tends to happen in the same months.

Measuring only what is drawn would therefore understate the debt in the very cases where the lender most needs an accurate figure.

The conversion factor is covered on its own page, with the Basel, Australian and UK tables. Under the Basel framework's foundation approach those are the same factors a standardised bank uses. Under the advanced approach, where a supervisor allows it, a bank may estimate its own EAD for undrawn revolving commitments, subject to a floor of the drawn amount plus 50% of the standardised off-balance-sheet figure. Its estimate must be a long-run default-weighted average and, where estimates swing with the cycle, appropriate to a downturn if that is more conservative. Everything else off the balance sheet stays on standardised factors.

Exposure is measured gross of specific provisions and partial write-offs. A derivative has its own counterparty exposure calculation. Under expected credit loss accounting, the estimate also has a time dimension: it follows the expected path of the balance, including scheduled repayments and likely drawings on commitments.

A lawnmower distributor, constructed for this page like every figure in it, has a US$6.0m term loan, a US$5.0m committed revolver with US$1.5m drawn and a US$0.4m performance bond. The bank's own records show that borrowers on similar lines used about 70% of the unused amount before default. Amounts in US$m.

The standard column uses the Basel factors of 40% for a commitment and 50% for a performance bond; the 70% is the example's, as are the PD and LGD. The right-hand column is a management view, and would not all be permitted as a capital input, since the bond would stay on its standard factor. Reading only the drawn balance understates the expected loss by more than a quarter against the bank's own experience.

Now suppose the distributor has not used more than US$3.5m of the revolver at any seasonal peak in five years, and at renewal the two sides agree a limit at that level.

Nothing was repaid. The bank has reduced what it could lose, and the capital that goes with it, by no longer making a promise the business was not using.

EAD usually sits between the drawn balance and the limit: at a 40% factor nearer the drawn balance, and on a bank's own experience sometimes nearer the limit. For a bank on internal ratings it is not reduced by collateral; the foundation approach says EAD is calculated without taking collateral into account. Security goes to loss given default, which is why the two numbers stay apart. Where a bank estimates the exposure on a derivative line, the nearest idea is potential future exposure, which models how a contract's value could move.

DEFINED IN ONE PARAGRAPH → · CREDIT CONVERSION FACTOR, WORKED → · EXPECTED LOSS, WORKED →

Limit size is a decision about EAD as much as about the business. A borrower asking for headroom it may not need is asking the bank to carry it, which is what the commitment fee pays for. A lender can shape the figure: the Basel foundation rules apply the factor to the lower of the unused line and any ceiling that constrains availability, such as one tied to reported cash flow, where the bank monitors it adequately. A borrowing base has that effect in practice.

The document does the rest. Conditions on each drawing, an uncommitted line and early warning from covenants all aim at the same moment, stopping the last drawings before they become the loss. Their value depends on the lender noticing in time.

CORPORATE LENDING AND CREDIT RISK → · RISK-WEIGHTED ASSETS, WORKED →