Exposure At Default (EAD)
The EaD stands for the Exposure at Default. As a company goes towards default it will normally attempt to increase its leverage (lend more). This is logical because the reason for default is generally a liquidity problem. The EaD model will thus look at the company’s ability to increase its exposure while approaching default. The degree in which this is possible will be dependant on the type of products (facilities) the company has and your banks ability to prevent excessive draw down on facilities. The products can be separated into three main categories.
1. Loans
2. Working capital facilities.
3. Potential exposures
Loans
Loans are products where the money is made available at predetermined moments and the customer is required to repay at predetermined moments. Therefore there is very little the company can do to increase the debt. Modeling these products is easy. The entire Expected Loss (EL) system calculates the Expected Loss in one year. Thus the Probability of Default (PD) is the probability that a customer goes into default in the next year. This means that on average the time until default will be six month’s. Therefore in order to calculate the Exposure at Default, simply add all scheduled payments to the customer and subtract all the scheduled repayments by the customer in the next six month’s. Because a default occurs once there is a failure to pay for 90 day’s (three month’s), you may assume that the repayments and interest payments in the last 90 days where not made. This leads to the following logic:
EaD = The Current exposure + scheduled payments next 6 months - scheduled repayments next 3 months + 3 months of missed interest payments.
Working capital facilities
A working capital facility is used by a company to manage their liquidity. The facility allows the company to borrow money up to a pre-set limit. The customer is free to borrow and repay any amount at any time as long as the total exposure remains below the limit. This freedom makes it a bit more difficult to model the EaD. It can be expected that the customer will increase its exposure as it moves towards default.
If your bank is a bit sloppy in its credit management the customer may even increase its exposure beyond the limit. To be prudent you could set the EaD equal to the limit (or exposure if this is already over the limit). If your bank is accepting draw downs beyond the limit an add-on could be applied (for instance 105% times the limit or exposure if this is already over the limit). The add-on can be determined by dividing the measured Exposure at Default by the limit, for each defaulted customer and averaging the outcomes. The model is shown graphically below. In the example the exposure is 50, the limit is 100 and the EaD is 105. This means the add-on is 5%.
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If the average measured Exposure at Default is less than the limit you can use a different model. The model should take into account the current exposure to the counterparty. This ensures that the calculated EaD does not drop below the current exposure. The counterparty will withdraw an additional amount ending up with an exposure at default somewhere in-between its current exposure and the limit. In other words the customer will withdraw a percentage of his remaining borrowing room (the difference between the current outstanding and the limit). When calculating the average borrowing roam use, make sure to exclude outliers. If a counterparty has gone into default first determine the borrowing room six month prior to default (the average time to default). Then determine what percentage of the borrowing room was drawn at default. This percentage can take on extreme values as the borrowing room increases and even be incalculable if the borrowing room is zero (because you can’t divide by zero). These extreme values should be excluded when calculating the average use of the borrowing room. The graph below depicts this model.
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In the example the current exposure is 50, the limit is 100 and the EaD is 80. This means that the borrowing room is 50 (limit minus exposure). The usage of the borrowing room is 60%. This is calculated by
Borrowing room usage = (EaD-current exposure)/Borrowing room
Potential exposures
These are products which might lead to an exposure. An example is a guarantee. The bank gives a guarantee for the customer to a third party. This guarantee will only translate into an exposure (on the customer) if this third party requests payment under the guarantee. Only a certain percentage of third parties will do so. To determine the exposure equivalent of a potential exposure you can use the Cash Conversion Factors (CCF) given in the standardized approach (Available in the articles on the standardized approach). You can also calculate your own CCF’s. Some of these products are sold in a structure similar to a working capital facility. This means the customer may use guarantees from the bank up to a certain limit. In this case the working capital model can be combined with the CCF. First determine the expected amount of guarantees issued (using the working capital facility model). Then convert this expected potential exposure into an expected exposure using the appropriate CCF.