How to calculate ECL, step by step

How to calculate ECL: the five steps

1. Exposure at default (EAD): how much will be owed at each future date if the borrower defaults then. For a bullet loan it stays at the principal; for an amortising loan it falls; for a credit card it includes expected drawdowns. See exposure at default and credit conversion factors.
2. Probability of default (PD): the marginal PD for each year, the chance of defaulting in that year and not before. If the annual PD conditional on survival is 2%, the marginal PD in year 2 is 98% x 2% = 1.96%. See lifetime PD.
3. Loss given default (LGD): the share of EAD that will not be recovered after collateral and recoveries, here 40%.
4. Discount: bring each year's expected loss back to the reporting date at the asset's original effective interest rate.
5. Add up: the first 12 months for stage 1; all years to maturity for stages 2 and 3.

An expected credit loss calculation, worked through

A bank holds a 5-year bullet loan of 1,000,000 at an effective interest rate of 8%. The annual PD, conditional on survival, is 2% and the LGD is 40%.

Year 1: 1,000,000 x 2.000% x 40% x 0.9259 = 7,407, the 12-month ECL. Adding all five years gives the lifetime ECL of 30,785, about four times as much. The cumulative lifetime PD is 9.61%, not 10%, because a borrower can only default once.

Which ECL applies: 12-month or lifetime?

A loan in stage 1, with no significant increase in credit risk since origination, carries 12-month ECL: 7,407 here. If credit risk increases significantly, the loan moves to stage 2 and the allowance jumps to lifetime ECL of 30,785, even though the borrower is still paying. In stage 3, the borrower has defaulted, the PD is 100%, and ECL is EAD x LGD, 400,000, less the time value of expected recoveries. See ECL stages explained.

How are economic scenarios included?

IFRS 9 requires an unbiased, probability-weighted amount. Most lenders calculate ECL under several macroeconomic scenarios, each with its own PDs and LGDs, and weight the results. If base-case ECL is 30,000 with a 60% weight, a downside of 60,000 with 30% and an upside of 20,000 with 10%, the reported ECL is 18,000 + 18,000 + 2,000 = 38,000, above the base case because losses rise faster in bad scenarios than they fall in good ones.

Is the calculation different for trade receivables?

Usually simpler. Companies apply the simplified approach, which always uses lifetime ECL, and most use a provision matrix of loss rates by ageing bucket instead of separate PDs and LGDs. See the IFRS 9 provision matrix and simplified vs general approach.

What are common mistakes in calculating ECL?

• Adding annual PDs together instead of using marginal PDs, which overstates lifetime PD.
• Discounting at a current market rate instead of the original effective interest rate.
• Using through-the-cycle PDs from a regulatory model without converting them to point-in-time, forward-looking PDs.
• Calculating ECL for the base case only, without weighting scenarios.

The ECL staging and lifetime calculator (Excel) reproduces this example; change the inputs to test your own loans. For the terms, see the ECL glossary.

This guide is general information. It is not tax or legal advice for your situation.