Exposure at default (EAD)

What is exposure at default?

The gross carrying amount expected at the moment of default, plus any accrued interest and expected further drawings, less expected repayments before then. It is the third ECL parameter: ECL = PD x LGD x EAD. For a 12-month ECL on a bullet loan, EAD is simply the balance; for lifetime ECL on an amortising loan, it is a profile that changes every year.

Exposure at default for an amortising loan

A 5-year loan of 1,000,000 at 8% is repaid in equal annual instalments of 250,456. The lender expects 5% of the remaining balance to be prepaid each year. The annual PD is 2% and the LGD 40%.

Treating the loan as if the full 1,000,000 were outstanding for five years would overstate lifetime ECL by 11,459. The Amortising EAD sheet of the EAD and CCF calculator (Excel) reproduces this schedule.

Why do prepayments matter?

A borrower who repays early cannot default later, so prepayments shorten the expected life and reduce EAD in later years. IFRS 9 requires the expected life to reflect prepayment expectations, based on behaviour observed for similar loans, which is especially important for mortgages, where prepayment rates are high and vary with interest rates.

Is accrued interest included in EAD?

Yes. The gross carrying amount includes interest accrued under the effective interest method, and a defaulting borrower usually stops paying before the default is recognised, so a few months' unpaid interest typically adds to EAD. Some lenders add an estimate of arrears built up between the last payment and the point of default.

How is EAD estimated for revolving facilities?

For overdrafts, credit cards and revolving credit facilities, borrowers often draw more as they approach default. EAD = drawn balance + credit conversion factor x undrawn limit. A facility with 400,000 drawn of a 1,000,000 limit and a 60% conversion factor has an EAD of 760,000. See credit conversion factors.

What is the EAD of a financial guarantee?

For a financial guarantee the lender has issued, EAD is the amount it expects to pay if the guaranteed party defaults, usually the guaranteed debt outstanding at that time, which may itself be amortising. Companies that guarantee a subsidiary's bank loan measure ECL on that basis in their separate financial statements.

What is EAD in stage 3?

Once a loan has defaulted, there is no longer a projection to make: EAD is the gross carrying amount at the reporting date, including accrued interest, and ECL depends on the expected recoveries, so LGD becomes the key estimate.

What are common EAD mistakes?

Using today's balance for every future year of an amortising loan; ignoring prepayments, which matter most for mortgages; leaving out undrawn limits on revolving facilities; and using the short contractual notice period of credit cards instead of the period the lender is actually exposed.

How long is the EAD profile?

For most loans, the maximum contractual period, including extension options the borrower controls. For revolving facilities such as credit cards that can be cancelled at short notice but in practice are not, IFRS 9 requires the period over which the lender is exposed to credit risk in practice, which can be several years.

Where to go next

See loss given default, probability of default and how to calculate ECL.

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