Exposure at Default

The exposure at default (EAD) pertains to the amount owed to the business. Therefore, apart from the type of claim, the amount of the claim is also a significant variable in the credit approval process. Four factors are considered in the segmentation of credit approval processes:

• type of borrower
• source of cash flows
• value and type of collateral
• amount and type of claim

Lines of credit: This is a credit source provided to an entity (obligor) by a bank. Some types of lines of credit are demand loan, term loan, revolving credit, and overdraft protection. Banks and businesses are required to estimate EAD for each facility type, which should reflect the chance of additional drawings by the obligor. The method used to estimate the EAD for lines of credit and off-balance sheet items is the Credit Conversion Factor (CCF) Method.

The amount which the borrower will owe to the bank at the time of default is the EAD. The following are the two types of credit exposures: n Fixed exposure: Exposures for which the bank has not made any future commitments to provide credit in the future and the on-balance sheet value gives the value of exposure. The value of the exposure is given by the following formula:

EAD = Drawn Credit Line

EAD for the fixed exposures will equal to the current amount outstanding on the balance sheet and as a result no modeling is required for Basel II requirements.

Variable exposure: Exposures in which the bank provides future commitments, in addition to the current credit. Therefore, the exposure will contain both on- and off-balance sheet values. The value of exposure is given by the following formula:

EAD = Drawn Credit Line + Credit Conversion Factor * Undrawn Credit Line

Where,

Drawn Credit Line = Current outstanding amount

Credit Conversion Factor = Expected future drawdown as a proportion of undrawn amount Undrawn Credit Line = Difference between the total amount which the bank has committed and the drawn credit line