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Exposure at Default (EAD)

The exposure at default measures the maximum amount that can be lost under default. Such an amount is generally unknown as of current date. It is measured using rules and models. Sources of uncertainty with respect EAD are numerous. For example, for lending products, the fraction drawn on a committed line of credit depends on the borrower's willingness to use the line. For derivatives traded over-the-counter, the amount subject to default risk is market driven, and can be determined either using simplifying rules or using models.

Loss Given Default (LGD)

Transaction-specific risk is captured by LGD in Basel 2. The LGD is the fraction of the amount at risk that is effectively lost under default, after work-out efforts and recoveries from guarantees. The recovery rate is 1- LGD in percentage of exposure. LGD depend on the type of guarantees attached to a transaction, and is subject to uncertainty. LGD models are mainly based on empirical data, and the financial industry is building up data to make LGD estimates more reliable.

Because of uncertainty attached to LGD, Basel 2 offers several ways for calculating LGD. Under the foundation approach, senior claims on corporates, sovereigns and banks not secured by recognized collateral are assigned a 45% LGD and all subordinated claims on corporates, sovereigns and banks are assigned a 75% LGD. Own estimates of LGD by banks are allowed only in the advanced approach. Otherwise, supervisory rules have to be applied.

LGD reduces directly the capital charges based either on eligible collateral or eligible third party guarantors. For third party guarantees, the credit protection is recognized for sovereign entities, PSEs, banks with a lower risk weight than the counterparty and for other entities rated A- or better. For collateral-based transactions, it is possible to offset a fraction of the exposure by a risk-adjusted value assigned by the collateral[1]. Conservative rules are used to consider drifts of value due to market movements. Supervisory methods are dealt with in the credit mitigation building block of this chapter.

Credit Conversion Factors (CCFs)

Credit conversion factors serve, as in Basel 1, for addressing exposures that are commitments rather than cash exposures, or contingencies and off-balance sheet commitments. Contingencies include guarantees given and received by a lender or any counterparty, whereby a guarantor commits to substitute to the borrower should the latter default on debt obligations. Other off-balance sheet items include derivatives and options.

Credit Components and Risk Weights

Capital charge is calculated as 8% times the risk weight of a transaction. In the standardized approach, the risk weights are defined by the regulators. In the IRB approaches, the regulator provides risk-weight functions, differentiated according to asset classes and sub-classes. For specialized lending and securitization exposures, risk weights are defined by specific rules.

  • [1] See the subsequent section on credit-risk mitigation.
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