Probability of Default and Expected Credit Loss
Data driven insights help set risk-based pricing and reserve sufficient capital for future potential losses.
Quickly identify and prioritize risks
CreditKernel meets IFRS 9 standards
Probability of Default
Measures the likelihood of counterparty default within 12 months, helping your team differentiate credit quality across borrowers.
Expected Credit Loss
Estimates potential credit losses from defaults, helping your business maintain adequate reserves for expected risks.
Risk Appetite
Align counterparty exposures and creditworthiness with risk appetite thresholds, preventing overextension and surprises.
Understanding Expected Credit Loss (ECL)
Expected Credit Loss (ECL) is a forward-looking measure used to estimate the potential financial loss you might incur if a counterparty defaults on their obligation. The calculation combine three key benefits:
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Calculates the potential financial loss from a credit decision.
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Translates credit risk into a simple monetary value.
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Defines the potential loss from a credit decision in straightforward dollar terms.
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The calculation combines three components:
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Probability of Default (PD): The likelihood that the counterparty will default over a specific time period, typically express as a percentage.
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Loss Given Default (LGD): The portion of the expression the lender expects to lose, expressed as a percentage, after accounting for recoveries such as collateral or guarantees.
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Exposure at Default (EAD): The total amount exposed to risk as the time of default, including outstanding balances.
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The formula is straightforward:
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ECL = PD x LGD x EAD
Example: Expected Credit Loss Calculation
Imagine a lender extending a loan to a counterparty with the following details:
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Probability of Default (PD) = 10% (0.10), indicating a 10% chance of default.
Loss Given Default (LGD) = 40% (0.40), meaning the lender expects to lose 40% of the loan amount if default occurs.
Exposure at Default (EAD) = $1,000,000, the total exposure at default.
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The expected credit loss (ECL) is 10%% x 40% x $1,000,000 = $40,000
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Interpretation
The lender estimates the potential credit loss of $40,000 for this loan, reflecting the combined effect of the counterparty's default risk, expected loss percentage, and exposure size.
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By using ECL, you can make informed decisions about reserves, pricing, and risk mitigation.
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Risk Appetite Alignment
Risk appetite thresholds define the level of credit risk your company is willing to accept while promoting transparent communication and a consistent review process.
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Your risk appetite guides where additional analysis is required. Credit profiles meeting your criteria qualify for Streamline reviews, allowing quick or automated approvals. Counterparties failing this test are categorized for Summary reviews, requiring deeper evaluation.
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Establishing Thresholds
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CreditKernel collaborates with your company to establish your Streamline approval amounts. These thresholds are not set by CreditKernel - nor should it be - since each one of our customers has their own unique risk appetite for counterparty credit risk.
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Risk appetite thresholds are defined by the likelihood of default (frequency) and size of the credit risk exposure.
Risk appetite thresholds are tailored to your company's specific needs. Common threshold tables include
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New or Existing Counterparty
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Industry
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Geography
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Your company's business units
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Example - Establishing Streamline Thresholds
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Each credit rating within the Kernel model, ranging from 1 (lowest risk) to 7, is linked to a dollar amount that defines your company's risk appetite.
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Your company's Streamline review risk appetite is reflected below by the credit exposure size.
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Green cells - Streamline review
Yellow cells - Full review
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In this example, you are extending trade credit to Company ABC, who has the following details:
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Credit Rating: 3
Credit Limit: $600,000​​
Interpretation
Company ABC meets your company's predefined risk appetite thresholds for a Streamline review, as highlighted in blue. The review can be quickly or automatically approved. This approach reduced manual effort and enhances the efficiency for lower-risk decisions.
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A couple other call outs regarding this specific threshold table. First, if a counterparty has a credit score of 7, all reviews fail the Streamline test and classified as Full. All reviews with credit limits above $1,000,000 also fail the Streamline test and classified as Full.
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Credit exposures can exceed the Streamline Approval Amount and when they do it is not the sole reason to say "No" or "Decline". The thresholds serve as a guideline to incorporate your companies risk appetite and facilitate additional communication and due diligence. ​​