If an asset suffers from a lower valuation or a loan defaults, the Exposure at Default figure is how much the firm will lose as a result of the default. The loss is contingent upon the amount to which the bank was exposed to the borrower at the time of default, commonly expressed as Exposure at Default (EAD)
Exposure At Default (EAD) is a measure of potential exposure (in currency) as calculated by a Basel Credit Risk Model for the period of 1 year or until maturity whichever is soonest.
A bank must provide an estimate of the exposure amount for each transaction (commonly referred to as Exposure at Default (EAD) in banks internal systems. All these loss estimates should seek to fully capture the risks of an underlying exposure.
For retail bank exposures, any change of a facility (e.g. extending the life of a mortgage to reduce monthly payments) is regarded as a default, so long as such reaging is undertaken in distressed circumstances to stop a customer not paying their mortgage at all.
This value is calculated taking account of the underlying asset, forward valuation, facility type and commitment details. This value does not take account of guarantees, collateral or security (i.e. ignores Credit Risk Mitigation Techniques with the exception of on-balance sheet netting where the effect of netting is included in Exposure At Default).
In most cases EAD will equal the nominal amount of the facility, but for certain facilities (e.g. those with undrawn commitments) it will include an estimate of future lending prior to default. Again as with LGD, under the foundation methodology EAD is estimated through the use of standard supervisory rules.
In the advanced methodology, the bank itself determines the appropriate EAD to be applied to each exposure, on the basis of robust data and analysis which is capable of being validated both internally and by supervisors. Thus a bank using internal EAD estimates for capital purposes might be able to differentiate EAD values on the basis of a wider set of transaction characteristics (e.g. product type) as well as borrower characteristics. As with PD and LGD estimates, these values would be expected to represent a conservative view of long-run averages, although banks would be free to use more conservative estimates. A bank wishing to use its own estimates of EAD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates.
For a risk weight derived from the IRB framework to be transformed into a risk weighted asset, it needs to be attached to an exposure amount. This can be seen as an estimation of the extent to which a bank may be exposed to a counterparty in the event of, and at the time of, that counterpartys default. In many banks internal credit systems, this is expressed as estimated exposure at default (EAD).
For on-balance sheet transactions, EAD is identical to the nominal amount of exposure. On-balance sheet netting of loans and deposits of a bank to a corporate counterparty will be permitted to reduce the estimate of EAD on an exposure subject to the same conditions as under the standardised approach. For off-balance sheet items, there are two broad types which the IRB approach needs to address: transactions with uncertain future drawdown, such as commitments and revolving credits, and OTC foreign exchange, interest rate and equity derivative contracts.
All estimates of EAD should be calculated net of any specific provisions a bank may have raised against an exposure
These requirements are very similar to the those for own-estimates of LGD. Banks are free to use their own estimates of EAD on facilities with uncertain drawdown, subject to meeting these requirements. As with LGD, these requirements are not prescriptive in terms of the factors which banks must consider in the assignment of exposures to EAD categories (e.g. facility types). Instead, the onus is on the bank to demonstrate that the criteria it uses are plausible and intuitive and can be supported by evidence.
In terms of assigning estimates of EAD to broad EAD classifications, banks may use either internal or external data sources. Given the perceived current data limitations in respect of EAD (in particular external sources) a minimum data requirement of 7 years has been set.