Exposure at default (EAD) is a measure used by financial institutions to assess their risk of loss due to a borrower or group of borrowers defaulting on their loan obligations. A lender must consider not only the amount of debt owed by the borrower, but also the likelihood that the borrower will default on the loan. This metric is calculated by taking the total amount (either face value or adjusted value) of the loan, given the current risk and debt profile of the borrower.

The use of EAD helps financial institutions to understand the risk of holding a loan and aids in setting the appropriate interest rate and loan terms. This is pertinent to lenders in order to ensure that their loan portfolios are able to withstand potential credit losses. In addition, capital is allocated based on the estimated credit risk of the loan portfolio. Banks must use strict internal protocols in order to compute the Total Credit Risk Capital, often using EAD, Loss Given Default (LGD) and the Probability of Default (PD) to arrive at the overall risk level of their loan portfolio.

EAD is a dynamic measure, which means that lenders often need to re-calculate the metric in order to adapt to changing market conditions and to react to changes in the borrower’s risk profile. During times of economic stress, financial institutions may face additional challenges in pricing loans and overseeing the quality of the loan portfolios. This can result in the banking industry becoming overexposed to certain sectors, or types of debt obligation, and can lead to spiraling events known as ‘cascading defaults’.

As a result of the 2008 Global Financial Crisis, governments around the world have taken steps to ensure that lax lending does not lead to similar events in the future. Current regulatory frameworks, such as the Basel III capital requirements in the European Union, mandate that lenders must monitor and assess their exposure to risk at all times. The use of EAD, LGD and PD are part of a number of tools and techniques employed by financial institutions in order to reserve funds and to cover potential losses should a borrower enter default. As a result, lending is able to continue in a safe and prudent manner while preserving the financial stability of the banking sector.