The expected loss is defined as follows:
Expected loss = probability of default (%) x (exposure at default – value of recovery)
The probability of default is an estimate of the likelihood that the borrowing firm may default. The exposure at default is the outstanding debt including unpaid interests at default. The net proceed that the creditors receive given a default is the ultimate recovery. The recovery rate is proportion of the exposure at default which is recovered (ultimate recovery divided by exposure at default).
Use and type of loan
Estimating probability of default
Estimating exposure at default and ultimate recovery (ratio)
Estimating the expected loss
Interest coverage ratio (cash or EBIT)
They rate debt according to the underlying risk. This risk is assessed based on a variety of financial ratios as shown in the example below from Standard & Poor’s:
The estimation of exposure at default is not always straightforward. Most banks take a conservative view and assume that the current debt equals exposure at default. Some banks try to estimate the exposure of default at the most critical point in time; i.e. the year where the probability for default is highest.
An estimation of the liquidation value typically follows these steps:
Book value of equity
+/– The difference between the liquidation value and book value of assets
+/– The difference between the liquidation value and book value of liabilities
+/– The liquidation value of off-balance sheet items
– Fees to lawyers, auditors, etc.
= Liquidation value