What is Expected Loss?
The expected loss (EL) is the amount of money that a company anticipates losing in the ordinary course of operations.These losses can be calculated with relative accuracy over short periods using statistical analysis.
The expected loss of a portfolio can be computed as a function of three factors:
- The probability of a risk event occurring.
- The monetary exposure to the risk event; and
- The expected severity of the loss if the risk event occurs.
A retail business, for example, that offers credit terms on products sales to its consumers (i.e., no need to pay right away) runs the risk of non-payment by some of those customers.
If the company has been in business for a while, it can utilise its operating history to estimate the percentage of yearly credit sales that will never be collected.
As a result, the size of the loss is foreseeable, and it is handled as a regular cost of doing business (bad debt charge on the income statement).
It can be priced into the cost of the goods directly in the retail business case. In a banking context, EL could be modelled as the product of a borrower’s probability of default (PD), the bank’s exposure at default (EAD), and the magnitude of the loss given default (LGD).
EL = EAD × PD × LGD
EL = Expected Loss
EAD = Exposure at Default
PD=Probability of Default
LGD= Loss Given Default
Let’s assume a ABC bank has lent money to XYZ corporation with EAD= USD 1mn, PD = 1% and LGD = 20%. EL would be:
EL = 1,000,000*0.01*0.1 = USD 2000
Why is expected loss important?
Due to the nature of the loan activity, the projected loss on a portfolio of loans represents the loss that must be accepted and priced. The level of risk and the time horizon considered are crucial factors in determining the probability of default and estimated loss.