4.7 Estimating Exposure at Default

Exposure at default is defined as the expected gross exposure of the facility upon default of the obligor (Basel Committee 2006a). While for certain kinds of loans the amount the bank is lending is fixed and predetermined, the issue of EAD is particularly relevant for loan commitments, since a distressed borrower is likely to use a substantial part of initially undrawn loan commitments before defaulting, unless the bank has the chance to revoke the commitment and is able to anticipate the problem. The problem is more relevant for high-quality borrowers, since they can obtain larger commitments and the difference between the drawn portion in normal conditions and at default may be larger (see Table 4-9).

As a consequence, Basel II forces banks adopting either the standardized or the FIRB approach to translate off-balance sheet items, such as loan commitments, into credit-exposure equivalents by multiplying them by a credit-conversion factor (see Basel Committee 2006a, 82 87 and 311 315). Only facilities that...