What is expected credit loss calculated by?

The expected credit loss is calculated using the probability of default multiplied by the loss given default. This approach captures the risk of a borrower defaulting on an obligation and quantifies the anticipated loss that will be incurred if that default occurs.

Understanding the components involved is crucial. The probability of default represents the likelihood that a borrower will fail to meet their debt obligations. The loss given default, on the other hand, measures the extent of loss in the event that a default occurs. This typically considers factors such as the recovery rate on the underlying collateral, if any, and the overall financial health of the borrower.

By multiplying these two factors, you arrive at the expected credit loss, which provides a metric for financial institutions to assess the credit risk of their loans and set aside adequate provisions. This calculation is pivotal in risk management and regulatory frameworks that aim to ensure that financial institutions maintain sufficient capital to cover potential losses.