What is Exposure at Default?

Exposure at default, also known simply as EAD, is the total amount of loss that a lender is facing when a borrower defaults on a loan. The term can be used to apply to the degree of risk associated with individual loans that are written by an institution such as a bank or mortgage company, or refer to the collective risk that is represented by all the currently active loans issued by the institution. In many cases, the calculation of exposure at default is used by financial institutions to structure their risk management models and thus minimize the effect of that exposure as much as possible.

The process of calculating a cumulative exposure at default normally involves multiplying each of the existing credit obligations by a specific percentage that is relevant to the type of loan issued, and any other extenuating factors that may apply to each of the loans. In most cases, this type of calculation is prepared to cover a period of twelve consecutive months, usually as one calendar year. The results of the calculations will represent the total amount of exposure that is possible in the event of default and thus allows the institution to create and manage an ongoing risk management process. By maintaining workable strategies that help to mitigate the degree of risk, it is possible to increase the chances of the institution remaining financially viable even if multiple loans do end up in default during the course of that year.

Investors will look closely at the exposure at default that is inherent with a given financial institution. By assessing the risk involved in the way that the institution does business, it is much easier to determine if the investor is likely to earn an equitable return by investing funds into the operation. Should the investor feel that a given bank or finance company has a degree of exposure that is out of balance with the assets of the business, there is a good chance he or she will refrain from investing in that institution, and look for investments elsewhere.

While the calculation of exposure at default is usually designed to project the possible exposure over the next twelve months, many institutions re-evaluate the exposure several times a year. This is because additional factors may have come into existence that have a positive or negative impact on those projections. In order to make sure that changing circumstances do not undermine the financial integrity of the lender, periodically recalculating the exposure at default makes it possible to deal with potential threats to the institution before they can have an enduring effect.