Thoughts on Modeling Practices in Exposure at Default
In the consumer credit risk arena, EAD (Exposure at Default) is a major component in the calculation of EL (Expected Loss) particularly in Line of Credit products such as Credit Card or HeLOC. While it is common to gauge EAD at the portfolio level based upon the utilization rate, a leading practice implemented in more complex banks is to estimate account-level EAD models with the inclusion of individual risk characteristics.
Empirically, as three risk measures, namely LEQ, CCF, and EADF, are employed to describe EAD at the account-level, each of them carries a different business meaning and therefore should be applied to different type of accounts. For instance, in a Credit Card portfolio, while LEQ should be applicable to most accounts, it might not be suitable for accounts with close to 100% utilization rates. In addition, as newly originated or inactive accounts do not have any account activity, EADF might be more appropriate.
The table below is a summary of three EAD measures together with their use cases in the practice. I hope that it is useful for consumer banking practitioners and wish the best in the coming CCAR (Comprehensive Capital Analysis and Review) 2015.