How do banks estimate exposure at default (EAD), especially for off-balance-sheet commitments?

Exposure at Default (EAD) measures how much a bank stands to lose IF a borrower defaults. For funded exposures it's straightforward, but unfunded commitments are trickier because borrowers tend to draw down lines before defaulting.

Funded Exposures (Simple):

• Term loan with $10M outstanding: EAD = $10M
• Bond holding at par $5M: EAD = $5M

Unfunded Commitments (Complex):

For revolving credit facilities, EAD includes both the current drawn amount and expected additional drawdowns:

EAD = Drawn Amount + CCF x Undrawn Commitment

Where CCF (Credit Conversion Factor) estimates the fraction of the undrawn line the borrower will use before defaulting.

Example — Thornfield National Bank's revolving facility to Westbrook Industries:

• Committed line: $50M
• Currently drawn: $30M
• Undrawn: $20M
• Estimated CCF: 60%

EAD = $30M + 0.60 x $20M = $30M + $12M = $42M

Why CCF > 0:

Borrowers approaching distress often:

1. Draw down remaining credit lines as other funding sources dry up
2. Use facilities more aggressively to meet operational needs
3. Attempt to access funds before the bank freezes the line

Empirical studies show CCFs of 40-75% for revolving facilities, higher for investment-grade borrowers (they have larger undrawn amounts).

Basel Approaches:

Other Exposure Types:

• Derivatives: EAD = Current exposure + Add-on for potential future exposure (SA-CCR methodology)
• Repo/Securities lending: EAD = max(0, Exposure - Collateral) with haircuts
• Guarantees: EAD = guaranteed amount x CCF

FRM Key Points:

• CCF is NOT a constant — it varies by facility type, borrower quality, and economic conditions
• Distressed borrowers draw down faster, creating 'wrong-way risk' (higher EAD precisely when PD is high)
• EAD and LGD can be correlated — secured revolvers have lower LGD but potentially higher EAD (collateral drawdown)
• SA-CCR replaced CEM (Current Exposure Method) for derivative EAD under Basel III

Master EAD estimation in our FRM Part II Credit Risk module.