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Lending & Credit Risk Portfolio Risk & CECL Allowance Calculation CECL Models

Probability of Default: Definition, Factors, and Calculation

Abrigo
August 11, 2023
Read Time: 0 min

Definition and Concept of Probability of Default

Probability of Default (PD) refers to the likelihood that a borrower, whether an individual or institution, will fail to meet debt obligations within a specified time period–typically one year. PD is a core component of credit risk assessment and plays a pivotal role in determining loan terms, capital requirements, and pricing. In practice, lenders use PD to estimate expected losses and to comply with regulatory frameworks like Basel III.

Factors Influencing Probability of Default

Several key variables influence a borrower’s probability of default. Common factors include:

  • Credit scores and credit ratings
    Strong indicators of a borrower’s creditworthiness.
  • Financial health
    Metrics such as debt-to-income ratio, liquidity, and cash flow.
  • Macroeconomic conditions
    Interest rates, unemployment, and inflation can all affect default likelihood.
  • Industry and geographic risk
    Borrowers in volatile sectors or regions may carry higher PD.

Understanding these variables helps lenders refine credit models and proactively manage portfolio risk. Probability of Default/Loss Given Default analysis is a method used by generally larger institutions to calculate expected loss. A probability of default (PD) is already assigned to a specific risk measure, per guidance, and represents the percentage expected to default, measured most frequently by assessing past dues. Loss given default (LGD) measures the expected loss, net of any recoveries, expressed as a percentage and will be unique to the industry or segment.



When combined with the variable exposure at default (EAD) or current balance at default, the expected loss calculation is deceptively simple:

Expected Loss Equation

Expected Loss = EAD x PD x LGD

While the equation itself may be simple, deriving the variables takes time and considerable analysis. PD and LGD represent the past experience of a financial institution but also represent what an institution expects to experience in the future. PD is typically calculated by running a migration analysis of similarly rated loans, over a prescribed time frame, and measuring the percentage of loans that default. That PD is then assigned to the risk level; each risk level will only have one PD percentage.

LGD measures the net loss percentage of those loans that defaulted within an industry or segment. An accurate LGD variable may be difficult to obtain if portfolio losses are different than expected or if the segment is statistically small. Industry LGDs are available from third party vendors, if necessary. The positive is that PD and LGD numbers are typically valid throughout an economic cycle, but they should be re-evaluated periodically or in the event of economic recovery or recession, merger, or significant changes in portfolio composition.

The main benefit to financial institutions using PD/LGD is the simple calculation: the quantitative reserve can be easily calculated within simple models that create directionally consistent expected loss numbers.  That consistency contributes to the use of this method among institutions. It also ties the risk rating process directly to the allowance for credit losses calculation via the PD. If actual net losses are not in line with predicted losses, a financial institution would need to determine if the credit review process routinely over- or understates customer risk ratings.

To learn more about the PD/LGD approach and the pros and cons of using it under the Current Expected Credit Loss Model (CECL),  download this infographic, CECL Methodologies: Pros and Cons for Your Portfolio. See how one financial institution incorporated PD/LGD into its allowance calculation. To gain confidence in your allowance calculations, explore CECL software endorsed by the American Bankers Association.

 

Assessment and Modeling Approaches

There are multiple methodologies for estimating PD, each with different use cases:

  • Statistical models
    Logistic regression and probit models based on historical data.
  • Machine learning models
    Algorithms like random forests or gradient boosting to improve predictive power.
  • Structural models
    The Merton model, for instance, uses a firm’s capital structure and asset volatility.
  • Reduced-form models
    Focus on estimating default intensity over time without modeling firm value explicitly.

Choosing the right model depends on available data, regulatory context, and desired accuracy.

Applications in Financial Products and Risk Management

PD is not only critical in credit lending but also in structuring and valuing financial products:

  • Credit default swaps (CDS)
    PD directly influences pricing by quantifying the chance of a credit event.
  • Loan pricing
    Helps set interest rates appropriate to the risk level.
  • Risk-weighted asset (RWA) calculations
    PD is used to calculate capital reserves under Basel guidelines.

These applications show how PD is embedded into modern financial risk management strategies.

Implications and Consequences of Default

When a borrower defaults, the consequences can be significant:

  • For lenders
    Financial loss, need for write-offs, and higher reserve requirements.
  • For borrowers
    Damaged credit rating, restricted access to future credit, and potential legal consequences.
  • Default triggers
    Typically include missed payments, covenant violations, or insolvency proceedings.

By accurately modeling PD, financial institutions can better prepare for and mitigate the consequences of default.



About the Author

Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo’s platform centralizes the institution’s data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth. Make Big Things Happen.

Full Bio

About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

Make Big Things Happen.