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CS Professional · Banking and Insurance - Laws and Practice · Risk Management in Banks and Basel Accords

A bank lends Rs 40 lakh at simple interest of 10 percent per annum for 9 months. The borrower is expected to default with a probability of 5 percent, and if default occurs the loss given default is 40 percent of the exposure, taken as the principal. What is the expected credit loss on the principal (PD x LGD x EAD)?

Expected credit loss is Rs 80,000. It equals probability of default 5 percent multiplied by loss given default 40 percent multiplied by exposure at default Rs 40 lakh. The interest rate and tenor are irrelevant here, and ignoring loss given default would wrongly give Rs 2 lakh.

  1. ARs 80,000Correct
  2. BRs 2,00,000
  3. CRs 1,60,000
  4. DRs 8,00,000

Explanation

Expected loss = PD x LGD x EAD = 0.05 x 0.40 x Rs 40,00,000 = Rs 80,000. Rs 2,00,000 ignores LGD (0.05 x 40 lakh). The interest period and rate are not needed for this calculation.

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