Expected credit loss (ECL)

What it is

Expected credit loss (ECL) is the average credit loss a lender expects on an exposure, weighted by the probability of each outcome and discounted to today. IFRS 9 requires every lender to hold a loss allowance equal to ECL. The horizon depends on the stage: 12 months for Stage 1 assets, the full remaining life for Stage 2 and Stage 3 assets.

Most models build ECL from three components: probability of default (PD), loss given default (LGD) and exposure at default (EAD), estimated period by period and discounted at the effective interest rate. The estimate must be unbiased and include reasonable and supportable forward-looking information, which in practice means several macroeconomic scenarios with weights.

Why it matters

ECL sets the size of provisions, so it drives reported profit and capital. Changes in scenarios, staging or model parameters can move the allowance by large amounts in one quarter. Supervisors and auditors look closely at scenario weights and at management overlays, the adjustments firms add when models miss a known risk.

Worked example

Illustrative numbers. A Stage 1 loan has an EAD of EUR 500,000 and an LGD of 30 percent. The bank uses three scenarios for the 12-month PD:

• Base, weight 60 percent, PD 2 percent: ECL = 500,000 x 2% x 30% = EUR 3,000.
• Upside, weight 15 percent, PD 1 percent: ECL = EUR 1,500.
• Downside, weight 25 percent, PD 5 percent: ECL = EUR 7,500.

The probability-weighted ECL is 0.60 x 3,000 + 0.15 x 1,500 + 0.25 x 7,500 = EUR 3,900. Using the base scenario alone would give EUR 3,000. The gap exists because losses rise faster in bad scenarios than they fall in good ones, which is why IFRS 9 asks for several scenarios.

Who uses it

• Credit Risk Model Developers build and recalibrate PD, LGD and EAD models and the scenario engine.
• Credit Risk Analysts run the quarterly provisioning cycle and explain movements.
• General Accountants book the allowance and the impairment charge.
• Model Validation Analysts review the models and overlays independently.
• External Audit (Financial Services) teams test the data, the scenarios and the judgements.
• Regulatory Reporting Analysts report allowances by stage in FINREP.

Common confusions

• ECL is an accounting allowance. Regulatory expected loss under the internal ratings based approach uses different parameters and feeds capital, so the two figures rarely match.
• A 12-month ECL covers losses from defaults in the next 12 months, and the loss itself can arise later.
• Management overlays are part of ECL. They should be documented, quantified and released when the model captures the risk.
• Stage 3 ECL uses a PD of 100 percent, so the allowance depends mainly on LGD and expected recoveries.