"EL" in finance can refer to two different things:
1. Expected Loss (EL)
Expected Loss (EL) is a key concept in credit risk management. It represents the average amount of money a lender expects to lose due to a borrower's default on a loan.
-
Calculation: EL is calculated by multiplying the Probability of Default (PD) by the Exposure at Default (EAD) and the Loss Given Default (LGD).
- PD: The likelihood that a borrower will default on their loan.
- EAD: The amount of money outstanding at the time of default.
- LGD: The percentage of the EAD that the lender is expected to lose.
-
Example: If a bank has a loan of $1 million with a PD of 5%, EAD of $1 million, and LGD of 40%, then the EL would be: 5% x $1 million x 40% = $20,000.
2. Exposure at Limit (EL)
Exposure at Limit (EL) is a term used in credit risk management to describe the maximum amount of credit exposure a lender has to a particular borrower. It is often used in conjunction with credit lines or revolving credit facilities.
- Example: If a bank has a credit line of $10 million for a customer, the EL for that customer is $10 million.
Understanding EL is crucial for financial institutions to:
- Assess risk: EL helps lenders to estimate the potential losses from credit defaults.
- Set loan pricing: EL is a key factor in determining the interest rate charged on loans.
- Manage capital: EL is used to calculate regulatory capital requirements for banks.
