Modeling exposure at default, credit conversion factors and the Basel II Accord

ABSTRACT The estimation of exposure at default (EAD) for accounts, together with the estimated probability of default (PD) and loss given default (LGD), is an important component of credit modeling in the Basel II Accord. Nevertheless, little work has appeared in the literature concerning the estimation of EAD. The Basel II Accord implies the use of a credit conversion factor (CCF) for revolving lines of credit, which is the ratio of the estimated additional drawn amount during the period up to 12 months before default over the undrawn amount at the time of estimation. This article uses theoretical arguments and real data to argue that the use of a CCF is unlikely to be appropriate. Alternative modeling approaches for EAD are proposed, and implications for banks attempting to satisfy the Basel II Accord are also discussed.