Glossary term
Probability of Default (PD)
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Probability of default is the estimated chance that a borrower will fail to meet its debt obligations within a stated period, most often one year. It is expressed as a percentage.
Explanation
PD is one of three main building blocks of credit risk measurement, next to loss given default and exposure at default. Lenders estimate it from rating models, scorecards, financial statements, payment history and economic conditions. A retail borrower may be scored on repayment behaviour, while a large company is scored on debt levels, cash flow and sector outlook. Two views are common: a through-the-cycle estimate that smooths out economic swings, and a point-in-time estimate that reflects today's conditions. Banks using internal ratings approaches for regulatory capital must back-test their PD estimates against actual defaults. Under accounting rules such as IFRS 9, PD also drives the calculation of expected credit losses. Underestimate it and loans carry prices and provisions that are too low; overestimate it and sound borrowers are turned away.
Example
Credit analysts give a small manufacturer a one-year PD of 2%, meaning that about 2 in every 100 similar firms are expected to default within twelve months. After the firm loses its largest customer and its cash flow weakens, the bank re-rates it and the PD rises to 7%. The loan is repriced at the next review and moves to closer monitoring.
Not to be confused with
- Loss given default
- PD is how likely a default is. Loss given default is how much would be lost, as a share of the exposure, if it happens.