The calculation of exposure at default (EAD) is different under foundation and advanced approaches. While under foundation approach (F-IRB) the calculation of EAD is guided by the regulators, under the advanced approach (A-IRB) the banks have greater flexibility on how they want to calculate EAD.
Calculating EAD under foundation approach
Under the first approach (i.e. Foundation IRB), the exposure at default is calculated taking account of the underlying asset, forward valuation, facility type and commitments. This value does not take account of guarantees, collaterals or securities, ignoring the credit risk mitigation techniques (with the exception of on-balance sheet netting where the effect of netting is included in EAD). For on-balance sheet transactions, EAD is identical to the nominal amount of exposure. On-balance sheet netting of loans and deposits of a bank to a corporate counterparty is permitted to reduce the estimate of EAD under certain conditions. For off-balance sheet items, there are two broad types which the IRB approach needs to address: transactions with uncertain future drawdown, such as commitments and revolving credits, and OTC foreign exchange, interest rate and equity derivative contracts.
Calculating EAD under advanced approach
Under the second approach (i.e. Advanced IRB), the bank itself determines the appropriate EAD to be applied to each exposure. A bank using internal EAD estimates for capital purposes might be able to differentiate EAD values on the basis of a wider set of transaction characteristics (for example based on the product type), as well as borrower characteristics. These values would be expected to represent a conservative view of long-run averages, although banks would be free to use more conservative estimates. A bank wishing to use its own estimates of EAD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates. All estimates of EAD should be calculated net of any specific provisions a bank may have raised against an exposure.
