PD, LGD and EAD — the model parameters

PD, LGD and EAD are the three numbers that, multiplied together, give Expected Credit Loss. Each has its own data source, owner and approval process. Getting them wrong is the difference between a defensible audit and a qualified opinion.

The ECL formula

For Stage 1 loans, ECL is the present value of credit losses expected over the next 12 months: ECL = EAD × PD_12m × LGD × discount. For Stage 2 and 3, lifetime PD replaces 12-month PD, and the calculation is summed across each year of remaining life.

eir is the effective interest rate of the loan, captured at origination. lifetime_pd_curve is built from segment-level PD term structures stored in ifrs9.assumption.

# Stage 1 — 12-month ECL
ecl = ead * pd_12m * lgd * discount_factor

# Stage 2/3 — lifetime ECL
ecl = 0.0
for year in range(1, remaining_life_years + 1):
    pd_marginal = lifetime_pd_curve[year] - lifetime_pd_curve[year - 1]
    ead_year = expected_outstanding_at_year(year)
    discount = 1.0 / ((1.0 + eir) ** year)
    ecl += ead_year * pd_marginal * lgd * discount

PD — probability of default

PD is the probability that a loan will default within a given horizon. We calibrate PD per portfolio segment — a combination of product, member type and loan band — because default behaviour is materially different across segments. A KES 5,000 emergency loan to a long-standing member behaves nothing like a KES 2M business loan to a six-month-old member.

Calibration is annual, with a quarterly review. The annual recalibration uses 3 years of historical default data, fits a logistic regression on origination characteristics, and produces a PD term structure (12m, 24m, 36m, 48m, 60m) per segment.

LGD — loss given default

LGD is the percentage of the exposure that is lost after recovery efforts. A loan secured by clean title to land has a very different LGD than an unsecured emergency loan. LGD is calibrated per collateral type using actual recovery data from the last 36 months of write-offs.

EAD — exposure at default

EAD is what the lender stands to lose at the moment of default. For closed-end loans it is the outstanding principal plus accrued interest. For revolving facilities (overdraft, credit line) it adds undrawn commitment × a Credit Conversion Factor (CCF).

EAD is computed live by the engine from mfi.loan at the snapshot date. No manual override is permitted — if the EAD looks wrong, the underlying loan record is wrong.

Versioning and approval

Every assumption row is versioned. When the Risk Manager updates a PD or LGD, the old row is end-dated and a new row is created with the new value and a forward effective date. Runs already posted are not affected; the next run picks up the new assumptions.

1. Risk Manager opens IFRS 9 → Configuration → Assumptions and clicks New version.
2. System creates draft versions of all rows.
3. Risk Manager edits PD / LGD values, attaches calibration memo.
4. Risk Committee reviews — typically annually at year-end recalibration.
5. CFO approves; effective date is set to the next quarter-end.
6. Old version is end-dated; new version is the active assumption set.

Discounting

ECL is discounted at the original effective interest rate (EIR) of the loan, captured at origination on mfi.loan.eir. EIR includes interest, fees and any premium/discount amortised over the life of the loan. For loans originated before EIR was captured (legacy migration), the nominal rate is used and the variance is documented in the audit pack.

Worked scenarios

Reference

ifrs9.assumption fields

Standard segment codes

Troubleshooting

See also

• Ifrs9
• Staging
• Macro Scenarios
• Quarterly Run
• Products