IFRS quantitative finance series
PD, LGD and EAD Under IFRS 9: Building a Coherent ECL Framework
PD, LGD and EAD are useful building blocks, but IFRS 9 measures expected cash shortfalls rather than prescribing one regulatory-style formula. A sound framework therefore uses the components as an implementation language while preserving the accounting objective.
Keep definitions aligned
Default, cure, write-off and recovery definitions must align across the three parameters. A PD calibrated to one default event cannot be combined safely with an LGD measured on another population. The exposure horizon, observation unit and treatment of multiple defaults should also be consistent.
Build conditional term structures
Lifetime measurement requires marginal default probabilities by future period, not a single cumulative number multiplied across all months. LGD should reflect recovery timing, collateral, cure and costs, while EAD should reflect contractual amortisation and plausible future drawings.
Avoid false precision
Parameter uncertainty can be more important than another decimal place. Banks should disclose material judgements, use overlays only for identifiable gaps and challenge whether segmentation hides concentrations or creates unstable estimates.
Quantitative expression
Implementation controls
- Use one governed default definition across components.
- Validate marginal and cumulative PD consistency.
- Reconcile EAD schedules to contractual systems.
- Measure uncertainty and concentration, not only point accuracy.