Enter Values
Key Formulas
EL = PD × LGD × EAD
PD = Default probability |
LGD = Loss given default |
EAD = Exposure at default
Credit Risk Metrics
Expected Loss (EL)
$400.0M
EL %
0.800%
Yellow
NPL Ratio
3.00%
Yellow
Coverage Ratio
120.0%
Green
Texas Ratio
17.3%
Green
NCO Rate
1.000%
Yellow
Reserve/Loans
3.60%
Green
Reserve Gap
$1,400.0M
Green
Warning:
Formula Breakdown
EL = PD × LGD × EAD
Step-by-step calculation of all credit risk metrics
Rating Thresholds
| Metric | Green | Yellow | Red |
|---|---|---|---|
| EL % | ≤ 0.5% | 0.5 – 2.0% | > 2.0% |
| NPL Ratio | < 2% | 2 – 5% | > 5% |
| Coverage | > 100% | 50 – 100% | < 50% |
| Texas Ratio | < 50% | 50 – 100% | > 100% |
| NCO Rate | < 0.5% | 0.5 – 1.5% | > 1.5% |
| Reserve/Loans | > 2% | 1 – 2% | < 1% |
| Reserve Gap | ≥ $0 | — | < $0 |
Model Assumptions
- Point-in-time estimates — PD, LGD, and EAD are static snapshots, not forward-looking (IFRS 9/CECL) projections.
- PD is annual — Represents one-year default probability; multi-year cumulative PD not modeled.
- LGD assumes no recovery timing — Does not discount recoveries for time value of money.
- EAD = current exposure — Does not model credit conversion factors for off-balance-sheet items.
- No PD–LGD correlation — Assumes independence between default probability and loss severity.
- Average loans = Total Loans — NCO rate uses period-end total loans as denominator (simplification).
- NPL classification follows 90+ day convention — Standard US regulatory definition; other jurisdictions may differ.
- PD and LGD are exposure-weighted averages — Assumed to represent the same portfolio and reporting date as EAD and Total Loans.
For educational purposes only. Not financial advice. Market conventions simplified.
Understanding Credit Risk & Loan Loss Provisions
What is Expected Loss?
Expected Loss (EL) is the cornerstone of credit risk measurement. It represents the average loss a bank expects from its loan portfolio over a defined period. The formula decomposes credit risk into three components:
Expected Loss Formula
EL = PD × LGD × EAD
Probability of Default × Loss Given Default × Exposure at Default
Probability of Default × Loss Given Default × Exposure at Default
Key Credit Risk Metrics
NPL Ratio
NPLs / Total Loans
Measures asset quality — the percentage of the loan book that has deteriorated past 90 days due.
Coverage Ratio
Reserves / NPLs
Measures provisioning adequacy — whether the bank has enough reserves for its problem loans.
The Texas Ratio
The Texas Ratio was developed by analyst Gerard Cassidy during the 1980s Texas banking crisis. It compares a bank's non-performing assets to its loss-absorbing capacity:
Texas Ratio
Texas Ratio = (NPLs + Other NPA) / (Tangible Equity + Reserves)
Values above 100% historically predict bank failure
Values above 100% historically predict bank failure
Important: A Texas Ratio above 100% means non-performing assets exceed the bank's loss-absorbing capacity. During the 2008 financial crisis, this metric gained renewed attention as an early warning signal for bank distress.
Basel Framework Context
- Under Basel II/III, banks use PD, LGD, and EAD for risk-weighted asset calculations
- Expected Loss determines provisioning needs; Unexpected Loss determines capital requirements
- The Internal Ratings-Based (IRB) approach allows banks to estimate their own risk parameters
- CECL (Current Expected Credit Losses) requires lifetime expected loss provisioning at origination
Frequently Asked Questions
Expected Loss equals Probability of Default (PD) times Loss Given Default (LGD) times Exposure at Default (EAD). It represents the average credit loss a bank anticipates over a given period. Banks use EL to set loan loss provisions — the reserves they hold against anticipated losses. Under regulatory frameworks like Basel III, EL determines the minimum provisioning requirement. If actual losses exceed EL, the bank's capital absorbs the difference (unexpected loss). A well-managed bank provisions at least enough to cover EL, keeping its capital available for unexpected losses.
The NPL Ratio (Non-Performing Loans / Total Loans) measures asset quality — what percentage of the loan book has deteriorated. The Coverage Ratio (Loan Loss Reserves / NPLs) measures provisioning adequacy — whether the bank has set aside enough reserves to absorb losses from those bad loans. A bank can have a low NPL ratio but poor coverage (few bad loans, but under-provisioned), or high NPL ratio with strong coverage (many bad loans, but well-provisioned). Regulators monitor both: NPL ratio flags portfolio deterioration, while coverage ratio flags whether the bank is prepared for it.
The Texas Ratio compares a bank's non-performing assets (NPLs plus foreclosed property) to its loss-absorbing capacity (tangible equity plus loan loss reserves). Developed by analyst Gerard Cassidy in the 1980s during the Texas banking crisis, a ratio above 100% means the bank's problem assets exceed its available cushion — historically a strong predictor of bank failure. Below 50% is generally considered healthy. Between 50–100% signals elevated stress. The ratio gained renewed attention during the 2008 financial crisis as a simple, effective early warning signal for bank distress.
Under Basel II/III, banks use PD, LGD, and EAD to calculate risk-weighted assets and minimum capital requirements. The Internal Ratings-Based (IRB) approach allows banks to estimate their own PD (and sometimes LGD and EAD) for each loan. Higher PD, LGD, or EAD means higher risk weights and more capital required. Expected Loss (PD × LGD × EAD) determines provisioning needs, while Unexpected Loss (derived from the same parameters plus correlation assumptions) determines capital requirements. This calculator focuses on the expected loss component — for capital adequacy ratios, see the Bank Capital Ratios Calculator.
Reserve/Loans (Loan Loss Reserves / Total Loans) measures how much of the entire loan portfolio is covered by reserves — a measure of overall conservatism. Coverage Ratio (Reserves / NPLs) measures reserves relative to known problem loans — a measure of preparedness for identified risks. A bank with few NPLs might have a low Coverage Ratio but adequate Reserve/Loans if its portfolio is fundamentally healthy. Conversely, a bank with high NPLs might show strong coverage but low Reserve/Loans if its problems are concentrated. Analysts use both metrics together: Reserve/Loans for broad provisioning philosophy, Coverage Ratio for adequacy against current credit deterioration. Note that a high Reserve/Loans ratio can also reflect a riskier portfolio, not just conservative provisioning.
Banks should increase provisions when: (1) credit quality deteriorates — rising NPLs, delinquencies, or charge-offs signal higher expected losses; (2) economic conditions worsen — recession indicators suggest future defaults will rise; (3) portfolio composition shifts — entering riskier lending segments; (4) regulatory requirements change — new accounting standards (like CECL in the US) require forward-looking provisioning; (5) the Coverage Ratio falls below 100% — meaning reserves don't fully cover current NPLs; (6) the Texas Ratio approaches or exceeds 100%. Under CECL (Current Expected Credit Losses), banks must provision for lifetime expected losses at origination, rather than waiting for loans to become impaired — a shift from incurred-loss to expected-loss accounting.
Disclaimer
This calculator is for educational purposes only. It uses simplified single-period expected loss models and standard regulatory definitions. Actual bank credit risk analysis involves forward-looking models (CECL/IFRS 9), correlation structures, portfolio segmentation, and macroeconomic scenarios. This tool should not be used for regulatory compliance or investment decisions.
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