Bank A has extended a commitment of $10,000,000 and assessed a probability of default of 5%. The loss given default based on historical data is estimated to be 30%. Bank B has extended a $5,000,000 commitment to a company with a lower credit quality. A default rate of 10% and loss given default of 20% is estimated. For Bank A to have a lower expected loss than Bank B, which of the following is TRUE? The recovery rate of:
A. Bank B’s loan will decrease to 90%.
B. Bank B’s loan will increase to 80%.
C. Bank A’s loan will increase to 90%.
D. Bank A’s loan will decrease to 80%.
Answer:C
Expected loss = AE × LGD × PD.
ELA = $10M × 5% × 30% = $150,000.
ELB = $5M × 10% × 20% = $100,000.
Bank A and Bank B have initial recovery rates of 70% and 80%, respectively. A decrease in Bank A’s loan to 80% is incorrect since 80% would be an increase in recovery rate. When recovery rate of Bank A increases to 90%, ELA = $10M × 5% × 10% = $50,000.