What is expected loss (EL)?

Expected loss is the mean loss a lender should anticipate over a given horizon. It combines three components: the probability the borrower defaults, the share of the exposure lost if it does, and the amount outstanding at default. Expected loss can be calculated for a single loan and summed across a portfolio.

Expected loss is a normal cost of lending that should be covered by loan pricing and, in accounting terms, by the allowance for credit losses. It differs from unexpected loss, the variability of losses around the average, which capital is meant to absorb. Lenders use expected loss to compare risk-adjusted returns across loans, set pricing and allocate portfolio limits.

A one-year expected loss is not the same as the lifetime loss estimate required under CECL, which covers the full contractual life of a loan. Expected loss calculations also assume the three components are independent, but in a downturn defaults rise and recoveries fall together. Estimates are only as good as their inputs, so stale PDs or optimistic LGDs carry straight through.