Probability of default (PD) and expected loss: how to estimate how much you risk on a customer
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In brief: the probability of default (PD) is the probability that a counterparty defaults within one year: this is the definition in EU Regulation 575/2013 on bank requirements. On its own it tells you little about a company that sells on credit; it becomes useful inside the expected loss formula, PD × LGD × EAD, that is probability of default × share lost in default × exposure at default. With this formula you can compare different customers and see where a guarantee or a down payment does the most good.
What is the probability of default?
Regulation (EU) 575/2013, the so-called CRR, in article 4, point 54, defines the probability of default as 'the probability of default of a counterparty over a one-year period'. It is the figure banks estimate for every customer they lend to, and which commercial scores translate into classes or points.
A PD of 2% means this: among one hundred companies with the same risk profile, about two are expected to default in the following twelve months. It does not say which two. That is why PD is used to set terms and prices across many customers, and it must always be accompanied by a judgement on the individual case.
What counts as 'default'?
The word sounds like a synonym for bankruptcy, but it is not. For banks, since 1 January 2021, the new European definition applies (article 178 of the CRR, EBA guidelines and the Commission Delegated Regulation of 2018). According to the Bank of Italy a borrower is in default if at least one of two conditions occurs:
- material arrears: an overdue amount that together exceeds an absolute threshold, €100 for retail exposures and €500 for others, and a relative threshold, 1% of the total exposure to the bank, for more than 90 consecutive days (180 in some cases, such as public administrations);
- unlikeliness to pay: the bank considers it unlikely that the borrower will pay in full without enforcing the guarantees.
The Bank of Italy also clarifies that overdue amounts can no longer be offset against available margins on other credit lines. The consequence for you: a customer can end up in default for its bank without any insolvency procedure underway, and from that moment it finds credit harder to obtain. This is one of the reasons why delays to suppliers often increase afterwards.
How is expected loss calculated?
The CRR, in article 158, calculates expected loss as PD × LGD, then multiplied by the value of the exposure. Applied to trade credit, the formula has three ingredients:
| Abbreviation | What it means | Where to get it |
|---|---|---|
| PD | Probability that the customer defaults within one year | From the customer's score or rating class, when the provider publishes the correspondence table |
| LGD | Loss given default: the share of the credit you lose if default occurs | From your own experience: unsecured trade credit recovers little; with guarantees, retention of title or insurance you lose less |
| EAD | Exposure at default: how much the customer owes you at the moment of default | From your maximum exposure: open invoices plus deliveries in progress |
Expected loss = PD × LGD × EAD.
An example with two customers
Hypothetical example, with numbers chosen to show the calculation:
| Customer A | Customer B | |
|---|---|---|
| Estimated PD | 1% | 6% |
| LGD (credit without guarantees) | 80% | 80% |
| Maximum exposure (EAD) | €60,000 | €15,000 |
| Expected loss | €480 | €720 |
Customer B buys a quarter as much as A but has a higher expected loss. If your margin on B is €1,000 a year, almost three quarters of it goes to risk. Now try asking B for a 50% down payment: the exposure falls to €7,500 and the expected loss to €360. The calculation tells you where a payment condition is worth more than a discount.
Why is expected loss not enough?
Expected loss is an average. Across a hundred small customers the average works; for a customer worth a third of your revenue it does not, because if it defaults you do not lose €480, you lose the whole exposure minus whatever share you recover. For this reason, alongside the calculation, two rules are needed:
- a ceiling per customer, that is an exposure limit you never exceed, whatever the PD: this is covered in the guide on credit limit;
- a concentration check: how much of your receivables depends on your top three customers.
How do you go from a rating class to a PD?
Only with the correspondence table from whoever calculated the class. Some providers publish it, others keep it confidential. If you do not have it, do not make it up: use the class to rank customers from most to least risky and apply different terms by band. For an SME, this ordered scale is already the most useful part of the model. How to read the scores of different providers is explained in the guide on company credit score.
What you can do from tomorrow
- Make a list of the customers with an exposure above a threshold you set.
- For each one, check the rating class and the estimated credit line.
- Calculate your maximum exposure and a prudent LGD, for example 80% for credit without guarantees.
- Sort by expected loss and start from the top: there, a down payment, shorter terms or a guarantee do the most good.
For the customers at the top of the list, the €99 Investigation report adds financial statements, properties in the company's name, corporate relationships and 12 months of Sentinella, which alerts you every week if status, shareholders, directors or financial statements change.
Sources
- FMA (Austrian financial supervisor), glossary: Probability of Default, referring to art. 4(1)(54) CRR (accessed 11/11/2026)
- Regulation (EU) 575/2013 (CRR), arts. 4, 158 and 178 (EUR-Lex)
- Bank of Italy, Entry into force of the new definition of default (accessed 11/11/2026)
- Bank of Italy, Q&A on the new definition of default (accessed 11/11/2026)
Frequently asked questions
What is the probability of default?
It is the probability that a counterparty defaults within one year, according to the definition in article 4 of EU Regulation 575/2013. A PD of 2% means that, out of one hundred companies with that profile, about two default within twelve months.
When is a company in default for the bank?
Since 1 January 2021, when its arrears together exceed €500 (€100 for retail exposures) and 1% of the exposure for more than 90 consecutive days, or when the bank considers it unlikely to pay without enforcing the guarantees.
How is expected loss on a customer calculated?
By multiplying the probability of default (PD) by the share you would lose in case of default (LGD) and by the exposure at the moment of default (EAD). With a PD of 1%, an LGD of 80% and an exposure of €60,000, the expected loss is €480.
Does default mean bankruptcy?
No. A company can be in default for its bank because its arrears exceed the thresholds, without any insolvency procedure being open. Bankruptcy, now called judicial liquidation, is a procedure declared by the court.
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