Probability of Default (PD) is the likelihood that a borrower will fail to meet its debt obligations over a given time horizon — typically one year — and is the foundational input in the Basel framework's Internal Ratings-Based (IRB) approach to credit risk capital.
PD is a core credit-risk metric that quantifies, as a percentage, how likely a borrower is to default within a defined period. In the Basel II/III/IV framework, banks using the Advanced Internal Ratings-Based (A-IRB) approach model PD for each credit exposure and use it — alongside LGD, EAD, and maturity — to calculate regulatory capital requirements under the risk-weighted assets formula: RWA = f(PD, LGD, EAD, M). BIS (Bank for International Settlements) publishes the Basel framework standards at bis.org/bcbs/. The Federal Reserve and OCC enforce Basel capital rules for U.S. banks through Regulation Q (12 CFR Part 3 for national banks; 12 CFR Part 217 for state member banks — federalregister.gov). Under A-IRB, banks estimate PD from internal historical default data; under the Standardized Approach, PD is proxied through external credit ratings or fixed regulatory weights. For small business borrowers, PD is estimated by lenders using credit bureau scores, financial statement ratios (DSCR, leverage, liquidity), time in business, and industry default experience. A borrower with a 2% one-year PD is considered investment-grade in most commercial frameworks; 10%+ PD corresponds to subprime / speculative-grade exposure. Higher PD drives higher loan pricing — lenders price the expected loss (PD × LGD × EAD) into the interest rate margin.
Lenders price for expected loss: Expected Loss = PD × LGD × EAD. A loan with 3% PD, 40% LGD, $100K EAD has $1,200 expected annual loss. The loan's spread must exceed this loss plus operating costs and required return on capital. Higher PD borrowers pay wider spreads to compensate for the statistical loss embedded in the book.
A credit score (FICO, PAYDEX) is an ordinal ranking — higher is better. PD converts that ranking into an absolute probability of default expressed as a percentage. Banks map their internal credit grades or external scores to PD ranges through calibration studies using historical default data.
The Basel Committee on Banking Supervision publishes the consolidated framework at bis.org/bcbs/publ/d424.htm. U.S. implementing rules are in Regulation Q (12 CFR Part 3 / 12 CFR Part 217), available at ecfr.gov.