Finance term
Probability of Default (PD)
Also known as: PD, default probability, Basel PD
Definition
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.
Detailed explanation
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.
◈ Worked example
- A commercial bank's internal model assigns a 0.5% one-year PD to a profitable, well-capitalized mid-market borrower — consistent with BBB investment-grade external ratings.
- A startup business with 6 months of operation, 580 FICO, and no collateral may carry a modeled PD of 15-25% — reflected in higher rates or outright decline at traditional banks.
- Basel III capital formula: for a corporate loan with 1% PD, 45% LGD, $1M EAD, the risk weight is approximately 100%, requiring roughly $80K of Tier 1 capital (8% × $1M RWA).
Common questions
The most-asked questions about Probability of Default (PD) — answered straightforwardly.
How is PD used in loan pricing? +
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.
What's the difference between PD and credit score? +
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.
Where is the Basel PD framework published? +
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.
Further reading
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