Why Expected Credit Loss Uses the Effective Interest Rate

Summary

The note explains why expected credit loss calculations discount loan cash flows using the effective interest rate, even though that rate already reflects credit risk. The key distinction is between measuring expected loss at origination and recognizing deterioration afterward. A loan may have credit risk reflected in both its interest rate and its expected cash flows without recording an initial expected credit loss relative to its origination price.

The effective interest rate primarily supports consistent interest income recognition and generally remains fixed as credit quality changes. Expected credit loss changes when expected cash flows worsen, so the two inputs serve different accounting purposes rather than simply counting the same risk twice. The discussion refers to IFRS and CECL but does not compare their detailed rules or address exceptions where accounting treatment can change the effective interest rate. It is an explanatory answer, not a worked calculation or empirical analysis.

Key ideas

• Expected credit loss is measured relative to the loan's origination or purchase position.
• Credit risk can be reflected in both the loan's pricing and its expected cash flows.
• The effective interest rate is mainly used to recognize interest income and generally stays constant as credit risk changes.
• Expected credit loss increases when expected cash flows deteriorate after origination.

Tags

# Discounting future cash flow for credit risk calculation


# Discounting future cash flow for credit risk calculation












In calculation of the expected credit loss (ECL) for a loan portfolio, regulatory frameworks like IFRS and CECL require that all loan cash flows are discounted based on the effective interest rate (EIR).

EIR essentially incorporates the credit risks of individual loans and it is based on loan rates. However, when we calculate ECL, we also include the default probability, which also incorporates the credit risks of individual loans.

So aren't we considering credit risk twice in the ECL calculation, first from the default probability consideration and the second from EIR? If so, should we discount the future cash flows with risk free rates?

Any insight would be highly appreciated.

## Answer by PBD10017 (score 1)

https://quant.stackexchange.com/a/85221

ECL measures relative increase expected loss from origination / purchase. It's purpose is not to assess the absolute loss, but only the loss that originator / buyer should be recording relative to their purchase / origination price. A loan / bond originated at 100 will have no ECL recorded and yet both coupon and discount rate will reflect credit risk. Only once the credit risk deteriorates will the expected cash flows change and EIR will stay the same. EIR's purpose is primarily interest income recognition and as such is preferred to stay constant (although it may change under certain accounting scenarios, but that's a different question).

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.