The LGD calculation is easily understood with the help of an example: If the client defaults with an outstanding debt of $100,000 and the bank or insurance is able to sell the security (e.g. a condo) for a net price of $80,000 (including costs related to the repurchase), then the loss amount is $20,000, and the LGD is 20% (= $20,000 / $100,000). Theoretically, LGD is calculated in different ways, but the most popular is 'gross' LGD, where total losses are divided by
exposure at default (EAD). Another method is to divide losses by the unsecured portion of a credit line (where security covers a portion of EAD). This is known as 'Blanco' LGD. If collateral value is zero in the last case then Blanco LGD is equivalent to gross LGD. Different types of statistical methods can be used to do this. Gross LGD is most popular amongst academics because of its simplicity and because academics only have access to bond market data, where collateral values often are unknown, uncalculated or irrelevant. Blanco LGD is popular amongst some practitioners (banks) because banks often have many secured facilities, and banks would like to decompose their losses between losses on unsecured portions and losses on secured portions due to depreciation of collateral quality. The latter calculation is also a subtle requirement of
Basel II, but most banks are not sophisticated enough at this time to make those types of calculations.
Calculating LGD under the foundation approach (for corporate, sovereign and bank exposure) To determine required capital for a bank or financial institution under Basel II, the institution has to calculate risk-weighted assets. This requires estimating the LGD for each corporate, sovereign and bank exposure. There are two approaches for deriving this estimate: a foundation approach and an advanced approach.
Exposure without collateral Under the foundation approach, BIS prescribes fixed LGD ratios for certain classes of unsecured exposures: • Senior claims on corporates, sovereigns and banks not secured by recognized collateral attract a 45% LGD. • All subordinated claims on corporates, sovereigns and banks attract a 75% LGD.
Exposure with collateral Simple LGD example: If the client defaults, with an outstanding debt of 200,000 (EAD) and the bank is able to sell the security for a net price of 160,000 (including costs related to the repurchase), then 40,000, or 20%, of the EAD are lost - the LGD is 20%. The effective loss given default (L_{GD}^*) applicable to a collateralized transaction can be expressed as L_{GD}^* = L_{GD}\cdot\frac{E^*}{E}
Haircut appropriate for currency mismatch between the collateral and exposure (The standard supervisory haircut for currency risk where exposure and collateral are denominated in different currencies is 8%) The *He and *Hc has to be derived from the following table of standard supervisory haircuts: However, under certain special circumstances the supervisors, i.e. the local central banks may choose not to apply the haircuts specified under the comprehensive approach, but instead to apply a zero H.
Calculating LGD under the advanced approach (and for the retail-portfolio under the foundation approach) Under the
A-IRB approach and for the retail-portfolio under the
F-IRB approach, the bank itself determines the appropriate loss given default to be applied to each exposure, on the basis of robust data and analysis. The analysis must be capable of being validated both internally and by supervisors. Thus, a bank using internal loss given default estimates for capital purposes might be able to differentiate loss given default values on the basis of a wider set of transaction characteristics (e.g. product type, wider range of collateral types) as well as borrower characteristics. These values would be expected to represent a conservative view of long-run averages. A bank wishing to use its own estimates of LGD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates. An LGD model assesses the value and/or the quality of a security the bank holds for providing the loan – securities can be either machinery like cars, trucks or construction machines. It can be mortgages or it can be a custody account or a commodity. The higher the value of the security the lower the LGD and thus the potential loss the bank or insurance faces in the case of a default. Banks using the
A-IRB approach have to determine LGD values, whereas banks within the
F-IRB do only have to do so for the retail-portfolio. For example, as of 2013, there were nine companies in the United Kingdom with their own mortgage LGD models. In Switzerland there were two banks as of 2013. In Germany many thrifts – especially the market leader
Bausparkasse Schwäbisch Hall – have their own mortgage LGD models. In the corporate asset class many German banks still only use the values given by the regulator under the
F-IRB approach. Repurchase value estimators (RVEs) have proven to be the best kind of tools for LGD estimates. The repurchase value ratio provides the percentage of the value of the house/apartment (mortgages) or machinery at a given time compared to its purchase price. ==Downturn LGD==