PDF Ebook What Do We Know About Loss Given Default?
The New Basel Accord will allow internationally active banking organizations to calculate their credit risk capital requirements using an internal ratings based (IRB) approach, subject to supervisory review. One of the modeling components is loss given default (LGD), the credit loss incurred if an obligor of the bank defaults. The flexibility to determine LGD values tailored to a bank’s portfolio will likely be a motivation for a bank to want to move from the foundation to the advanced IRB approach. The appropriate degree of flexibility depends, of course, on what a bank knows about LGD broadly and about differentiated LGDs in particular; consequently supervisors must be able to evaluate “what a bank knows.” The key issues around LGD are: 1) What does LGD mean and what is its role in IRB? 2) How is LGD defined and measured? 3) What drives differences in LGD? 4) What approaches can be taken to model or estimate LGD? By surveying the academic and practitioner literature, with supportive examples and illustrations from public data sources, this paper is designed to provides basic answers to these questions. The factors which drive significant differences in LGD include place in the capital structure, presence and quality of collateral, industry and timing of the business cycle.
The New Basel Accord, expected to be implemented at year-end 2006, will require internationally active banks to use more risk sensitive methods for calculating credit risk capital requirements (Pillar 1 of the New Basel Capital Accord, or “Basel 2”). This paper discusses a key technical component of the Accord, “loss given default” (LGD) for corporate exposures.
The Accord allows a bank to calculate credit risk capital requirements according to either of two approaches: a standardized approach which uses agency ratings for risk-weighting assets and an internal ratings based (IRB) approach which allows a bank to use internal estimates of components of credit risk to calculate credit risk capital. Institutions using IRB need to develop methods to estimate these key components. One of these components is loss given default (LGD), the credit loss incurred if an obligor of the bank defaults. Since many U.S. banking organizations are likely to implement IRB, banks and supervisors alike will soon need to understand LGD (as well as other components), including various issues around it, to evaluate actual or planned implementations of IRB. By surveying the academic and practitioner literature, with supportive examples and illustrations from public data sources, this paper will give readers a basic understanding of LGD and discuss some of the key issues – which are:
• What does LGD mean and what is its role in IRB?
• How is LGD defined and measured?
• What drives differences in LGD?
• What approaches can be taken to model or estimate LGD?
This paper is designed to provide some basic answers to these questions. Since these questions do not have settled answers, this paper explores the limits of current knowledge (theoretical and empirical), including LGD experience using available data sources, and provides some preliminary guidance in model development and estimation.
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PDF Ebook What Do We Know About Loss Given Default?
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