What Is Loss Given Default?

Loss given default (LGD) is the amount of money that a bank or other financial institution is projected to lose when a borrower defaults on a loan.

LGD can be shown as a percentage of total exposure at the time of defaul🎶t or as a single dollar value of potential loss.

A financial institution’s total LGD is calculated after a review of all outstanding loans using cumulative loཧsses and exposu🅺re.

Understanding LGD

Banks and other financial institutions determine credit losses by analyzing actual loan defaults.

Quantifying losses can be complex and require an analysis of several variables. How credit losses are accounted for on a company’s financial statements includes determining both an 澳洲幸运5官方开奖结果体彩网:allowance for credit losses and an 澳洲幸运5官方开奖结果体彩网:allowance for doubtful accounts.

Consider if Bank A lends $2 million to Company XYZ an💞d the company defaults. Bank A’s loss is not necess🅷arily $2 million.

O♚ther factors must be considered, such as the amount of collateral, whether installment payments have been made, and whether the bank makes use of the court system for reparations from Company XYZ.

With these and other factors considered, Bank A may, in reality, have sustained a far smaller loss than the initial $2 million loan. Determining the amount of loss is an important and fairly common parameter 澳洲幸运5官方开奖结果体彩网:in most risk models.

The Basel Model

LGD is an essential component of the Basel Model (Basel II), a set of international banking regulations. It is used in the calculation of 澳洲幸运5官方开奖结果体彩网:economic capital, expected loss, and regulatory capital.

The expected loss is calculated as a loan’s LGD multiplied by both its 澳洲幸运5官方开奖结果体彩网:probability of default (PD) and the financial institution’s 澳洲幸运5官方开奖结果体彩网:exposure at default (EAD).

How to Calculate LGD

澳洲幸运5官方开奖结果体彩网: There are different ways 🌜to calcul💛ate LGD.

1. A common variation considers the exposure at default and recovery rate. Exposure at default is an estimated value that predicts the amount of loss a bank or credit union may experience when a deb𒁏tor defaults on a loan.

The recovery rate is a risk-adjusted measure to right-si💯ze the default based on the 🦄likelihood of the outcome.

LGD (in dollars) = Exposure at Default (EAD) x (1 - Recovery Rate)

2. Another basic variation compares the potential net collectible proceeds to the outstanding debt. This formula🌱 provides a general ratio of what portion of debt is expected to be lost:

LGD (as a percentage) = 1 - (Potential Sale Proceeds / Outstanding Debt)

Of these two meᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚthods, it is more common to see the first formula used as it is a more conservative apprꦺoach to reflect the maximum potential loss.

It cಌan often be difficult to assess what the potential sale proceeds are, especially considering multiple collateral assets, disposition costs, timing of payments, and liquidity of each asset.

LGD vs. EAD

Exposure at default is the total value of a loan that a bank is exposed toꦦ at 🎉the time that a borrower defaults.

For example, if a borrower🥂 takes out a loan for $100,000 and two years later, the amount left on the loan is $75,000. The borrower൲ defaults. The EAD is $75,000.

When analyzing 澳洲幸运5官方开奖结果体彩网:default risk, banks will often calculate the EAD on a loan as it aims to predict the🃏 amount the bank will be exp꧅osed to when a borrower defaults. EAD constantly changes as a borrower pays down their loan.

🐻 The main difference between LGD and EAD is that LGD takes into consideration any financial amount recovered on the default. For this reason, EAD represents a more conservative measurement since it is the higher figure. LGD is more often the best case scenario that relies on multiple assumptions.

For example, if a borrower defaults on their car loan, the EAD represents the remaining loan amount in default. If the bank repossesses the car and ꧑sells it to recover a portion of the EAD, the recovered𒉰 amount gets factored into the LGD calculation.

Example of LGD

Imagine that a borrower takes out a $400,000 loan for a condo. After making installment payments on the loan for a few years, the borrowඣer experiences financial difficulties.

It is estimated that the borrower has an 80% chance of default, which means the recovery rate is 20%. The outstanding loan balance is $300,000, and the bank will be able to sell the condo for $200,000 upon 𒀰foreclosure.

To calculate the LGD in dollars, compare the amount at risk to the likel🤡ihood of default. Using the first formula above, the lender finds that $240,000 is at risk ﷽of default.

LGD (in dollars omitting collateral) = $300,000 x (1 - 0.20) = $240,000

Alternatively, LGD can be calculated as a percentage that typically incorp🅷ora༒tes the value of the collateral.

Although the first formula is easier to calculate, it does not factor in the 澳洲幸运5官方开奖结果体彩网:disposition proceeds of the condo in the event of default.

So, using the second formula above, when considering the collateral value the lender should anticipate losing 33% of its capital should the condo owner default.

LGD (as percentage including collateral) = 1 - ($200,000 / $300,000) = 33.33%

The Bottom Line

When making loans, banks tend to reduce their risk as much as they can. They evaluate a borrower and determine the risk factors of lending to that borrower, including the probability that they will default on the loan and how much the bank stands to lose if defaultꦜ occurs.

Loss given default (LGD), pro꧅bability of default (PD), and exposure at default (EAD) are calculations that help banks quantify their potential losses.