Understanding Loss Given Default (LGD)
Loss given default (LGD) is the estimated amount of money a financial institution loses when a borrower defaults on a loan. LGD is expressed as a percentage of total exposure at the time of default or as a specific dollar value of potential loss. A comprehensive calculation of an institution’s total LGD involves reviewing all outstanding loans, assessing cumulative losses, and evaluating exposure.
Key Takeaways
- Loss given default (LGD) is crucial for financial institutions to anticipate expected losses from loan defaults.
- The expected loss on a loan is calculated using LGD, probability of default (PD), and exposure at default (EAD).
- Exposure at default is the loan’s total value when a borrower defaults.
- Calculating the cumulative expected losses on all loans is vital for any financial institution.
- LGD is a core component of the Basel Model (Basel II), which sets international banking regulations.
Delving Into Loss Given Default (LGD)
Credit losses are measured by analyzing loan defaults, which require considering various variables. This quantification process accounts for credit losses in financial statements, including allowances for credit losses and doubtful accounts.
Imagine Bank A lends $2 million to Company XYZ, and the company defaults. Bank A’s loss isn’t necessarily the $2 million initial loan. Factors like collateral, installment payments made, and potential legal recoveries affect the actual loss, which could be far less than $2 million.
Accurately determining the loss amount is pivotal in risk models. LGD plays a significant role in the Basel Model (Basel II), contributing to estimating economic capital, expected loss, and regulatory capital. The expected loss calculation involves multiplying LGD by both PD and EAD. Collateralized loans or secured debts benefit lenders, often resulting in lower interest rates for borrowers.
How to Calculate LGD
Multiple methods exist for calculating LGD.
A typical method considers exposure at risk and recovery rate:
LGD (in dollars) = Exposure at Default (EAD) * (1 - Recovery Rate)
Alternatively, another method compares net collectible proceeds to outstanding debt:
LGD (as percentage) = 1 - (Potential Sale Proceeds / Outstanding Debt)
Generally, the first formula is more conservative, reflecting maximum potential loss. Assessing sale proceeds can be challenging due to multiple collateral assets, disposition costs, payment timelines, and asset liquidity.
LGD vs. Exposure at Default (EAD)
Exposure at default (EAD) is the total value a bank risks losing when a borrower defaults. For instance, if a borrower’s remaining loan of $100,000 drops to $75,000 after two years and then defaults, EAD is $75,000.
When assessing default risk, banks often compute EAD to predict their exposure in case of borrower default. EAD fluctuates as the borrower repays the loan. Loan types, such as mortgages or student loans, have different default thresholds.
The key difference is that LGD factors in recovery post-default, making EAD a conservative measure due to it being a higher figure. LGD usually incorporates optimistic recovery assumptions. For example, if a car loan defaults, EAD is the defaulted loan’s amount. Selling the vehicle can recover part of the EAD, considered in LGD calculation.
Example of Loss Given Default (LGD)
Consider a borrower with a $400,000 condo loan. After several years of payments, the borrower’s financial situation worsens, indicating an 80% default probability (20% recovery rate). The outstanding balance is $300,000, and the condo’s foreclosure value is $200,000.
Calculating LGD in dollars without considering collateral involves:
LGD (in dollars, excluding collateral) = $300,000 * (1 - 0.20) = $240,000
To include collateral in the calculation (as a percentage):
LGD (as percentage, including collateral) = 1 - ($200,000 / $300,000) = 33.33%
Interpretations and Practical Insights
Loss given default (LGD) measures the potential financial loss without considering recovery, expressed as a percentage of total exposure at the time of default. It informs banks on how much they could lose when defaults occur.
Frequently Asked Questions
What Are PD and LGD?
LGD refers to the losses banks experience when borrowers default, while PD measures the likelihood of a borrower defaulting on a loan.
What Is the Difference Between EAD and LGD?
EAD denotes the loan’s value at risk during a borrower default. LGD considers the post-default recovery process.
Can LGD Be Zero?
In theory, yes. If a financial model predicts full recovery, LGD can be zero, though this scenario is rare.
What Is Usage Given Default?
Usage given default equates to exposure at default (EAD), indicating the loan value left when the borrower defaults.
Conclusion
Banks aim to minimize risks when lending. They assess borrowers’ default probabilities and potential losses if defaults occur. Loss given default (LGD), probability of default (PD), and exposure at default (EAD) aid banks in quantifying possible losses, enabling better risk management.
Related Terms: Probability of Default, PD, Exposure at Default, EAD, credit risk, economic capital.
