Loss given default

Loss given default or LGD is the share of an asset that is lost if a borrower defaults.

It is a common parameter in Risk Models and also a parameter used in the calculation of Economic Capital, Expected loss or Regulatory Capital under Basel II for a banking institution. This is an attribute of any exposure on bank's client. Exposure is the amount that one may lose in an investment.

The LGD is closely linked to the Expected Loss, which is defined as the product of the LGD, the Probability of Default (PD) and the Exposure at Default (EAD).

LGD is the share of an asset that is lost when a borrower defaults. The recovery rate is defined as 1 minus the LGD, the share of an asset that is recovered when a borrower defaults.

Loss given default is facility-specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of collateral and the degree of subordination.

The LGD calculation is easily understood with the help of an example: If the client defaults with an outstanding debt of $200,000 and the bank or insurance is able to sell the security (e.g. a condo) for a net price of $160,000 (including costs related to the repurchase), then the LGD is 20% (= $40,000 / $200,000).

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.

...
Wikipedia