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 can꧒ be show⭕n as a percentage of total exposure at the time of default or as a single dollar value of potential loss.

A financial institution’s total LGD is calculated after a review of allﷺ outstanding loans using cumulative losses 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开奖号码历史查询:allowance for credit losses and an 澳洲幸运5开奖号码历史查询:allowance for doubtful accounts.

Consider if Bank A lends $2 million to Company XYZ and the company defaults. B♏ank A’s loss is not neces🏅sarily $2 million.

Other factors must be considered, such as♑ the amount of collateral, whether installment payments have been made, and whether the bank makes𝔍 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开奖号码历史查询: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开奖号码历史查询: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开奖号码历史查询:probability of default (PD) and the financial institution’s 澳洲幸运5开奖号码历史查询:exposure at default (EAD).

How to Calculate LGD

澳ౠ洲幸运5开奖号码历史查询: There are different ways to calculate 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 experien🅰ce when a debtor defaults on a loan.

The recovery rate is a risk-adjusted measure to right-size 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 m🅷ethods, it is more coꦅmmon to see the first formula used as it is a more conservative approach to reflect the maximum potential loss.

It can often be difficult to assess wh🔯at 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 to at the time that a bor💛rower d꧟efaults.

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

When analyzing 澳洲幸运5开奖号码历史查询:default risk, banks will often calculate the EAD on a loan as it aims to predict the amount the bank will be exposed 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 takꦯes 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 sells it to recover a portion of the EAD, the recovered 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 borrower experiences fi𝄹nancial 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 ab🦩le to sell the condo for $200,000 upon foreclosure.

To calculate the LGD in dollars, compare the amount at risk to the likelihood 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 ღtypically incorporates the value of the collateral.

Although the first formula is easier to calculate, it does not factor in the 澳洲幸运5开奖号码历史查询: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 pro🐼bability thꦰat they will default on the loan and how much the bank stands to lose if default occurs.

Loss given defau🌃lt (LGD), probability of default (PD), and exposure at default (EAD) are calculations that help banks quantify their 💫potential losses.