What is 'Loss Given Default - LGD'

Loss given default (LGD) is the amount of money a bank or other financial institution loses when a borrow defaults on a loan. The most frequently used method to calculate this loss compares actual total losses to the total amount of potential exposure sustained at the time that a loan goes into default. In most cases, LGD is determined after a review of a bank’s entire portfolio, using cumulative losses and exposure for the calculation.

BREAKING DOWN 'Loss Given Default - LGD'

Banks and other financial institutions determine credit losses by analyzing actual loan defaults. Quantifying losses, while at times a simple task, can be complex and requires an analysis of several variables. An analyst takes these variables into account, along with all the loans issued by a bank, to determine LGD.

For example, consider that Bank A loans $2 million to Company XYZ, and the company defaults. Bank A’s loss is not necessarily $2 million. Other factors must be considered, such as the amount of assets the bank may hold as collateral 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.

The Basel Model

Determining the amount of loss is an important and fairly common parameter in most risk models. LGD is an essential piece of the Basel Model (Basel II) as it is used in the calculation of economic capital, expected loss or regulatory capital. LGD is most closely tied to expected loss, which is the resulting product of LGD, probability of default (PD) and exposure at default (EAD).

Gross LGD

Though there are a number of ways to calculate LGD, the most favored among many analysts and accountants is gross calculation. The reason for this is largely because of its simple formula, comparing total losses to total exposure. This method is also the most popular because academic analysts typically have access only to bond market data, meaning that collateral values are unavailable, unknown or unimportant.

Simple Example

Consider that a borrower takes out a loan for a condo, but then defaults with an outstanding debt of $200,000 on the loan. The bank forecloses on the condo (which was the security on the loan) and is able to sell it, gaining a net price of $160,000. With costs relating to the repurchase included, the LGD is 20% ($40,000 / $200,000).

RELATED TERMS
  1. Exposure At Default - EAD

    A total value that a bank is exposed to at the time of default. ...
  2. Loan Loss Provision

    An expense set aside as an allowance for bad loans (customer ...
  3. Default

    1. The failure to promptly pay interest or principal when due. ...
  4. Default Probability

    The degree of likelihood that the borrower of a loan or debt ...
  5. Temporary Default

    A bond rating that suggests the issuer might not make all of ...
  6. Allowance For Bad Debt

    A valuation account used to estimate the portion of a bank's ...
Related Articles
  1. Personal Finance

    What is a Loan Loss Provision?

    Banks set aside loan loss provisions to cover losses from bad loans.
  2. Insights

    Why and When Do Countries Default?

    Countries can default on their debt. This happens when the government is either unable or unwilling to make good on its fiscal promises.
  3. Investing

    Analyzing A Bank's Financial Statements

    A careful review of a bank's financial statements can help you identify key factors in a potential investment.
  4. Investing

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  5. Small Business

    Calculating (Small) Company Credit Risk

    Determining creditworthiness of smaller and medium-sized corporations isn't as easy as for larger companies, but these tips can help.
  6. Investing

    Will Energy Exposure Tank Wells Fargo? (WFC)

    Discover the reasons Wells Fargo's portfolio of loans to speculative shale oil and gas exploration and production companies will not tank the bank.
  7. Investing

    Banks Helped By Lower Loan Loss Provisions

    Many banks saw improved credit quality in the first quarter of 2011 leading to lower loan loss provisions.
  8. Investing

    Bank Earnings Face Pressure With Oil Under $40

    U.S. banks face difficult times ahead amid falling oil prices even with help from the Federal Reserve
  9. Financial Advisor

    Junk Bond

    Find out more about these bonds that have a high risk of default.
  10. Personal Finance

    Explaining Risk-Weighted Assets

    Risk-weighted assets is a banking term that refers to a method of measuring the risk inherent in a bank’s assets, which is typically its loan portfolio.
RELATED FAQS
  1. What level of default rate is typical for the credit services industry?

    Learn how default rates affect businesses in the credit services industry, and what rates are considered normal for a company ... Read Answer >>
  2. What are the differences between delinquency and default?

    Find out more about loan delinquency, loan default, and the difference between a loan borrower defaulting and being delinquent ... Read Answer >>
  3. What special powers does the government have to collect student loans?

    Contact student loan companies before student loans default, as the government has the power to get its money. Prior to default, ... Read Answer >>
  4. What is the difference between student loan default and delinquency?

    Learn the differences between simply becoming delinquent on your student loans vs. actually defaulting on your student loan ... Read Answer >>
  5. Why do high profiting sales mitigate credit risk?

    Learn more about credit risk in loaning to individuals and businesses. Understand how credit risk is determined and the impact ... Read Answer >>
Hot Definitions
  1. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
  2. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  3. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta by investing in securities that differ from the market index ...
  4. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
  5. Hard Fork

    A hard fork (or sometimes hardfork) is a radical change to the protocol that makes previously invalid blocks/transactions ...
  6. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
Trading Center