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).
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.
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).