What Is Loss Given Default (LGD)?
Loss given default (LGD) is the amount of money a bank or other financial institution loses when a borrower defaults on a loan, depicted as a percentage of total exposure at the time of default. A financial institution’s total LGD is calculated after a review of all outstanding loans using cumulative losses and exposure.
- The loss given default (LGD) is an important calculation for financial institutions projecting out their expected losses due to borrowers defaulting on loans.
- The expected loss of a given loan is calculated as the LGD multiplied by both the probability of default and the exposure at default.
- An important figure for any financial institution is the cumulative amount of expected losses on all outstanding loans.
Understanding Loss Given Default (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. An analyst takes these variables into account when reviewing all loans issued by the bank to determine the LGD. How credit losses are accounted for on a company’s financial statements include determining both an allowance for credit losses and an allowance for doubtful accounts.
For example, consider that Bank A lends $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, whether installment payments have already been made to reduce the outstanding balance, 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.
Determining the amount of loss is an important and fairly common parameter in most risk models. LGD is an essential component of the Basel Model (Basel II), a set of international banking regulations, as it is used in the calculation of economic capital, expected loss, and regulatory capital. The expected loss is calculated as a loan’s LGD multiplied by both its probability of default (PD) and the financial institution’s 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, which does not take into account the value of collateral on the loan. This calculation of LGD compares the dollar amount of the potential or actual loss to the total amount of exposure at the time that a loan goes into default. This method is also the most popular, because academic analysts typically have access only to bond market data, meaning that the values of collateral are unavailable, unknown, or unimportant.
The most popular method among accountants and analysts of determining the LGD is gross calculation, which does not involve the value of collateral on the loan.
Example of Loss Given Default
Imagine a borrower takes out a $400,000 loan for a condo. After making installment payments on the loan for a few years, the borrower faces financial difficulties and defaults when the loan has an outstanding balance, or exposure at default, of $300,000. The bank forecloses on the condo and is able to sell it for $240,000. The net loss to the bank is $60,000 ($300,000 – $240,000), and the LGD is 20% ($300,000 – $240,000)/$300,000).
In this scenario the expected loss would be calculated by the following equation: LGD (20%) X probability of default (100%) X exposure at default ($300,000) = $60,000. If the financial institution were projecting out a potential but not certain loss, the expected loss would be different. Using the same figures from the scenario above, but assuming only a 50% probability of default, the expected loss calculation equation is: LGD (20%) X probability of default (50%) X exposure at default ($300,000) = $30,000.