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. Credit Default Contract

    Security with a risk level and pricing based on the risk of credit ...
  2. Default Probability

    The degree of likelihood that the borrower of a loan or debt ...
  3. Strategic Default

    A deliberate default by a borrower. As the name implies, a strategic ...
  4. Temporary Default

    A bond rating that suggests the issuer might not make all of ...
  5. Default Premium

    The additional amount a borrower must pay to compensate the lender ...
  6. Recovery Rate

    The extent to which principal and accrued interest on a debt ...
Related Articles
  1. Taxes

    Understanding Default Risk

    Default risk is the chance that companies or individuals will be unable to pay their debts.
  2. Personal Finance

    What is a Loan Loss Provision?

    Banks set aside loan loss provisions to cover losses from bad loans.
  3. 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.
  4. 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.
  5. 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.
  6. Investing

    How Basel 1 Affected Banks

    This 1988 agreement sought to decrease the potential for bankruptcy among major international banks.
  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

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  9. Personal Finance

    Credit Default Rate Hits 4-Year High

    The default rate on bank credit cards has risen for the fifth consecutive year.
  10. Financial Advisor

    Emerging Market Defaults: Beware of Second Wave

    Emerging market corporate defaults have the potential to be the biggest risk to global markets.
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 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 >>
  3. If there are two plans and one is terminated, creating a distributable event, can ...

    It depends. If the loan is in good standing - the participant did not default on the loan and the loan meets other statutory ... Read Answer >>
  4. 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 >>
  5. Why do banks write off bad debt?

    Learn more about the practice of banks writing off bad debts and removing them from their books, including a hypothetical ... Read Answer >>
Hot Definitions
  1. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  2. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  3. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  4. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  5. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  6. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
Trading Center