What Is Loss Given Default (LGD)?
Loss Given Default (LGD) refers to the anticipated monetary loss that a bank or financial institution may experience when a borrower fails to repay a loan. This metric is typically expressed as a percentage of the total exposure at the time of default or in terms of a specific dollar amount. Financial entities ascertain their overall LGD by evaluating the cumulative losses and exposures associated with all outstanding loans.
Key Takeaways
- The Loss Given Default (LGD) is a pivotal metric for financial institutions to forecast potential losses resulting from loan defaults.
- The expected loss from a specific loan is determined by multiplying the LGD with both the probability of default and the exposure at default.
- Exposure at default constitutes the total loan value at the moment of borrower default.
- An essential figure for financial institutions is the aggregate anticipated losses across all outstanding loans.
- LGD plays a crucial role in the Basel Model (Basel II), an international framework of banking regulations.
Understanding Loss Given Default (LGD)
The determination of credit losses by banks and financial institutions involves an analysis of actual loan defaults, which necessitates the assessment of various variables. Accounting for credit losses in a company’s financial statements involves establishing provisions for both credit losses and doubtful accounts.
In a scenario where, for instance, Bank A lends $2 million to Company XYZ and the company defaults, Bank A’s loss is not automatically $2 million. Factors such as collateral amount, payment history, and legal actions taken by the bank against Company XYZ are considered. Consequently, Bank A’s actual loss post-default may be significantly lower than the initial loan amount.
Assessing the quantum of loss is a critical factor in most risk models. LGD is a fundamental element of the Basel Model (Basel II), playing a role in determining economic capital, expected loss, and regulatory capital. The expected loss is calculated by multiplying a loan’s LGD with both its probability of default (PD) and the financial institution’s exposure at default (EAD).
Secured debt, such as loans with collateral, offers advantages to both lenders and borrowers through potentially lower interest rates.
How to Calculate LGD
Various methodologies exist for determining LGD.
One common approach involves considering the exposure at risk and recovery rate. Exposure at default estimates the potential loss a bank might incur in case of a borrower defaulting on a loan. The recovery rate is a risk-weighted measure that adjusts the default impact based on likelihood.
The formula for calculating LGD in dollars is: LGD (in dollars) = Exposure at Risk (EAD) * (1 – Recovery Rate)
Another method involves comparing potential net collectible proceeds to outstanding debt, offering a broad indication of the expected debt loss.
LGD (as a percentage) = 1 – (Potential Sale Proceeds / Outstanding Debt)
The first formula is commonly favored due to its conservative nature, reflecting the maximum potential loss. However, assessing potential sale proceeds can be complex, accounting for multiple factors like collateral assets, disposition costs, payment timing, and asset liquidity.
Loss Given Default (LGD) vs. Exposure at Default (EAD)
Exposure at default denotes the total loan value that a bank faces being at risk of losing when a borrower defaults. This figure evolves as borrowers repay their loans.
When evaluating default risk, banks frequently compute the EAD on a loan to estimate the bank’s potential exposure upon borrower default.
Loan types like mortgages or student loans have specific default timelines to consider. Understand the applicable default timeline for your loan.
The key distinction between LGD and EAD is that LGD incorporates recovery from defaults into the calculation. EAD, being the more conservative measure, represents the higher value, while LGD often reflects best-case scenarios under various assumptions.
For example, if a borrower defaults on the remaining balance of a car loan, EAD would be the defaulted amount left. However, if the bank can sell the car post-default, the recovery proceeds are considered in calculating LGD.
Example of Loss Given Default (LGD)
Let’s consider a scenario where a borrower takes a $400,000 condominium loan, starts facing financial challenges, and has an 80% chance of default with a 20% recovery rate. The outstanding loan balance is $300,000, and the bank can sell the condo for $200,000 upon foreclosure.
Calculating LGD in dollars involves evaluating the amount at risk against the default probability, which in this case is interpreted as $240,000.
LGD (in dollars excluding collateral) = $300,000 * (1 – 0.20) = $240,000
Another calculation method determines LGD as a percentage, factoring in collateral value. While the former formula is simpler, it overlooks the condo’s liquidation proceeds in case of default. Using this alternate approach shows a 33% expected loss if the condo owner defaults, considering the collateral.
LGD (as a percentage with collateral included) = 1 – ($200,000 / $300,000) = 33.33%
What Does Loss Given Default Mean?
Loss Given Default (LGD) signifies the financial loss incurred by a bank following a borrower’s loan default, adjusted for any recovery, presented as a fraction of total exposure at the point of default.
What Are PD and LGD?
LGD stands for Loss Given Default and represents the bank’s loss upon a borrower’s loan default. PD, or Probability of Default, quantifies the likelihood of a borrower defaulting on their loan.
What Is the Difference Between EAD and LGD?
EAD refers to Exposure at Default, indicating the loan value that the bank may lose upon borrower default. Loss Given Default represents the potential loan value at risk of loss, accounting for asset sale proceeds, expressed as a percentage of the total exposure.
Can Loss Given Default Be Zero?
Loss Given Default can theoretically be zero in the modeling of LGD by financial institutions if full loan recovery is expected. However, this scenario is uncommon in practice.
What Is Usage Given Default?
Usage Given Default is an alternate term for Exposure at Default, representing the total remaining loan value when a borrower defaults.
The Bottom Line
During lending decisions, banks aim to mitigate risks by assessing borrowers to gauge potential default risks and potential loss magnitudes. Loss Given Default (LGD), Probability of Default (PD), and Exposure at Default (EAD) are essential metrics enabling banks to quantify probable losses.
Correction—Nov. 3, 2023: This article has been edited to correct an inaccurate example of loss given default.