What Is Loss Given Default?

What Is Loss Given Default?

Let me explain loss given default, or LGD, directly to you: it's the amount of money I, as a bank or financial institution, am projected to lose if a borrower defaults on their loan.

You can think of LGD as a percentage of the total exposure at default or just a flat dollar amount for the potential loss.

To get the total LGD for all my outstanding loans, I review cumulative losses and exposure across everything.

Key Takeaways

Understand this: LGD is vital for me as a financial institution because it projects my expected losses from defaults.

The expected loss on a specific loan comes from multiplying LGD by the probability of default and the exposure at default.

Exposure at default is simply the total value of the loan when the borrower defaults.

I always track the cumulative expected losses on all loans, and LGD plays a big role in the Basel II regulations for international banking.

Understanding LGD

When I determine credit losses, I analyze actual loan defaults in my portfolio.

Quantifying these losses gets complex, involving multiple variables, and it affects how I account for allowances for credit losses and doubtful accounts on my financial statements.

Take this example: if I lend $2 million to Company XYZ and they default, my loss isn't automatically $2 million.

I have to factor in collateral, any payments already made, and even court actions for recovery from Company XYZ.

Once I consider all that, my actual loss might be much smaller than the original loan amount, and LGD helps me parameterize this in my risk models.

The Basel Model

LGD is a core part of the Basel II model, which sets international banking regulations, and I use it to calculate economic capital, expected loss, and regulatory capital.

Specifically, expected loss equals the loan's LGD times its probability of default (PD) and my exposure at default (EAD).

Remember, secured loans with collateral benefit me as the lender by reducing risk, and they can mean lower interest rates for you as the borrower.

How to Calculate LGD

There are a couple of ways I calculate LGD, and I'll walk you through them.

One common method uses exposure at default and recovery rate: LGD in dollars is EAD times (1 minus recovery rate), where recovery rate adjusts for the likelihood of recovering funds.

Another way looks at potential sale proceeds versus outstanding debt: LGD as a percentage is 1 minus (potential sale proceeds divided by outstanding debt).

I prefer the first method because it's more conservative and reflects maximum potential loss, especially since estimating sale proceeds can be tricky with factors like multiple assets, costs, timing, and liquidity.

LGD vs. EAD

Exposure at default, or EAD, is the total loan value I'm exposed to when you default—for instance, if you borrow $100,000 and default with $75,000 left, EAD is $75,000.

I calculate EAD regularly as you pay down the loan, since it changes over time.

The key difference is that LGD factors in any recovered amounts, like from selling repossessed assets, making EAD the more conservative, higher figure without those assumptions.

For example, if you default on a car loan, EAD is the remaining balance, but LGD subtracts what I recover from selling the car.

Be aware that default definitions vary by loan type, like mortgages or student loans, so check the days without payment that trigger default for yours.

Example of LGD

Let's say you take out a $400,000 loan for a condo, make some payments, then hit financial trouble with an 80% chance of default, meaning a 20% recovery rate.

The outstanding balance is $300,000, and I estimate I can sell the condo for $200,000 after foreclosure.

Using the dollar formula without collateral initially: LGD is $300,000 times (1 minus 0.20), which equals $240,000 at risk.

Alternatively, as a percentage including collateral: LGD is 1 minus ($200,000 divided by $300,000), or about 33.33%.

The first way is simpler but ignores collateral proceeds, while the second gives a fuller picture of expected loss percentage.

Frequently Asked Questions

What does loss given default mean? It's the money I lose when you default on a loan, after recoveries, as a percentage of exposure at default.

What are PD and LGD? LGD is the loss amount on default, while PD is the probability that you'll default.

Can LGD be zero? Theoretically yes, if my model shows full recovery, but it's rare in practice.

What is usage given default? It's another name for exposure at default, the remaining loan value on default.

The Bottom Line

When I make loans, I minimize risk by evaluating you as a borrower, including default probability and potential loss.

Calculations like LGD, PD, and EAD help me quantify those potential losses precisely.