Glossary term
Loss Given Default (LGD)
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Also known as: LGD
Loss given default is the share of an exposure a lender expects to lose if the borrower defaults, after counting what can be recovered from collateral, guarantees and the borrower's remaining assets.
Explanation
LGD is one of the three main inputs to credit loss calculations, with probability of default and exposure at default. It is usually shown as a percentage of the exposure. A well secured loan has a low LGD, since the lender can sell the collateral, while an unsecured loan ranking behind other creditors has a high one. Estimates draw on past recovery data, which reflect the value of collateral, the legal process and its cost, how long recovery takes, and the borrower's industry. Recoveries are discounted for the time taken. Downturn conditions matter, since collateral values often fall just when defaults rise, so Basel rules ask for a downturn LGD. Under the foundation IRB approach supervisors set LGD values, and under the advanced approach banks estimate their own. Credit teams use it to price secured against unsecured loans and to size provisions.
Example
A bank lends 1 million secured on equipment. After the borrower defaults, the equipment is sold for 600,000 and legal and handling costs of 50,000 are paid, leaving 550,000 recovered. The loss is 450,000, so the realised LGD is 45%. For new loans of this type, the bank uses past cases like this one to estimate the expected percentage.
Not to be confused with
- Exposure at Default
- EAD is the amount outstanding when default happens. LGD is the share of that amount not recovered.