Economics in a picture
Considering the loss given default (LGD) as invariant to macroeconomic conditions may underestimate credit losses
The likelihood of a credit loss materialization is tied to the borrower’s probability of default (PD) while the severity of such loss in the event of default is accounted for the loss given default (LGD). Empirical evidence has shown a positive relation between default rates and loss given default rates. During economic downturns, defaults occur more frequently, assets decrease in value and recovery rates tend to be smaller.
Based on a conceptual exercise that integrates the relation between PD and LGD on the corporate loan portfolio of Portuguese banks it is possible to evaluate by how much credit risk can be underestimated when assuming an invariant LGD and to infer the necessary add-on to LGD that reflects downturn conditions. The results suggest that, except for very high LGD values, assuming an invariant LGD leads to a significant underestimation of credit risk. In the base case it is found that LGD should have an add-on of approximately 15 percentage points (pp). A sensitivity analysis for a wide range of possible LGD values shows that only for high values of expected LGD – values where there is not much more a lender could lose - the add-on should be below 10 pp.
For more details see Santos (2020): “The relation between PD and LGD: an application to a corporate loan portfolio”, published in Banco de Portugal Economic Studies (Vol. 6, N. 3).
Prepared by António Santos. The analyses, opinions and findings expressed above represent the views of the author and not necessarily those of Banco de Portugal or the Eurosystem.
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