Loss given default

The loss given default (LGD) represents the entity’s expectation (entity often being an insurer but also other entities) of the extent of loss on a defaulted exposure. The LGD varies by type of borrower, type and seniority of claim and availability of collateral or other credit support. The LGD is expressed as a percentage loss per unit of exposure at the time of default (EAD).

The LGD is calculated on 12 months or lifetime basis, where the 12M LGD is the percentage of loss expected to be made if the default occurs in the next 12 months and the lifetime LGD is the percentage of loss expected to be made if the default occurs over the remaining expected lifetime of the loan. Loss given default Loss given default

Default’ is not itself actually defined in IFRS 9. Loss given default Loss given default

Entities must instead reach their own definition and IFRS 9 provides guidance on how to do this. The Standard states that when defining default, an entity shall apply a default definition that is consistent with the definition used for internal credit risk management purposes for the relevant financial instrument and consider qualitative indicators (for example, financial covenants) when appropriate. Loss given default

However, there is a ‘rebuttable presumption’ that default does not occur later than when a financial asset is 90 days past due unless an entity has reasonable and supportable information to demonstrate that a more lagging default criterion is more appropriate.

The term ‘Default’ is used in building models to measure Expected Credit Losses (ECL). The use of this model is in correlation with a credit risk of the company for which it is necessary to determine basic variables of the model: Exposure at Default (EAD), Loss Given Default (LGD) and Probability of Default (PD).

ECL = EAD x LGD x PD Loss given default

EAD is the amount of money that is invested in a certain financial instrument that is exposed to credit risk. Basel legislation define EAD as the gross exposure under a facility upon default of an obligor, which is a parameter used in the calculation of bank’s capital. Outside Basel, it is known as “credit exposure“ which represents a loss that a lender would suffer if the borrower (counterparty) fully defaults on his debt (e.g. cannot repay the loan received). Loss given default

In practice, ECL calculation uses bookkeeping balance of the account for certain financial instrument as at reporting date of the balance sheet for which ECL is calculated (e.g. for calculating annual ECL for 20xx for the given loan the balance of account “loans given“ in assets in the balance sheet as at 31 December 20xx). Loss given default

The LGD has been defined above. On the other hand, the recovery rate (RR) is calculated as “1 – LGD“. So, the recovery rate is the remaining share of a financial asset that we expect to recover when a borrower defaults. For example, if a entity provides credit of 1.000 HRK, and the debtor starts to experience some difficulties, the part of credit that is expected that the debtor will repay at RR = 55%, 1,000 × 55% = 550 HRK, and the part of credit the entity will lose as the complement LGD = 1 – RR = 1 – 0.55 = 0.45 × 100 = 45%; 1,000 × 45% = 450 HRK. Loss given default

When calculating the value of LGD, the impact of exposure with or without collateral also needs to be assessed. In the aforementioned example, the value of LGD on the loan is 45% (which corresponds to Basel’s recommendation) because there is no collateral as a means of insurance and as a result the credit risk is more significant. Alternatively, if a security has been received as a collateral for the loan, the effective Loss Given Default will be less than 45% (so, in other words a larger rate of return than the previously 55% for the use of collateral in case of default.

The probability of default (PD) represents the likelihood of a borrower defaulting on its financial obligation, either over the next 12 months (12M PD) or over the remaining lifetime (Lifetime PD) of the obligation. PD is a key parameter under Basel. PD calculation includes the analyses of debtor’s cash flow adequacy in servicing debt, operating margin, percentage of leverage used, and declining liquidity. Loss given default

There are many ways to estimate PD. It can be done by analyzing the historical database of actual defaults that really happened to the subject entity or by observing the prices of credit default swaps (CDS), bonds and options on common shares. But, the most practical way is to directly use external ratings from S&P, Fitch and Moody’s that are based on historical data across the financial market. Those external ratings imply a certain level of default probability and are (or should be) objective and neutral. Loss given default Loss given default

For calculating ECL two types of PDs are used. For stage 1, in case of a low credit risk, 12-month PD is used as the estimated Probability of Default occurring within next 12 month (one year) or over the remaining maturity of the financial instrument (e.g. receivables) that is less than 12 months. For stage 2 and 3, in case of a significant increase of credit risk, the lifetime PD needs to be calculated as the estimated Probability of Default occurring over the remaining life of the financial instrument, which is over 1 year. Loss given default Loss given default

Probability weighted scenarios Loss given default Loss given default

ECL measurement under IFRS 9 requires entities to model their ECL number as per the forward-looking scenarios taking into account every possibility of stressed and favourable economic conditions. The ECL should be a probability weighted number based upon an outcome of multiple scenarios. To build these scenarios, various ECL components (PD, LGD and EAD) can be varied to capture the most stressed and most favourable parameters over the historical period, and to compute ECL under different scenarios in order to arrive at probability weighted ECL.

Loss given default

Loss given default

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