Loss given by default

Understanding Loss Given Default (LGD)

Introduction to LGD

• The video introduces the topic of Loss Given Default (LGD) within the context of credit risk, emphasizing its importance for banks and financial institutions.

• LGD is defined as the loss incurred when a borrower defaults on a loan, which occurs when they are unable to repay it.

Components of Credit Risk Models

• The speaker outlines three critical components in credit risk modeling: Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).

• These components collectively help calculate Estimated Credit Loss (ECL), which represents the total anticipated loss for banks if borrowers default.

Basic Calculation of LGD

• An example illustrates how to calculate LGD: If a customer borrows 120 rupees but has paid back only 45 before defaulting, the LGD would be calculated as 75 rupees.

• The definition of default is clarified; typically, a borrower is considered in default after being delinquent for 90 days.

Realized LGD vs. Override LGD

• Realized LGD refers to actual losses adjusted by bank policies or external factors, such as economic conditions affecting repayment ability.

• Override LGD involves adjustments made by bank executives based on qualitative assessments about borrowers' situations that may not be reflected in standard calculations.

Steps to Calculate LGD

• The first step in calculating LGD is identifying customers who have defaulted and gathering relevant data about their loans.

• Two primary approaches for calculating LGD are discussed: accounting-based methods and cash flow-based methods, each with distinct methodologies.

Applications of Calculating LGD

• Understanding and predicting potential losses from defaults helps banks manage risks effectively across different loan portfolios.

Understanding LGD and Regulatory Frameworks in Banking

Role of Regulators in Banking

• The application of Loss Given Default (LGD) is heavily influenced by regulatory bodies, such as the Reserve Bank of India (RBI) and the Office of the Superintendent of Financial Institutions (OSFI) in Canada. These regulators establish rules for calculating various components related to credit risk.

Key Components in Credit Risk Calculation

• Banks utilize several critical factors to calculate expected credit losses (ECL), including:

• Risk Rating: A measure that assesses the risk associated with individual customers.

• Loss Given Default (LGD): Represents potential loss when a borrower defaults.

• Exposure at Default (EAD): Anticipated exposure amount at the time of default.

• Probability of Default (PD): Likelihood that a borrower will default on their obligations.

Understanding Risk Ratings

• Risk ratings, also referred to as Customer Risk Ratings (CRR), indicate how likely an individual customer is to meet their banking obligations. This rating plays a crucial role in determining overall credit risk.

Transactional Level Factors

• EAD and PD are considered transactional-level factors:

• EAD: An estimate rather than an actual value, indicating anticipated exposure during default scenarios.

• LGD: Reflects the amount lost if a borrower defaults, emphasizing its importance in assessing financial risks.

Summary Insights on LGD and Approaches

• The discussion covers various approaches to calculating LGD, including:

• Accounting-based approaches versus cash flow-based approaches.