The recovery rate is defined as 1 minus the LGD, the share of an asset that is recovered when a borrower defaults.
The LGD calculation is easily understood with the help of an example: If the client defaults with an outstanding debt of $200,000 and the bank or insurance is able to sell the security (e.g. a condo) for a net price of $160,000 (including costs related to the repurchase), then the LGD is 20% (= $40,000 / $200,000).
Haircut appropriate for currency mismatch between the collateral and exposure (The standard supervisory haircut for currency risk where exposure and collateral are denominated in different currencies is 8%) The *He and *Hc has to be derived from the following table of standard supervisory haircuts: However, under certain special circumstances the supervisors, i.e. the local central banks may choose not to apply the haircuts specified under the comprehensive approach, but instead to apply a zero H. Under the A-IRB approach and for the retail-portfolio under the F-IRB approach, the bank itself determines the appropriate loss given default to be applied to each exposure, on the basis of robust data and analysis.
Thus, a bank using internal loss given default estimates for capital purposes might be able to differentiate loss given default values on the basis of a wider set of transaction characteristics (e.g. product type, wider range of collateral types) as well as borrower characteristics.
The higher the value of the security the lower the LGD and thus the potential loss the bank or insurance faces in the case of a default.
In Germany many thrifts – especially the market leader Bausparkasse Schwäbisch Hall – have their own mortgage LGD models.
In the corporate asset class many German banks still only use the values given by the regulator under the F-IRB approach.
Furthermore, practitioners are of want of data since BIS II implementation is rather new and financial institutions may have only just started collecting the information necessary for calculating the individual elements that LGD is composed of: EAD, direct and indirect Losses, security values and potential, expected future recoveries.
Naturally, when more defaults without losses are added to a sample pool of observations LGD becomes lower.
In 2010 researchers at Moody's Analytics quantify an LGD in line with the target probability event intended to be captured under Basel.
[2] Their results are based on a structural model that incorporates systematic risk in recovery.
The following formula can be used to compare LGD estimates from one time period (say x) with another time period (say y): LGDy=LGDx*(1-Cure Ratey)/(1-Cure Ratex) In Australia, the prudential regulator APRA has set an interim minimum downturn LGD of 20 per cent on residential mortgages for all applicants for the advanced Basel II approaches.
The 20 per cent floor is not risk sensitive and is designed to encourage authorised deposit-taking institutions (ADIs) to undertake further work, which APRA believes would be closer to the 20 per cent on average than ADIs’ original estimates.
According to BIS (2006) institutions implementing Advanced-IRB instead of Foundation-IRB will experience larger decreases in Tier 1 capital, and the internal calculation of LGD is a factor separating the two Methods.