LGD Is a Calculation System, Here's the Explanation!

LGD is an estimate of the amount of money a bank or other financial institution loses when a borrower defaults on a loan. 

LGD ( Loss given default) is expressed as a percentage of total exposure at the time of default or a one dollar value of potential loss. A financial institution's total LGD is calculated after reviewing all outstanding loans using cumulative losses and exposure.

LGD is a financial loss that is ultimately borne by the bank when the borrower stops making loan payments. The LGD value is expressed as a percentage of the bank's total exposure when the borrower defaults.

LGD is part of the Basel Framework, which sets standards for international banking. 1 Understanding this metric helps banks and financial institutions project the expected loss from borrower defaults.

LGD Is?

Bank and institution Other finance determines credit loss by analyzing actual loan defaults. Measuring losses can be complex and requires analysis of multiple variables.

How credit losses are recorded on a company's financial statements, including determining an allowance for credit losses and an allowance for doubtful accounts.

Consider if Bank A loans $2 million to Company XYZ, and the company defaults. Bank A's loss is not necessarily $2 million.

Other factors to consider such as the amount of collateral, whether installment payments have been made, and whether the bank uses the court system for reparations from Company XYZ.

Taking these and other factors into consideration, Bank A may, in fact, incur a much smaller loss than its original $2 million loan.

Determining the amount of loss is an important parameter and is quite common in most risk models. LGD is an important component of the Basel Model (Basel II), a set of international banking regulations, as used in calculations of economic capital, expected loss, and regulatory capital.

The expected loss is calculated as the LGD of the loan multiplied by the probability of default (PD) and the financial institution's exposure to default (EAD).

Example of Loss Given Default (LGD)

Imagine a borrower taking out a $400,000 loan for a condo. After making loan installment payments for several years, borrowers started to face financial difficulties.

It is estimated that borrowers have 80 percent default. The outstanding loan balance is $300,000, and the bank will be able to sell the condominium for $200,000 upon foreclosure.

To calculate Loss given default in dollars, compare the amount at risk to the probability of default. In this situation, the lender interprets the $240,000 at risk of default.

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Alternatively, LGD can be calculated as a percentage which usually includes the collateral value. Although the above formula is easier to calculate, it does not take into account the disposition of the condo yield in the event of default.

Using the second variation, lenders must anticipate losing 33 percent of their capital if the condo owners default when considering the value of the collateral.

LGD is part of the Basel Framework, which sets standards for international banking. So using the example above, how do banks calculate LGD?

There are a number of different calculations that can be used, but most accountants prefer rough calculations because of its simplicity. The gross calculation compares the total amount of money with the exposure at default.2

Using the example above, the borrower defaults on a $250,000 mortgage, but after making $20,000 mortgage payments over the course of a year.

So the default exposure is $230,000. The bank foreclosed on the house and was able to sell it for $150,000. The bank's net loss was $80,000, and the LGD was 35 percent.

Loss Given Default (LGD) Vs Exposure at Default (EAD)

LGD and exposure at default (EAD) are two important metrics that banks use to understand their financial risk. The EAD needs to be known before you can calculate LGD.

However, EAD measures the total exposure to losses when a borrower defaults on a loan. For example, if a borrower takes out a $ 250,000 mortgage and pays $ 20,000 before defaulting, the EAD is $ 230,000.

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The EAD keeps changing as the borrower makes additional payments on the loan. In addition, this figure does not take into account the money that banks can earn by selling collateral for loans.

Hopefully this article can provide benefits for all Vicigers friends!