Loss Given Default (LGD)

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Definition of Loss Given Default (LGD)

LGD or Loss given default is a common parameter used to calculate economic capital, regulatory capital, or expected loss. A financial institution loses the net amount when a borrower fails to pay EMIs on loans and ultimately becomes a defaulter.

In recent times, the instances of defaults have grown exponentially. The sluggish oil and commodity marketsCommodity MarketsThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities.read more in the last couple of years have led to the downfall of several companies across sectors. Hence, loss-given default (or “LGD”) analysis has become imperative for analyzing any credit. In simple terms, Loss Given Default Definition is the amount of loss incurred by a lender when a borrower defaults, expressed in percentage.

Key Takeaways

  • LGD, or Loss Given Default, is a typical metric to determine whether economic capital, regulatory capital, or projected loss is the default. The financial institution loses the net amount if a borrower fails to make their loan EMIs and eventually defaults.
  • Creditors use distressing scenarios on borrowers to determine LGD, including haircuts on assets like inventories, receivables, and machinery. It is crucial for creditors.
  • Banks follow Basel regulations and use the Expected Loss formula to set aside funds for potential loan losses. It includes Loss Given Default, Probability of Default, and Exposure at Default.
Loss Given Default

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Simple Basic LGD Example

Let us take a simple example of a bank, say HDFC, which lends $1 million to Mr. Sharma to buy an apartment worth $1.2 million. The apartment is mortgaged or provided as collateral to the bank. Of course, before the actual disbursement and approval of the loan, HDFC performs due diligence on Mr. Sharma’s credit profile, which would include the following:

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Practical Industry LGD Example – Kingfisher Airline

The extreme scenario that comes to the top of our minds when we think of default is the infamous Kingfisher Airlines story.

  • The 17 banks that have a total loan outstanding of INR9,000 Cr (SBI being the biggest lender – lending ~25% of the total outstanding), which includes INR7,000 Cr principal and the rest penal interest with Kingfisher Airlines, have been facing a hard time.
  • We recall how the company was regarded as a wilful defaulter by several banks in 2015.
  • As per the RBI guidelines, a wilful defaulter is the one who has defaulted in meeting certain repayment obligations (even when it can repay) or has utilized the money from the lender for purposes other than what the finance was availed for.
  • Have you ever thought about the number of losses the banks could incur on their loans to Kingfisher?
  • In Aug 2016, the Airlines’ assets worth INR700 Cr were put on auction, including assets such as the erstwhile Kingfisher house headquarters, cars, Mr. Mallya’s jet, Kingfisher Villa in Goa (famous for hosting parties by Mr. Mallya), as well as several brands and trademarks.
  • Assuming that Kingfisher Airlines, which stopped operating after 2012, had only these assets for disposal, the banks would be able to recover only INR700 Cr, i.e., only ~8% on their outstanding loan of INR9000 Cr.
  • In layman’s terms, the average LGD for the banks on Kingfisher loans can be considered 92% in this scenario! On a separate note, Mr. Mallya owns INR7,000 Cr worth of assets, including several investments, land, and properties.
  • If Mr. Mallya willfully comes to rescue its lenders, he could repay most of the debt outstanding, in which case the average LGD for these banks could be lower.

Collateral and LGD

Subordination and LGD calculation

During the liquidation scenario, one important aspect that we also need to look closely at is the subordination debtSubordination DebtIn case of liquidation of a company, rankings are provided to various debts for repayment, wherein the kind of debt which is ranked after all the senior debt and other corporate Debts and loans is known as subordinated debt, and the borrowers of such kind of debt are larger corporations or business entities.read more. The SBI and UCO banks could have lent to Kingfisher airlines in several tranchesTranchesTranches refer to the segmentation of a pool of securities with varying degrees of risks, rewards, and maturities to appeal to investors.read more. The secured loans (or loans secured by collateral) would be paid as a priority over the unsecured loans.

Let us understand what these tranches and priorities mean with the help of a simpler example. A UK-based company XYZ has the following liabilities on its balance sheet:

Liability (GBP million)AmountCollateral value at the time of default
Administration claims70
Underfunded pension obligations80
Senior Secured loan – 1st lien100120
Senior Secured loan – 2nd lien50
Senior Unsecured loan60None
Subordinated loan50None
Total410

Let us assume a scenario where the company XYZ is left with assets worth GBP300 million and has filed for bankruptcy. Of course, the assets do not completely cover the liabilities, which total GBP410 million. The creditors would need to settle the claims in court. In such a case, the liabilities would be repaid according to a priority order. Let us see how the recovery waterfall works for XYZ’s creditors:

LiabilityAmountRecoverable amountRecoverable AmountThe recoverable amount of an asset is the present value of the expected cash flows that will result from the asset's sale or use, and is determined as the greater of two amounts: the asset's fair value as reduced by related selling costs, and the asset's value in use.read moreRecovery rate (RR)LGD
Trade payables706491%9%
Underfunded pension obligations8080100%0%
Senior Secured loan – 1st lien100100100%0%
Senior Secured loan – 2nd lien503264%36%
Senior Unsecured loan602440%60%
Subordinated5000%100%
Total410300

LGD estimate:

  • In the above examples, we calculated LGDs in default scenarios, for which we already knew values under stressed cases. However, for a creditor to a well-functioning company, it could be difficult for the credit team to come up with LGDs of each type of its liabilities under a default scenario.
  • In such cases, historical empirical results (based on past defaults) could help estimate the LGD for a loan facility.
  • It is also imperative for the creditors to apply distressing scenarios to its borrowers while determining the LGD, which could involve applying haircuts to its assets such as inventories, receivables, and machinery.
  • The credit team must look at the materiality of senior debt above the priority order of the loan they would be lending.

Let us see how to analyze the materiality of senior debtSenior DebtSenior debt refers to the loan that the company must repay first if it shuts down or goes bankrupt. Such debts have the lowest interest rates and risks due to their highest priority and are often secured by collateral. Banks and the bond market are two options for businesses to raise these debts.read more.

Loan provisioning and Loss Given Default

Conclusion

In conclusion, the credit teams across various banks must detect potential defaults, such as Kingfisher Airlines, well in advance and save itself from a significant hit on its balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more. A Conservative approach and well-thought-out stress cases could help the banks cut down on the NPA levels.

Frequently Asked Questions (FAQs)

What is Long run Loss Given Default?

The Long-run Loss Given Default is determined by calculating the average LGDs over a while, considering the number of defaults that occurred during that period.

What is the difference between EAD and LGD?

As part of the Basel Framework, LGD plays a vital role in global banking regulations. It helps financial institutions anticipate and understand their potential losses from borrower defaults. Exposure at default (EAD) is the total loss exposure in the event of default.

How is LGD related to other credit risk metrics?

LGD is closely related to other credit risk metrics, such as Probability of Default (PD) and Exposure at Default (EAD). These three metrics form the basis of the Basel II and Basel III frameworks for regulatory capital calculations.

Are there industry standards for LGD values?

There are no strict industry standards for specific LGD values, as they vary based on the institution’s internal models, credit risk assessment practices, and the nature of the loans or assets. However, regulatory guidelines and best practices provide general guidance on LGD estimation.

Reader Interactions

Comments

  1. Ranjith says

    Thanks Dheeraj ! I am from IT background so Its really helpful for my work .

    • Dheeraj Vaidya says

      Thanks for your kind words!