What it means
When a borrower defaults, the lender usually does not lose everything. It may be able to sell collateral (assets pledged as security), claim against the borrower's remaining assets or receive payments through a restructuring.
LGD measures what remains unrecovered after all of that. LGD depends on the type of loan, the security and the legal system.
A mortgage secured by a property will usually have a lower LGD than an unsecured credit card balance. Senior debt, which ranks first in line for repayment, generally has a lower LGD than subordinated debt, which ranks behind it.
Recovery costs and timing matter. The lender may spend money on legal fees, valuers and sales commissions, and the cash may arrive years after the default.
Careful models therefore discount the recoveries back to the date of default and deduct the costs, rather than using a simple headline figure. LGD is one of three building blocks of expected loss, along with probability of default and exposure at default.
Multiplying the three gives the average loss a lender should expect on a loan or portfolio. Banks use the result to price loans, set aside provisions and calculate regulatory capital.
For non-lenders, the concept is useful when assessing credit risk on customers or investments in debt. A supplier that gives a customer $500,000 of credit should consider what it could recover if the customer fails, including whether it holds any security or credit insurance.
The answer drives the decision on credit limits, security and insurance. Regulation and accounting standards both rely on LGD.
Banks using internal models estimate it to set capital, and lenders applying expected credit loss accounting use it to calculate the provisions on their balance sheets. Estimates must be tested against actual recoveries, and a downturn LGD is often used so that losses are not understated when conditions are at their worst.
In practice
Real-world examples
Example 1
A bank makes a $400,000 loan secured on a commercial building. If the borrower defaults and the property sells for $320,000 after costs, the bank loses $80,000. The LGD is 80,000 / 400,000 = 20%.
Example 2
A credit card issuer expects to recover only 15% of the balances that go bad. Its LGD on unsecured cards is therefore 85%. It prices the cards with a high interest rate to cover the expected losses, and it treats the recovery of the remaining 15% as a collections task rather than a collateral sale.
Example 3
A bond investor holds senior notes in a retailer that goes into insolvency. The recovery from the sale of assets pays 55 cents on each dollar owed. The investor's LGD on the notes is 45%, and the fund sets its reserve for the holding using that figure.
Think of it
Imagine crashing a car with insurance. The damage is total, but you still salvage and sell the engine parts for scrap. The Loss Given Default is the gap between the car's original value and the scrap money you actually kept.
Formula
Calculation
LGD = (Exposure at default - Recoveries) / Exposure at default
Expected loss = Probability of default x LGD x Exposure at default
A bank has lent $2,000,000 secured on equipment, and the borrower defaults. After selling the equipment and paying costs, the bank recovers $1,200,000. LGD is (2,000,000 - 1,200,000) / 2,000,000 = 800,000 / 2,000,000 = 40%. If the probability of default was 3%, expected loss was 0.03 x 0.40 x 2,000,000 = $24,000.Case study
Seen in the real world
Dunmore Credit Partners is an illustrative, fictional lender to small manufacturers. It had priced all of its equipment loans as if the machines would be sold for 70% of their value on default. When two borrowers failed, the finance team discovered that specialised machines fetched only about 35% at auction.
The risk manager recalculated LGD by type of equipment. General purpose machines had an LGD of about 40%, while specialised ones were closer to 65%. Dunmore raised its pricing on specialised machinery, asked for larger deposits and began to test its recovery assumptions against every auction result, which the illustrative figures suggested would bring expected losses back in line with its target.
Watch out
Common mistakes
- Assuming collateral value equals recovery, when forced sales, costs and delays reduce what the lender receives.
- Confusing LGD with the probability of default, which measures how likely a default is and not how much is lost.
- Using one LGD for all loans, when the type of security, the seniority of the debt and the borrower's industry create large differences in what is recovered.
Questions
People also ask
What is the difference between LGD and recovery rate?
They are two sides of the same coin, because LGD equals one minus the recovery rate.
How do banks use LGD?
They use it with default probability and exposure to estimate expected losses, set provisions, price loans and calculate capital requirements.
Can LGD change over time?
Yes, it varies with property prices, the economy and the speed of the legal process, and it is typically higher in downturns when many borrowers fail and collateral is sold into a weak market.