Loans are a convenient financing tool that emerges as a win-win solution for the lender as well as the borrower. While the borrower can use the funds to meet any personal or business requirements, the lender earns a handsome interest and generates income for themselves.
However, not all loans are smooth sails. Financial institutions often come across situations where the borrower is unable to pay back the loaned amount. Needless to say, such situations can cause considerable losses to the lender.
To avoid such scenarios from arising, lending institutions often undergo assessments and calculations to have a clear picture of potential losses and take measures to manage those risks. Loss Given Default (LGD) is one such calculation method that most financial institutions actively use.
Read on to learn more about the LGD model credit risk, including its importance and methods of calculation.
Understanding Loss Given Default
In simple terms, Loss Given Default, or LGD, is the estimated amount of money that a financial institution can lose if the borrower fails to pay back the loan amount. The LGD of a loan can be expressed as a percentage or as a numerical value of the total sum exposure at the time of default.
Calculating the Loss Given Default of a loan is a critical component in the overall credit risk calculation. With this, a lender is able to sanction only those loans whose risks are well within its loss appetite.
Moreover, the LGD model credit risk is not a static value. It varies depending on the collateral, seniority of debt, and the prevalent market conditions. For instance, the LGD percentage of a defaulted loan is usually lower when it is secured with a collateral. This is because a good chunk of the default amount can be recovered by liquidating those assets.
LGD Calculation
There are multiple ways to calculate the Loss Given Default of a particular credit case. However, we will be focusing on two widely used Loss Given Default formulas.
LGD calculation formula 1:
The first formula is used to find the LGD model credit risk in numerical values.
LGD (Numerical value) = Exposure at Default (EAD) x (1 - Recovery Rate)
Here,
Exposure at Default can be defined as the estimated value that the lending institution can lose if the borrower defaults on its repayment.
Recovery Rate can be defined as the proportion of the defaulted loan amount that can be recovered through the sale of assets or other means.
LGD calculation formula 2:
The second formula is used to find the LGD model credit risk as a percentage term.
LGD (Percentage) = 1 - (Potential Sale Proceeds / Outstanding Debt)
Here,
Potential Sale Proceeds signify the total amount that can be recovered through selling the assets associated with the defaulted loan.
Outstanding Debt is the remainder of the loan amount that the borrower was not able to pay back.
Example Scenario
To better understand the usage of the above calculations, let us have a look at a hypothetical scenario:
X Bank has extended a loan of Rs. 50,00,000 to a small tech startup called “ Star Innovations." The loan agreement includes numerous terms and conditions, including collateral in the form of company assets and equipment.
Star Innovations ensured timely payments for the next two years. Unfortunately, due to unforeseen market conditions and operational challenges, Star Innovations defaults on its loan.
It was estimated that the startup had a 60% chance of defaulting. This meant that the recovery rate would stand at 40%. Similarly, it was also recorded that Star Innovations had an outstanding loan amount of Rs. 30,00,000, out of which Rs. 15,00,000 can be recovered by liquidating company assets and equipment.
Based on these details, we can calculate the numerical value of Loan Given Default in the following manner:
LGD (Numerical value) = EAD x (1 - Recovery rate)
LGD (Numerical value) = 30,00,000 x (1 - 0.4 )
LGD (Numerical value) = 30,00,000 x 0.6
LGD (Numerical value) = 18,00,000
So, the numerical value of LGD stands at Rs. 18,00,000
Similarly, we can calculate the percentage value of LGD as well:
LGD (Percentage) = [1 - (Potential Sale Proceeds / Outstanding Loan)] x 100%
LGD (Percentage) = [1 - (15,00,000 / 30,00,000)] x 100%
LGD (Percentage) = [1 - ½] x 100%
LGD (Percentage) = ½ x 100% = 50%
Hence, from the above calculation, we can find that the LGD percentage of the loan stands at 50%.
Why Is Loss Given Default Important?
The Loss Given Default model has significant importance for the following reasons:
1. Risk Management: LGD calculation helps the lender quantify the potential loss in case of any loan default. This allows financial institutions to make an informed decision about approving loans to an entity.
2. Pricing: Through proper assessment of the risk associated with a particular loan, the lender can come up with a better pricing strategy. With this, they can charge an interest rate that commensurate with the risk.
3. Regulatory Compliance: The Basel II regulatory framework mandates prior LGD calculation to ensure that banks maintain appropriate risk management strategies and capital buffers against credit risk.
4. Portfolio Optimisation: With the help of LGD, banks can optimise their credit portfolios by properly managing their high and low-risk credits.
To Sum Up
Loss Given Default is one of the most important concepts used for credit risk management. It allows creditors to have a better estimate of the losses caused by a potential loan default. The metric also aids financial institutions in better managing their risks and avoiding risky credits. Thus, lenders can not only ensure more profitability but also leave room for stability and continuous growth.
At Tata Capital, we have maintained proper risk management measures to ensure that you get access to business loans at affordable terms. Head on to our website today or download our app to get swift access to funds at competitive business loan interest rates.
The details mentioned in this blog may change from time to time and from vendor to vendor or government policies.
11 June 2024
5 mins read
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