When a borrower fails to repay a loan, it results in a loss for the lender. To manage and prepare for such risks, financial institutions rely on a metric called Loss Given Default. It refers to the portion of a loan that a lender stands to lose if the borrower defaults, after accounting for any recoveries. This measure is a key part of credit risk management and helps lenders estimate potential losses, decide loan terms, and set aside reserves accordingly. In this article, we explain what loss given default means, why it matters in lending, and how it is calculated in practice.
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.
Why Is Loss Given Default Important?
The Loss Given Default model has significant importance for the following reasons:
- 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.
- 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.
- 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.
- Portfolio Optimisation: With the help of LGD, banks can optimise their credit portfolios by properly managing their high and low-risk credits.
How to Calculate Loss Given Default
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.
Formula 1:
LGD = Exposure at Risk (EAD) * (1 – Recovery Rate)
This formula uses two factors: exposure at risk and the recovery rate. Exposure at default estimates the loss a bank or credit union may face if a borrower defaults on a loan. The recovery rate helps adjust the loss based on how much of the defaulted amount is likely to be recovered.
Formula 2:
LGD (as a percentage) = 1 – (Potential Sale Proceeds / Outstanding Debt)
This method compares the expected proceeds from selling assets to the outstanding debt. It provides an estimate of the portion of debt that is likely to be lost based on potential sale proceeds.
Of the two methods, the first is more commonly used because it gives a more conservative estimate of the maximum possible loss. The second method can be harder to apply, as it’s difficult to estimate sale proceeds due to factors like multiple assets, selling costs, payment timing, and asset liquidity.
Example Scenario
X Bank provided a loan of Rs. 50,00,000 to “Star Innovations,” a tech startup, with company assets as collateral. After two years of on-time payments, the startup defaults due to market challenges. The probability of default is 60%, meaning the recovery rate is 40%. The outstanding loan is Rs. 30,00,000, with Rs. 15,00,000 recoverable from liquidating assets.
To calculate the numerical LGD:
LGD = Exposure at Default (EAD) × (1 – Recovery Rate)
LGD = 30,00,000 × (1 – 0.4) = 30,00,000 × 0.6 = Rs. 18,00,000
To calculate the percentage LGD:
LGD = [1 – (Sale Proceeds / Outstanding Loan)] × 100%
LGD = [1 – (15,00,000 / 30,00,000)] × 100% = 50%
Thus, the LGD is Rs. 18,00,000 or 50%, indicating that the lender is likely to lose half of the outstanding loan amount.
Conclusion
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 prioritise effective risk management to ensure you have access to business loans on favorable terms. Visit our website or download our app for quick access to funds at competitive business loan interest rates.
FAQs
LGD is influenced by factors such as collateral type, asset recoverability, borrower’s condition, legal and operational costs, market conditions, and the efficiency of the recovery process.
The half-life of LGD refers to the time taken to recover half of the potential loss. It varies based on collateral type, default circumstances, and the recovery methods used.
The cure rate is the percentage of defaulted loans that are recovered or repaid. A higher cure rate results in a lower LGD, indicating more effective recovery efforts.
LGD cannot exceed 100%. It represents the percentage of a loan that is lost, and a value above 100% would indicate a loss greater than the total loan amount, which isn’t possible.
LGD can be zero if the lender recovers the full loan amount through collateral or other means, meaning there’s no loss from the default.
25 April 2025
4 mins read
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