Loss Given Default (LGD)

Posted on by user

Loss Given Default (LGD)

Loss Given Default (LGD) measures the portion of an exposure a lender expects to lose if a borrower defaults, after accounting for any recoveries. It can be expressed as a dollar amount or as a percentage of exposure at default (EAD). LGD is a core input for credit risk measurement and capital regulation.

Key takeaways

  • LGD quantifies expected loss severity on default, after recoveries.
  • Expected loss (in dollars) = Probability of Default (PD) × LGD × Exposure at Default (EAD).
  • EAD is the loan amount outstanding when default occurs; LGD reflects recoveries (collateral, repayments, legal recoveries) net of disposal costs.
  • LGD is used in risk models and regulatory frameworks (e.g., Basel II/III) to determine economic and regulatory capital.

How LGD is used

Lenders combine three components to estimate expected credit losses:
* Probability of Default (PD) — likelihood borrower will default.
* Exposure at Default (EAD) — outstanding balance at default.
* Loss Given Default (LGD) — fraction of EAD not expected to be recovered.

Expected loss (EL) formula:
EL = PD × LGD × EAD

What affects LGD

Factors that influence LGD include:
* Collateral type, quality and liquidity
* Seniority and legal priority of the claim
* Recovery and disposition costs (legal, auction, repair)
* Timing of recovery and market conditions
* Any pre-default repayments or partial recoveries

Secured loans (with collateral) generally have lower LGD than unsecured loans.

Common ways to calculate LGD

Two common approaches:

  1. Recovery-rate approach (often used in models)
  2. LGD (dollars) = EAD × (1 − Recovery Rate)
  3. Recovery Rate = proportion of EAD expected to be recovered (net of costs)

  4. Example: if EAD = $300,000 and assumed recovery rate = 20% → LGD = 300,000 × (1 − 0.20) = $240,000

  5. Collateral / proceeds approach

  6. LGD (percentage) = 1 − (Net Sale Proceeds / Outstanding Debt)
  7. Example: if EAD = $300,000 and net sale proceeds from collateral = $200,000 → LGD% = 1 − (200,000 / 300,000) = 33.33% → LGD = $100,000

Notes:
* The recovery-rate approach depends on modeled assumptions about recoveries and may be more conservative if low recovery rates are assumed.
* The collateral approach uses estimated disposal proceeds but must factor in disposition costs, timing and asset liquidity.

LGD vs EAD

  • EAD is the exposure amount at the moment of default (e.g., outstanding principal plus applicable accrued interest).
  • LGD is the portion of that exposure expected to be lost after recoveries.
  • EAD is usually the higher, gross figure; LGD reflects net loss after recovery.

Example

Borrower outstanding balance (EAD): $300,000
Estimated net sale proceeds from collateral: $200,000

Using the collateral approach:
* Recovery rate = 200,000 / 300,000 = 66.67%
* LGD% = 1 − 0.6667 = 33.33%
* LGD (dollars) = 300,000 × 0.3333 = $100,000

If instead a model assumes a recovery rate of 20% (due to uncertainty or expected high costs), then:
* LGD = 300,000 × (1 − 0.20) = $240,000

This illustrates how assumptions about recoveries materially change LGD estimates.

Frequently asked questions

What does LGD mean?
* LGD is the expected loss a lender bears when a borrower defaults, after netting recoveries, expressed in dollars or as a percentage of EAD.

How do LGD and PD differ?
* PD measures the likelihood of default. LGD measures the severity of loss if default occurs. Both are needed to estimate expected loss.

Can LGD be zero?
* Theoretically yes — if full recovery is certain, LGD = 0. In practice, a zero LGD is rare because recoveries often involve costs or residual shortfalls.

What is Usage Given Default (UGD)?
* Usage given default typically refers to EAD — the amount outstanding at default.

Bottom line

LGD is a fundamental measure of loss severity in credit risk management. Accurate LGD estimation requires careful assessment of collateral, recovery processes, legal costs, and market conditions. Combined with PD and EAD, LGD enables lenders to quantify expected losses, price credit appropriately, and determine capital needs.