In order to calculate the CREDIT RISK CAPITAL of a financial institution we require 3 very important components:
- PD– Probability of Default (what is the likelihood that the customer will not pay back the loan amount and default)
- LGD– Loss given Default (Given the account has defaulted, what is the loss after recovery i.e. 1- Recovery )
- EAD– Exposure at Deafault (what is the exposure of the financial institution at the default)
As per IFRS9 standard, a person who misses the monthly installment againt its Loan/Credit Card for 3 consecutive months or 90 days past the due date is said to be a defaulter.
This article covers two main questions on Loss given default– WHY and HOW is LGD calculated?
WHY : Given the 2008-2009 financial crisis, a financial institution is expected to calculate new Impairment with a forward looking ‘expected credit loss’ framework as apposed to the current incurred loss model, which could not realize credit loss at a early stage and underestimated the loss during economic downturns.
As per IFRS9 the financial institutions are required to adjust the Expected credit loss in the Profit and loss statement, thus reducing the profits. Thus LGD is calculated as a part of the Expected credit Loss calculations.
- LGD1 is applied to the in-oder book and impaired book(i.e. Stage 1 & 2)
- LGD2 is applied to the defaulted book.(i.e. Stage 3)
HOW : In this article we explain the simple procedure of calculating LGD, with the chain ladder method but, first let’s understand what LGD is-
Suppose- you give a loan of Rs.2,00,000 to Mr. A. He is able to pay you back Rs. 1,10,000 and defaults on the rest, through some collection agency you are able to get another Rs.50,000 and for that you pay Rs.5,000 to the collection agent.
Therefore: Loss Given Default = 2,00,000 +5,000 – (1,10,000+50,000) = 45,000
i.e. 22.5% LGD.
Now, once we have understood the core content lets understand calculating LGD at a portfolio level with the help of chain ladder method.
Chain ladder is an acturial method that uses Run-off triangle appoach to calculated incurred but not reported recoveries based on past trend. It is used under the assumption that the past trend will continue in the future as well.
We compile the data(defaulted accounts) to form the development triangle. Its called a triangle because recoveries made are calculated at month on month level, so older the default month more the recoveries and new the default month less the number of recoveries.
Once we have the triangle we calculate the development factors in order to forcast the recoveries, so as to cover the lower part of the triangle.
Development factors calculated are based on moving average method, where a new factor is calculated based on the average of past months data (say 12 months or 18 months) based on the total historical data that we can use. Normally if we have 60 months of historical data, so with a development factor of 12 months we can predict up to 48 months of recovery.
As depicted in the graph above,
Development Factor =12 month average of revoveries at nth month/ 12 month average of recoveries at (n-1)th month.
These factors are then further multiplied with actual recoveries to populate the lower part of the triangle.
Which is summated at default month level to cen the recovery rate at each month,
Thus LGD = 1- Recovery Rate.