The new Basel Capital Accord (Basel II) is going to be embedded in the risk management practices at many financial institutions shortly, but the academic and financial world are still discussing about several topics related to the new capital adequacy rules. One of the most important and prominent examples among these topics is the link between loss given default (LGD) and the economic cycle. If this link exists, which is suggested by an extensive literature, the Vasicek model used in the Basel Accord does not take into account systematic correlation between probability of default (PD) and LGD and, to compensate for this deficiency, downturn LGD estimates are required to be used as an input to the model. However, often banks lack an extensive LGD data history covering a full economic cycle, especially for retail assets. In this paper, we propose a simple and realistic solution that can be adopted in order to derive conservative estimates of LGD. Using data covering a set of retail loans (secured and unsecured), we investigate the relation between LGD and the credit cycle over the period from 2002 to 2007. Our results show that when ultimate recoveries instead of recoveries over a few days immediately after the default event are used, the linkage between LGD and the credit cycle is often insignificant (e.g., for two out of three retail asset classes). This implies that the conservatism required by the supervisory authorities should not always be added to LGD estimates used to estimate banks’ capital requirements.
The Basel II Framework Document issued by the Basel Committee in June 2006 requires banks to use estimates of Loss Given Default (LGD) that reflect “economic downturn conditions” in order to be compliant with the Advanced Internal Rating Based (A-IRB) requirements. The Framework Document describes approaches to quantify these “downturn LGDs” in general terms, but deliberately leaves specific details of the quantification process for supervisors to develop in collaboration with the banking industry. The requirement that IRB banks use economic-downturn LGD is intended to ensure that Pillar I capital requirements properly reflect material systematic volatility in credit losses over time. To the extent that recovery rates on defaulted exposures may be lower during economic downturn conditions than during "normal" conditions, a capital rule aimed at guaranteeing sufficient capital to cover realized losses during adverse circumstances should reflect this tendency.
Many academic papers (e.g., Izvorsky, 1997; Altman et al., 2005; Covitz and Han, 2005; Acharya et al., 2007) have demonstrated that negative economic cycles and high default periods carry with them higher loss-given-default expectations than if the probability of default (PD) and recovery rate variables were considered stochastic but independent. However, at the same time, these studies rarely use data about ultimate recoveries (i.e., the total amount recovered after a sufficiently long recovery period typically set equal to one or two years) and were never applied to retail portfolios. The recoveries considered in these studies were generally the ones that occur during the days immediately after the default event. However, banks need to use ultimate recoveries when estimating LGD for regulatory capital purposes and this can lead to significantly different conclusions than those reported in prior studies.
Criteria for the quantification of LGD are described in paragraph 468 of the Framework Document. These criteria specify that LGD cannot be less than the long-run default-weighted average loss given default calculated based on the average economic loss of all observed defaults within the data source for that type of facility or pool. In addition, a bank must take into account the potential for the LGD of the facility/pool to be higher than the default-weighted average during a period when credit losses are substantially higher than average. However, it is also stated that for certain types of exposures, loss severities may not exhibit such cyclical variability and LGD estimates may not differ materially (or possibly at all) from the long-run default-weighted average.