Realised LGD

From Open Risk Manual

Definition

Realised LGD denotes the empirically measured Loss Given Default on the basis of an organizations own credit underwriting history. The concept is particularly relevant in the context of regulated banks, where such estimates are used among others for the determination of own fund requirements[1] .

Realised LGD estimates form the basis for the Long-run Loss Given Default which is one of the key Basel Risk Parameters

ECB TRIM Requirements

Institutions should estimate LGDs on the basis of their own loss or recovery experience. Institutions may supplement their own historical data on defaulted exposures with external data. The more own loss experience (i.e. the more internal defaults) an institution has, the less importance it needs to give to external data.

Institutions should ensure that their own historical experience contains a minimum number of defaults in order to determine whether external data are sufficiently representative.

To ensure that LGD estimations are accurate and are not underestimated as a result of different external and internal recovery processes, institutions should place greater importance on comparisons of internal recovery processes with the recovery processes underlying the external data, in cases where a high weight is assigned to external data. In such cases, a higher category “A” MoC should be considered, in order to reflect the uncertainty of the estimation under paragraph 37(a)(viii) of the EBA GL on PD and LGD.

When institutions use information derived from the market price of defaulted financial instruments to supplement their internal loss or recovery experience data, there is a risk of misspecification of their LGD estimates. To mitigate this risk, institutions should ensure the following:

  • institutions should verify whether the development sample is representative of the application portfolio at least in terms of regions and product type, even when those variables have not been identified as relevant risk drivers;
  • losses derived from market prices should be increased to reflect indirect costs, as specified in paragraph 146 of the EBA GL on PD and LGD.

Calculation of Realised LGD

Article 4(1)(55) of the CRR defines LGD as the ratio of the loss on an exposure due to the default of a counterparty to the amount outstanding at default. For the purposes of Article 181(1)(a) of the CRR, institutions are required to calculate realised LGD. To comply with this requirement, it is the ECB’s understanding that institutions should calculate realised LGD under paragraphs 100 to 103 and 131 to 146 of the EBA GL on PD and LGD. In addition, when performing this calculation institutions should follow the observations in the succeeding paragraphs.

In accordance with Article 181(1)(h) of the CRR, institutions must have estimates of LGD in-default and expected loss best estimate (ELBE) on defaulted exposures. To comply with this requirement, it is the ECB’s understanding that all principles regarding the calculation of realised LGD should be applied for the estimation of LGD on non-defaulted exposures and for the estimation of LGD in-default and ELBE on defaulted exposures, unless mentioned otherwise (that is, if the reference date is considered instead of the date of default).

Where, in the case of retail exposures and purchased corporate receivables, institutions derive LGD estimates from realised losses and appropriate estimates of PDs in accordance with Articles 161(2) and 181(2)(a) of the CRR and under paragraph 103 of the EBA GL on PD and LGD, all the principles regarding realised LGD should apply to realised losses.

Definition of Default and Loss

Institutions must document the specific definitions of default and loss used internally and ensure that they are consistent with the definitions set out in the CRR. To comply with these requirements, institutions should have in place sufficiently detailed policies and procedures to ensure that the realised LGD is calculated consistently and accurately, including the implementation of the definition of economic loss. These policies and procedures should include sufficiently detailed documentation to allow third parties to replicate the calculation of realised LGD. To ensure that the policies and procedures are implemented in an appropriate and adequate manner, the calculation process should be regularly reviewed by an independent unit.

Facility Level Calculation

Institutions should calculate the realised LGD at facility level for each default. In exceptional cases, the ECB considers institutions to be compliant with the requirement to calculate realised LGD at facility level if they can prove that the recovery is not performed at individual facility level but at a more aggregated level (for example, several facilities of the same or different types secured by the same collateral). The realised LGD can therefore be calculated at a more aggregated level than individual facility level.

For this exceptional deviation from the calculation of realised LGD at facility level to be acceptable, institutions should:

  • provide evidence that recovery at aggregated level is legally enforceable.
  • on a regular basis (as often as review of estimates is performed or more often), provide evidence that recovery at a more aggregated level than single facility level is in practice enforced. This evidence should be based on the institution’s historical practice and data and demonstrate that both the recovery process and its outcomes in terms of realised loss or recovery are the same for all the facilities considered at the aggregated level. Specifically, institutions should be able to prove that all collateral within an aggregation is called irrespective of the product triggering default (thus, for a current account as for a home loan) and that realised loss or observed recovery is the same for all types of facility within the aggregation.
  • for retail exposures where institutions use definition of default at facility level in accordance with the last sentence of Article 178(1) of the CRR, ensure that the default is triggered for all aggregated facilities.
  • ensure that the parameters are applied in a manner that is consistent with how they have been estimated, i.e. across aggregated facilities;
  • ensure that no bias results from the aggregation of facilities, by validating the estimates (PD, LGD, CCF) at the more aggregated level also.

Economic Loss Basis

Institutions are required to calculate realised LGD, which is defined by Article 4(1)(55) of the CRR as the ratio of the loss on an exposure due to the default of a counterparty to the amount outstanding at default. Furthermore, Article 5(2) of the CRR defines loss as an economic loss, including material discount effects, and material direct and indirect costs associated with collecting on the instrument. In accordance with these provisions, it is the ECB’s understanding that institutions should calculate realised LGD as a ratio of the economic loss to the outstanding amount of the credit obligation at the moment of default, including any amount of principal, interest or fee (hereinafter outstanding amount at default). To calculate realised LGD, institutions should follow paragraphs 131 to 146 of the EBA GL on PD and LGD. In addition, they should pay particular attention to the following points.

  • Outstanding amount at default includes any part of the exposure that has been forgiven or written-off before or at the date of default (paragraph 134 of the EBA GL on PD and LGD). This amount is equal to the accounting value gross of credit risk adjustment (i.e. “provisions”) (Article 166(1) of the CRR). This amount also includes interest and fees capitalised in the institution’s income statement before the moment of default. However, interest and fees capitalised after the moment of default are not considered (paragraphs 137-138 of the EBA GL on PD and LGD). Where institutions include additional drawings after the moment of default to estimate CCFs, these additional drawings discounted to the moment of default are added to the outstanding amount at default in the denominator (paragraphs 139-142 of the EBA GL on PD and LGD). In other words, institutions should ensure that the exposure used for CCF estimation is consistent with the denominator of the LGD.
  • Economic loss is calculated under paragraph 132 of the EBA GL on PD and LGD. This also applies in the specific case of facilities that return to non-defaulted status, where losses arising from payment delays are expected to be accounted for as well as the “artificial cash flow” envisaged by paragraph 135 of the EBA GL on PD and LGD.
  • When recoveries are not directly observed but calculated on the basis of the difference between exposure values at two consecutive dates or derived, even partially, from some other treatment, all assumptions should be duly justified and clearly documented in order to adequately replicate the recovery flows that occur during the recovery process in accordance with letters a) and b) above. Institutions are expected to pay particular attention to the treatment of interest and fees capitalised after default, the treatment of additional drawings and the treatment of write-offs.

Material Discounts

The economic loss as defined in Article 5(2) of the CRR also includes material discounts. In the understanding of the ECB, paragraph 134 of the EBA GL on PD and LGD refers to all losses incurred through forgiveness or write-off, including all losses that can trigger a default under Article 178 of the CRR, as further specified in the EBA GL on the definition of default. Therefore, where a default has been triggered by a sale of a credit obligation, the loss as calculated in accordance with paragraph 44 of the EBA GL on the definition of default should be taken into full consideration. Similarly, and where institutions open new facilities to replace previously defaulted facilities as part of restructuring or for technical reasons, the realised loss should reflect the decrease in the degree of financial obligation arising from changes in the contractual conditions (i.e. material forgiveness or postponement of payment of principal, interest, or fees). The amount by which the financial obligation has diminished should be calculated under paragraph 51 of the EBA GL on the definition of default.

No-Loss Exposures

Realised LGD for individual facilities may be zero or lower when it is the actual result of the recovery process (for example, where additional recoveries offset the discounting effect and costs). Institutions should, however, pay particular attention to no-loss exposures, since they may reveal issues with the calculation of realised losses – for example, costs not being adequately allocated to recovery processes, or inadequate treatment of amounts forgiven or written off.

Multiple Defaults

For the purpose of LGD estimation and in order to ensure an appropriate measurement of economic loss as defined in Article 5(2) of the CRR, institutions should consider an exposure that returns to normal status and subsequently defaults in a short period of time as being constantly defaulted from the moment the first default occurred. This treatment should be applied under paragraph 101 of the EBA GL on PD and LGD. In addition, institutions should follow the observations in the following paragraphs.

  • When the proportion of subsequent defaults occurring on individual facilities over a period of more than nine months is significant, institutions should either substantiate the independence of both (or more) default events or extend the period considered for the identification of multiple defaults under paragraph 101 of the EBA GL on PD and LGD. Substantiating independence means providing sufficient evidence establishing that the second (or subsequent) default is unconnected with the original default event. It may include analysis of the curing process.
  • Time considered between two defaults is conditional upon the existence and length of probation periods. For historical data where institutions have not adopted the minimum three-month probation period on non-distressed restructured facilities under paragraph 71 of the EBA GL on the definition of default, they should consider a 12-month period for the application of paragraph 101 of the EBA GL on PD and LGD. Where they have not adopted the minimum 12-month probation period on distressed restructured facilities under paragraph 72 of the EBA GL on the definition of default, they should consider a 21-month period for the application of paragraph 101 of the EBA GL on PD and LGD.
  • In the particular case of an institution opening new facilities to replace previously defaulted facilities as part of restructuring or for technical

reasons, it should be able to make or trace a connection between the restructured facility and the facility (or facilities) previously advanced and which it is restructuring.

Recent Defaults

Under paragraph 147 of the EBA GL on PD and LGD, default observations that are triggered close to the time of the LGD estimation process (i.e. observations with a recent default when the LGD is being estimated) are part of the historical observation period and should be included in the reference dataset (RDS). Since for these recent defaults only limited information is available regarding the full recovery process, the treatment of incomplete recovery processes envisaged in paragraph 158 of the EBA GL on PD and LGD is more complex and could add uncertainty to the LGD estimates. It is the ECB’s understanding that to mitigate this risk institutions may establish a minimum period of time during which the default should be observed in order for it to be considered in the calculation of the observed average LGD. This minimum period should be adequately justified and institutions should ensure that all relevant information regarding defaults observed for a shorter period (e.g. a change in the characteristics of defaults) is considered in the LGD estimates. In any case this period should not be longer than 12 months.

Long Recovery Processes

For the purposes of LGD estimation (and validation), long recovery processes are expected to be considered as closed under paragraph 156 of the EBA GL on PD and LGD. The objective of defining the maximum period of the recovery process (“time-to-workout”) is to avoid situations where institutions give consideration to overly optimistic recoveries from open exposures that are already at a very advanced stage of the recovery process. To achieve this, the specification of the “time-to-workout” should be supported by evidence of the observed pace of recoveries and be consistent with the nature of the products concerned, the type of exposures and the operational recovery process. In addition, the institution should substantiate and clearly document the studies that support the formulation of the time-to-workout and should pay particular attention to the following:

  • The specific moment after the date of default at which nearly nil evolution of the average cumulative recovery rates is observed. For example, when the cumulative recovery curves show a pronounced increase after which they flatten out, the time spent in default after the significant increase occurs could be used directly as the time-to-workout, especially in the case of unsecured exposures.
  • The period of time after the date of default where the cumulative percentage of closed/recovered exposures flattens.
  • The number of exposures used to construct the curves referred to at letters (a) and (b) above, in order to identify situations where only a few cases contribute to the shape of the curves.
  • The expected recovery rate conditioned to vintages higher than the time-to-workout.
  • For secured exposures, the share of exposures for which recoveries from collateral have not yet been realised.


References

  1. ECB guide to internal models - Credit Risk, Sep 2018

Contributors to this article

» Wiki admin