LGD Risk Factors

Definition

LGD Risk Factors denotes, in broad terms, the risk factors (drivers) affecting the eventual Loss Given Default of credit portfolios, i.e. the degree to which the creditor will recover the scheduled cash flows of a loan or credit product.

Usage

To the degree that such risk factors can be quantified and modelled, they can be used in the construction in Loss Given Default Models. Many LGD risk factors are overlapping with those impacting the valuation of non-performing loans. The primary difference is that LGD Risk assessment is performed potentially years ahead of any default event, hence the possible range of economic and asset market conditions is very wide.

Indicative List

A primary determinant of loss given default is whether the credit exposure (loan etc.) is secured by collateral and if so,

• the value of the collateral versus the exposure (at origination)
• the type of collateral (its ex-ante expected value volatility)
• the presence of guarantees

Additional factors may involve:

• borrower characteristics (business model, other credit products)
• product characteristics (purpose of funds, liquidity of such products in traded markets)
• applicable legal jurisdiction (borrower versus lender friendly)
• the sectoral and broader economic environment (dynamic drivers)

NB: The following list is cumulative across all types of obligors and credit products. The literature can be mixed on the presence of those factors in the various segments but they are potential candidates.

Static Factors

• Obligor Size, Sector or Industry as it affects the nature of assets, business models and their volatility
• Instrument Type, in particular whether a Bond or a Loan
• Collateral used as security, in particular the Loan to Value Ratio
• Seniority Class (e.g. Senior, Mezzanine, Junior, Subordinated Debt for Bonds)
• Loan Covenants / other risk mitigation clauses in the lending agreements
• Loan Guaranty
• Geographical Attributes, in particular the Legal framework in the applicable Jurisdiction which determines the balance of rights between borrowers and creditors

Dynamic Factors

• Macroeconomic Factors which determine the overall viability and value of an obligor's finances
• More specific Sectoral / Industrial conditions relevant to the obligor's finances
• The performance and liquidity of asset markets in which collateral must be sold

Issues and Challenges

• Most studies typically address one component of LGD Risk, namely eventually recovered amounts. The timing of workouts may have particularly strong dependence on specific factors (e.g. legal framework).