Benchmarking loss given default discount rates

Abstract

This paper provides a theoretical and empirical analysis of alternative discount rate concepts for computing loss given default (LGD) rates using historical bank workout data. It benchmarks five discount rate concepts for workout recovery cashflows in order to derive observed LGDs in terms of economic robustness and empirical implications: contract rate at origination, loan-weighted average cost of capital, return on equity (ROE), market return on defaulted debt and market equilibrium return. The paper develops guiding principles for LGD discount rates and argues that the weighted average cost of capital and market equilibrium return dominate the popular contract rate method. The empirical analysis of data provided by Global Credit Data (GCD) shows that declining risk-free rates are in part offset by increasing market risk premiums. Common empirical discount rates lie between the risk-free rate and the ROE. The variation in empirical LGDs is moderate for the various discount rate approaches. Further, a simple correction technique for resolution bias is developed and increases observed LGDs for all periods, particularly recent periods.