Modeling Downturn LGD in a Basel Framework

Abstract

Under the Advanced Internal Rating-Based Approach of the Basel Accord banks are requested to calculate their Loss Given Default (LGD) aiming to reflect economic downturn conditions. We attempt to provide a methodology for the estimation of downturn effects on LGD with strict focus on the Basel requirements. The methodology is applied to historical default loss data from the PECDC database. It is essential to properly take into account time related effects like workout periods (time to resolution) and the Basel default definition. We find that for the class of large corporates the effect of downturn in a basic model with crisis indicator is statistically significant. Dependency of LGD and default rate is significant if a cash-flow weighted timestamp was applied to the LGD. A significant impact of macroeconomic factors like GDP growth rate could not be shown. Given spare data of resolved defaults under Basel default definition, also due to still pending workout periods, it is too early to conclude with certainty if and how much the LGD is affected by macroeconomic variables.