Modelling LGD for unsecured retail loans using Bayesian methods

Abstract

Loss Given Default (LGD) is the loss borne by the bank when a customer defaults on a loan. LGD for unsecured retail loans is often found difficult to model. In the frequentist (non-Bayesian) two-step approach, two separate regression models are estimated independently, which can be considered potentially problematic when trying to combine them to make predictions about LGD. The result is a point estimate of LGD for each loan. Alternatively, LGD can be modelled using Bayesian methods. In the Bayesian framework, one can build a single, hierarchical model instead of two separate ones, which makes this a more coherent approach. In this paper, Bayesian methods as well as the frequentist approach are applied to the data on personal loans provided by a large UK bank. As expected, the posterior means of parameters that have been produced using Bayesian methods are very similar to the frequentist estimates. The most important advantage of the Bayesian model is that it generates an individual predictive distribution of LGD for each loan. Potential applications of such distributions include the downturn LGD and the stressed LGD under Basel II.