Abstract
This paper presents an contemporary approach for development and validation of Loss given default (LGD) in accordance with the Basel Accords standards. The modeling data set has been based on data on recoveries of outstanding debts from corporate entities in Republic of Serbia that defaulted. The aim of the paper is to develop a LGD model capable of confirming the validity of historically observed LGD estimates on the sample of corporate entities that defaulted. The modelling approach in this research is based on average LGD without time or exposure weightening. The probability density function of realized empirical LGDs has been created by beta distribution usage. The validation process on proposed LGD model has been performed by throughout testing of: cumulative LGD accuracy ratio, mean square error calculation and regression analysis. On the basis of obtained results, the possibilities of application of the developed LGD model are proposed and discussed.
Highlights
In the context of credit risk modeling, the term “validation” includes the set of processes and activities that contribute to the standpoint that risk components adequately characterize relevant risk aspects, the risk components being the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD)
The validation framework includes all aspects of validation which are, in this context, defined by general principles of validation published by the Basel Committee on Banking Supervision [03]
The calculation was based on the entire portfolio i.e. there was no segmentation according to any particular criteria and taking in account the limited size of available data set
Summary
In the context of credit risk modeling, the term “validation” includes the set of processes and activities that contribute to the standpoint that risk components adequately characterize relevant risk aspects, the risk components being the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD). LGD represents the credit risk parameter that plays an important role in contemporary banking risk management practice. It contributes as the key risk parameter in regulatory capital calculation according to IRB approach [4], as well as for banks’ internal risk management process. Primary reason for such incentive is the permission for the banks to use the real LGDs from experience instead of fixed regulatory LGDs. The aim of LGD estimate is to accurately and efficiently quantify the level of recovery risk inherited within a defaulted exposure. The new IFRS 9 standard extends the usage of LGD for calculation of risk weighted assets, as currently under Basel Capital Accord IRB approach, but for calculation of loan loss provision and allowances
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