6 LGD-estimointi

6.1.1 LGD-estimointimenetelmät

6.2.1 Riskitekijät

6.3.1 Taloudellisen tappion ja toteutuneen LGD:n laskeminen

With regard to costs to be included in the calculation of the economic loss the proposal follows the distinction between direct and indirect costs, depending on whether or not they are directly attributable to a given exposure. It has been specified that all direct costs should be considered material, whereas immaterial indirect costs may be excluded from the calculation.

To reflect the full level of loss, it is proposed that institutions should look into costs not only after the moment of default but also before that date. If the costs incurred by the institution due to diminished credit quality of the exposures but before recognition of default are not included in the exposure value at the moment of default, they should be taken into account in the calculation of economic loss. Otherwise these costs would not be accounted for in the estimation of risk parameters, and LGD would be underestimated.

Long-run average LGD

The specification of the historical observation period is based on the assumption that it should be as broad as possible, and should contain data from various periods with differing economic circumstances. These differing economic circumstances refer not only to the moment of default but also to the moment of realising recoveries from different sources. In this context, it was deemed inappropriate to allow elimination of any data that reflects an institution’s internal experience, as this would lead to a loss of valuable information. Hence, it was specified that all available internal data should be taken into account in the long-run average LGD. This internal experience may additionally be supplemented by external data where necessary.

It has been clarified that the long-run average should be calculated as an arithmetic average of realised LGDs on all observations from the specified historical observation period, and that it should be weighted by the number of defaults. The only exemption from this rule under the CRR is specified in Article 181(2) of the CRR, according to which institutions may apply higher weights to more recent data in the case of retail exposures. However, the use of this exemption requires appropriate justification and evidence that it leads to better LGD estimates.

In accordance with Article 181(1)(a) of the CRR, all observed defaults have to be taken into account in the calculation of long-run average LGD; hence, incomplete recovery processes should also be included. These incomplete processes carry valuable information, in particular about the most recent observations, and cases that are particularly difficult and therefore require longer recovery processes. Exclusion of this information would not only lead to loss of relevant, up-to-date information, but could also lead to underestimation of LGD, and this was therefore considered inappropriate.

However, to obtain a realistic value of long-run average LGD, the incomplete recovery processes should be included with future recoveries that are expected to be realised. The value of future recoveries is not an objective, observed measure but has to be estimated based on the recoveries factually observed on those cases that are already closed. As a result, the ‘long-run average LGD’ will also be a measure that is not fully objective, as it contains components that are estimated.

To obtain a fully objective intermediate measure, it is proposed that institutions should also calculate the ‘observed average LGD’ taking into account realised LGDs only on those defaults that are related to closed recovery processes, including those that are treated as closed because they have reached a certain threshold in terms of the time in default, i.e. a maximum length of the recovery process during which additional recoveries can be reasonably expected. Although this objective measure will not include any elements of estimation, it has to be kept in mind that it may not accurately reflect the real experience, as the cure and high-recovery cases may be over-represented. More difficult cases usually stay longer in recovery processes, and therefore they are likely not to be included in the ‘observed average LGD’.

Therefore, the ‘observed average LGD’ has to be adjusted to account for the most recent experience based on the incomplete recovery processes, to obtain an adequate long-run average LGD. For this purpose, institutions should estimate the most likely future recoveries on cases where the processes are not yet complete. As such estimates can be provided only where sufficient data exists to support them, it is proposed that institutions should estimate future recoveries only until a certain point in time, i.e. the maximum length of the recovery process during which a sufficient number of recoveries were actually observed in similar cases. The assumptions underlying the expected future costs and recoveries should be adequately justified and back-tested.

Finally, it is also proposed that where the calculation of realised LGD results in a negative number, i.e. where profit has been realised on a defaulted exposure, this should be floored at zero in the calculation of observed average LGD and long-run average LGD. This floor should be applied at the level of individual observation, as it would not be appropriate to allow any netting effects in that regard between the observations included in the RDS, especially where these observations may have been observed in different periods of time.

Calibration of the estimates to long-run average LGD

While the flexibility is left for institutions to choose an appropriate estimation methodology, it is also necessary that, regardless of this choice, the estimates be calibrated to the long-run average LGD. The calibration may be performed either on a portfolio level or on a grade or pool level, depending on the chosen estimation methodology. In both cases, the calibration sample, i.e. the sample of exposures used to compare the average LGD estimates with the long-run average LGD, should be the same as the sample used to calculate the long-run average LGD. In accordance with Article 181(1)(b) of the CRR, these estimates reflecting the long-run average LGD should be used whenever they are more conservative than the estimates reflecting the downturn conditions.