Chapter 6: LGD estimation

The concepts of economic loss and realised LGD are the basis for LGD estimation and any differences in the calculation may lead to significantly different and non-comparable LGD estimates. Therefore, it was considered essential to specify these concepts in detail, including the treatment of fees, interest and additional drawings after default, discounting rate, and costs. The specification was based on the definitions included in the CRR, but provides more detailed clarifications on the practical application of these definitions.

In particular, additional clarification is provided on the calculation of realised LGD for the observations that returned to non-defaulted status. It is considered that an assumption that these cases are always related to zero loss would not be prudent. Instead, institutions should calculate the loss realised on these exposures in the same manner as for all other defaulted observations, with the only difference being that an artificial cash flow is added to the calculation in the amount of the outstanding obligation at the moment of the return to non-defaulted status. Therefore, for the purpose of calculating the realised LGD, the exposure that returned to non-defaulted status would be treated in the same manner as if it was fully repaid at the date of the change of status.

The additional artificial cash flow should be discounted to the moment of default in the same manner as all other cash flows. This not only will ensure consistency with the fully repaid observations, but is also consistent with the concept of discounting factor, which reflects uncertainty around the cash flows on defaulted exposures that existed at the moment of default.

With regard to the treatment of fees, interest after default and additional drawdowns after default (referred to in the CRR as additional drawings), it was considered that, to reflect correctly the level of loss, these should also be included in the calculation up to the moment of default. Therefore, all fees and interest outstanding at the moment of default should be included in the amount of outstanding obligation at the moment of default. In this sense, the treatment of fees and interests should be consistent, as the economic sense of these measures is similar, and whether the obligors in default are charged interest or fees may only depend on the institution’s pricing policy.

Furthermore, in specifying the treatment of additional drawings after the moment of default, it was considered that the resulting measure of realised LGD should be consistent with the exposure value that will be used for the purpose of calculation of capital requirements. Hence, where additional drawings after default are included in the conversion factors, the outstanding amount in the denominator of the realised LGD should also include such drawings. However, in the case of retail exposures, where the conversion factors do not include any drawings after the moment of default, the denominator of the realised LGD should also reflect only the outstanding amount at the moment of default. As a result, lower exposure value (based on lower conversion factors) will be compensated for by higher LGD.

Similarly, in the case of additional fees or interests that are capitalised after the moment of default, as these are generally not included in the conversion factors they should not increase the amount outstanding at the moment of default. It is also considered that, as such fees and interests are not related to outgoing cash flow, they should not increase the economic loss in the numerator of the realised LGD. However, where these additional fees cover costs that were incurred by the institution, these should be included in the calculation of economic loss as costs. It is assumed that the unrealised gains from fees and interest should not be considered losses if they are not related to any expenses incurred by the institution. However, recoveries on those items are profits realised by the institution and hence can decrease the economic loss. Therefore, all recovery cash flows realised on a given exposure should be included in the calculation of realised LGDs.

To keep consistency between the LGD and exposure value, including conversion factors, different calculation of the denominator of the realised LGD is proposed, depending on whether or not additional drawings after default are included in the estimation of conversion factors or not. However, this optionality does not refer to the measure of economic loss, i.e. the numerator of the realised LGD, as this should be an objective value that adequately reflects the actual value of loss experienced by the institution. As additional drawings after default are related to an outflow of cash from an institution, they should always be included in the calculation of economic loss in the numerator of realised LGD.

The EBA has considered various possibilities with regard to the discounting rate, and analysed various practices in that regard. Approaches used by institutions include the use of discounting factors based on effective interest rates of the underlying loans, various add-ons in the range of 0 to 10% and even higher in some cases, and various underlying internal and external interest rate benchmarks. As significantly different approaches are currently used by institutions, the discounting factor was recognised as one of the main drivers of non-risk-based variability of the LGD estimates. The proposed solution of using interbank funding rates and a 5% add-on has the advantage of being simple and contributing to increased comparability of LGD estimates. It is considered appropriate that the discounting rate should not depend on the credit standing of the institution, so the discounting rate does not reflect funding costs but rather is focused on the uncertainty inherent in the recovery processes and the time value of money. For exposures in currencies other than the euro, and for observations from before the adoption of euro, an equivalent interest rate should be used that is applicable for the currency of the exposure. This comparable rate should be sufficiently liquid to reflect the level of risk at the date of default in a correct manner.

The discounting rate specified in the GL is expected to reflect the average economic conditions that are adequate for the purpose of the long-run average LGD. It is not considered to be associated with downturn conditions. The downturn adjustment should be specified in accordance with the requirements of the RTS on the nature, severity and duration of economic downturn, which will be specified on the basis of Article 181(3)(a) of the CRR.

While the level of the add-on is consistent with the results of the IRB survey carried out across the institutions and reflects a balanced figure between the discounting rates applied within and outside the euro area, the adequacy of the 5% add-on will be further analysed and, if necessary, reviewed before the date of application of these GL. Furthermore, the EBA will also aim to publish a list of equivalent interbank rates for currencies other than euro, which should be used for the purpose of realised LGD calculation for exposures denominated in those currencies.

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.