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Loss Given Default is the magnitude of likely loss on the exposure: this is termed the Loss Given Default (LGD), and is expressed as a percentage of the exposure.
Loss Given Default is facility-specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of
collateral and the degree of subordination.
Loss Given Default is determined in one of two ways. Under the foundation methodology, LGD is
estimated through the application of standard supervisory rules, which differentiate the level
of Loss Given Default based upon the characteristics of the underlying transaction, including the presence
and type of collateral. The supervisory rules and treatments were chosen to be conservative.
The starting point proposed by the Committee is use of a 50% LGD value for most
unsecured transactions, with a higher LGD (75%) applied to subordinated exposures. For
transactions with qualifying financial collateral, the LGD is scaled to the degree to which the
transaction is secured, using a haircut methodology adapted from that described for the
standardised approach. For transactions with qualifying commercial or residential real estate
collateral, a separate set of supervisory LGD values and recognition rules are applied. All
other transactions are viewed as unsecured for this regulatory purpose.
In the advanced methodology, the bank itself determines the appropriate Loss Given Default to be
applied to each exposure, on the basis of robust data and analysis which is capable of being
validated both internally and by supervisors. Thus, a bank using internal Loss Given Default estimates for
capital purposes might be able to differentiate Loss Given Default values on the basis of a wider set of
transaction characteristics (e.g. product type, wider range of collateral types) as well as
borrower characteristics. As with PD estimates, these values would be expected to represent
a conservative view of long-run averages, although banks would be free to use more
conservative estimates. A bank wishing to use its own estimates of LGD will need to
demonstrate to its supervisor that it can meet additional minimum requirements pertinent to
the integrity and reliability of these estimates.