Estimating Conservative Loss Given Default

The new Basel Capital Accord (Basel II) is going to be embedded in the risk management practices at many financial institutions shortly, but the academic and financial world are still discussing about several topics related to the new capital adequacy rules. One of the most important and prominent examples among these topics is the link between loss given default (LGD) and the economic cycle. If this link exists, which is suggested by an extensive literature, the Vasicek model used in the Basel Accord does not take into account systematic correlation between probability of default (PD) and LGD and, to compensate for this deficiency, downturn LGD estimates are required to be used as an input to the model. However, often banks lack an extensive LGD data history covering a full economic cycle, especially for retail assets. In this paper, we propose a simple and realistic solution that can be adopted in order to derive conservative estimates of LGD. Using data covering a set of retail loans (secured and unsecured), we investigate the relation between LGD and the credit cycle over the period from 2002 to 2007. Our results show that when ultimate recoveries instead of recoveries over a few days immediately after the default event are used, the linkage between LGD and the credit cycle is often insignificant (e.g., for two out of three retail asset classes). This implies that the conservatism required by the supervisory authorities should not always be added to LGD estimates used to estimate banks' capital requirements.