Probability of default and loss given default analysis

Sageworks
May 7, 2014
Read Time: min

Probability of Default/Loss Given Default analysis is a method used by generally larger institutions to calculate expected loss. A probability of default (PD) is already assigned to a specific risk measure, per guidance, and represents the percentage expectation to default, measured most frequently by assessing past dues. Loss given default (LGD) measures the expected loss, net of any recoveries, expressed as a percentage and will be unique to the industry or segment.

When combined with the variable exposure at default (EAD) or current balance at default, the expected loss calculation is deceptively simple:

Expected Loss = EAD x PD x LGD

While the equation itself may be simple, deriving the variables takes time and considerable analysis. PD and LGD represent the past experience of a financial institution but also represent what an institution expects to experience in the future. PD is typically calculated by running a migration analysis of similarly rated loans, over a prescribed time frame, and measuring the percentage of loans that default. That PD is then assigned to the risk level; each risk level will only have one PD percentage.

LGD measures the net loss percentage of those loans that defaulted within an industry or segment. An accurate LGD variable may be difficult to obtain if portfolio losses are different than expected or if the segment is statistically small. Industry LGDs are available from third party vendors, if necessary. The positive is that PD and LGD numbers are typically valid throughout an economic cycle but should be re-evaluated periodically or in the event of economic recovery or recession, merger or significant changes in portfolio composition.

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The main benefit to financial institutions using PD/LGD is the simple calculation: the FAS 5 general reserve can be easily calculated within simple models that create directionally consistent expected loss numbers. That consistency contributes to the use of this method among institutions.

It also ties the risk rating process directly to the ALLL calculation via the PD. If actual net losses are not in line with predicted losses, a financial institution would need to determine if the credit review process routinely over- or understates customer risk ratings.

To learn more about the PD/LGD approach and the pros and cons of using it under the Current Expected Credit Loss Model (CECL),  download this infographic, CECL Methodologies: Pros and Cons for Your Portfolio.

About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest real-time database of private-company financial information in the United States. The company was acquired in 2018 and is now part of Abrigo.

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About Abrigo

Abrigo is a leading technology provider of compliance, credit risk, and lending solutions that community financial institutions use to manage risk and drive growth. Our software automates key processes — from anti-money laundering to fraud detection to lending solutions — empowering our customers by addressing their Enterprise Risk Management needs.

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