Loss given default (LGD) is the financial loss a bank ultimately incurs when a borrower stops making loan payments. The LGD value is expressed as a percentage of the bank’s total exposure at the time when a borrower defaults.
LGD is part of the Basel Framework, which sets the standard for international banking. Understanding this metric helps banks and financial institutions project their expected losses from borrower defaults.
Definition and Example of Loss Given Default
When a borrower fails to repay a loan, their lender experiences a financial loss. The loss that a financial institution incurs is known as loss given default (LGD). LGD is expressed as a percentage of total exposure at the time when the default occurred.
For instance, let’s say a borrower wants to purchase a home for $250,000 and takes out a mortgage from a local bank. The home that the borrower purchases is used as collateral for the loan.
Before the bank approves the mortgage, it checks the borrower’s credit score and performs its due diligence. It finds the borrower has no history of default, so the bank approves the mortgage.
But a year after purchasing the home, the borrower loses their job and defaults on their mortgage. This doesn’t mean the bank has lost exactly $250,000, as there are other factors that have to be considered.
The bank still has an asset it can use as collateral and the borrower had already made a year’s worth of mortgage payments. LGD can help the bank determine how much money was actually lost from the default.
If you’re looking to take out a loan, putting down some type of collateral benefits both you and your lender. Your lender takes on less risk, and as a result, you’ll likely be rewarded with lower rates on the loan.
How Loss Given Default Works
LGD is a part of the Basel Framework, which sets standards for international banking. So using the above example, how can a bank calculate the LGD?
There are a number of different calculations that can be used, but most accountants prefer gross calculation because of its simplicity. Gross calculation compares the total amount of money with the exposure at time of default.
Using the example above, the borrower defaulted on a $250,000 mortgage, but after making $20,000 in mortgage payments over the course of a year.
So the exposure at the time of default is $230,000. The bank forecloses on the home and is able to sell it for $150,000. The bank’s net loss is $80,000, and the LGD is 35%.
If you’re facing a foreclosure on your home due to extenuating circumstances, you may be able to stop it. Contact your lender immediately to see what your options are.
Loss Given Default (LGD) vs. Exposure at Default (EAD)
|Loss given default||Exposure at default|
|The amount of money a bank loses when a borrower defaults on a loan||The total loss exposure at the time of default|
|Is expressed as a percentage||Can be expressed as a dollar amount or percentage|
|Accounts for funds the bank is able to recoup by selling off the collateral||Doesn’t account for any money the bank can recover by selling off the collateral|
LGD and exposure at default (EAD) are two important metrics banks use to understand their financial risk. The EAD needs to be known before you can calculate the LGD.
However, EAD measures the total loss exposure when a borrower defaults on the loan. For instance, if a borrower takes out a $250,000 mortgage and pays $20,000 before defaulting, the EAD is $230,000.
The EAD is constantly changing as the borrower makes additional payments toward a loan. In addition, this figure doesn’t account for the money the bank could recoup by selling off the collateral toward the loan.
- Loss given default (LGD) is the financial loss a bank ultimately incurs when a borrower defaults on loan payments.
- LGD is an aspect of the Basel Framework, a set of international banking regulations.
- LGD is an important metric that helps financial institutions project and understand their expected losses from borrower defaults.
- Exposure at default (EAD) is the total loss exposure at the time of default.
Bank for International Settlements. “The Basel Framework.” Accessed Feb. 3, 2022.
Bank of International Settlements. “CRE - Calculation of RWA for Credit Risk.” Accessed Feb. 3, 2022.
Federal Reserve Bank of Dallas. “Understanding the Exposure at Default Risk of Commercial Real Estate Construction and Land Development Loans,” Page 6. Accessed Feb 3, 2022.