Rating Models and Validation - Oesterreichische Nationalbank

III ESTIMATING AND VALIDATING LGD/EAD AS
RISK COMPONENTS
7 Estimating Loss Given Default (LGD)
While it is common practice in many banks to calculate PDs without using the
results to calculate Basel II regulatory capital requirements, these institutions
are now also focusing on estimating LGD and EAD due to the requirements
of Basel II. It is not possible to discuss the estimation of these two parameters
without referring to Basel II, as no independent concepts have been developed
in this field to date. Therefore, institutions which plan to implement their own
LGD estimation procedures in compliance with the draft EU directive face a
number of special challenges. First, in contrast to PD estimates, LGD estimation
procedures cannot rely on years of practical experience or established
industry standards. Second, many institutions do not have comprehensive loss
databases at their disposal.
This chapter presents potential solutions for banksÕ in-house estimation of
LGD as well as the current state of development in this area. We cannot claim
that this chapter presents a conclusive discussion of LGD estimation or that the
procedure presented is suitable for all conceivable portfolios. Instead, the objective
of this chapter is to encourage banks to pursue their own approaches to
improving LGD estimates.
The LGD estimation procedure is illustrated in chart 80 below.
Chart 80: LGD Estimation Procedure
In this chapter, we derive the loss parameters on the basis of the definitions
of default and loss presented in the draft EU directive and then link them to the
main segmentation variables identified: customers, transactions, and collateral.
We then discuss procedures which are suitable for LGD estimation. Finally, we
Rating Models and Validation
Guidelines on Credit Risk Management 139