Rating Models and Validation - Oesterreichische Nationalbank

ity of the realization market and the marketability of the object. A finer differentiation
would not have been justifiable due to the size of the data set used.
Due to the high variance of recovery rates within segments, the results have
to be interpreted conservatively. The recovery rates are applied to the value
at realization. In this process, the value at default, which is calculated using a
cash flow model, is adjusted conservatively according to the expected average
liquidation period for the segment.
Estimating Interest Loss
In practice, interest loss is estimated on the basis of the interest payments lost
due to the default. In this process, the agreed interest for the residual term is
discounted, for example using the current risk-free term structure of interest
rates. Therefore, the resulting present value implicitly contains potential refinancing
costs as well as the spread components process and overhead costs, risk
premiums, and profit. There are also practical approaches which account for the
increased equity portion required to refinance the amount not written off over
the liquidation period. The bankÕs individual cost of equity can be used for this
purpose. The practical examples implemented to date have not taken the opportunity
costs of lost equity into account.
Estimating Workout Costs
The estimation method selected for calculating workout costs depends on the
organizational structure and the level of detail used in cost unit and cost center
accounting. The type and scope of the estimation method should reflect the significance
of workout costs for the specific customer or transaction type using
the available accounting information. If a bank has a separate restructuring
and liquidation unit for a specific business segment, for example, it is relatively
easy to allocate the costs incurred by that department.
In one practical implementation of a model for object financing transactions,
experts estimated the time occupied by typical easy and difficult restructuring/
liquidation cases for an employee with the appropriate qualifications. Based on
accounting data, costs per employee were allocated to the time occupied, making
it possible to determine the cost rates for easy and difficult liquidation cases.
Historical rates for easy and difficult liquidation cases were used to weight these
cost rates with their respective probabilities of occurrence.
Combining Book Value Loss, Interest Loss and Workout Costs
to Yield LGD
In order to calculate LGD, the individual loss component estimates have to be
merged. In this context, it is important to note that the collateral recoveries are
expressed as a percentage of the secured portion and bankruptcy proceeds as a
percentage of the unsecured portion of the loan, and that workout costs are
more specific to cases than volumes. In order to calculate LGD, the individual
components have to be merged accordingly for the credit facility in question. In
this context, estimated probabilities of occurrence first have to be assigned
to the post-default development scenarios preselected for the specific facility
type (cf. section 7.4.2). Then it is necessary to add up the three estimated loss
components (book value loss, interest loss, and workout costs). It is not neces-
Rating Models and Validation
Guidelines on Credit Risk Management 161