CP10 (Full Document) - European Banking Authority

228. In principle, supervisors do not require any specific technique for
LGD estimation (or for estimating other IRB parameters). However,
institutions will have to demonstrate that the methods they choose
are appropriate to the institution’s activities and the portfolios to
which they apply. The theoretical assumptions underlying the models
must also be justified. The CRD does not permit the use of estimates
based purely on judgemental considerations.
229. An institution must choose a technique or a combination of
techniques for quantifying estimated LGD. The four main alternatives
are Workout LGD, Market LGD, Implied Market LGD, and Implied
Historical LGD. The latter two techniques are considered implicit
because they are not based directly on the realised LGD of defaulted
facilities. The analysis of methods provided below does not relieve
institutions of their responsibility to conduct their own analysis of
which of the methods (if any) best fits its business, or whether some
other method might be more appropriate.
230. In the Workout LGD technique, the cash flows resulting from the
workout and/or collections process, properly discounted, are
calculated. Calculations for the exposures that are currently held by
the institution has to be based on actual recovery data in order to
produce a forward­looking estimate. The calculation should not be
based solely on the market value of collateral; appropriate
adjustments should be applied.
231. The calculation of default­weighted average of realised LGDs (Annex
VII Part 4 Paragraph 73), requires the use of all observed defaults in
the data sources. Observed defaults include incomplete work­out
cases, although they will not have values for the final realisation of
LGD because the recovery process has not ended.
232. Institutions should incorporate the results of incomplete workouts (as
data/information) into their LGD estimates, unless they can
demonstrate that the incomplete workouts are not relevant. The
assessment of relevance should take into account market specifics
and should show that the exclusion of incomplete workouts does not
lead to underestimation of LGD and has no material impact on LGD
estimations.
233. When institutions include incomplete work­outs in the calculation of
the default­weighted average of realised LGDs, they should:
· Document and demonstrate the pertinence of their approaches,
including, in particular, their choice of observation period and
their methodologies for estimating additional costs and recoveries
beyond this period and, if necessary, within this period.
· Include additional costs and recoveries that are likely to occur
beyond the initial time frame considered in their LGD estimations.
If institutions are using recovery rates not higher than the already
collected recoveries, then the estimated LGD will be based on a
measure of average realised LGDs.
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