CP10 (Full Document) - European Banking Authority

234. The Workout LGD technique can be applied using either direct
estimates or a two­step approach. When direct estimates are used, a
quantitative estimate is derived for each individual exposure based
on its specific characteristics. In a two­step approach, an average
LGD is estimated for all exposures covered by the same facility grade
or pool. If a pooling approach is used in the Retail exposure class,
individual direct estimates must be averaged to produce an LGD for
the pool, because it is necessary to produce an aggregated LGD for
all exposures in a pool. However, the CRD proposal also allows Retail
estimates to be derived using grades, in a similar way to those for
Corporate, Institution, and Sovereign exposures. Where this method
is used, there is no need to aggregate LGD estimates for Retail
exposures.
235. A direct estimation procedure allows the automatic calculation of
each of the discrete elements that make up LGD, based on the
experience of each of the corresponding elements in an RDS which is
relevant for the element in question (e.g., real estate recovery
values, or discount rates). One example of a direct estimation
procedure is a statistical model which uses risk drivers as
explanatory variables. Under a two­step procedure there would
instead be an overall adjustment to the LGD applied to the grade or
pool as a whole, to reflect the extent to which the average LGD for
the requisite RDS is not representative of the forward­looking longrun
default weighted average (or economic downturn estimate).
236. Market information may be used in a number of different ways in
LGD estimation. Historical market prices realised on collateral or in
exchange for some or all of the claim on the obligor will inform
estimates in the RDS, when the Workout LGD technique is being
used. Current market prices of collateral on current exposures will
influence their estimated LGD. As an alternative to Workout LGD, the
RDS may instead be derived from the observation of market prices
on defaulted bonds or marketable loans soon after default or upon
their emergence from bankruptcy. If a institution uses market
information as an alternative to workout LGD (for example, in the
case of scarce data), the market data must conform to the general
requirements for the use of external data (see section 3.4.4. on data
sources). An institution may derive the best estimate of expected
loss for its defaulted exposures directly from their market prices
where these exist. LGD estimates based on the market prices of
defaulted obligations are known as Market LGDs. It is also possible to
derive estimated LGDs from the market prices of non­defaulted loans
or bonds or credit default instruments. These are referred to as
Implied Market LGDs.
237. LGD estimates based on an institution’s own loss and recovery
experience should in principle be superior to other types of
estimates, all other things being equal, as they are likely to be most
representative of future outcomes. However, such estimates may be
improved by the careful use of external information such as market
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