Loss Given Default is the magnitude of likely loss on the exposure: this is termed the Loss Given Default (LGD), and is expressed as a percentage of the exposure.
Loss Given Default is facility-specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of collateral and the degree of subordination.
Loss Given Default is determined in one of two ways. Under the foundation methodology, LGD is estimated through the application of standard supervisory rules, which differentiate the level of Loss Given Default based upon the characteristics of the underlying transaction, including the presence and type of collateral. The supervisory rules and treatments were chosen to be conservative. The starting point proposed by the Committee is use of a 50% LGD value for most unsecured transactions, with a higher LGD (75%) applied to subordinated exposures. For transactions with qualifying financial collateral, the LGD is scaled to the degree to which the transaction is secured, using a haircut methodology adapted from that described for the standardised approach. For transactions with qualifying commercial or residential real estate collateral, a separate set of supervisory LGD values and recognition rules are applied. All other transactions are viewed as unsecured for this regulatory purpose.
In the advanced methodology, the bank itself determines the appropriate Loss Given Default to be applied to each exposure, on the basis of robust data and analysis which is capable of being validated both internally and by supervisors. Thus, a bank using internal Loss Given Default estimates for capital purposes might be able to differentiate Loss Given Default values on the basis of a wider set of transaction characteristics (e.g. product type, wider range of collateral types) as well as borrower characteristics. As with PD estimates, these values would be expected to represent a conservative view of long-run averages, although banks would be free to use more conservative estimates. A bank wishing to use its own estimates of LGD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates.