Definition and Example of Loss Given Default (LGD)
Loss Given Default (LGD) is the financial loss incurred by a bank when a borrower defaults on loan payments. LGD is part of the Basel framework, which is a set of international banking regulations. LGD is an important measure that helps financial institutions anticipate and understand expected losses from defaults by borrowers. Exposure at Default (EAD) is the total exposure loss at the time of default.
How Loss Given Default Works
LGD is part of the Basel framework, which sets the standards for international banks. For example, how can a bank calculate LGD? There are several different calculations that can be used, but most accountants prefer the gross total calculation for its simplicity. The gross total calculation compares the total financial amount to the exposure at default.
In the example above, the borrower defaulted on a loan of $250,000 but paid $20,000 in loan payments over the year. Therefore, the exposure at default is $230,000. The bank seizes the home and is able to sell it for $150,000. The net loss to the bank is $80,000, and the LGD is 35%.
Loss Given Default (LGD) vs. Exposure at Default (EAD)
Loss Given Default refers to the financial amount lost by the bank when the borrower defaults on the loan. Exposure at Default is the total exposure loss at the time of default. It is expressed as a percentage or financial amount.
LGD and Exposure at Default (EAD) are important measures used by banks to understand financial risks. The exposure at default must be known before you can calculate LGD. However, EAD measures the total loss when the borrower defaults on the loan. For example, if a borrower takes out a loan of $250,000 and pays $20,000 before defaulting, the exposure at default is $230,000.
The exposure at default constantly changes with additional borrower payments towards the loan. Furthermore, this figure does not take into account the amount that the bank can recover from selling the collateral provided for the loan.
Source: https://www.thebalancemoney.com/what-is-a-loss-given-default-5218106
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