A measure of downturn loss given default (downturn LGD) that accounts for regulatory capital requirements for banks in order to ensure that financial institutions’ own funds are sufficient to absorb potential losses, particularly at the worst time during the economic cycle (the trough). Downturn loss given default (DLGD) represents the loss given default (LGD) at the worst time of the economic cycle, and hence it is used as an input in calculating a bank’s economic capital (EC), which, by design, is meant to cover possible losses incurred over and above expected levels.
Financial institutions can determine the potential unexpected credit portfolio losses from defaulted loans (non-performing loans or bad books), by using own estimates of the exposure at default (EAD), the probability of default (PD), and the loss given default (LGD), i.e., that part of the exposure at default that is expected to be lost due to occurrence of default.
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