A key metric that is used in quantitative risk analysis, reflecting the monetary amount that an entity (a bank, financial institutions, etc.) loses, or is set to lose, when a borrower defaults on a loan (or any financial obligation). For its estimation, the probability of default (PD) is used to account for the probability or likelihood that a borrower will default over the course of an obligation’s term. The estimated loss is expressed as a percentage of the total exposure of the entity at the time of default.
This metric is commonly used in risk models and in the calculation of economic capital, expected loss or regulatory capital for a bank and similar financial institutions. It plays a significant role for risk-based decision making including risk-adjusted pricing. The quality of the estimation of such losses can determine an entity’s ability to get an edge cover competing entities.
For bank loans, the calculation is typically based on discounted recovery cash flows.
It is known for short as LGD.
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