Credit loss and systematic loss given default

Abstract

Credit loss varies from period to period, both because the default rate varies and because the loss given default (LGD) rate varies. The default rate has been tied to a firm’s probability of default (PD) and to factors that cause default. The LGD rate has proved more difficult to model because continuous LGD is more subtle than binary default and because LGD data is scarcer and lower in quality. Studies show that the two rates vary together systematically (see Altman and Karlin (2010) and Frye (2000)). Systematic variation works against the lender, who finds that an increase in the number of defaults coincides with an increase in the fraction “percentage”? that is lost in a default. Lenders should therefore anticipate systematic LGD within their credit portfolio loss models, which are required to account for all material risks. This paper presents a model of systematic LGD that is simple and effective. It is simple in that it uses only parameters that are already part of standard models. It is effective in that it survives statistical testing against more complicated models. It may, therefore, serve for comparison in tests of other models of credit risk as well as for the