Default Recovery Rates and Lgd in Credit Risk Modelling and Practice

Abstract

Abstract Three main variables affect the credit risk of a financial asset: (i) the probability of default (PD); (ii) the ‘loss given default’ (LGD), which is equal to one minus the recovery rate in the event of default (RR); and (iii) the exposure at default. While significant attention has been devoted by the credit risk literature to the estimation of the first component (PD), much less has been dedicated to the estimation of RR and to the relationship between PD and RR. This article, which presents a detailed review of the way credit risk models, developed during the last thirty years, have treated the recovery rate and, more specifically, its relationship with the probability of default of an obligor, is organized as follows. Sections 2, 3, and 4 review these three different approaches, together with their basic assumptions, advantages, drawbacks, and empirical performance. Section 5 examines credit value-at-risk models. Section 6 considers the more recent studies explicitly modelling and empirically investigating the relationship between PD and RR. Section 7 discusses Bank of International Settlement efforts to motivate banks to consider ‘downturn LGD’ in the specification of capital requirements under Basel II. Section 8 reviews the very recent efforts by the major rating agencies to provide explicit estimates of recovery given default. Section 9 revisits the issue of procyclicality and Section 10 presents some recent empirical evidence on recovery rates on both defaulted bonds and loans, and also on the relationship between default and recovery rates. Section 11 concludes.

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