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Unexpected Recovery Risk and LGD Discount Rate Determination

Author

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  • Jiří Witzany

Abstract

The Basle II parameter called Loss Given Default (LGD) aims to estimate the expected losses on not yet defaulted accounts in the case of default. Banks firstly need to collect historical recovery data, discount the recovery income and cost cash flow to the time of default, and calculate historical recovery rates and LGDs. One of the puzzling tasks is to determine an appropriate discount rate which is very vaguely characterized by the regulation. This paper proposes a market consistent methodology for the LGD discount rate determination based on estimation of the systematic, i.e. undiversifiable, recovery risk and a cost of the risk.

Suggested Citation

  • Jiří Witzany, 2009. "Unexpected Recovery Risk and LGD Discount Rate Determination," European Financial and Accounting Journal, Prague University of Economics and Business, vol. 2009(1), pages 61-84.
    • Handle: RePEc:prg:jnlefa:v:2009:y:2009:i:1:id:63:p:61-84
    DOI: 10.18267/j.efaj.63
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    References listed on IDEAS

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    1. Edward Altman & Andrea Resti & Andrea Sironi, 2004. "Default Recovery Rates in Credit Risk Modelling: A Review of the Literature and Empirical Evidence," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 33(2), pages 183-208, July.
    2. Acharya, Viral V. & Bharath, Sreedhar T. & Srinivasan, Anand, 2007. "Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries," Journal of Financial Economics, Elsevier, vol. 85(3), pages 787-821, September.
    3. Jon Frye, 2000. "Collateral damage detected," Emerging Issues, Federal Reserve Bank of Chicago, issue Sep.
    4. Greg M. Gupton, 2005. "Advancing Loss Given Default Prediction Models: How the Quiet Have Quickened," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 34(2), pages 185-230, July.
    5. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, issue Oct.
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    Cited by:

    1. Jiří Witzany & Michal Rychnovský & Pavel Charamza, 2012. "Survival Analysis in LGD Modeling," European Financial and Accounting Journal, Prague University of Economics and Business, vol. 2012(1), pages 6-27.

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    More about this item

    Keywords

    Credit risk; Discount rate; Loss given default; Recovery rate; Regulatory capital;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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