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Unexpected Recovery Risk and LGD Discount Rate Determination

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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. Jon Frye, 2000. "Collateral damage detected," Emerging Issues, Federal Reserve Bank of Chicago, issue Sep.
    2. repec:bla:ecnote:v:33:y:2004:i:2:p:183-208 is not listed on IDEAS
    3. 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.
    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. Janette Larney & Arno Botha & Gerrit Lodewicus Grobler & Helgard Raubenheimer, 2025. "A cost of capital approach to determining the LGD discount rate," Papers 2503.23992, arXiv.org.
    2. 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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    Keywords

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    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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