Is the Regulatory Downturn LGD Adequate? Performance Analysis and Alternative Methods

Abstract

This paper addresses the inconsistency of downturn definition adopted by the conditional PD under the IRBA and the downturn LGD (latent variable based versus macroeconomic based). This will potentially result in risk underestimation and inadequate capital coverage. We confirm this underestimation by Monte Carlo simulation based on 18 years default database of over 50 international large banks. The simulation shows that the current regulatory downturn LGD does not pass the minimum survival probability of 99.9% as traditionally required in the IRBA. Our developed method incorporates latent variables to address the aforementioned inconsistency and performs with a survival rate of 99.9%. Further, it also outperforms the Foundation IRBA in terms of accuracy. In contrast to other conditional LGD models in the literature, our method is applicable not only to market-based LGD but to workout LGD as well.

Keywords: Basel Accord, Internal Ratings-Based Approach, Downturn Loss Given Default, Systematic Risk, Latent Variable, Global Credit Data

JEL Classification: G18, G21, G28