Estimating Conservative Loss Given Default

26 Pages Posted: 26 May 2008 Last revised: 15 Jun 2013

See all articles by Gabriele Sabato

Gabriele Sabato


Markus Schmid

University of St. Gallen - Swiss Institute of Banking and Finance; University of St. Gallen - School of Finance; Swiss Finance Institute; European Corporate Governance Institute (ECGI)

Date Written: September 10, 2008


The new Basel Capital Accord (Basel II) is going to be embedded in the risk management practices at many financial institutions shortly, but the academic and financial world are still discussing about several topics related to the new capital adequacy rules. One of the most important and prominent examples among these topics is the link between loss given default (LGD) and the economic cycle. If this link exists, which is suggested by an extensive literature, the Vasicek model used in the Basel Accord does not take into account systematic correlation between probability of default (PD) and LGD and, to compensate for this deficiency, downturn LGD estimates are required to be used as an input to the model. However, often banks lack an extensive LGD data history covering a full economic cycle, especially for retail assets. In this paper, we propose a simple and realistic solution that can be adopted in order to derive conservative estimates of LGD. Using data covering a set of retail loans (secured and unsecured), we investigate the relation between LGD and the credit cycle over the period from 2002 to 2007. Our results show that when ultimate recoveries instead of recoveries over a few days immediately after the default event are used, the linkage between LGD and the credit cycle is often insignificant (e.g., for two out of three retail asset classes). This implies that the conservatism required by the supervisory authorities should not always be added to LGD estimates used to estimate banks' capital requirements.

Keywords: Loss given default, Basel II, Bank capital requirements, Credit risk, Recovery rate

JEL Classification: G21, G28

Suggested Citation

Sabato, Gabriele and Schmid, Markus, Estimating Conservative Loss Given Default (September 10, 2008). Available at SSRN: or

Gabriele Sabato (Contact Author)

Wiserfunding ( email )

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United Kingdom


Markus Schmid

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Unterer Graben 21
St. Gallen, 9000

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000

Swiss Finance Institute

c/o University of St. Gallen
Dufourstrassse 50
St. Gallen, SG 9000

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels

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