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

37 Pages Posted: 12 Jun 2019

See all articles by Thomas Hartmann-Wendels

Thomas Hartmann-Wendels

University of Cologne - Department of Banking

Christopher Paulus Imanto

University of Cologne - Department of Banking

Date Written: June 3, 2019

Abstract

This paper addresses the inconsistency of downturn definition adopted by the conditional PD under the IRB approach 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 IRB approach. 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 IRB approach 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, Advanced IRB Approach, Foundation IRB Approach, Downturn LGD, Systematic Risk, Latent Variable

JEL Classification: G18, G21, G28

Suggested Citation

Hartmann-Wendels, Thomas and Imanto, Christopher Paulus, Is the Regulatory Downturn LGD Adequate? Performance Analysis and Alternative Methods (June 3, 2019). Available at SSRN: https://ssrn.com/abstract=3398246 or http://dx.doi.org/10.2139/ssrn.3398246

Thomas Hartmann-Wendels

University of Cologne - Department of Banking ( email )

Albertus-Magnus-Platz
D-50923 Cologne
Germany

Christopher Paulus Imanto (Contact Author)

University of Cologne - Department of Banking ( email )

Albertus-Magnus-Platz
Cologne, 50923
Germany

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