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The relation between PD and LGD: an application to a corporate loan portfolio

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  • António Santos

Abstract

This article performs a conceptual credit risk exercise for the Portuguese banks’ aggregate loan portfolio of non-financial corporations within the Basel IRB framework and that takes into account that default rates and loss given default rates vary together systematically. The article estimates the loss distribution and several credit risk metrics for each year between 2006 and 2019 using a one-year simulation-based single-factor model. The results suggest that, except for very high LGD values, assuming a constant LGD leads to a significant underestimation of credit risk. This conclusion is in line with the Basel recommendation to use a downturn LGD instead of expected LGD to compensate for not explicitly modeling the PD/LGD relation. In the base case it is found that, in order to account for downturn conditions, expected LGD should have an add-on of approximately 15 percentage points. A sensitivity analysis points to an add-on below 10 percentage points for only high levels of expected LGD.

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  • António Santos, . "The relation between PD and LGD: an application to a corporate loan portfolio," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    • Handle: RePEc:ptu:bdpart:r202009
    as

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    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
    3. Dirk Tasche, 2004. "The single risk factor approach to capital charges in case of correlated loss given default rates," Papers cond-mat/0402390, arXiv.org, revised Feb 2004.
    4. Düllmann, Klaus & Trapp, Monika, 2004. "Systematic Risk in Recovery Rates: An Empirical Analysis of US Corporate Credit Exposures," Discussion Paper Series 2: Banking and Financial Studies 2004,02, Deutsche Bundesbank.
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