BIS paper on loss given default in economic downturns

13 July 2005

The Basel Committee on Banking Supervision issued a document on guidance on the estimation of loss given default (LGD) during economic downturn conditions. The paper provides principles that banks are expected to fulfil in order to become eligible to use own-estimates of LGDs within the internal ratings-based approach of Basel II.

The potential for realised losses to be higher than average during times of high default rates may be a material source of unexpected credit losses for some exposures. The Committee has decided that elaborating the requirements based on a sufficiently flexible principles-based approach seems most appropriate at this time. The Committee will continue to monitor industry practice and encourage the development of appropriate approaches to this issue.

This document is organised into six sections. Section I defines terms used throughout this document. Section II articulates a principle for the quantification of LGD parameters consistent with paragraph 468 of the Framework Document. Section III discusses a principle for discounting recovery cash flows used in LGD estimation. Section IV discusses the possibility that for validation purposes supervisors may request that banks provide supplemental information on the average loss rate given default for some exposures. Section V provides guidance to supervisors concerning the development of fallback solutions that might be permitted on a transitional basis in circumstances where banks cannot satisfy the principle articulated in Section II. Section VI clarifies the relationship between the LGD quantification requirements in paragraph 468 and stress testing requirements discussed in paragraphs 434 and 435 of the Framework Document.

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