Loss given default (LGD) is the percentage of exposure expected to be lost if a borrower defaults. Economic LGD measures the shortfall after considering the present value of recoveries, collateral proceeds, guarantees, restructuring payments, and material collection or workout costs.
LGD is conditional on default. It does not measure how likely default is; probability of default does that.
Key Takeaways
- LGD measures severity after default, while PD measures the chance that default occurs.
- The denominator is exposure at default, not necessarily the original loan amount or current balance.
- Economic recoveries should reflect timing and material workout costs, not just nominal cash collected.
LGD = 1 - recovery rate only when both metrics use the same EAD, discount date, costs, and recovery scope.- Expected LGD, realized LGD, downturn LGD, accounting loss severity, and market-implied recovery are different measures.
- Collateral can reduce LGD, but only after lien, valuation, priority, liquidation, delay, and cost risks are considered.
A simplified economic-loss formula is:
$$
\text{LGD} = \frac{\text{EAD} - \text{Present value of net recoveries}}{\text{EAD}}
$$
Equivalently, when definitions match:
$$
\text{LGD} = 1 - \text{Economic recovery rate}
$$
| Input | What to define |
|---|
| EAD | Principal, accrued amounts, expected draws, and other exposure included at default |
| Recovery cash flows | Cash collections, collateral sale proceeds, guarantees, restructurings, and asset distributions |
| Recovery costs | Legal, servicing, collateral preservation, sale, and indirect workout costs included by the method |
| Discounting | Rate and date used to convert delayed cash flows to value at default |
| Resolution end point | When a default case is considered cured, sold, written off, or closed |
Changing one definition can materially change LGD even when the underlying workout cash flows do not change.
Worked Example: Net Economic LGD
Assume a loan has $1,000,000 of EAD at default. Over the workout, gross nominal recoveries total $620,000. Because the cash arrives over time, its present value at the default date is estimated at $590,000. The present value of material direct and indirect workout costs is $40,000.
$$
\text{Net recovery value} = \$590{,}000 - \$40{,}000 = \$550{,}000
$$
$$
\text{LGD} = \frac{\$1{,}000{,}000 - \$550{,}000}{\$1{,}000{,}000} = 45\%
$$
The matching economic recovery rate is 55%. A nominal gross recovery ratio would be 62%, but it ignores delay and costs and therefore is not the complement of this economic LGD.
If the loan’s one-year PD were 2%, the simplified expected loss would be:
$$
0.02 \times \$1{,}000{,}000 \times 0.45 = \$9{,}000
$$
Types of LGD
| LGD measure | What it describes | Typical use |
|---|
| Expected LGD | Forward-looking conditional severity estimate | Underwriting, pricing, portfolio risk |
| Realized LGD | Economic loss observed on completed or sufficiently mature defaults | Back-testing and model development |
| Long-run average LGD | Average severity across a defined history and default population | Calibration and regulatory analysis |
| Downturn LGD | Severity calibrated to adverse economic conditions | Prudential capital and stress testing |
| Market-implied LGD | Severity inferred from prices or credit spreads under a valuation model | Trading and market-risk analysis |
These measures should not be substituted without adjustment. Market prices can include liquidity, risk premiums, and discount-rate effects beyond expected workout loss.
What Drives LGD
- Seniority and lien priority: junior claims generally recover after senior claims.
- Collateral: type, value, volatility, location, perfection, control, and liquidation time matter.
- Guarantees and insurance: enforceability, coverage, exclusions, and guarantor strength matter.
- EAD growth: borrowers may draw committed lines before default.
- Cure and restructuring: modified terms can create recoveries over a longer period.
- Legal regime: insolvency stays, priority rules, enforcement rights, and court delays affect value.
- Workout strategy: foreclosure, sale, restructuring, collection, and timing choices change proceeds and costs.
- Economic cycle: collateral prices and buyer demand can weaken when defaults are concentrated.
- Data treatment: open defaults, multiple defaults, cures, sales, and missing costs affect observed LGD.
Collateral Does Not Set LGD by Itself
Suppose a $1 million loan is secured by property appraised at $1.2 million. That does not establish a zero LGD. The lender may face prior liens, taxes, maintenance, legal expense, market decline, selling costs, and a multi-year delay. The relevant amount is the recoverable value available to the lender after priority, costs, and timing, not the headline appraisal.
Loan-to-value can inform LGD, but a model also needs enforceability, collateral liquidity, borrower-specific facts, and workout evidence.
How LGD Is Estimated
- Define default, cure, redefault, and case-closure rules.
- Establish EAD consistently for each defaulted exposure.
- Collect all recovery cash flows and material direct and indirect costs.
- Discount cash flows to the default date under the chosen methodology.
- Segment defaults by drivers such as product, seniority, collateral, and jurisdiction.
- Address unresolved or incomplete workouts without selecting only quick recoveries.
- Calibrate long-run and downturn estimates where required.
- Back-test predicted LGD against realized outcomes and investigate overrides.
Common Mistakes
- Using the original loan amount instead of EAD.
- Ignoring draws, accrued amounts, or other exposure at default.
- Treating gross nominal collateral proceeds as net economic recovery.
- Omitting legal, servicing, preservation, and sale costs.
- Ignoring the time between default and recovery.
- Assuming every secured loan has lower LGD than every unsecured loan.
- Using average LGD without matching seniority, collateral, jurisdiction, and cycle.
- Calculating
1 - recovery rate when the two measures use different definitions.
Risks and Limitations
LGD estimates can be unstable because defaults are infrequent, workouts take years, and recovery practices change. Closed-case samples can bias results toward faster resolutions, while unresolved defaults require estimation. Collateral and legal outcomes can be correlated with the economic downturn that caused default, making average-period LGD too optimistic for stress use.
This page is educational and is not regulatory, lending, accounting, valuation, investment, model-validation, or personalized financial advice.
Authoritative Sources
- Expected Loss: Combines LGD with PD and EAD in a simplified model.
- Recovery Rate: Recovery-side complement when measurement definitions match.
- Probability of Default: Likelihood of default rather than loss severity.
- Collateral: Asset support that can affect recovery only after enforceability, priority, timing, and costs.
- Debt Recovery: Collection and workout process generating post-default cash flows.
FAQs
Is LGD always one minus recovery rate?
Only when LGD and recovery rate use the same EAD, recovery scope, costs, discounting, and measurement date. Otherwise the shortcut can be wrong.
Can LGD exceed 100%?
Some economic-loss definitions can produce LGD above 100% when accrued exposure and workout costs exceed recoveries, although regulatory or model rules may impose separate bounds or treatment.
Does collateral guarantee a low LGD?
No. Lien defects, prior claims, falling values, illiquidity, enforcement delay, and costs can materially reduce net recovery.
What is downturn LGD?
It is an LGD estimate calibrated to adverse economic conditions, when collateral values, resolution times, and recovery outcomes may be worse than long-run averages.