Alternative ways for loss-given-default estimation in retail banking

Abstract

The cornerstone of retail banking risk management is the estimation of the expected losses when granting a loan to the borrower. The expected losses are determined by three parameters. The first is the probability of default (PD) of the borrower. The methods of PD estimation were studied in detail by previous authors, and the most common method is credit scorecard development. The second parameter is exposure at default (EAD). Except for revolving loans, it is known in advance, it is the current balance (principal amount plus accrued interests) of the loan. Finally, there is a third parameter that defines the expected losses. This is the so-called loss given default (LGD) which is in effect the share of EAD, which is irretrievably lost in the event of default. This paper discusses several econometric techniques which allow one to obtain estimates of the LGD parameter.