How this instrument works
Loss given default is the fraction of a defaulted exposure a lender never gets back once collateral is sold, guarantors are pursued, and the workout file finally closes. It is expressed as a percentage of the balance owed at the moment of default, so a lender who recovers three-quarters of what was owed carries a 25% LGD on that position — the complement of the recovery rate, stated as a loss rather than a return.
The formula subtracts the recovered amount from the exposure at default and divides by that same exposure, because what matters to a bank's reserve is the money the workout process actually failed to bring back, not the money originally lent or the collateral's appraised value. A senior secured corporate loan and an unsecured credit-card balance can share an identical exposure and still land on opposite ends of the LGD scale, because the collateral behind one recovers cash the other never had a claim on.
This sheet takes the recovered figure as reported, which is a simplification. A full bank model discounts each recovery cash flow back to the default date at the loan's effective rate and subtracts the direct cost of collecting it — legal fees, appraisal, workout staff time — before running this same subtraction, so a bank's published LGD on a similar loan can sit a few points above the raw figure this instrument returns.
- Enter the balance owed at the moment the borrower defaulted into Exposure at default, $.
- Enter the cash actually clawed back through collateral sale, litigation or workout into Amount recovered, $.
- Read Loss given default, % — the share of that exposure the recovery process never returned.
- Compare the figure against your book's typical range for that collateral class to see whether a specific workout ran better or worse than the norm.
Worked example — the $500,000 default
Take a $500,000 commercial loan that stops performing. The bank seizes and sells the pledged collateral, pursues the personal guarantee, and closes the workout file having recovered $300,000 in cash. Enter exposure at default of $500,000 and amount recovered of $300,000, and the instrument returns a loss given default of 40% — four of every ten dollars owed at default were never recovered.
That 40% rarely stands alone. A bank multiplies it by the probability of default and the exposure at default on this same loan to build its expected credit loss reserve, then checks whether the actual workout outperformed or lagged the LGD assumption already baked into its IFRS 9 or Basel internal-ratings-based model for loans of that collateral type.
Questions
How is loss given default different from probability of default?
Probability of default (PD) is the chance a borrower stops paying at all, expressed as a percentage tied to a time horizon. Loss given default only applies after that event has already happened — it measures how much of the exposure the lender still failed to recover once the default and workout process ran their course. A loan can carry a low PD and a high LGD, or the reverse; the two figures are multiplied together in a reserve calculation, never substituted for each other.
Why isn't the recovered amount discounted for time value here?
A bank rarely recovers the full amount on the day of default — collateral sale, litigation and negotiated settlements can stretch across months or years, so a full model discounts each recovery cash flow back to the default date at the loan's effective rate and subtracts the direct cost of collecting it. This sheet takes the recovered figure as given so the core subtraction stays visible; a production IFRS 9 or Basel model layers discounting and cost deductions on top of it.
What loss given default figure is normal for a given loan?
It depends on collateral and seniority far more than on the borrower's industry. Well-collateralized residential mortgages often land in the 10-30% range because the property backs most of the balance. Unsecured credit-card and personal-loan defaults commonly run 60-90% because there is nothing to seize. Senior secured corporate debt typically sits below subordinated or unsecured tranches of the same borrower's capital structure.
How does loss given default feed into expected credit loss?
Expected credit loss is built from three figures multiplied together: probability of default, exposure at default, and loss given default. A bank might combine a 2% PD, a $500,000 exposure, and a 40% LGD to reserve roughly $4,000 against that single loan. LGD is the severity term in that product — it states how large the loss is once a default actually occurs, separate from how likely that default was to begin with.
Can loss given default fall below zero or exceed 100%?
Not in this simplified ratio, since the amount recovered cannot exceed the exposure it is subtracted from, and a full recovery floors the result at 0%. Some published bank figures do drift slightly negative or past 100% once litigation costs, workout staff time and interest accrued during collection are folded in as additional losses beyond the original balance — this instrument deliberately leaves those add-on costs out.
Why track loss given default instead of just the recovery rate?
Recovery rate and loss given default are the same fraction viewed from opposite sides — recovery rate is the amount recovered divided by exposure, and LGD is one minus that, restated as a share lost rather than a share returned. Bank capital and provisioning rules under Basel and IFRS 9 are built around loss severity, so stating the figure as a loss keeps it on the same footing as probability of default and exposure at default, which are also loss-side inputs.
References
- FDIC — Current Expected Credit Losses (CECL) resources
- Bank for International Settlements — The Basel Framework, credit risk
- Federal Reserve — Supervision and Regulation letters
Read this first: This instrument shows arithmetic, not advice. Real offers add fees, taxes and terms that vary by lender and place — verify the figures against your actual paperwork before deciding anything.