Guidance on the estimation of loss given default (Paragraph 468 of the Framework Document)

Following publication of "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" (the Basel II Framework Document) in June 2004, a number of interested parties including industry associations and national supervisors asked the Basel Committee on Banking Supervision (the Committee) to provide further clarification surrounding the quantification of loss-given-default (LGD) parameters used for Pillar 1 capital calculations. In particular, the Committee was asked to further elaborate on the so-called "downturn LGD" standard described in paragraph 468 of the Framework Document. This paragraph requires that estimated LGD parameters must "reflect economic downturn conditions where necessary to capture the relevant risks." The same paragraph indicates that "supervisors will continue to monitor and encourage appropriate approaches to this issue." The LGD Working Group (the Working Group) was established in September 2004 to engage in a dialogue with industry concerning appropriate approaches to meeting the requirements of paragraph 468 and to determine whether it would be useful for the Committee to provide further guidance to industry and supervisors in this area.

Over the last several months, the Working Group has surveyed practitioner and academic research, national supervisors represented on the Working Group have held bilateral discussions with their banks, and the Working Group as a whole has met with a number of banks and industry associations. The following three findings have been drawn from this work. First, the potential for realised recovery rates to be lower than average during times of high default rates may be a material source of unexpected credit losses for some exposures or portfolios. Failing to account for this possibility risks understating the capital required to cover unexpected losses. Second, data limitations pose an important challenge to the estimation of LGD parameters in general, and of LGD parameters consistent with economic downturn conditions in particular. Third, there is currently little consensus within the banking industry with respect to appropriate methods for incorporating downturn conditions in LGD estimates. A significant body of academic and practitioner research on this issue has developed that shows a range of results concerning the potential impact of downturn conditions on LGDs. The extent and manner by which potential dependencies between default rates and recovery rates are reflected in internal economic capital models varies considerably across institutions.

Given these findings, the Committee has determined that a principles-based approach to elaborating on the requirements of paragraph 468 is most appropriate at this time. This approach is intended to ensure that banks have systems in place for identifying downturn conditions and for incorporating these conditions into LGD estimates where appropriate. The principles articulated in this document are designed to be flexible enough to allow for a range of sound practices and to encourage continued work in this area, while also clarifying the Committee's expectations. These principles are not intended to amend the Revised Framework or to introduce any new rules. The Committee will continue to monitor industry practice through the Accord Implementation Group and may provide additional guidance as industry practices evolve.

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.