The relation between PD and LGD

Abstract

This article performs a conceptual credit risk exercise for the Portuguese banks’ aggregate loan portfolio of non-financial corporations within the Basel IRB framework and that takes into account that default rates and loss given default rates vary together systematically. The article estimates the loss distribution and several credit risk metrics for each year between 2006 and 2019 using a one-year simulation-based single-factor model. The results suggest that, except for every high LGD values, assuming a constant LGD leads to a significant underestimation of credit risk. This conclusion is in line with the Basel recommendation to use a downturn LGD instead of expected LGD to compensate for not explicitly modeling the PD/LGD relation. In the base case it is found that, in order to account for downturn conditions, expected LGD should have an add-on of approximately 15 percentage points. A sensitivity analysis points to an add-on below 10 percentage points for only high levels of expected LGD. (JEL: G17, G21, G32)