4.1.1
| For risk management purpose and to comply with accounting and regulatory requirements, the majority of institutions develop models to estimate the potential loss arising in the event of the default of a facility or obligor. These are referred to as Loss Given Default models (“LGD”). These models serve several purposes including, but not limited to provision estimation, credit portfolio management, the economic capital estimation and capital allocation. For the purpose of the MMG, and to ensure appropriate model management, the following components are considered as separate models:
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| | (i) | TTC LGD models, and |
| | (ii) | PIT LGD models. |
| The definitions of through-the-cycle (“TTC”) and point-in-time (“PIT”) are similar to those used under the section on PD models.
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4.1.2
| Institutions should develop and manage these models through a complete life-cycle process in line with the requirements articulated in the MMS. In particular, the development, ownership and validation process should be clearly managed and documented.
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4.1.3
| Institutions are expected to meet minimum expected practices for the development of LGD models. For that purpose, the construction of LGD models should include, at a minimum, the following steps:
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| | (i) | Regular and comprehensive collection of data, |
| | (ii) | Accurate computation of realised historical LGD, |
| | (iii) | Analysis of the LGD drivers and identification of the most relevant segmentation, |
| | (iv) | Development of TTC LGD model(s), and |
| | (v)
| Development of PIT LGD model(s).
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4.1.4
| This section elaborates on the concepts and methods that institutions should incorporate in their modelling practice. In particular, institutions should pay attention to the appropriate estimation of recovery and losses arising from restructured facilities. Restructuring should not always be considered as a zero-sum game leading to no financial impact. In some cases the present value (“PV”) mechanics can lead to limited impact; however, restructuring events generate execution costs, delays and uncertainty that should be fully identified and incorporated into LGD modelling.
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4.1.5
| Institutions are strongly recommended to apply floors on TTC LGD and PIT LGD across all portfolios for several reasons. There is limited evidence that default events lead to zero realised losses. An LGD of zero leads to zero expected loss and zero capital consumption, thereby creating a biased perception of risk and misguided portfolio allocation. LGD floors contribute to sound decision making for risk management and lead to more realistic provisioning. The value of the floor should be five percent (5%) for all facilities, except in the following circumstances:
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| | (i)
| The facility is fully secured by cash collateral, bank guarantees or government guarantees, and/or |
| | (ii) | The institution provides robust evidence that historical LGDs are lower than 5%. |
| In all circumstances, LGD should not be lower than one percent (1%).
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