The next step in the modelling process involves the computation of historical realised LGD based on the data previously collected. The objective is to estimate the recovery and loss through a ‘workout’ approach for each of the identified default event.
4.3.2
The computation of LGD relies on the appropriate identification and quantification of the total recoveries and expenses linked to each default event. Institutions should implement a robust process to perform the necessary computation to estimate LGD at the lowest possible granularity level.
4.3.3
Institutions can develop their own methodologies for the estimation of historical realised LGD. However, their approach should incorporate, at a minimum, the components listed in this section and the corresponding categories of workout outcomes.
4.3.4
Institutions are expected to compute LGD at the time default (t) as the ratio of the total loss incurred divided by the Exposure At Default. When modelling LGD time series, the time of reference should be the date of default. We note LGD as a function of time t, as LGDt, then t is the date of default, which is different from the time at which the recovery cash flows where collected. The total recovery is noted Recoveryt and the total loss is noted Losst. Institutions should therefore estimate realised LGD for each default event with the following formula:
4.3.5
The recovery is derived from all cash inflows and expenses occurring at future times after the default event and discounted back to the default date. The recovery cash flows should not be higher than the amount of recoveries that can legally be obtained by the institution. The discount rates should reflect the time-value of money plus the uncertainty surrounding the cash flows. Additional considerations for restructured facilities are presented at the end of this section. If several facilities are secured by one or several collaterals, institutions should implement a clear collateral allocation mechanism from the obligor level to each facility. The computations of Recoveryt and Losst depend on the workout outcome. The estimation method should incorporate the following components.
Table 4: Recovery and costs per type of outcome
Outcome
Components of recovery and costs
(1) Cured & not restructured
(a)
Indirect costs, as defined in the data collection section.
(2) Cured & restructured
(a)
Potential reduction in present value upon restructuring the facility.
(b)
Direct costs, as defined in the data collection section.
(c)
Indirect costs, as defined in the data collection section.
(3) Not cured & secured
(a)
When applicable, present value of discounted collateral proceedings back to the default date
(b)
Direct costs, as defined in the data collection section.
(c)
Indirect costs, as defined in the data collection section.
(d)
Cash flows received but not associated with collateral liquidation.
(4) Not cured & unsecured
(a)
Recovered cash flows. Effect of discounting these cash flows back to the default date, function of the time to recovery.
(b)
Indirect costs, as defined in the data collection section.
(5) Unresolved
These should be treated as per the following article.
4.3.6
The treatment of unresolved default cases (incomplete workouts) creates a material bias in the estimation of LGD. Consequently, institutions should establish a clear process for the treatment of these cases and understand their impact on the estimation of historical realised LGD.
(i)
Institutions should define criteria to decide on whether the recovery process of a default case should be considered closed. A degree of conservativeness should be included in this estimation to reflect the uncertainty of the recovery process. This means that if doubts persist regarding the possibility of future cash inflows, the recovery process should be considered closed.
(ii)
Institutions should put in place clear criteria to include or exclude unresolved cases in their estimation samples. For that purpose, a maximum length of resolution period (from the date of default) should be established by obligor segment. The objective is to choose a duration that is sufficiently short to maximise the number of recovery cases flagged as ‘closed’ and sufficiently long to capture a fair recovery period.
(iii)
It is recommended that open default cases with a recovery period longer than four (4) years should be included in the LGD estimation process, irrespective of whether they are considered closed. For the avoidance of doubt, all closed cases with a shorter recovery period should, of course, be included. Banks are free to use a shorter maximum duration. Longer maximum duration, however, should be avoided and can only be used upon robust evidence provided by the institution.
(iv)
Default cases that are still unresolved within the maximum length of the recovery process (i.e. shorter than 4 years) should preferably be excluded for the purpose of estimating historical LGDs. Institutions have the option to consider adjustments by extrapolating the remaining completion of the workout process up to the maximum resolution period. Such extrapolation should be based on documented analysis of the recovery pattern by obligor segment and/or product type observed for closed cases. This extrapolation should be conservative and incorporate the possibility of lower recovered cash-flows.
Table 5: Treatment of unresolved default cases
Recovery status
Shorter recovery than the maximum recovery period
Longer recovery than the maximum recovery period
Closed cases
Included. All discounted cash-flows taken into account.
Included. All discounted cash-flows taken into account.
Open cases
Excluded. Possible inclusion if cash-flows are extrapolated.
Included. All discounted cash-flows taken into account.
4.3.7
Institutions should not assume that restructuring and rescheduling events necessarily lead to zero economic loss. For restructuring associated with material exposures, an estimation of their associated present value impact should be performed. If no PV impact is readily available, then the terms of the new and old facilities should be collected in order to estimate a PV impact, according to the methodology outlined in the dedicated section of the MMG. In particular, if the PV impact of the cash flow adjustment is compensated for by a capitalisation of interest, institutions should include an incremental credit spread in discounting to reflect the uncertainty arising from postponing principal repayments at future dates. Such credit spread should then lead to a negative PV impact.
4.3.8
For low default portfolios, institutions may not have enough data to estimate robust historical recovery patterns. In this case, institutions should be in a position to demonstrate that data collection efforts have taken place. They should also justify subsequent modelling choices based on alternative data sources and/or comparables. Furthermore, portfolios with high frequency of cure via restructuring should not be considered as portfolios with low default frequency. Restructured facilities could be recognised as defaults depending on circumstances and in compliance with the CBUAE credit risk regulation.
