Finance term
Loss Given Default (LGD)
Also known as: LGD, recovery rate, credit loss severity
Definition
Loss Given Default (LGD) is the proportion of a credit exposure a lender expects to lose if the borrower defaults — the inverse of the recovery rate. A 40% LGD means lenders expect to recover 60 cents on the dollar after default costs.
Detailed explanation
LGD quantifies credit loss severity and is one of the three primary inputs in the Basel IRB capital framework (alongside PD and EAD). Formally: LGD = 1 − Recovery Rate, where Recovery Rate = (proceeds recovered − workout costs) / EAD. Recovery depends on collateral type and quality, seniority of the debt, bankruptcy process efficiency, and economic conditions at time of default.
The Basel Committee establishes minimum LGD floors for A-IRB banks (bis.org/bcbs/publ/d424.htm): 25% for unsecured senior corporate exposures, lower for secured lending with recognized collateral. The Federal Reserve's SR 11-7 (Guidance on Model Risk Management) requires banks to validate LGD models regularly (federalreserve.gov/supervisionreg/srletters/sr1107.htm). The FDIC's Risk Management Manual addresses loss estimation in examination guidance (fdic.gov/regulations/examinations/supervisory).
For small business lending, LGD differs significantly by loan type: SBA 7(a) loans guaranteed up to 85% have very low effective LGD for lenders; unsecured business lines of credit and MCAs carry the highest LGDs (often 70-90%). Lenders use LGD alongside PD to set reserves and pricing — a high-LGD loan requires more capital and wider spread even if PD is moderate.
◈ Worked example
- SBA 7(a) loan with 75% SBA guarantee: effective LGD for the lender on the guaranteed portion approaches 0%; on the unguaranteed 25%, LGD depends on collateral.
- Unsecured business line of credit to a restaurant with no collateral: LGD estimate 75-85% — after default, workout costs and low recovery on trade assets leave little for the lender.
- Secured equipment loan (lathe, excavator): collateral liquidation typically recovers 40-70% of equipment value; LGD = 30-60% after repo/auction costs and time value.
Common questions
The most-asked questions about Loss Given Default (LGD) — answered straightforwardly.
What is the difference between LGD and recovery rate? +
LGD + Recovery Rate = 100%. If a lender expects to recover 55 cents per dollar after a default (net of legal and workout costs), LGD = 45%. LGD is the loss-focused metric used in capital calculations; recovery rate is the same concept expressed from the creditor's proceeds perspective.
How does collateral reduce LGD? +
Collateral provides an asset the lender can seize and liquidate to recover principal after default. Real property, equipment, and accounts receivable as collateral reduce LGD by providing an alternative recovery source. The reduction depends on collateral quality, liquidation speed, and the LTV at origination — lower LTV = lower LGD.
Does LGD matter for the interest rate on my loan? +
Yes. Lenders price for Expected Loss = PD × LGD × EAD. A secured loan with low LGD carries a lower expected loss, enabling lower pricing. An unsecured loan with high LGD demands a wider spread to compensate for severity risk even if the borrower's default probability is moderate.
Further reading
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