An Upper Bound of Loss Given Default for Exposures to Financial Institutions

Abstract

Under the Basel III Advanced Internal Ratings Based (AIRB) approach, banks have to estimate the parameters probability of default (PD), exposure at default (EAD) and loss given default (LGD) in order to be able to calculate the required regulatory capital they have to hold for their banking book credit exposures. Of the three parameters, LGD is considered by many the one whose estimation is most challenging. As a consequence, LGD estimates for comparable exposures by different banks may vary significantly and thus cause unjustified variability of risk weights and capital ratios. Based on similar observations, the UK PRA (Prudential Regulation Authority) recently suggested that from July 2015 banks should no longer use their own estimates of LGDs and EADs for central governments, public sector entities and financial institutions for regulatory capital purposes. Instead the banks should apply the parameter values provided in the Foundation Internal Ratings Based (FIRB) approach. Accordingly, in particular, the AIRB banks’ own estimates of LGDs for senior unsecured exposures to financial institutions would have to be replaced by a constant value of 45%. This clearly addresses the concerns with regard to unjustified variability of risk weights for comparable exposures. One might question, however, whether 45% is an appropriately conservative value for unsecured bank exposures. This note presents some reasons why this might be the case.

Keywords: Loss Given Default, regulatory capital requirements, Foundation Internal Ratings Based Approach

JEL Classification: G28