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A Non-parametric Approach to Incorporating Incomplete Workouts into Loss Given Default Estimates

by Grazia Rapisarda of the Royal Bank of Scotland, and
David Echeverry of the Royal Bank of Scotland

November 16, 2010

Abstract: When estimating Loss Given Default (LGD) parameters using a workout approach, i.e. discounting cash flows over the workout period, the problem arises of how to take into account partial recoveries from incomplete workouts. The simplest approach would see LGD based on complete recovery profiles only. Whilst simple, this approach may lead to data selection bias, which may be at the basis of regulatory guidance requiring the assessment of the relevance of incomplete workouts to LGD estimation. Despite its importance, few academic contributions have covered this topic. We enhance this literature by developing a non-parametric estimator that - under certain distributional assumptions on the recovery pro les - aggregates complete and incomplete workout data to produce unbiased and more efficient estimates of mean LGD than those obtained from the estimator based on resolved cases only. Our estimator is appropriate in LGD estimation for wholesale portfolios, where the exposure-weighted LGD estimators available in the literature would not be applicable under Basel II regulatory guidance.

JEL Classification: C14, G32.

Keywords: Credit risk, bank loans, loss-given-default, LGD, incomplete observations, mortality curves

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