Modelling Downturn Loss Given Default

by Raffaella Calabrese of University of Milano-Bicocca, and
Johan A. Elkink of University College Dublin

November 2012

Abstract: Basel II requires that the internal estimates of Loss Given Default (LGD) reflect economic downturn conditions, thus modelling the "downturn LGD". In this work we suggest a methodology to estimate the downturn LGD distribution. Under the assumption that LGD is a mixture of an expansion and a recession distribution, an accurate parametric model for LGD is proposed and its parameters are estimated by the EM algorithm. Finally, we apply the proposed model to empirical data on Italian bank loans.

Keywords: Downturn LGD, Mixed random variable, Mixture, Beta density.

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