Choosing the Discount Factor for Estimating Economic LGD
by Iain Maclachlan of Australia and New Zealand Banking Group Ltd.
Abstract: Banks must measure the loss arising from counterparty default in order to achieve Advanced-IRB compliance under the proposed Basel II minimum regulatory capital framework. Which discount rate to use on cash received post-default is a question that is the subject of considerable disagreement amongst practitioners and banking supervisors. We review alternative extant proposals and develop a new method for choosing an appropriate discount rate contingent upon the risk of the recovery cash flow. An example of how supervisory determined LGD discount rates could be set is demonstrated. Empirically, the required rate of return on defaulted corporate bonds is shown to be similar in magnitude to the yield on BB rated debt. For defaulted small and medium enterprise (SME) bank loans, the mean discount rate is found to be similar, on average to the contract rate pertaining at the time of default.
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