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Background Note on LGD Quantification

by the Basel Committee on Banking Supervision

December 6, 2004

Introduction: The Basel II revised Framework Document issued by the Basel Committee in June 2004 (henceforth called the Framework Document) requires IRB banks to use estimates of LGD parameters that reflect "economic downturn conditions where necessary to capture the relevant risks."1 The Framework Document describes approaches to quantifying these "downturn LGDs" in general terms, but deliberately leaves specific details of the quantification process for supervisors to develop in collaboration with the banking industry. The Basel Committee recognises that the quantification of LGD parameters in general, and of downturn LGDs in particular, is evolving and for this reason the Committee has announced its intention to continue to work with industry to develop appropriate approaches to quantifying downturn LGDs.

In September 2004 the Basel Committee's Capital Task Force (CTF) and its Accord Implementation Group (AIG) agreed to set up a joint working group to share views and consider appropriate approaches to clarifying supervisory expectations regarding LGD estimates. In the coming months the LGD Working Group plans to review the existing academic and practitioner literature and engage in a dialogue with industry. The Working Group plans to adopt a two-track approach to accomplishing its work. Over the near-term the Working Group will investigate ways to promote cross-bank consistency in LGD reporting. Such consistency is necessary to properly assess the quantitative impact of Pillar I capital requirements as supervisors and the banking industry move toward implementation of Basel II. Over the longer term the Working Group plans to investigate whether there exist consensus notions of "sound practice" with respect to the data inputs, quantification methods, and validation procedures needed to develop accurate downturn LGDs.

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