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Guidance on Paragraph 468 of the Framework Document

by Basel Committee on Banking Supervision

July 2005

Introduction: Following publication of "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" (the Basel II Framework Document) in June 2004, a number of interested parties including industry associations and national supervisors asked the Basel Committee on Banking Supervision (the Committee) to provide further clarification surrounding the quantification of loss-given-default (LGD) parameters used for Pillar 1 capital calculations. In particular, the Committee was asked to further elaborate on the so-called "downturn LGD" standard described in paragraph 468 of the Framework Document. This paragraph requires that estimated LGD parameters must "reflect economic downturn conditions where necessary to capture the relevant risks." The same paragraph indicates that "supervisors will continue to monitor and encourage appropriate approaches to this issue." The LGD Working Group (the Working Group) was established in September 2004 to engage in a dialogue with industry concerning appropriate approaches to meeting the requirements of paragraph 468 and to determine whether it would be useful for the Committee to provide further guidance to industry and supervisors in this area.

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The Text of Paragraph #468:
468. A bank must estimate an LGD for each facility that aims to reflect economic downturn conditions where necessary to capture the relevant risks. This LGD cannot be less than the long-run default-weighted average loss rate given default calculated based on the average economic loss of all observed defaults within the data source for that type of facility. In addition, a bank must take into account the potential for the LGD of the facility to be higher than the default-weighted average during a period when credit losses are substantially higher than average. For certain types of exposures, loss severities may not exhibit such cyclical variability and LGD estimates may not differ materially (or possibly at all) from the long-run default-weighted average. However, for other exposures, this cyclical variability in loss severities may be important and banks will need to incorporate it into their LGD estimates. For this purpose, banks may use averages of loss severities observed during periods of high credit losses, forecasts based on appropriately conservative assumptions, or other similar methods. Appropriate estimates of LGD during periods of high credit losses might be formed using either internal and/or external data. Supervisors will continue to monitor and encourage the development of appropriate approaches to this issue.