Loss Given Default

This is the loss that the bank or other financial institution is supposed to loose if a borrower defaults on a loan.  There are many method used to calculate this. The bank or the financial institution never calculate the loss for a single institution rather they calculate it for the portfolio as a whole. It is also one of the tools in risk management. It is mainly used by the bankers and financial institution. The loss given default is one of a difficult factor to determine, this is because the loss given default cannot be calculated directly. Let us illustrate it with example. If a company X has bought some 10 crore ` as loan, it defaults after some time. In the above case the bad debt for the bank is not 10 crore ` as it can be seen. If we make a close note into it, the actual loss to the bank is less than that amount. The bank can sell the asset that the company has used as mortgage to get the loan and reduce the loss.

Loss given default is determined by two methods they are,

• Under the foundation methodology is the method where loss given default is found using the standard supervisory rule. In this the level of loss is found by analyzing the characteristic of the underlying transaction.
• Advanced methodology is the method bank itself differentiates the loss given default that must be fixed to each and every exposure. In this method the bank must be well informed about the exposure, it must be well informed about the economic climate as well. The bank must make complete assessment over the exposure before allocating the loss given default value to that particular exposure.

The investor can use these data’s to make decision regarding investment in that company. If the loss given data for a particular company is good then it shows that the company is stable and is good for investment. If the loss given default is a bad one then the investor can hold his/her investment plan. It is useful for the bank to a greater extend. Bank can make loan sanction decision based on the loss given data of that exposure.