Frye Loss Given Default and strongEconomicstrong Capital - chicagofed.org.pdfVIP

Loss Given Default and Economic Capital Jon Frye Senior Economist Federal Reserve Bank of Chicago 312-322-5035 Jon.Frye@Chi.FRB.org July 4, 2004 Submitted to appear in Economic Capital Ashish Dev, ed., 2004 Risk Publications The views expressed are the authors and do not necessarily represent the views of the management of the Federal Reserve Bank of Chicago or the Federal Reserve System. Introduction Lenders know that any loan might default. They also know that the default rate of any portfolio can rise. When the default rate rises, the portfolio might experience losses. Lenders must have capital to absorb the possible loss. A second effect can compound\ the loss. This is the variation in loss given default, or LGD. LGD is the fraction of exposure lost when a loan defaults. Lenders find that when the default rate rises, the LGD rate tends to rise as well. When thinking about possible loss, variation of the default rate is only half the picture. The variation of LGD can be just as important. This chapter develops a framework for understanding the coordinated rise of the default rate and the LGD rate and their effect on economic capital. Both rates connect to an underlying systematic risk factor. As will be seen, this brings into being two distributions of LGD. These distributions play distinct roles in the analysis that leads back to economic capital. In this analysis, two pitfalls stem from themes developed earlier, and each leads to an understatement of risk. These pitfalls are ignoring a source of systematic risk while measuring LGD and conflating the two distributions