Downturn LGD: A More Conservative Approach for Economic Decline Periods

TL;DR

This paper investigates the relationship between default rates and loss given default in a Brazilian bank's retail home equity portfolio, proposing a conservative estimation method for economic downturns to improve risk assessment accuracy.

Contribution

It introduces a methodology to incorporate conservatism into LGD estimates during economic declines, based on observed correlations with default rates.

Findings

Established a statistical correlation between RD and LGD during downturns

Proposed a conservative LGD estimation approach for economic decline periods

Enhanced risk parameter estimation aligning with regulatory requirements

Abstract

The purpose of this paper is to identify a relevant statistical correlation between rate of default, RD, and loss given default, LGD, in a major Brazilian financial institution Retail Home Equity exposure rated using the IRB approach, so that we may find a causal relationship between the two risk parameters. Therefore, according to Central Bank of Brazil requirements, a methodology is applied to add conservatism to the estimation of the Loss Given Default parameter at times of economic decline, reflected as increased rates of default.