Glossary
Loss Given Default (LGD)
Loss given default (LGD) is the percentage of a loan's exposure that a lender ultimately loses when a borrower defaults, after accounting for recoveries from collateral, guarantees and other sources, net of collection costs. It equals one minus the recovery rate and is one of the three core components of expected credit loss.
Formula
Example
A borrower defaults owing $2,000,000. The lender forecloses and sells the collateral for $1,600,000, then pays $200,000 in legal, holding and selling costs, for net recoveries of $1,400,000. LGD = ($2,000,000 - $1,400,000) / $2,000,000 = 30%, and the recovery rate is 70%. If the property had sold for only $1,200,000, LGD would have been 50%.
How it is used in underwriting
LGD links collateral and structure to credit risk. Lenders estimate it from the value of collateral under distressed conditions, the loan's position in the capital structure, guarantor support, workout costs and the time needed to recover. Senior secured loans with strong collateral have low LGD; unsecured or subordinated loans have high LGD. Banks use LGD estimates for pricing, risk ratings, allowance for credit losses and regulatory capital. Underwriters can reduce LGD through lower LTV, additional collateral, guaranties and covenants that allow early intervention before value deteriorates.
A common mistake is estimating LGD from today's appraised value. Defaults tend to happen when values are falling, so recoveries should assume stressed values, longer marketing times and carrying costs such as taxes, insurance and interest that stops being paid. Time matters: a recovery that takes three years is worth less in present value than one received immediately, and many models discount recoveries. LGD also varies by asset type. Real estate recoveries depend on property and market, receivables recoveries depend on collection, and recoveries on enterprise value loans depend on whether the business can be sold as a going concern.
Frequently asked questions
What is the difference between LGD and probability of default?
Probability of default measures how likely a borrower is to default within a period. LGD measures how much of the exposure is lost if default occurs. Expected loss multiplies the two together with exposure at default. A loan can have a high default probability but low LGD if it is well secured.
How do lenders reduce loss given default?
Lenders reduce LGD by taking senior secured positions, lending at lower LTV or advance rates, requiring guaranties, monitoring collateral, setting covenants that allow early action, and structuring cash management. Prompt workout and realistic collateral valuation also improve recoveries when defaults occur.
Is LGD the same as loss severity?
They are closely related and often used interchangeably. Loss severity is the common term in mortgage and structured finance markets, while LGD is common in banking and credit risk modeling. Both describe the share of exposure lost after recoveries on a defaulted loan.
Related terms
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