LGD (Loss Given Default) is the percentage of an exposure a lender expects to lose if the borrower defaults, after counting recoveries from collateral, guarantees and collections. It equals one minus the recovery rate, so expecting to recover 35 cents per euro means an LGD of 65%. The workout method discounts net recoveries back to the default date and compares them with exposure at default. Multiplied by probability of default and exposure at default, it gives expected loss, the basis for IFRS 9 provisions, and for banks on internal models it drives regulatory capital. Foundation IRB banks use fixed CRR values, such as 45% for senior financial-sector exposures. Buyers of loan books price on recovery curves by cohort.
How do you calculate LGD
The workout method takes defaulted loans, sums recoveries net of collection costs, discounts them back to the default date and compares the result with the exposure at default.
Illustrative example: a fintech lender has €200,000 outstanding when a business borrower defaults. Over 18 months it recovers €90,000 from selling pledged equipment and €20,000 through collections, and spends €10,000 on legal and agency fees. Net recoveries are €100,000 before discounting, so the realised LGD is 50%; discounting those recoveries for the 18 months it took pushes the figure higher.
Market-based LGD uses the trading price of defaulted bonds or loans shortly after default, and implied LGD is backed out of credit spreads. Lenders with short histories, which describes most young fintechs, rely on collateral haircuts and industry benchmarks until they have enough defaults of their own.
LGD, PD and EAD: the expected loss formula
Expected loss = PD × LGD × EAD. A €5 million portfolio of SME loans with a 4% one-year PD and a 45% LGD has an expected loss of €90,000, the starting point for IFRS 9 provisions and for loan pricing. Halving LGD through better collateral cuts expected loss by exactly as much as halving PD, which is why secured lenders can accept borrowers that unsecured lenders decline.
What LGD do regulators assume
Under the EU Capital Requirements Regulation, banks using the foundation internal ratings-based approach do not estimate LGD themselves. Article 161 sets 40% for senior exposures to non-financial corporates without eligible collateral, 45% for senior exposures to financial-sector entities, 75% for subordinated exposures and 11.25% for eligible covered bonds. Banks with permission for the advanced approach model their own LGD, which must reflect downturn conditions. Standardised-approach banks and non-bank lenders do not use LGD in capital formulas, but auditors and investors still expect it in provisioning models.
Why LGD matters when buying a lender or loan book
For a buyer of a lending fintech or a portfolio of non-performing loans, LGD drives price more directly than headline arrears. Two books with an 8% default rate are worth very different amounts if one recovers 70% through security and the other 15% through debt collection. Buyers ask for recovery curves by cohort, the age and size of the default data set, and evidence that LGD assumptions in the seller's model match what collections have actually delivered.