Realised LGD Measurement - frequently asked question

What are APRA’s expectations when measuring realised economic loss, prior to collection costs, for loss given default (LGD) estimation?

An ADI with IRB approval is required under APS 113 Attachment A paragraph 89 to measure economic loss for LGD purposes. To ensure that ADIs measure economic loss (prior to collection costs) consistently, APRA has the following expectations¹:

1. There will be a single probability of default (PD) and LGD event per account over a 12-month observation period. That is, where an account defaults multiple times over the 12-month period, one default will be recorded and the aggregate loss of the default events will be calculated.

2. There are three common approaches for calculating realised LGD currently adopted within the industry: i) discounting actual recovery cash flows; ii) discounting change in balances; and iii) discounting write-off amounts. The discounted write off approach has limitations and cannot be used in all circumstances (refer paragraph 13 of this FAQ).

3. Calculating realised loss using discounting of actual recovery cash flows would be appropriate under all circumstances and is APRA’s preference.

4. Under the change-in-balances approach, recoveries are calculated as follows:



Recovery_t = Balance_t-1 – Balance_t – Write-off_t + Post-default Interest_t + Post-default Fees_t    



where Balance represents the gross facility balance that includes post-default accrued interest and fees.²t is typically measured in months but could be in other units.

5. Under the discounted write-off approach, realised loss is the sum of discounted write-off amounts less post-default fees. I.e.:

where WO, Fee, and DF denote write-off, post-default fee and discount factor respectively. t=0 and t=T represent the time of default and the end of the work out period respectively.

6. Post-default drawings are implicitly factored into LGD under the change-in-balances approach (as a negative recovery in paragraph 4) and the discounted write-off approach. To ensure consistency, we expect ADIs to incorporate post-default drawings in LGD rather than EAD when actual recovery cash flows are used.

7. For defaults that resolve with no write-off, realised loss can be set equal to zero before the allocation of collection costs.

8. ADIs that are subsidiaries of foreign banks should discuss with APRA if they wish to use compliance with relevant realised LGD measurement requirements in their parent company’s home jurisdiction as a substitute for meeting APRA’s expectations in this FAQ.

Retail and SME Retail

9.For the purpose of including discount effects into economic loss measurement, it would be appropriate to discount cash flows using facility specific contractual interest rates at the time of default.³

10. Where facility specific interest rates are unavailable, an ADI can use product level average contractual interest rate at the time of default. Product categories should be determined such that interest rates within each product category are sufficiently homogenous. For example, low rate credit cards as a standalone product category instead of credit cards.

11. Any one of the three approaches described in paragraph 2 would be appropriate to calculate realised loss for Retail and SME Retail exposures. However, APRA expects a consistent approach to be adopted across Retail and SME Retail asset classes.

Non-retail

12. Where an ADI has historical contractual interest rates associated with individual defaulted facilities, APRA expects the ADI to discount the cash flows using the facility specific interest rate. Any one of the three approaches described in paragraph 2 can be used.

13. APRA recognises that some ADIs do not readily have historical contractual interest rates associated with individual defaulted non-retail facilities. In this case, APRA expects an ADI to discount cash flows at the RBA cash rate (or a comparable central bank overnight lending rate in the currency of the exposure) at the time of default, plus 5 per cent. The discounted write-off approach would not be appropriate in this case.

14. APRA expects a consistent approach to be adopted across the non-retail asset class. 

15. Irrespective of the option chosen, an ADI must ensure compliance with APS 113 Attachment A Paragraph 54.

Documentation

16. As good practice, ADIs should disclose the realised LGD calculation approach (including the discount rate methodology) in validation and modelling documents where appropriate.

Numerical example

Consider a defaulted facility with a post-default contractual interest rate of 0.8 per cent per month, which keeps accruing post-default, and an exposure at default of $100,000. The customer makes a post-default drawdown of $10,000 in month 6 and is charged a $100 fee. The entire balance is written off after 10 months. Table 1 below shows the calculated cash flows and the resulting realised LGD (before collection costs) at default.

Table 2 below shows the calculated cash flows and the resulting realised LGD (before collection costs) at default if the bank recovered the entire amount after 10 months. Note that even though the calculated LGD is -0.1 per cent, it should be set equal to zero per cent according to paragraph 7 of this FAQ.

Footnotes

¹ For the purpose of this FAQ, collection costs are direct or indirect costs associated with collecting on an exposure but are not charged to a customer. We expect such costs to be factored into LGD.

² The post-default interest term becomes zero if interest charges are not added to a customer’s facility balance.

³ For facilities that specify a different interest rate in the event of default, the post-default interest rate should be used.