Loss Given Default (LGD)

What Is Loss Given Default?

Loss given default (LGD) is the portion of a loan or other credit exposure that a lender expects to lose if the borrower fails to repay and the debt goes into default. It is usually expressed as a percentage of the amount owed at the time of default. For example, an LGD of 40% means the lender expects to lose 40 cents of every dollar outstanding, after accounting for what it can recover.

LGD is a core input in credit risk measurement. It is typically considered alongside probability of default and exposure at default, which together help estimate the expected loss on a loan or portfolio.

How It Works

LGD is closely tied to the recovery rate, which is the portion of the debt the lender expects to get back. The two add up to 100%, so LGD equals one minus the recovery rate.

Recoveries can come from several sources:

• Selling or enforcing claims on collateral, such as property or equipment
• Proceeds from the borrower's remaining assets during bankruptcy or liquidation
• Payments made under a restructuring or negotiated settlement

Costs also matter. Legal fees, the time spent resolving the default, and discounts applied when assets are sold quickly all reduce recoveries and push LGD higher. Secured loans backed by strong collateral usually have a lower LGD than unsecured loans, because the lender has something to fall back on.

Formula and Example

Expected loss is commonly estimated with this relationship:

Expected Loss = Probability of Default × Loss Given Default × Exposure at Default

Suppose a bank has a $100,000 loan outstanding, estimates the borrower's default probability over a year at 2%, and sets LGD at 45%. The expected loss is 2% × 45% × $100,000, or $900. This is a simplified illustration, not a prediction for any real loan.

Why It Matters to Investors

Investors in bonds, loans, and bank stocks encounter LGD indirectly. Credit analysts use it to judge how much a creditor might lose if an issuer fails, which affects how risky a debt instrument appears. Banks use LGD estimates to set loss reserves and capital, and regulatory frameworks such as the Basel accords incorporate LGD into their risk-based capital rules.

LGD is only an estimate. Actual losses depend on economic conditions, asset values, and how long a workout takes, so realized losses can differ substantially from projections.